By Kerry Szymanski of Harmonic Edge*
Posted: Jul 17, 2009
Effective research is the foundation for a good trading plan. To conduct your research, you are going to have to make some assumptions about the best way to trade a market. How does one go about making these initial assumptions? Essentially, you must draw on your knowledge of the markets and various trading principles you have learned.
If you have spent time studying the price behavior of a market, you will begin to notice patterns in the way a market trades. The first step is to gather examples of the pattern you are interested in trading. I generally recommend 100 samples.
Preparing Your Chart Samples
Each chart should clearly show the pattern you are interested in trading. You should also include any indicators on the chart that you intend to use as filters. Print out your samples and put them in a binder. Spend some time studying these charts and thinking about the most effective way to trade the pattern you have identified.
The purpose of this process is to build a framework for your research. Do not overly complicate matters or fall victim to "paralysis of analysis". Here are the areas you need to address:
- What precisely defines the pattern I am trading?
- Can I identify certain conditions in advance where the pattern tends to fail?
- What precisely constitutes pattern completion?
- At what point has the pattern failed?
- How much do I have to risk to determine whether or not the pattern is going to work?
- When should stops be moved?
- Where should I take profits?
Once you have this framework in place, you can begin to gather the hard statistical data to evaluate your trading assumptions. These facts need to be carefully collated into a spreadsheet on a trade-by-trade basis, so you can evaluate the data.
If you are dealing with only one market, the process is straightforward. If you are evaluating a pattern in multiple markets, it becomes more complex, and you will need to think in terms of percentages instead of points. You may also look at something like Fib ratios, trailing 1-bar lows or highs following bearish or bullish reversals or pullbacks to a moving average as ways to take profits across a series of trades in different markets.
One of the important things all good trade plans do is carefully control risk while at the same time creating the opportunity for greater profits to accumulate. Once risk is eliminated, you have a free trade. This is best accomplished through the use of multiple-unit trade strategies and paying yourself as the market makes money available to you.
Once you have completed a sample of 100 trades, it's time to analyze how your trading assumptions about this pattern worked. How many wins and how many losses? What is the average win as compared to the average loss? What was the largest drawdown over the course of your sample?
You may need several revisions before you come upon the right combination. Once you are satisfied with how your trade plan seems to perform, it is time for a practice run on a simulator in real time. If your practice run is successful, it's on to trading with actual risk capital.
It is important to continue to track your trading of any pattern carefully because market conditions do change over time, and you may need to make subtle changes to your plan for optimum results.
*Reprinted (and modified) with permission from Kerry Szymanski
