I can give an answer that works for me, but I can’t guarantee it will work for anyone else.
As NB noted, I like my trades to have a story behind them, like their will be optimism as a new PM takes office in Jolly Ole England, or The Ausies will sell raw materials to China, just as China sells products to the US. As long as the trade follows my story I stay in it and when it doesn’t, I get out and look for another good story. Of course, the heart of this system is a prediction to start with.
So every trade I enter is a prediction of the trend. Even if I’m range trading, say from Bollinger band to Bollinger band, I’m still predicting that price will continue between bands and not go half way and sharply reverse. I am prepared to exit quickly if price reverses, but I am predicting that it wont.
When I enter a trade, I want as many things on my side as possible. Say I’m trading the 4 hour chart, my favorite. Before I enter, I will look at a dozen things and I will take a trade where several things seem to be working on my side. This is all about trying to find a direction that has some small increase in probability over random chance of continuing for a short time after entry. So what I am really doing is predicting the direction price will take immediately after I enter.
Everyone has their favorite candle formations, indicators, S/R and pivot points, moving averages, trend lines and other strategies. Additionally I will look at some fundamental data before I make a decision. I wouldn’t plan on going long right now on the Euro, simply because it doesn’t agree with my belief about the fundamentals driving the trend in that currency. But, I realize that price can do anything, so every trade is a balance between having the courage of my convictions and considering the opposite case, or more specifically, what the other trader who is taking the opposite side of the trade is thinking. Often that trader is one of the worlds best working the desk at Goldman Sachs, or a central bank with inside information, so I consider their opinion very carefully. If I don’t understand why the trader on the other side of the trade is taking the trade, I study some more.
I do have a set of hard and fast rules, like I only trade in the direction of the trend of the time frame one above my home chart, and I only trade in the direction that the fast over slow Stoch is pointing two time frames below my home chart, and a few others. I also always look for direct price action that confirms my belief about price just a moment before entry. If price doesn’t confirm, I just wait until it does. Sometimes my rules might give me a slight edge on entry, but I realize that edge is likely small. As long as I can be successful more than 50%, I have a chance. But for me at least, that absolutely requires some prediction to be made.
If I do everything perfectly, maybe I can get entries that go in the predicted direction 60% or more of the time. I understand I will take many small losses when price goes against me, and my goal is to keep those losses absolutely as small as possible. I quickly manually exit if price goes immediately against me on entry to a trade, usually holding my entry loss to only a few pips plus spread. If the trade immediately goes in my favor, I consider it a good entry by my definition and I move on to completely separate set of rules to manage the trade. At that point, the prediction is made and was confirmed by price action just after entry so I’m no longer in the business of prediction of price direction.
Perhaps that is what you have heard. Once you have entered a trade, you no longer predict price direction. Right or wrong, you have already made your prediction and at that point you can only manage the trade to maximize profit and minimize any possibility of loss. I agree with that philosophy. I realize that even after I’ve found what I consider to be a good entry, about half the time I’ll have to exit with only a very few pips profit to prevent a winner from turning into a loser. From there on out, the profit I make is just a statistical distribution based on market forces that I have no control over.
My personal trend following method takes advantage of the “fat tail” of real world price movement distributions and “Black Swan” events. As long as the trend continues, as defined by an up trend makes higher lows or a down trend makes lower highs, I stay in it. I search for that few percent of trend moves that persist longer than a perfect normal distribution math model would predict to exist. I also take advantage of “Black Swan” events when they occur in my favor. Those events should only be in my favor 50% of the time, but careful studies have revealed that in a down trend, the market will shrug off good news and react sharply to bad news. This is probably more due to the psychology of traders than actual market forces, but then again, group psychology is a market force.
In any case, once I have made an entry, I do not try to predict price at all, I just react to price movements. I do that with pending conditional orders that will either increase my position if price continues in my direction, or take me out of the trade with maximum profit if price moves against me.
There are traders that say that if you do all the other things right, you can just flip a coin to determine entry direction and still make about the same profit. I haven’t heard of many people getting rich flipping a coin, so I can’t recommend that strategy. Every successful trader I know works very hard to put themselves into a position to win, and it’s only after the fact that it looks like luck. If there is such a thing as luck, it seems to be on the side of those who work the hardest to put themselves in a position to win. Of course, that’s just my own opinion.
Happy Trading
