10. October 2016

How to make your trading checklist work for you (and not the other way around)
Make yourself a practical checklist that ensures a great trade

If you want to trade, you need a good checklist. A pilot uses a thorough checklist before take-off, and so should you. Especially if you want to survive the flight - which is more or less the idea of it.

You already have a checklist, even if you don't know it. It might be unwritten, but you do have some kind of "thing I need to check before I plunge in". You don't walk out on a 5 meter high diving board and then jump blindfolded into the pool. You always look before you jump. So your short list can look like this:
 

1. Is there any water in the pool?
2. Are there people swimming just below the diving board?                              

That is a simple list and easy to remember, so it is all "basic and common logic". We need the same thing in trading.
 

You and I are not the only one who has experienced this: We are serious in our approach to the market and we want to trade in the best way possible. So we make a checklist. And then the checklist gets bigger and bigger, and it consumes so much time that in a short while we start to trade without using the checklist – but we still feel guilty for trading without it. Sounds familiar? Checklists have a way of growing and devouring their makers. That is why I offer "2 rights and 1 wrong" in how to make checklists work for you – and not make you work for the checklist.
 

Two right things and a wrong
There are two things about a good check list that I'm pretty sure about, and there's one thing where I know I'm wrong. Let's go through them:
 

1. I know this: You should not have a check list. You must have two. At least.
    
2. I know this: Building the ultimate list is wrong. That’s when it gets really, really long and contains every possible and impossible thing, making it a tedious bore to use. And then, of course, you stop using it. Don't build the "ultimate list".
    
3. I know my present checklist is wrong. A checklist evolves over time, and for the better. Like a pair of shoes that pinch you at the beginning, but the more you wear them the better they feel. So the checklist I'll give you below is a version 2.8. There will be a version 3.0 and a version 4.0 that is far superior. My current checklist is not ultimate. It will evolve. So will yours.

So here goes the two checklists you must have
 

Checklist A - Dipping your toes
You have several reasons for entering a trade. Some times you simply have a good hunch that this can develop into a really good trade, but all the setup and signals are not in place. So I enter a trade with a very small amount of money, and that way I’m "in" and follow the development more keenly. I call this "dipping your toes". The amount is so small that it doesn't matter, but it keeps the trade in my view. And here I don't need a big, comprehensive check list because I already know that it doesn't have all the signals for a real, substantial trade. That was the whole point of it. It's a curiosity, a gut feeling trade, and you just test the waters without jumping full in. Of course your checklist should be small and very basic for such a trade.
 

1. Do you think you have a good idea you want to test? If yes, go ahead.
    
2. Make the size so small that you can stand to lose 50% without blinking an eye (but put a sensible stop-loss anyway). That takes the stress out of the trade. You are making a "test" and that is a noble pursuit.
    
3. Write down the aim/idea of the test. And write whether it worked or not. That way you collect more test results and you grow your knowledge.

It was a revelation for me when I developed this short version. It gave me permission to be faster on the trigger and test more freely without a dinosaur checklist looming over me.
 

Checklist B - The real jump in the pool
Here you commit more serious money and so you want a more comprehensive checklist. This is business.

A checklist is only good to the extent that it is practical to execute. Many lists are simply too long. Either you follow them meticulously and get analysis paralysis (and the train has left the platform before you board), or you simply make the trade and then afterwards glance cursorily at the check list. Neither is good. So I think that your checklist should be fashioned in steps.

In this template I'll focus on "my" time frame and my tools, but you can easily adjust it to your time frame and tools.

TECHNICAL
I like to start with the technical check-list first. This is easy and quick. If the answer is "no", then I don't bother looking at the next checklist (the fundamentals).

1. Does the trade follow your personal edge?
   Be clear, what is your edge? A technical setup or a fundamental flair? The trade you are looking at must follow this. Write your edge down in the checklist.
    
2. Are you trading with the trend?
   The main question is, are you trading with the trend? Use a moving average to determine where the bigger trend is going, or use trendlines or "higher highs, higher lows". What you use is part of your edge, but you've got to trade the trend. And use the weekly chart and its moving average to see if this agrees with your perception of the trend. (Realize that the trend could be sideways, and that point has to be specifically covered in your trade plan).
    
3. Make a spread analysis between price and a moving average.
   Think of the moving average as a "value zone" that prices will revert to. Prices can get very far away from the moving average, but only so far. Make a historical comparison of how far the spread can go. Don’t invest to the wrong side when the difference is too high as mean reversion is likely to come in.
    
4. Does an overall Elliott wave count agree with the trade?
   You don’t have to master the Elliott tool, but a basic knowledge can get you far in determining a trend and a correction. Here's a blog post about Elliott and RSI.
    
5. Is the MACD above the signal line?
   The current movement could be a correction and not a trend, so we need a break above the MACD signal to verify that it is a real trend.
    
6. Is the RSI showing divergence or overbought/oversold areas?
   These two things could stop the trade. Divergence is a really good tool. I don’t like the term overbought/oversold (the topic of another blog post) but it works!
    
7. Are there any really obvious support/resistance levels nearby?
   This could potentially stop a trade.
    
8. Have you remembered to look at all time frames: Monthly, weekly, daily?
   Simple question: If the daily trend is up, what is the weekly trend? What is the monthly trend? If there is a difference, which one will win? Here's a blog post about the three time frames.
    
9. Are any short or long cycles starting or ending?
   This is my own special tool, but you can replace it with your own tool

These 9 points must give either a yes or no to a trade.

FUNDAMENTAL
If the technical analysis says "yes", then I need to continue the check-list with some fundamental data. Otherwise I'm flying with radar only (technical), without seeing the ground (fundamentals).

1. Are any earnings release coming out soon?
   In that case be careful, or avoid buying until the release is out.
    
2. Are there any major FED announcements or job reports etc. coming out?
   Don't trade up to these events as the market can be crazy just before and just after.
    
3. What are other stocks in the same industry doing?
   Same or higher increase? Any of them leading? It's quick to make a comparison chart, so don't skip this. The result makes you think.
    
4. What is the leading competitor up to right now?
   This is the same as no. 3, but here you evaluate the competitive power of each company and their "edge". It’s subjective, but necessary to make you think. If you trade a commodity like aluminium, then the “competitor” could be the other LME metals. If you invest in oil, then compare with gas and coal. There is normally always a competitor and you don’t want to be in the dark as to what they are doing right when you are about to enter a trade.
    
5. Check earnings, cashflow etc.
   The fundamentals is a very broad category, but you need at least 1-3 fundamentals like earnings, cashflow etc to warn you of any troubles in the company.

These 5 points either confirm the "technical yes" or it makes you more hesitant. 

The technical list is more quick, and the fundamental list is more slow. I know that you can easily get "analysis paralysis" if the list is too long and slow. And maybe you are just a technical trader, so you don't want the fundamentals. Anything's fine. It is your edge. But making a habit out of asking the fundamental questions will make you grow, so try it.

MACRO
If the fundamental analysis also says "yes", then I cross reference with the macro check list.

This is not something you have to analyze at every trade. I update the macro economy once every month - after hours - and this serves as background information. But when trading, I just double check to see if it is in alignment or is giving warning signals.
 

1. Macro background information update:
   GDP quarterly growth, PMI, FED interest rate meetings, Non-farm payrolls data etc.
    
2. How has the instrument performed under similar macro economical circumstances.
   Find two incidents in the past where the GDP growth cycle was at the same stage as this month. The big question then is - how did the stock react those two times? Finding the commonality is an eyeopener. Don't underestimate the macro economy.

Fusion + patience
Now you fuse Technical + Fundamental + Macro into a coherent list. 9+5+2 = 16 points.
They don't all have to agree, but you must see a story that makes sense for you. Learn to distinguish what factors are important. It is - despite all my effort - still somewhat of a long list, but try to keep it simple.

Rule: Is the trade evident - or do you have to "squeeze" meaning into it? If you have to "squint" your eyes to figure it out, then it's likely too complicated. Sometimes we just "want to trade" and jump on anything without discipline. So ask yourself the question whether you are seeing something real (based on your above mentioned "edge"), or whether you are "trigger happy". Understanding your own state of psychology is often the key root to good trading.

The checklist can perhaps be added with single thing, patience, as Jim Rogers put it: "By forcing myself to wait until there was a trade that appeared so compelling that I could not stand the thought of not taking it, I had vastly improved my odds.”
 

There is a ton of things I didn't put in my checklist. You can be big on calculating the risk/reward ratio. That is fine, so put it in your list. Just resist the temptation to make the check lists longer and longer. If you are new you need to expand your check list somewhat but really seasoned traders keep pruning the lists to more and more basic elements without overcomplicating things. For each item on your check list you should ask: "Is this information really useful in my trading decision? If the answer is not a resounding yes, then it will only distract you. Don't confuse information with decision.
 

Not a word about this

There are other things I deliberately don't write about here because it doesn't relate to a checklist:

1. Have a written trade strategy.
    
2. Make a trade plan
    
3. Use a very clear and strict risk-management plan
    
4. Set predefined stop-losses before entering the trade
    
5. Analyze every trade to find what went right and what went wrong.             

All of this is worth several blog posts, and is essential. You can say that all these things needs to be in place first, as foundation, before you can write a good checklist.

Psychology

A final note to when you make your own check list. Ponder this question: Are you too quick with the trigger finger, or are you too “gun shy”, slow and want endless confirmation signals? The answer to this question should have a big impact on your check list. There is no shame in being either type, you just need to compensate. If you are too slow, then don't build a very long list that will then act as a very good excuse to  keep you away from any trade. If you are too quick and impatient, then make a commitment to an "absolutely essential list" before you trade. In the end it is about understanding yourself and compensate for your bias. Know yourself.

So here we are, journeying from a checklist to the psychology of the age-old "Know thyself". Trading is not just trading. It is expanding your view of the world. And at the same time it is a pressure test of your own psychological core. A journey outward and a journey inward. That's why it's so worthwhile. Check your checklist before flying. Have a good flight!!