Market Action – Sticking to Fundamentals
Based on fears that America is heading into another recession, and that the European debt problems aren’t solved, the Dow fell 512 points on Thursday, August 4, 2011, the biggest drop since December 2008. After hours on Friday, August 5, 2011, for the first time in history, the S&P cut America’s credit rating from AAA to AA+”. The VIX, Wall Street’s so-called fear index, had a dramatic spike on the following Monday, with the end result being a 634-point loss.
In the June edition of the Rich Dad newsletter, we discussed fear, and how dramatic drops in very short timeframes can occur when fear sets in. The main point in that article is that for the technical trader, there is no room for emotions like fear and hope. These emotions handicap a professional trader and, at best, limit what a trader can be become. At worst, they can devastate a trader’s capital through poor decisions.
When a trader sticks to their rules and follows their trading plan, days like those that occurred in the past couple of weeks are just another day at the office. When traditional investors are panicking that their 401ks are losing value, and other traders have their face sunk deep into the palms of their hands, the disciplined technical trader is relaxed. Depending on their rules, the disciplined technical trader is either taking only small losses on current positions, sitting out of the action, or actually making decent profits as the deadlines scream panic.
The reason traders who are adept at technical analysis can be so relaxed is that they have a trading plan. No matter what the market throws at them, they have trades they can make and tools and techniques that allow them to increase their chances of success. The foundation of many trader’s trading plan is what is known as the 5 Ts of Trading
The 5 Ts of Trading
The 5 Ts of trading is a way of organizing and categorizing knowledge as you learn to successfully trade. The 5 Ts are as follows:
Trade Identification
Trade Triggers
Trade Targets
Tradable Instruments
Trade Management
Systematically going through each of the 5 Ts as you make trades takes the emotion out of trading. While others are frantic, the trader who applies the 5 Ts can carefully apply his/her knowledge and experience to the trade at hand, and increase the probability of success, no matter what the market may be doing.
Trade Identification – What to Trade & How to Find It
Most people who participate in the markets know one way to trade—they buy stocks. The problem with this should be self evident, but if we want to put a kind spin on this approach, we can simply say that this limits a traders potential. The market can be up, down, or in a holding pattern and trading sideways for long periods of time. Those adept at technical analysis can identify through trends, support and resistance, pivots, candlestick patterns, and other indicators what the chart is showing, and make the correct trade based on the trade set up. Stocks trending up may be primed for a bullish breakout, or may have a pattern that indicates a bullish retracement. Stocks trending downward may be set up for a bearish breakdown or bearish retracement. A stock in a holding pattern may be in a prime set up for a covered call.
Regardless of what the market is doing, you should be well versed in your trading approaches to know what trade to do. When others are panicking, you may have prime set ups and profit opportunities.
Triggers – Your Call to Action
Emotion often appears when traders are about to or want to make a trade. Caught up in the surety of what they think will happen, they enter the trade based on hope, and then sit back and watch the results. Please don’t ever do this.
As a student of technical analysis, you should only enter trades when an event that occurs on a chart materializes. This is your trigger. A trigger can take many forms, depending on the trade setup. In the case of a breakout, it can be when a certain price point is hit. It can also manifest itself in the formation or failure of pivots, through pattern confirmation, and candlestick formations. Depending on the type of trade you are doing and your personal rules, the moment you enter the trade is when the corresponding technical event happens. Not when you think, or you guess, or when you want to make it trade. The chart will tell you when to enter and that is the moment of entry.
Targets – Reasonable Expectations
The third T is the target point at which we are estimating the stock may hit based on our analysis of the chart. In laymen’s terms, this is the goal of the trade, or what we anticipate the stock hitting (or falling to). Many traders when they enter trades try to hit a home run with every trade. These types of traders soon go back to their day jobs as successful trading is often based on steady success. Home runs do occasionally happen, and there are ways to manage trades that don’t force us to exit a trade immediately upon reaching our target, but we should try to have reasonable expectations when we initially choose the target of our trade.
Trade Management – Manage and Divert Risk
The fourth T—trade management—is what allows traders to sleep soundly at night. Successful traders know their risk tolerance and allocate their funds for each trade accordingly. Gamblers risk it all, while those who succeed in the long term never put so much of their trading funds on one trade to adversely affect them.
A key part of trade management also involves the use of stops. The first, second, and third rule of every trade should be the use of a stop. Nobody likes to lose on any trade, but losing trades do occur. The worst thing that can happen is for the trader to chase their money hoping the trade will turn around. This is the worst situation to be in for a stop to kick in, the fundamental analysis that made the trade appealing has now disappeared and you are truly gambling.
The fifth T—tradable instrument—relates directly to trade management. Whether you choose to purchase stocks or use options or other instruments often is tied directly into your risk tolerance.
Rich Dads Education’s Master Trader course goes over the 5 Ts in detail and applies them to numerous trade setups that can occur. For the next four months of the Rich Dad newsletter, we will go over each of these areas in detail. In the mean time, remember to maintain discipline and follow your personal rules. While the VIX might have hit a 52- week high, your own personal VIX should remain nice and steady.