This column was originally published on RealMoney on Sept. 27 at 12:00 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.
In response to
Tuesday's article about the benefits of thinking through a trade before acting, several readers asked me to expand a bit on the idea of creating a trading plan.
Trading plans differ from one trader to the next, from one stock to the next and from one set of market conditions to the next. One of the fascinating (and frustrating) aspects of the stock market is the ever-changing landscape. Each trader has his own level of risk tolerance, ability to manage a trade and typical holding period.
With that said, there are a few common aspects of any trading plan.
First, determine the profit potential for the trade. This is different than a profit target. Good traders let their profitable trades run as long as possible. But it's important to consider the trade's potential so that you can honestly define risk.
For example, if the stock is currently just $2 below an obvious resistance point, then consider the profit potential for the trade to be $2. Now, the stock might ultimately thrust right through that resistance level. But who cares? We're just creating our plan to determine whether we want to take the trade. Hope for the best, but plan for the worst. The profit potential is $2.
Next, now that you have the profit potential of the trade nailed down, look for the risk.
If you expect the stock to rally, then how far must it fall to prove that you are wrong? The smaller the decline, the better. Don't just set a dollar stop based on how much money you are willing to lose. Set a stop based on a price level which, if visited, proves your analysis incorrect.
Finally, check the stock's sector and industry group. Stocks are like wolves; they move in packs. If the whole group is strong, then the chances of booking a nice gain are maximized. Don't trade a lone wolf unless you have a specific reason for doing so.
These are just a few components of a trading plan, but everybody needs to start somewhere. Consider these ideas before your next trade. Create your plan. Then you can move on to the next challenge -- following your plan.
Let's look at some reader requests.
has advanced about 30% since its late 2005 low, but over the last few months, the stock has been churning in a series of lower highs and higher lows on its weekly chart. This type of congestion ultimately gives way to an increase in "directional volatility." But let's throw away the million-dollar words and just say that when support and resistance lines start to converge, the stock's going to either break higher or lower in dramatic fashion. Occasionally traders talk about a coiled spring, right? This is one that appears to be springing higher.
has been moving higher over the past few months. Rather than try to find some logical sequence to the troughs on the daily chart, I've highlighted the last three major peaks in the uptrend (the most recent -- and tentative -- one being Monday).
The stock has continued to move higher with no sign of letting up. However, a long entry now is a risky trade because the stock can pull back well below $32 before you'd know whether the price drop was just a pullback or a reversal. I'd hope for a correction closer to $32. Then I'd buy.
The Nasdaq Stock Market
has been hammering out a base for the past few months. A couple of weeks ago, the stock broke above $30 and has been churning in a tight range ever since. If you're already long, try putting a stop below the breakout point. If the stock falls back into the previous trading range, why continue to hold it? If it moves above $32, I'd consider adding to the position.
looks a bit like the Nasdaq stock, only the trading action has been more volatile. But over the past couple of weeks, Schwab has been digesting its gains since the breakout above $16.50. An uptrending RSI continues to confirm the price action. Schwab is in a great industry group now as brokers like
are all being bid higher.
If Schwab falls back below $17, check the other stocks in the group. If they are all rolling over, I'd consider closing the trade. But if they are still strong, chances are that Schwab is just consolidating a bit more.
W Holding Co.
is consolidating a breakout above established resistance at $5.50. At the same time, W moved back above the 50-day moving average. Notice how last Friday's low held above $5.50, which establishes that level as new support. Since the test of the breakout level, the stock has advanced almost 8%. If you're long, try putting a stop back below $5.50. I'd wait for a breakout above $6 before taking additional stock.
Be careful out there.
At the time of publication, Fitzpatrick was long Goldman Sachs, though positions may change at any time.
Dan Fitzpatrick is a freelance writer and trading consultant who trades for his own account in Encinitas, Calif. He is a former co-manager of a hedge fund and teaches seminars on technical analysis, options trading and asset-protection strategies for traders and business owners. Fitzpatrick graduated from the McGeorge School of Law and was a fellow at the Pacific Legal Foundation, a nonprofit public interest firm specializing in constitutional law. He also practiced law in the private sector before pursuing trading as a full-time career. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Fitzpatrick cannot provide investment advice or recommendations, he appreciates your feedback;
to send him an email.