How to Confirm a Trade Setup

​In a recent class, we discussed how to confirm a trade setup. I would pick up on that for today's blog and address some of the known challenges traders face in confirming their trades. To start, let's point out the facts: no one wants to lose money on their trades and everyone wants ​their trades to be profitable or at least break even.

However, this is not reality. It is inevitable that we will lose money on some, and possibly the majority of trades. That does not mean we have to lose money over time, but we do have to be prepared that in the world of trading, a person is pretty much guaranteed to place some bad trades. The distinction here is what we qualify as "bad trades."

Bad Trades

Most people think a "bad trade" means they lose money. Since society is conditioned that losing money is bad and we all need to get rich quick, anytime money is lost, it is considered bad. But a well-balanced trader understands a "bad trade" is one that you should never have considered in the first place.

In the world of trading, it is entirely possible to have a great trade setup, it confirms, thereby making it a great trade, and then the trade does the opposite, and you lose money. This does not mean it was a bad trade. It was still a good trade; it just happened to lose money. Seasoned traders understand this principle.

Much of the psychology of good trading comes down to the vocabulary we use. If a trader is constantly saying, "I lost money on some bad trades," it is reinforcing the idea that anytime money is lost, it is a bad trade. Professional traders use the term "drawdown."

Drawdown is built into good trading systems. It is planned for. It is expected that a certain percentage of trades will have a loss and quite possibly reach their maximum loss potential. So professional traders plan for that and bake it into the system. This is an important distinction between professional traders and the amateur trader.

Putting the Odds on Your Side

Traders who profit over time have more realistic expectations than the amateur traders who enter the trading space. They know what the odds are. For starters they know that some trades are going to lose money - this is expected. It's not a matter of if one will lose money, it's a matter of when.

They also know the odds of success and plan for them. If a trader buys a stock, the odds of that trade being profitable are 33%. The stock could move up, it could move down, and it could move sideways. One of the three directions would make money, whereas the other two would not. (and yes a sideways trade is a losing trade because of commissions and opportunity cost).

So one of the first rules professional traders make is the assumption that they may have to lose as many as 66% of their trades to get to their winning trades. However, even if you only make money on 1 out of 3 trades, you can still make profit over time if you manage a good reward/risk ratio.

If you manage to keep your risk to just $1 for every $3 that you plan to make, over time, even if you lose 2 out of 3 trades, you will still be a profitable and winning trader. Professional traders know this.

And finally, professional traders manage the odds by doing quality analysis that helps them choose trades that have a higher probability of being a winning trade.

There are many processes one could use for trade confirmation, but at TSU, we teach a basic five steps of trade confirmation. Here it is:

5 Steps of Trade Confirmation

  • Identify the areas of buying & selling pressure: support & resistance
  • Identify the trend
  • Check any Chart Patterns
  • Check any Candlestick Patterns
  • Confirm Indicator signals

Identify Areas of Buying and Selling Pressure

Every stock is going to have areas where buying and selling pressure shows up. Support & Resistance is the technical term we use. There are multiple tools available to identify these areas, as well.

We always start by teaching the support and resistance line drawing method; however, one could also garner this information from Ichimoku Clouds, Fibonacci lines, and to some extent, Bollinger Bands.

The key is that you identify where the buying and selling pressure will be.

Identify the Trend

To put the odds on your side, it is best to trade in the direction of the primary trend. So naturally Identifying that trend is rather important. We typically start teaching students to identify the trend with the moving averages.

This is one of the oldest and most time-tested techniques for clear trend identification. However, again, there are multiple tools. You could also use Ichimoku Clouds and Bollinger Bands, as well as a few other techniques. What you cannot afford to do is be blinded to the trend!

If the predominant trend is down, you better not be placing heavy bullish trades, and if the predominant trend is up, you had best not be placing bearish counter trades.

Chart Patterns

The third component, chart patterns, can be used to help confirm a trade or maybe reveal a potential reversal you may not see coming. There are three classifications of chart patterns: Continuation patterns, reversal patterns, and consolidation patterns. Each of these patterns can help anticipate the future move.

Candlestick Patterns

Candlesticks are one of the greatest gifts to modern trading - they give us very good insight into day by day trading sentiment. Little two-day reversals can tell us to avoid a trade completely, or they may confirm that this is a trade we should take with confidence.

​Indicators

Finally, the last piece is indicators. Indicators should be used to either a) confirm what the first four steps of analysis already told you, or b) alert you to something you did not see. Most of the time indicators will confirm what you already expected in the trade.

But much like the temperature gauge in your car, sometimes an indicator will warn you to "something going on under the hood" that you didn't see. They are the final piece of confirmation.

Pulling It All Together

The benefit of having a five steps of trade confirmation like the one listed above is it gives you as a trader, a checklist of different perspectives to look at the trade. Good analysis must consider what the other side of the trade is thinking.

If you are bullish, you must ask, "why would someone be bearish." If you can get into the analysis and consider the other perspective, you will have a better chance to truly weigh the sides and choose the most likely direction based on the weight of the evidence.

​Wrap Up

It's impossible to make all trades for a profit, but professional traders know that they can put the odds on their side. By first understanding the odds and then doing a good analysis process to confirm the most likely trades, professional traders can beat the market over time. Here's the best part.

Professional traders are just like you - they are just people. The big difference is they have spent more time honing their craft and refining their "game." If you are willing to hone your skills and refine your game, you too can beat the market and trade for cash.

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