Anatomy of a Trade: These 4 Steps Keep Trading Simple

With so many indicators and forms of analysis, taking trades may seem overwhelming – there’s always conflicting information and varying viewpoints. But there is a simple trading strategy.

Break every trade down into four parts, and only focus on one part at a time. Here are the four steps that form the anatomy of every trade. Keep your focus on these for simple trading.

1. The Setup

This setup is what’s needed for a trade to potentially occur. There are thousands of trade setups, ideally you should only trade one or two if you want to keep your trading simple. Assume for a moment you use a moving average (MA) crossover strategy. You buy when a 50-period MA crosses above a 200-period MA from below (this is not an endorsement of this method, just an example). For other trade setups see the Trading Strategies section.

When the 50-period is above the 200-period MA, there is no possible trade setup. You do nothing. When the 50-period moves below the 200-period you now have a potential trade setup you’ll want to watch for. If the MAs are far apart, the setup is still a ways away and of no concern. When the 50-period approaches the 200-period, be on high alert, as a trade is potentially setting up.

Having a setup lets you know when you should be trading and when you shouldn’t. No setup, no trading. If a setup is forming, proceed to next step.

2. Establish Your Exits

You have a trade setup forming. Your next step is to determine if you should take the trade, if it “triggers” (step three).

A trade requires an exit. How will you exit this trade? Consider the possibility of the trade being a loser or a winner … you need an exit in either case. Once you’ve established this, if you’re comfortable with taking the trade, then you can trade the setup if your trade trigger occurs (next step).

With an MA crossover strategy the exits can be quite simple. Whether the trade is profitable or unprofitable, exit when the 50-day MA moves back below 200-day. Unfortunately this type of exit creates large risk, since the price can fall a long way before sell signal is given.

To offset this problem with the strategy, you may choose to exit profitable trades when the 50-day crosses below the 200-day MA, but also input a stop loss to protect capital in the case of a losing trade. Determine exactly where you will place this stop loss, and confirm to yourself that you won’t exit a profitable trade until the 50-day MA crosses below the 200-day MA. Your exits are now determined.

Learn about the 4 Ways to Exit a Losing Trade.

Charts courtesy of StockCharts.com.

trading exit chart example
Figure 1. Establishing Exits on a Trade, Before It’s Taken

For advanced traders, also consider whether you’ll allow yourself to alter your exit method once in a trade. What you decide here determines what you will do; think it through and then stick to what you decide during the trade.

During this stage, also consider your position size and the percentage of your account you’re willing to risk on the trade. While you don’t know your exact entry price yet, you can estimate it, and use the estimated entry point along with your stop loss to determine your risk. Too much risk? Avoid the trade. If you can risk more, don’t alter the parameters of the trade, instead, increase your position size. For more on determining position size and risk, see Which Position Sizing Strategy Is for You?

Once you’ve established how you will exit (based on your strategy), and you are comfortable to proceed with the trade—should it “trigger”—move to the next step.

3. The Trade Trigger

A trade setup isn’t a signal to enter a trade. The setup just lets you know a trade could happen.

Actually entering a trade requires a “trigger.” With the MA crossover method, the trigger may be “Enter a trade on the day the 50-period crosses above the 200-period.” As soon as that occurs, you enter a trade. That very precise event triggers you into action. Before this you simply wait.

trade trigger chart example
Figure 2. Using a Trade Trigger to Enter a Trade

Trade triggers vary by strategy, but it should be something precise, and relatively rare, which tells you now is the time to act and get into a trade. The trade trigger is something used on every trade (for a particular strategy); it doesn’t change based on the whims of the trader.

4. Trade Management

Once in the trade, your only goal is to manage the trade as laid out in step two. Place stop loss orders and take profits as dictated in step two.

Once in the trade, no new decisions are made. How you will manage this trade has been determined in advance. This relieves a lot of psychological pressure, because you have a plan, and all you need to do is follow it. This is done on every single trade.

Bringing It Together

You only need to focus on one thing at a time:

  1. No trade setup, no trade. You don’t even need to watch the market. Set an alert that will notify you when a trade setup is starting to form.
  2. Once a trade setup is forming your only job is to assess if you want to trade it, and how you will trade it – establish your position size, and how you will exit the trade (win or loss).
  3. Based on step two, if all the qualities of the trade are acceptable, take the trade if it triggers. If it doesn’t trigger, there is no trade.
  4. Once the trade is in place, your only job is to manage the trade as specified in step two.

The Bottom Line

Each trade is composed of four parts: Setup, Exits/Risk/Profit, Trade Trigger and Trade Management. At any one time you only need to think about the elements related to the stage of the trade you are in. Most of the time, this means doing nothing. Trading is as much about knowing when not to trade as it is about actually trading. Once in a trade, follow the plan you laid out in prior steps. This helps avoid making impulsive and emotional decisions when real money is on the line. Trade only one or two strategies, and know them very well. This four step process keeps you focused on what needs to be done for simple trading.

Cory Mitchell