I believe all traders should create a trading plan, a document which lays out exactly how they will trade. The trading plan tells the trader what strategies to use, how and when to enter and exit positions, as well as what position size to take. Unfortunately, most novice traders never take this step. If you don’t have a plan, you should create one, but at minimum you should be running through a mental checklist before you make a trade. If you do have a trading plan your mental checklist should just confirm that the trade you’re about to make conforms to your overall strategy. If you don’t have a trading plan, go through a checklist, similar to the one below, before making a trade.
The Checklist Advantage
A trading checklist makes sure there is valid evidence for taking a trade. If you have a trading plan, the checklist is basically a quick spot check to make sure you are following your strategy. When you don’t have a plan, the checklist at least makes sure you are looking to see whether a trade is worth taking or not.
While the checklist serves as a tool for compiling evidence in favor of a trade, it also includes criteria that will likely filter some trades. Whether through lack of favorable or evidence, or the presence of unfavorable evidence, the checklist serves to help you make more high probability trades, and fewer low probability trades.
There isn’t a definitive checklist that will be right be for everyone, since we all trade in different ways using different strategies and on different time frames, so the checklist items below are for guideline purposes only. I encourage you to make your own trading checklist based on criteria that is relevant to your situation. That said, I thinking the following checklist items will help most traders confirm or reject potential trades.
The checklist is there to help you see if a trade is worth taking, therefore, it should be a series of questions or statements which help you determine that.
Most of my strategies involve trading in the direction of the trend, therefore, one checklist item for me is:
• Is the trade in the direction of the overall of trend?
If the answer is “yes” that is positive evidence for the trade. If the answer is “no” I better have some very good evidence for taking the trade. If there is no real evidence–other than hoping the trade works out–the trade shouldn’t be taken.
Another question that I feel is good to ask is:
• Am I entering at a favorable point?
This question is designed to make you question your timing of the trade. Are you getting in too early, jumping in and hoping there is a reversal which hasn’t started yet? Or possible the move has been going on for hours and may be nearing the end right as you’re thinking of getting in.
I don’t use the next checklist item on every trade, as it isn’t always applicable, but when it is it can be very useful.
• Is a correlated market or index confirming the direction of my trade?
If you buy a stock and want it to go up, then normally you will also want the stock index(s) and/or specific sector index to also be going up. If you are trading the EUR/USD and want it to go higher, you can look to see if other pairs that typically move in a highly correlated fashion with the EUR/USD are also rising. The GBP/USD is often highly correlated to the EUR/USD, so these two pairs can be used to confirm each other. Check out which indexes or assets are correlated to the assets you trade.
Next we want to look at the potential profit relative to the risk.
• Does the profit potential of the trade outweigh the risk?
If it does, that’s good. If it doesn’t then how does your trading style compensate for this? If the potential profit is less than the risk you need to win more trades than you lose. So if you take these trades you should have evidence that you can come out ahead after a large number of trades.
A final checklist item is to use other technical tools for confirmation.
• Is a technical indicator/tool confirming or rejecting the trade?
I advise only using one to two indicators all the time. Then only use those indicators to confirm or reject trades. Avoid the temptation to start using a new indicator just because it confirms a trade. Find one or two technical indicators or technical tools that you like, and stick with them.
While the best option is to create a trading plan which tells you exactly what to do in a given situation, at minimum you should be running through a quick trading checklist. By going through a checklist before you place a trade, you’re more likely to take high probability trades instead of impulsive or emotional ones. Your personal checklist should help filter out low probability trades, by making sure there is some evidence to support your trade. The checklist only works though if you use it objectively. If a trade doesn’t stand up to scrutiny, then don’t make the trade.