The critical task in trading is to assemble a complete working trading method. involves a step by step approach and once you master that you can put together several systems. Many time members or traders share a concept with me and all I do is put together a working system by using inter changeable parts like entries, exits, entry set ups, exit set ups etc. Think of these as lego blocks. Your task is to assemble them together.
The basic framework for putting a method together is:
Vehicle selection:We need some valid way to select the universe of stocks we would be trading. We want to select the most profitable markets to trade. Because market is dynamic, we want to do this process dynamically as against using a static framework.
Now when it comes to vehicle selection most of the time we use some attribute based model to select stocks. So when we say use earnings+ROE+margin to cull out 100 stocks , it is a three attributes vehicle selection system. Or if we use a one year price growth to select stock then we are using price growth as single attribute to choose vehicle.
There are several factor based models to choose equities. The growth investors choose vehicles based on attributes like earnings, sales, margin, etc. Value investor choose equity based on factors like free cash flow, p/e, p/b, etc. You can choose vehicles based on attributes like market cap, size, trading volume, price, fund ownership, insider buying, year of IPO, country of origin, sector and so on.
We should only select attributes for vehicle selection which will give us most profitable opportunities. Many of these attributes have been studied to death and we know certain attributes like earnings, momentum, neglect work consistently. So we base our methods on that. The CANSLIM method is based on historical study of top 500 performers in market and isolating the attributes which lead to their growth. Boucher method uses a combination of CANSLIM kind of character plus breakaway stock behaviour attributes to choose vehicle. There are potentially thousands of ways to select vehicles. Now this step is very critical because if we select more profitable markets to trade with then, we increase our probability of being profitable. Vehicle selection is also a function of time scale you want to trade. If you are day traders, the attributes you would look for in a vehicle will be a combination of high trading volume, clear direction, large intra day range and enough volatility to make potential trading profits worth the risk and expense of trading. That is the reason many day traders choose stock index or bond futures or currencies to trade.
Entry Selection: Once we select vehicle we select entry method. What kind of entry we want to make on this vehicle. Breakout, pullback, scaled, timed , etc are some of the entry choices we have.
We use a set up to enter. So in IBD 200 and DT we use a set of six conditions. Together when all the six conditions are present, it is our hypothesis and experience that there is an ideal set up for entry. In CANSLIM presence of certain chart patterns is a set up. In earnings breakout , a certain event, neglect and magnitude of earnings growth is a set up.
Again you can put together n number of setups for entries. But the objective should be clear, to enter a properly selected vehicle at the start of a potentially profitable stage. Setups are entry triggers.
Exit Selection: Again exits is a setup. If certain conditions are fulfilled we will exit. Exit strategy has multiple considerations. Your first exit is based on entry setup failure. This helps us protect our trading capital in event of the failure of entry signal. Our second exit is based on meeting our intended profit objective. Now we can add third exit criteria to same trading mix of say 5 day time stop at entry. Now objective of this exit is to avoid dead money. Now if we want to further refine our exit we can design a exit condition saying exit on 20% profit or at end of two weeks, whichever is earlier. Again the objective of such exit is to avoid slow moves. We can take a different approach and design a partial exits. Where we exit 25% of position on 10% profit and move rest of our stop to a trailing exit stop. We can even build more complicated rule based exits to manage risk better.
Risk selection: Once you have the above three elements of trading mix together, then you add risk selection to the mix. Risk selection strategies are designed to manage risk of capital loss, to avoid catastrophic losses, to manage open position risk, to increase returns by use of leverage, or to decrease volatility of returns. This determines how much you will risk per position. How many total positions you will have. What setup conditions will lead to you risking higher amounts or reducing risk. This is again very critical part of your trading mix. One of the reason I developed Market Monitor was to manage fluctuation in returns. Previous to designing MM I used to have wild swings in profits. MM is a risk management setup. So when it is bullish you can increase risk and decrease risk when it signals bearish phases. Similarly on individual positions I use very conservative risk strategy to avoid catastrophic loss. Day traders and short term swing traders typically need to take higher risk per position as they need to maximize returns. Plus because they are micromanaging the trade, they can reduce risk by quick exit.
All these elements of trading mix are equally important and needs to be looked at in totality. When all elements are properly put together, you have a working profitable trading system. The process is iterative and testing and back testing can help you fine tune each element of the mix.
But at some stage, you need to stop that process and trade the system for sometime to understand what really works and why. Excessive fine tuning, is mostly unproductive, and may lead to distraction from trading. Most of the effort in such designing is one time and after that you need to fine tune it from time to time. Setups often deteriorate if lot of people use the same thing or systems become widely known, but basic logic does not change and you can always change setup conditions.