Determination of trading plan and terms of its assembly

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Trading Plan

What Is a Trading Plan?

A trading plan is a systematic method for identifying and trading securities that takes into consideration a number of variables including time, risk and the investor’s objectives. A trading plan outlines how a trader will find and execute trades, including under what conditions they will buy and sell securities, how large of a position they will take, how they will manage positions while in them, what securities can be traded, and other rules for when to trade and when not to.

Most trading experts recommend that no capital is risked until a trading plan is made. A trading plan is a researched and written document that guides a trader’s decisions.

Key Takeaways

  • A trading plan is a roadmap for how to trade, and no trades should be placed without a well-researched plan.
  • The plan is written down and followed. It is not altered unless it is found not to work (make money) or the trader finds a way to improve it.
  • A basic trading plan includes entry and exit rules, as well as risk management and position sizing rules. The trader may add additional rules at their discretion to control when and how they trade.

Understanding the Trading Plan

Trading plans can be built in a variety of different ways. Investors will typically customize their own trading plan based on their personal goals and objectives. Trading plans be quite lengthy and detailed, especially for active day traders, such as day traders or swing traders. They can also be very simple, such as for an investor that just wants to make automatic investments each month into the same mutual funds or exchange traded funds (ETFs) until retirement.

Automatic Investing and Simple Trading Plans

Brokerage platforms allow investors to customize automated investing at regular intervals. Many investors use automated investing to invest a specific amount of money each month into mutual funds or other assets.

While the process is automated, it should still be based on a plan that is written down. This way the investor is more prepared for what will happen each month, and the planning process will likely also force them to consider what to do if the market doesn’t go their way.

For example, a 30-year old may decide to deposit $500 each month into a mutual fund. After three years, they check their balance and they have actually lost money. They have deposited $18,000 and their holdings are only worth $15,000.

The trading plan outlines not only what to do to get into positions, but also states when to get out.

Buy-and-hold investors may simply automatically invest and they don’t sell anything until retirement. They may even have a rule of not looking at their holdings.

Other investors may choose to automatically invest only after the stock market has fallen by 10%, 20%, or some other percentage. Then they start to make (larger) monthly contributions. Or, other investors may choose to automatically invest every month, but have sell rules for if their investments start to decline too much in value.

Automatic investors should also decide how much capital they are going to allocate to each investment. This isn’t a random decision. It should be well-thought-out and researched, then written down in the plan and followed.

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While automatic investing is simple, a trading plan is still required to navigate the ups and downs of the investments.

Tactical or Active Trading Plans

Short-term and long-term investors may choose to utilize a tactic trading plan. Unlike automatic investing where the investor buys securities at regular intervals, the tactical trader is typically looking to enter and exit positions at exact price levels, or only when very specific requirements are met. Because of this, tactical trading plans are much more detailed.

The tactical trader needs to come up with rules for exactly when they will enter a trade. This could be based on a chart pattern, the price reaching a certain level, a technical indicator signal, a statistical bias, or other factors.

The tactical trading plan must also state how to exit positions. This includes exiting with a profit, or how and when to get out with a loss. Tactical traders will often utilize limit orders to take profits and stop orders to exit their losses.

The trading plan also outlines how much capital is risked on each trade, and how position size is determined.

Additional rules may also be added which specify when it is acceptable to trade and when it isn’t. A day trader, for example, may have a rule where they don’t trade if volatility is below a certain level, as there may not be enough movement or opportunity. If volatility is below a certain level, they don’t trade, even if their entry criteria is triggered.

Altering a Trading Plan

Trading plans are meant to be well-thought-out and researched documents, written by the trader or investor, as a roadmap for what they need to do in order to profit from the markets. Plans shouldn’t change every time there is a loss or a rough patch. The research that goes into making the plan should help prepare the trader for the ups and downs of investing and trading.

Trading plans should only be altered if a better way of trading or investing is uncovered. If it turns out a trading plan doesn’t work, it should be scrapped. No trades are placed until a new plan is made.

Example of a Trading Plan—Position Sizing and Risk Management

A trading plan can be quite detailed, and at minimum should outline what, when, and how to buy; when and how to exit positions, both profitable and unprofitable; and it should also cover how risk will be managed. The trader may also include other rules, such as how securities to trade will be found, and when it is or isn’t acceptable to trade.

To give an example of what one of these sections could look like, let’s assume a trader has determined their entry and exit rules. That is, they have determined where they will enter, and where they will take profits and cut losses. Now, they need to come up with risk management rules.

Rules or topics to include in the trading plan may include:

Only Risk 1% of Capital Per Trade

That means that the distance between the entry point and stop-loss point, multiplied by the position size, can’t be more than 1% of the account balance. This rule governs position size, because position size is the only unknown and needs to be calculated. The trader may opt to risk 2%, 5%, or 1.5%.

Assume a trader has a $50,000 account. That means they can risk $500 per trade (1% of $50,000). They get a trade signal that says to buy at $35 and place a stop loss at $34. The difference between the entry and stop loss is $1. Divide the total amount they can risk by this difference: $500 / $1 = 500 shares. If they buy 500 shares and lose $1, they lose $500 which is their maximum risk. Therefore, if they want to risk 1%, they buy 500 shares.

Leverage or No Leverage

The trading plan should outline whether leverage can be used or not, and how much if it is allowed. Leverage increases both returns and losses.

Correlated or Uncorrelated Assets

Part of the risk management process is determining whether correlated assets are allowed to be traded, and to what degree. For example, an investor must decide if they are allowed to take full positions in two stocks that move very similar. Doing so could result in double-risk if both hit the stop loss, but also double-profits if the targets are reached.

Trading Restrictions

A trading plan may include curbs that stop trading when things aren’t going well. For example, a day trader may have a rule to stop trading if they lose three trades in a row, or lose a set amount of money. They stop trading for the day and can resume the next day. Other trading restrictions may include reducing position size by a set degree when things are not going well, and increasing position size by a set amount when things are going well.

The risk management section of the trading plan may include all these rules, customized by the trader. It may also include other rules that help the trader manage their risk according to their objectives and risk tolerance.

10 Steps to Building a Winning Trading Plan

There is an old expression in business that, if you fail to plan, you plan to fail. It may sound glib, but people that are serious about being successful, including traders, should follow those words as if they are written in stone. Ask any trader who makes money on a consistent basis and they will probably tell you that you have two choices: 1) methodically follow a written plan or 2) fail.

If you already have a written trading or investment plan, congratulations, you are in the minority. It takes time, effort, and research to develop an approach or methodology that works in financial markets. While there are never any guarantees of success, you have eliminated one major roadblock by creating a detailed trading plan.

Key Takeaways

  • Having a plan is essential for achieving trading success.
  • A trading plan should be written in stone, but is subject to reevaluation and can be adjusted along with changing market conditions.
  • A solid trading plan considers the trader’s personal style and goals.
  • Knowing when to exit a trade is just as important as knowing when to enter the position.
  • Stop-loss prices and profit targets should be added to the trading plan to identify specific exit points for each trade.

If your plan uses flawed techniques or lacks preparation, your success won’t come immediately, but at least you are in a position to chart and modify your course. By documenting the process, you learn what works and how to avoid the costly mistakes that newbie traders sometimes face. Whether or not you have a plan now, here are some ideas to help with the process.

Disaster Avoidance 101

Trading is a business, so you have to treat it as such if you want to succeed. Reading a few books, buying a charting program, opening a brokerage account, and starting to trade with real money is not a business plan—it is more like a recipe for disaster.

A plan should be written—with clear signals that are not subject to change—while you are trading, but subject to reevaluation when the markets are closed. The plan can change with market conditions and might see adjustments as the trader’s skill level improves. Each trader should write their own plan, taking into account personal trading styles and goals. Using someone else’s plan does not reflect your trading characteristics.

Investing After the Golden Age

Building the Perfect Master Plan

No two trading plans are the same because no two traders are exactly alike. Each approach will reflect important factors like trading style as well as risk tolerance. What are the other essential components of a solid trading plan? Here are 10 that every plan should include:

1. Skill Assessment

Are you ready to trade? Have you tested your system by paper trading it, and do you have confidence that it will work in a live trading environment? Can you follow your signals without hesitation? Trading the markets is a battle of give and take. The real pros are prepared and take profits from the rest of the crowd who, lacking a plan, generally give money away after costly mistakes.

2. Mental Preparation

How do you feel? Did you get enough sleep? Do you feel up to the challenge ahead? If you are not emotionally and psychologically ready to do battle in the market, take the day off—otherwise, you risk losing your shirt. This is almost guaranteed to happen if you are angry, preoccupied, or otherwise distracted from the task at hand.

Many traders have a market mantra they repeat before the day begins to get them ready. Create one that puts you in the trading zone. Additionally, your trading area should be free of distractions. Remember, this is a business and distractions can be costly.

3. Set Risk Level

How much of your portfolio should you risk on one trade? This will depend on your trading style and tolerance for risk. The amount of risk can vary, but should probably range from around 1% to 5% of your portfolio on a given trading day. That means if you lose that amount at any point in the day, you get out of the market and stay out. It’s better to take a break, and then fight another day, if things aren’t going your way.

4. Set Goals

Before you enter a trade, set realistic profit targets and risk/reward ratios. What is the minimum risk/reward you will accept? Many traders will not take a trade unless the potential profit is at least three times greater than the risk. For example, if your stop loss is $1 per share, your goal should be a $3 per share in profit. Set weekly, monthly, and annual profit goals in dollars or as a percentage of your portfolio, and reassess them regularly.

5. Do Your Homework

Before the market opens, do you check what is going on around the world? Are overseas markets up or down? Are S&P 500 index futures up or down in pre-market? Index futures are a good way of gauging the mood before the market opens because futures contracts trade day and night.

What are the economic or earnings data that are due out and when? Post a list on the wall in front of you and decide whether you want to trade ahead of an important report. For most traders, it is better to wait until the report is released rather than taking unnecessary risks associated with trading during the volatile reactions to reports. Pros trade based on probabilities. They don’t gamble. Trading ahead of an important report is often a gamble because it is impossible to know how markets will react.

6. Trade Preparation

Whatever trading system and program you use, label major and minor support and resistance levels on the charts, set alerts for entry and exit signals and make sure all signals can be easily seen or detected with a clear visual or auditory signal.

7. Set Exit Rules

Most traders make the mistake of concentrating most of their efforts on looking for buy signals, but pay very little attention to when and where to exit. Many traders cannot sell if they are down because they don’t want to take a loss. Get over it, learn to accept losses, or you will not make it as a trader. If your stop gets hit, it means you were wrong. Don’t take it personally. Professional traders lose more trades than they win, but by managing money and limiting losses, they still make profits.

Before you enter a trade, you should know your exits. There are at least two possible exits for every trade. First, what is your stop loss if the trade goes against you? It must be written down. Mental stops don’t count. Second, each trade should have a profit target. Once you get there, sell a portion of your position and you can move your stop loss on the rest of your position to the breakeven point if you wish.

8. Set Entry Rules

This comes after the tips for exit rules for a reason: Exits are far more important than entries. A typical entry rule could be worded like this: “If signal A fires and there is a minimum target at least three times as great as my stop loss and we are at support, then buy X contracts or shares here.”

Your system should be complicated enough to be effective, but simple enough to facilitate snap decisions. If you have 20 conditions that must be met and many are subjective, you will find it difficult (if not impossible) to actually make trades. In fact, computers often make better traders than people, which may explain why nearly 50% of all trades that now occur on the New York Stock Exchange are generated by computer programs.

Computers don’t have to think or feel good to make a trade. If conditions are met, they enter. When the trade goes the wrong way or hits a profit target, they exit. They don’t get angry at the market or feel invincible after making a few good trades. Each decision is based on probabilities, not emotion.

9. Keep Excellent Records

Many experienced and successful traders are also excellent at keeping records. If they win a trade, they want to know exactly why and how. More importantly, they want to know the same when they lose, so they don’t repeat unnecessary mistakes. Write down details such as targets, the entry and exit of each trade, the time, support and resistance levels, daily opening range, market open and close for the day, and record comments about why you made the trade as well as the lessons learned.

You should also save your trading records so that you can go back and analyze the profit or loss for a particular system, drawdowns (which are amounts lost per trade using a trading system), average time per trade (which is necessary to calculate trade efficiency), and other important factors. Also, compare these factors to a buy-and-hold strategy. Remember, this is a business and you are the accountant. You want your business to be as successful and profitable as possible.

The percentage of day traders that quit within two years, according to a 2020 paper titled “Do Day Traders Rationally Learn About Their Abilities” by Barber, Lee, Liu, and Odean.

10. Analyze Performance

After each trading day, adding up the profit or loss is secondary to knowing the why and how. Write down your conclusions in your trading journal so you can reference them later. Remember, there will always be losing trades. What you want is a trading plan that wins over the longer term.

The Bottom Line

Successful practice trading does not guarantee that you will find success when you begin trading real money. That’s when emotions come into play. But successful practice trading does give the trader confidence in the system they are using, if the system is generating positive results in a practice environment. Deciding on a system is less important than gaining enough skill to make trades without second-guessing or doubting the decision. Confidence is key.

There is no way to guarantee a trade will make money. The trader’s chances are based on their skill and system of winning and losing. There is no such thing as winning without losing. Professional traders know before they enter a trade that the odds are in their favor or they wouldn’t be there. By letting their profits ride and cutting losses short, a trader may lose some battles, but they will win the war. Most traders and investors do the opposite, which is why they don’t consistently make money.

Traders who win consistently treat trading as a business. While there is no guarantee that you will make money, having a plan is crucial if you want to be consistently successful and survive in the trading game.

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