Only Take a Trade If It Passes This 5-Step Test

Step 1: The Trade Setup 

When evaluating a trade, it is essential to identify a confluence of factors that align with the overall trading strategy. These could include those derived from trend following, mean reversion, momentum, or bar chart and candlestick patterns.

This evaluation typically begins by assessing market trends and strength using tools such as moving averages or the average directional index (ADX), followed by confirming volume to validate price action, especially around breakouts or breakdowns.

Volatility conditions, measured by indicators such as the average true range (ATR), help determine whether the environment suits the requisite trading strategy. Meanwhile, technical analysis signals, including candlestick formations, moving average convergence divergence (MACD) crossovers, and bar chart patterns, can help with more precise entry cues.

Another important factor is ensuring that the trade offers a favorable risk-reward setup and aligns with the broader market, including macroeconomic factors and asset class or sector performance. Every element should reinforce the trading framework, helping to filter out noise, stay disciplined, and focus only on high-probability prospects.

Step 2: The Trade Trigger

You should pull the trigger on a trade only after a trading setup has confirmed it’s time to act. Common triggers include break confirmations, momentum reversals supported by the divergence of the relative strength index (RSI), and candlestick patterns, as well as pullbacks to key levels, such as moving averages and Fibonacci retracements, within a trend.

Intraday traders may look for VWAP reclaims, while swing traders often use MACD crossovers in the direction of the prevailing trend. The entry signal must reinforce, not contradict, the existing setup. In addition, traders should remain disciplined and only enter trades when conditions clearly align with their strategy.

Step 3: The Stop Loss

Setting a stop loss is an integral part of rigorously managing your risks. It protects capital, reduces emotional decision making, and allows for proper position sizing based on a predefined risk tolerance.

Whether based on price structure, ATR, moving averages, or a fixed percentage or dollar amount, the stop-loss order should reflect both strategy and market conditions. The goal is to place the stop logically so it’s tight enough to limit losses, but not so close that normal price noise stops out the position too early.

Furthermore, position size should be considered. One way to do so is to calculate the account risk divided by the distance between entry and stop-loss to ensure that the position stays within the risk parameters.

Step 4: The Price Target

It’s just as important to set a clear profit target. It not only anchors the expected return but ensures that the trades maintain a favorable risk-reward ratio.

Whether using chart patterns, trend channels, Fibonacci extensions, or a fixed multiple of risk, profit targets should be based on objective, measurable price structures. For greater flexibility, especially in trending markets, a trailing stop-loss order, based on a percentage, pip amount, ATR, or moving average, can help lock in profits while allowing the trade to run.

Step 5: Assess the Risk-Reward Ratio

For consistency and long term success, traders should apply the risk-reward ratio (RRR). This measure ensures that potential gains justify the risks taken. Even with a moderate win rate, a favorable RRR makes the trading strategy profitable over time.

Before entering any trade, calculate this ratio by comparing your profit target against your stop loss placement. For example, risking $1 to potentially gain $2.50 creates a favorable 2.5:1 RRR. Disciplined traders establish minimum RRR thresholds (typically 2:1 or higher) and refuse setups that fall short, regardless of how “certain” the trade feels. 

Position sizing should align precisely with your predetermined risk tolerance—e.g., never going over 1% to 2% of your trading capital on a single position. This approach transforms random trading into a mathematical edge, where consistency, not occasional home runs, builds wealth.

Additional Considerations

Beyond technical setups and risk management, traders must also consider external market catalysts that significantly impact price action, introduce volatility, and temporarily invalidate technical indicators. Incorporating these elements into a trading plan can improve decision-making and help avoid costly blind spots. Some of these additional considerations include the following:

• Economic events: Major releases, such as labor reports, inflation data, and GDP reports, or central bank decisions, can cause sudden directional moves across markets. Therefore, it is wise to avoid new positions just before these events, unless you are specifically trading the news.
• Earnings reports: Company earnings often lead to overnight gaps and unpredictable reactions, making it risky to hold positions into these releases unless the trade is structured with defined risk.
• Geopolitical developments: Events such as wars, elections, or trade tensions can rapidly shift global risk sentiment, impacting sectors including energy, defense, and emerging markets.
• Sector-specific news: Regulatory changes, mergers and acquisitions, or supply chain disruptions can drive isolated strength or weakness, so tracking related exchange-traded funds helps assess broader participation.
• Market breadth and sentiment: Indicators like the VIX, put-call ratio, or advance-decline lines help confirm or challenge trade setups by revealing the underlying health of market momentum.

The Bottom Line

This five-step test is a practical and disciplined way to help traders stay aligned with their strategy by ensuring each trade meets key criteria: trend direction, a valid setup, a confirmed entry signal, defined risk through a stop-loss order, and a clear profit target with a forward risk-to-reward ratio. This structure not only filters out low-quality trades but also reinforces consistency, reduces emotional decision making, and protects capital—the cornerstones of professional trading.