By Rob Colville on November 18, 2016 in
Do you ever wonder how much information you really need to make an informed decision about a trade idea? I mean, how much analysis is too little, what amount can be considered “just right,” and at what point do you have so much that you run the risk of the dreaded “analysis paralysis?”
Perhaps needless to say, these are all rather relative questions considering some traders may feel confident acting on a trade idea with little more than a chart pattern and some hope on their side, while others like to consider practically every technical, fundamental, and hybrid factor imaginable before trading. Believe it or not, there’s even an indicator that keys off of the price of a McDonald’s Big Mac, and some traders and investors inevitably use it!
To help you conduct the “right” amount of analysis for you, however, here are seven questions you may want to consider when analysing a particular trade idea. Perhaps it’s safe to say that once you’ve sufficiently answered these, you’ve developed a sound enough understanding of the trading landscape to act confidently without fearing you know too little, nor being conflicted while trying to analyse too much.
Trading with the trend in your favour is such an important premise under the Lazy Trader methodology that in many cases, if the answer to the above question is “No,” then it very well could result in the invalidation of the initial trade idea. Now, reversal trades are valid and even advisable from time to time when enough factors are working in their favour, but day in and day out, the most prudent trades will be those taken in the direction of the trend.
To discern whether the “Trend is your friend,” simply check out the price action on the chart and draw a simple trend line to see whether the market in question is in a sustained uptrend or downtrend, or if there’s a range in play. When trading an uptrending market, the strongest trade idea would be to buy pullbacks; meanwhile, amidst an overall downtrend, selling rallies would be most advisable. And finally, when trading in sideways market conditions, you’ll likely trade your best by buying at or near the bottom of the range and selling at or near the top.
In addition to the technical validity of the set-up, nothing will make a trader more excited about a given trade idea than an exemplary reward/risk profile. And, conversely, few factors will cause a trader to give up on a trade idea faster than the realization that the reward isn’t worth the risk. That’s why it’s crucial to analyse reward/risk profile and never trade unless it’s working decidedly in your favour.
Calculating reward/risk profile:
Most traders will require at least 2:1, and plenty strongly prefer 3:1 or higher in order to justify placing their hard-earned account capital to work in the markets. We use 2:1 as a required minimum but often take trades that promise reward/risk in excess of 4:1 or more, which, when coupled with a strong chart pattern always makes for a trade idea you can pursue with confidence.
For technical traders, it goes without saying that most any trade idea must have a valid chart pattern(s) at its core. And note the mention of patterns, plural, in this case, too, as often, as we saw with the recent AUDCAD set-up below, there can be more than one chart pattern in play at one time.
Here, in particular, there’s the apparent completion of an AB=CD type of pattern occurring before the pin bar reversal that might ultimately be used as a trigger to sell the pair at or near horizontal resistance overhead. Can you spot both price patterns on the chart?
This, of course, is a reversal trade that’s decidedly higher risk and lower probability, but with proven and verifiable price patterns creating a technical basis for this trade idea, it’s one that was worthy of consideration nonetheless.
That wouldn’t have been the case, however, if one or both of those price patterns had been invalidated. For example, if the “AB” leg of the rally from about the 0.9400 level did not equal the length of the “CD” leg, or especially if the bearish pin bar reversal that printed up near the 1.03 level were not testing that key horizontal resistance level. So herein lies the importance of valid price patterns, and it’s why no trade idea should ever be considered—by technical traders, anyway—in the absence of (at least) one.
In Part 2 of this multi-part series, we examine possible confirmation signals that can add a degree of confidence and validation to an existing trade idea. Don’t miss that, and in addition, remember that an entire library of trading education and in-depth instruction is available anytime to Lazy Trader members. Claim your no-risk trial membership today by clicking the banner below!