Part 2 Homework: Framing a Trading Plan

 | Dec 24, 2012 | 1:30 PM EST
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To read the first part of Bob Byrne's series on doing your investing homework, click here.

Everyone has a plan 'till they get punched in the mouth.

-- Mike Tyson

In my view, framing a trade plan has more to do with understanding the market's current conditions than identifying a specific candlestick pattern, the location of a MACD or what some analyst at Morgan Stanley might have said on CNBC's "Squawk Box."

In Part 1 of this series, I reviewed the tasks I perform on a daily basis, and while I understand that it may seem like a tremendous amount of work, I assure you it becomes easier and second nature with only a minimal amount of practice. In fact, except during exceptionally volatile times, I am able to get through my daily analysis of the e-minis within 35 to 45 minutes.

Here are the tasks that should be performed on a weekly basis, though more frequent analysis may be required during times of heightened volatility.

  1. I place little emphasis on typical indicators (oscillators, MACDs and so forth), as they generally fail to add value to my particular style. That being said, I do keep an eye on the more popular (simple) moving averages (10-, 20-, 50- and 200-day). Make note of any averages that have supported price in a meaningful way in the past, and then check current price in relation to that respective average. Additionally, make note of any instance where the 10-day simple moving average breaks above or beneath the 50- and/or 200-day SMA. The only indicator I use on a daily basis is a volume-weighted average price (VWAP), but this will be addressed in a forthcoming article.
  2. Review a longer-term chart (weekly and monthly). Are prices trending higher, lower or stuck in horizontal chop (balance)? What would need to occur to place the primary trend in jeopardy? If prices have recently begun trading counter to the primary trend, are you confident that the current move is merely a secondary reaction and not the beginning of a new trend? What must occur to reverse the primary (and secondary if one is currently in place) trend?
  3. Are new highs and lows expanding or contracting? (This is especially important as the indices approach new highs or lows.) Check the percentage of stocks trading above their 40- and 200-day SMA (I pull this data from Worden's TC2000). Make note of the stocks you watch most frequently and observe how they are responding to breaks of four-week highs and lows. Are breakouts and breakdowns cutting off demand or supply or attracting increasing amounts?
  4. Review current correlations. How is the bond market moving in relation to the equity market (are they trading inverse of each other or in lockstep)? How are equity futures moving in relation to the euro and U.S. dollar index? What about gold and oil futures? If you're trading oil, be sure to review the Canadian currency futures. If you're trading gold, be sure to review the Aussie currency futures.
  5. If you're actively trading these names, perform this review daily: Identify the market-moving and higher-beta stocks (the assumed market leaders). Analyze their recent performance and whether they're beginning to lag or lead the broader averages (the Es, Nq and Ym futures). An obvious example would be to review Apple (AAPL) or Google (GOOG) in relation to the Nq futures, especially when the Nq is approaching major swing highs or lows.
  6. Do some sector analysis. Which sectors are performing best and worst (in relation to the broader market)? Understand how the performance of specific sectors might affect the way traders perceive broader risk as it relates to the Es, Nq or Ym.

There are many more studies and considerations you may find useful in your own analysis, but these are the ones I perform on a regular basis to further my own understanding of context.

Knowing that many of you find value in various typical indicators (oscillators etc.), I want to make clear that I am not knocking their use or existence. They simply do not play a large role in my own analysis. On occasion I may pull up an RSI, MACD or even a stochastic oscillator, but for the most part I am able to get comfortable with where I believe the market is by analyzing price, a handful of chart patterns, some straightforward trendlines and a volume profile. This is my approach, but it certainly isn't the only one.

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