How to Design a Decision-Making Tree

Spikers and Members of SpikeTrade.com carefully plan their trades. Most are discretionary
traders who have written down their trading plans, which we call decision-making trees.
Here are a few quotes about such trees from the book Come into My Trading Room by Dr.
Alexander Elder:
A beginner never writes down a plan because he has nothing to write. He is having too much fun
chasing hot tips and trying to make a quick killing. Even if he wanted to write, he wouldnt know
where to begin. A serious amateur or a semipro who writes down a plan, including money
management rules, is on his way towards the expert level.

What is the difference between a decision-making tree and a mechanical trading system?
The main difference between a trading plan and a mechanical system is the degree of freedom
it allows traders. Trading systems are rigid, while plans lay down the main rules but leave you
free to use your judgment.
A trading plan includes a few unbreakable rules along with more flexible recommendations
which call for an exercise of judgment. Your judgment grows with experience. A trading plan
includes the principles for selecting markets, defines the types of trades, generates buy and sell
signals, and allocates trading capital. When you write a plan, avoid the temptation to make it
allencompassing. Know when to stop. Write down your rules but indicate where you will use
your judgment at the moment of decision.

Today we share with you the specific decision-making trees developed in recent Traders Camps.
Please read them to see what they have in common and how they differ and then start developing
your own decision-making tree.

You can see Spikers decision-making reflected in How I Got My Gold on the main page of
SpikeTrade. If you become a Member, you will also receive access to Spikers profiles, telling you
how they plan their trades.
Thank you for joining us as a Guest.
Please consider joining us as a Member to enjoy greater resources!
Dr. Alexander Elder & Kerry Lovvorn
SpikeTrade.com

There is a chapter on Decision-Making Trees in Come into My Trading Room. If you

have not read this book, you can order it from www.elder.com. Their prices are among the lowest,
and you can ask to have your book autographed to you!

Decision-Making Tree
2008
PART ONE: INTRODUCTION
1
A personal mission statement including goals Decide what markets to trade and decide
general view of where we are. (In this plan we will focus on stocks) Why am I trading? Improving
psychology, knowledge, how will I know when I accomplish this? One option to focus, establish a
personal dividend paid out of super profits. Set performance goals.
2
Select the strategy that appeals to you personally (Are you a long, short, value, momentum
trader?) (In this plan we will focus on swing trading; you can modify for other types of trading.)
3
Define the characteristics of the market you want to swing (this plan will apply to long
trades only). These conditions will serve as flags that a potential trade exists.
Short term oversold (near the lower channel line) MACD divergence False downside
breakout Kangaroo tails Force Index down spike
Pullback to value in an uptrend
Weekly EMA rising, Daily EMA rising, price below fast EMA

We need to
of these

write definitions for each

conditions.

1
Define
target and stop
ENTRY TRIGGER:
red line PROFIT
channel line
history of
line and put a stop
level below the
conditional orders to place target and stop after your trade is executed.

entry trigger, profit

for any type trade
Place a buy order at the
TARGET: At the upper
STOP: Measure the
penetrations of the red
at or below the deepest
EMA. Consider using

2
Money Management % Risk per trade, will it be the same for every trade? Trade Sizing:
small (.5%), medium (1%) or large (2%) based on how confident we feel. As beginners, stay small.
The 6% Rule: stop trading for the rest of the month after hitting a 6% limit of drawdown
plus open risk.
PART TWO: THE ACTUAL TRADE
1. Screen the markets to find the condition we seek
a. Write down a Market view for next week that will have impact on our trade sizing.
b. Narrow down on the best stocks that meet our condition. Option: Do industry group review
Option: Look at your favorite 50 trading stocks Consider filtering out stocks in advance of earnings,
Fed reports, option expiration week, stock splits, and do not short into dividends.

Find two to four stocks you like best. **Avoid the delusion that you will find the best stock
one of the best is enough!
1
Compare Reward to Risk parameters for our best stocks. Make the final selection (preferably
more than one)
2
Ask: Do I have available risk based on the 6% Rule? If not, consider whether you want to free
up capital by closing other positions or moving stops. If yes, how much will you risk on this trade?
Use the Iron Triangle to size the trade. (Divide total risk per trade by the distance from the entry
to the stop.) If the stock is not yet ready for a trade, put it on your Watch list.
3

Create a Diary Entry

Place your orders (Entry plus conditional target and stop.)

5
Document your fills. Track slippage and commissions. Consider writing psychological notes.
Update diary. Consider canceling orders for runaway stocks.
6

Monitor your trade, adjusting both targets and stops, as MA and envelopes keep changing

7
Once the trade is completed, update the diary and create a reminder to return in two
months
END OF MONTH
update equity curve Consider separate equity curves for different tactics, along with a combined
curve Recalculate 6% and 0.5 2% size

Decision Making Tree

2007
1. Money management - does the 6% rule allow me to trade?
a. If the answer is no, just paper trade
b. If yes, go to step 2.
2. Am I generally bullish or bearish?
a. New high/low index trend
b. Trend of the S&P
3. How do I find stocks to consider for trading?
a. Find interesting industry groups
i. Look at stocks in the group from the cheapest up (to about $10)
ii. Quickly mark interesting stocks
iii. Rule out any stocks trading under mil shares daily
iv. Work up interesting stocks
b. Listen to rumors and news [whatever stock I find, drop into my own system]
i. Spike
ii. Media
iii. Friends
4. analyze interesting stocks for risk/reward
5. Define your favorite time frame [My favorite is daily]
2. Go one time frame up
3. Make a strategic decision [Am I a bull, bear or undecided?]
a. Compress the chart to the max cheap or expensive?
b. Slope of moving average?
c. Price above or below value?
d. MACD bullish or bearish? Any divergences??? If stock in a straight line, horizontal or diagonal,
MACD tends to degrade to zero and its signals not useful
e. Force Index how strong? Any divergences??? Recent spikes?
f. Are we interested in looking at the daily chart? If the weekly chart makes you bullish or bearish
proceed to the daily; otherwise, move on to the next stock
4. Return to the daily chart to make tactical decision
Where to buy?
What is profit target?
What is the stop?
Slope of moving average?
Price above or below value?
MACD bullish or bearish? Any divergences???
Force Index how strong? Any divergences??? Recent spikes?
Does this stock belong to an A, B or C group?
Establish target (probably on a weekly chart)
Establish stop (probably on a daily where you do NOT expect the stock to go)
Divide the distance from entry to target by the distance of entry to stop; need better than 2:1
ratio
If we have a distant entry point in mind, do we place a Chihuahua order?

5. What money management rule will I apply? 2% or lower?

6. How many shares am I allowed to buy?

a. How many will I buy?
7. Complete record keeping
8. Continue to monitor

Decision Making Tree

2006
(based on a $100,000 stock account, no current positions, )
1. Money
a. Does the 6%-rule allow me to trade?
b. If yes, what is my 2% limit?
2. Check all market indices (weekly)
a. How bullish or bearish?
b. Change from previous week bullish or bearish (taking the temperature of the market)
3. Check all market sectors, industry groups
a. How bullish or bearish overall?
b. Change from previous week bullish or bearish?
c. Most strong / Most weak sectors Most strong = stopped declining, starting to pick up Weakest =
stopped rising, went flat, bear. divergences
4. Look for the strongest stocks in strongest groups
a. Cheap
b. Exclude low volume
c. History and prospects ($18/$2 vs. $200/$2)
d. Consider group leaders and laggards
5. Look for the weakest stocks in weakest groups
a. Expensive
b. Exclude low volume
6. Buy candidates
a. Start with a weekly chart
i. Cannot be red
ii. Was red, is blue
iii. Look for divergences
iv. Is the rubber band overstretched?
v. Set potential price targets
b. Go to the daily chart
i. Cannot be red
ii. Is the channel worth trading?
iii. Is it in the sweet zone?
iv. Are the indicators saying buy?
v. Stop level
7. Count money
a. The 2%-rule / maximum size
b. Entry to Stop / Entry to Target ratio
8. Action

a. Place your limit orders

b. Try to risk similar size
c. If uncertain or fearful, reduce size (2 goals of trading: to make money and to learn)
d. Entries in spreadsheet and trading diary

9. Manage trade
a. Daily marketwatch updates
b. Buy slow, sell fast
c. Pull up stops (remember to contact broker)
d. Reevaluate targets
e. Add to positions?
10. Exit trade
a. Update spreadsheet and diary
b. Rate and analyze performance (incl entry and exit)

Decision Making Tree

2005
1. Does the 6% rule allow me to trade this month?
a. Do I want to use 6% limit or less at this time?
b. Make a total risk decision consciously
2. What markets will I trade? This decision tree will be for stocks
3. Broad Index review (Dow, NASDAQ, S&P) - Generals
a. Monthly indices Are we in a bull market, a bear market or a transitional market?
b. Weekly charts for intermediate trends
c. Bonds, Gold, Crude (if desired)
d. New Highs New Lows
e. Look at the calendar: FED announcements, options expiration
f. Awareness of time: seasonality, duration of current trend
4. Index and sector review (TC or similar program, Impulse or another method)
a. Index review (electronics, real estate etc.)
b. Sector review (Media General Groups in TC)
i. Express my level of bullishness and bearishness of the market
ii. Where is the action? Find especially bullish and bearish groups
5. Select tradeable stocks (find rich dirt)
a. Quickly scan component stocks of selected groups and subgroups for attractive longs (in strong
groups) and shorts (in weak groups)
b. Prune the list to end up with rich dirt
i. Apply volume filter
ii. Price filter (buy cheap, short expensive)
iii. Cut out stocks that dont talk to me
6. Select stocks to trade (what is my analytical process)
a. Monthly cheap or dear
b. Weekly trend, Impulse, divergences
c. Daily trend, Impulse, divergences, envelopes, volume, Force Index
d. Aim to buy below value, short above value
7. Zoom in on every stock (process rich dirt)
a. Entry, stop and target (consider using envelopes)
b. Compare risk/reward and select the best candidates
8. Trade sizing
a. Decide on risk allocation to bull and/or bear
b. Decide on 2% or smaller
c. Decide the number of shares
d. Place the limit order, stop and possibly target
9. Housekeeping
a. Enter the trade in a spreadsheet (Marketwatch, Organizer etc.)
b. Create a diary entry
10. Manage the position
a. Adjust stops, profit targets, size
b. Do-a-Martin when necessary
c. Exit position earlier than planned, if necessary (shoot longs with red weekly Impulse, shoot shorts with
green weekly Impulse)
d. Add intermediate documentation, if desired

11. Dealing with closed positions

a. Complete spreadsheet and diary
b. Assemble statistics on your trading
c. Watch out for psychological trends in your trades