Without a trading plan, successful trading is unlikely – you’re effectively driving blind.
The problem is new traders fail to recognise the significance of a trading plan. This may address why many traders find it difficult to accomplish their goals in this business.
A trading plan, be it fundamental or technical analysis, is a comprehensive body of rules, designed to cover each aspect of your trading. It is your business plan. Included within the trading plan is a trading strategy, a framework to enter and exit the markets along with risk and money-management rules.
Having a trading plan helps reduce the emotional impact. Emotional traders typically bypass rational behaviour, leading to impulsive and foolish decisions.
Know thyself
Before a trading plan is designed, it’s important to understand the reasons behind why you want to become a trader or an investor.
Is it financial rewards, a career change and the freedom it can offer, additional retirement funds or is it you simply have an interest in the financial markets? Whatever it is, knowing why helps determine what type of trading style and, ultimately, trading plan, to adopt.
An example might be someone looking to top up their retirement fund, though lacks the time to trade intraday. In this case, position or swing trading, trading styles that place emphasis on longer-term swings, might be an approach to consider.
Important elements needed to shape a successful trading plan
Overall market risk:
The staple behind any trading plan places strong emphasis on risk and money management principles.
Overall market risk is the pre-determined maximum permissible capital at risk at any one time.
An example is an account with overall market risk set to not exceed 4% of the total account equity. Two open trades with a risk of 2% hits the risk ceiling. Four open trades risking 1% also reaches the threshold.
What about if a trade’s risk is at breakeven? Technically speaking, risk is never reduced until the position is liquidated. However, unless a major event causes the market to gap, breakeven stops are generally honoured, therefore. opening another trade is mostly acceptable, though is trader dependent.
Protective stop-loss placement:
While the practice of employing protective stop-loss orders is sometimes questioned, many support the use of a stop and should, therefore, be included in your trading plan. It helps contain risk.
Although the stop value must adhere to your maximum overall permissible risk (see above), it should also be positioned as and where your strategy dictates.
For instance, a long (buy) trade at the top edge of a demand area, an approach based on price action, traditionally states that protective stop-loss orders are best suited a few points south of the zone.
Risk/reward:
The risk/reward ratio measures how much your potential reward is, for every dollar you risk. A risk/reward ratio of 1:3 means you’re risking $1 to potentially make $3. A risk/reward ratio of 1:5 means you’re risking $1 to possibly make $5. This is an incredibly important aspect of a trading plan’s risk profile.
Determining the risk/reward ratio of your trading strategy, however, means little without understanding the win/loss ratio – the win/loss or success ratio is a trader’s number of winning trades relative to the number of losing trades.
Suppose a strategy’s average risk/reward is 1:5, meaning a risk of 20 points gains 100 points. In isolation, you’d be hard pressed to find a trader on the planet pass on these stats. Yet, what if this strategy managed to achieve these gains only 15-20% of the time? Although a marginally profitable strategy, it doesn’t boast the appeal it once did. Without the win/loss ratio taken into account, it’s impossible to understand a strategy’s potential, in terms of risk/reward.
The bottom line is to ensure your method has a positive expectancy, the amount we expect to make for every $ of risk we take. It is the return we can expect over the long run.
Knowing when enough is enough:
Having the discipline to know when to stop trading is good risk management, and a skill often overlooked. It helps avoid revenge trading, an emotional response to recover losses, and helps curb greed. For that reason, it might be an idea to incorporate the following rules in your trading plan:
- Profitable trading day – target achieved. Sign off and shut down the computer.
- Maximum permissible daily loss of 2% reached. Sign off and shut down the computer.
- If no setups are present, trying to create one is seldom a good idea. In this case it’s best to sign off and do something else.
Hardware risk:
Should your computer malfunction whilst in a trade or your internet suddenly trips out, do you have a plan in place to deal with this?
An easy way to overcome this is have an additional (back-up) internet connection and invest in a mini portable generator. Further to this, always have the telephone contact details of your broker nearby.
Money management:
Trading capital should always be money you can afford to lose, period. If you drain the account, it should make little difference to your current standard of living.
In the event of a large drawdown, what plan do you have to help manage this? A trading plan should include a cut-off point. For example, if your overall account equity drops below 25%, all trading should seize until you recognise the cause(s) behind the drawdown. This helps eliminate the risk of a margin call.
Position size:
Having set your overall market exposure, the size of your position should never surpass this value. Being disciplined and sticking to your noted risk parameters is crucial. It doesn’t matter how much conviction you have in a particular setup, it can still fail. Position sizing, therefore, is a vital component that deserves the utmost respect.
Trading strategies
Trading strategies, a framework to enter and exit the markets, vary dependent on the trader. Despite the differences, each trading plan must display definite rules of engagement for both entry and exit signals. This defines the setup.
A setup is a repetitive pattern that provides a high-probability signal to trade. Whilst recommended to note each rule in detail, a simplistic approach is often best. The last thing you want to do is scrutinise long-winded notes before entering a trade.
Having an edge, a technique, observation or approach that creates an advantage, that has been back tested enhances your odds of success in the live markets, assuming you have the discipline to follow the trading plan.
It is also quite common for traders to have more than one strategy. Although having alternative methods has benefits, newer traders may want to consider focusing on one approach to begin with.
Market selection
At some point in your trading plan you must decide which markets to trade. Ideally, these are the instruments you back tested your strategies on. It is also advisable to focus on only one or two markets to begin with, such as, currencies and commodities. This helps avoid overtrading.
Trading times
If you’re trading strategy involves breakouts, being active during the London/US sessions is likely best as this is the time we typically see liquidity enter the markets. On the other side of the coin, a range trader may look at trading during times when liquidity is lower, such as the Asian session.
Note the times required to be at the trading desk, and adhere to it. This might only be an hour a day for some. The idea behind this is to help stop overtrading, instil discipline and merge your trading business into everyday life.
The strategy, along with your allotted trading times and market selection, are crucial elements that have an important role to play in a trading plan. Failing to respect these rules makes trading a difficult endeavour.
Goal setting
Having something to strive for is an essential part of your trading plan. It is how we develop and ultimately progress. Goal setting is a component that not only focuses on financial objectives; it should also look at developmental goals as well. Some examples of developmental goals might be:
- Sticking to your setup’s rules and not deviating.
- Respecting risk and money management principles.
- Adhering to your set trading times.
By focusing on becoming a skilled and disciplined trader, the financial rewards will follow.
Trading goals are best structured throughout the year, setting annual, quarterly, monthly and weekly objectives. An example of an annual goal could be to improve your trading knowledge by reading books on psychology or a particular area you struggled with last year. Additionally, you may want to note your expected yearly return here, too.
Some traders do not set weekly, monthly or even quarterly financial goals. They find setting realistic annual percentage goals less stressful, effectively working with time on their side. Weekly, monthly and quarterly goals are probably best suited to developmental objectives.
What can a trading plan do for you?
The purpose of this article was to highlight fundamental components needed in a trading plan.
You may have a strong trading strategy, boasting a high win rate, but without correct risk and money management principles defined within the overall trading plan, you’ll likely still lose money.
To wrap up, the following lists some of the reasons why a trading plan is beneficial and why it is required to successfully operate in the market:
- Without a trading plan, the act of trading becomes frustrating, stressful and a pointless exercise. Following a plan helps employ discipline and structure.
- Takes away much of the decision-making process – the trading setup is either present or it’s not. When live funds are on the line, a trading plan helps maintain a certain amount of equanimity and keeps you from making illogical and often impetuous mistakes.
- Gives you the ability to monitor your progress, identify mistakes and alter the trading plan accordingly. Keeping a trading journal helps.
- Allows financial and developmental goals to be clearly defined.
- Identifies the markets you wish to engage in.
- Produces a clear understanding of risk and money management principles.
- Organises times of trade.