Chapter 11: How to Trade

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Breakout indicators

A trader can enter based on a breakout of a key price level, a trend line break, a moving average, or a chart pattern

Support

Is a price level on a chart that reflects the lowest price in a time frame

Resistance

Is a price level on a chart that has been the highest price in a time frame

Breakouts

Breakout trading is when you buy or sell at the begginning of a new price range, as the old one has broken through a loss of support, or a breakout above resistance

Homework

An entry signal must be based on how it performed in the past, or after studying historical charts to identify and quantify previous success rates

Probabilities

The larger the sample size of past data on the entry setup, the better the odds are that the setup has statistical validity. Testing hundreds of examples is a great place to start

Exit strategy

High winning percentages are difficult for many traders, especially with tight stop losses. It is much simpler path to profitability to capture the majority of trends in your trading time frame, instead of trying to be right about every entry. A great formula to use is the 3:1 risk/reward ratio

It´s not your entries that make you money, but how you manage your exits that will determine whether a trade is profitable. Your initial stop loss is your bodyguard against big losses.

If you are wrong

Your stop loss level has to be set outside the range of ordinary price noise that occurs in your own time frame.

If you are right

A trailing stop is used by raiding your initial stop loss, as the asset trends in your favor

Position sizing

The total dollar value of the asset being traded is your position size. The percentage of capital the trader is willing to lose, and the correct location of the stop loss, will determine position sizing.

If your position size correctly, then no single losing trade will ever be more than 1% of your total trading capital

Example:

If a trader wants to trade the $SPY and their entry signal is a break over the 50 day simple moving average at $200, and their stop loss is a 2% loss of the 50 day back to $196, with a loss of $4 a share then the trader can trade 250 shares of $SPY

$100,000 account

1% risk 0 $1,000

Stop loss of $4 to $196

Position size will be 250 shares at $50,000

We calculate the position size by taking $4 as the dollar stop and dividing by $1,000 as our maximum loss, this equals 250 shares. The stop is based on the 50 day being lost by 2% of the asset to prove to the trader that the 50 day break out signal failed

$200 - $196 0 $4 divided by $1,000 = 250 shares

Risk exposure

To manage drawdowns most effectively, a maximum of three trades should be open at any one time

Volatility

Base potential stop levels on the previous ten days trading ranges. If you are trading a stock with a $5 average daily trading ranges a position size of 200 shares for a $100,000 trading account would be the maximum position sizing you could use to avoid the daily price noise if you are trying to capture multiple day trends

The formula is: Position size = (TTC * %TTC) / SV

TTC is total trading capital

%TTC is the percentage of total capitalto risk per trade

SV is the stock´s volatility (10-day average of the true range)

What we learned

Your ability to correctly and consistently implement your entry signals, exit strategy, and position sizing will determine your success as a trader