Trading Concepts: Creating a Trading Plan
Start a business, you need a plan. With no direction or planning for how you’ll make a profit, your business likely doomed. Trading is no different, if you want to succeed, you’ll need to think of trading like you would a business. After all, through your research, skills and ultimately your money you’re making an investment in yourself, which hopefully will produce consistent profits and the lifestyle you desire. This doesn’t happen by accident (at least not often). It happens by creating a plan for your trading, and outlining exactly how you will trade. Creating a solid plan is a key step that all beginning traders should take, as failing to do this will likely result in simply failing.
Creating a plan leaves your emotions out of trading. When you watching your trade turn into a big loss or a big gain your mind can spin, causing you to deviate from the original strategy you had in mind, if you had one. The trading plan takes care of this. It gives you methodical instruction on exactly how to handle each trading situation should arise. It also tells you how to handle multiple trades. As a trader you may want to make more than one trade, but because you are anxious about your other trade you decide to skip out on a good opportunity. Alternatively, you may take on too many trades, exposing yourself to too much risk. A solid trading plan not only tells you how and why you are making trades, but also how you will handle a number of trades (if you so choose).
Probably the main benefit is that when you follow a plan you see what works and what doesn’t, and can monitor your results. Random trades, where you just buy and sell for any reason that strikes you, provide no useable feedback, because yours wins and losses will be as random as the impulses that generated the trade. Only by following a plan can you see if the strategies you are using actually work, or not, so you can make calibrated adjustments to improve.
Before You Begin
In order to create an effective trading plan, you need to consider several things thing before you begin:
- What style of trading best suits my personality? If you are someone who is low-key and prefers little drama, then you will likely want a trading style that is more in line with swing trading or investing. If you like action, then align your trading style with a more active style of trading such as short-term/day trading.
- Are you going to trade binary options, stocks, forex, futures, or a combination? Each has advantages and disadvantages; pick your markets(s) so you can create a plan for that market(s).
- What are your objectives? Why are you trading? Simple saying you want to make more money isn’t clear enough. Define what you want to make, and why–buy a car, buy a house, pay for kids school, etc. Your trading plan is the plan to get there, based on your resources, trading style and how often you trade. How often you trade will likely be determined by the entry and exit rules for your trades.
There are many excellent trading strategies out there, or you can create your own. Some basic entry methods are covered in my recent article Capitalizing on Lower Highs and Higher Lows in Price. Once you find a strategy you like, use this section of your plan to outline exactly how you will enter trades based on the strategy.
Your entry rules outline what market criteria must be in place for you take a trade. Here are some questions to ask yourself to get started. Does an indicator need to reach a certain level to take a trade? Does the price need to break an important level? Do entry signals need to occur on a specific chart, such as a 5 minute, 15 minute, or hourly chart. Do all trade signals get traded, or will you use a filter to screen some trades out? Do you enter exactly when a criteria is hit, or do you wait for a price bar to close before entering?
Think about your strategy, and then formulate exactly how you will enter those trades. If you use multiple strategies, this process must be done for each individual strategy.
How to get out of a trade is arguably more important than how you get in, since your exit is where you make or lose money. Therefore, your exit rules must stipulate exactly how you get out of both winning and losing trades based on your strategy.
If you are trading binary options, your profits and losses are fixed and therefore this section may be quite brief, since your broker essentially exits your trades for you. If you trade other assets, this section can get quite extensive.
You’ll need to determine where you will place a stop-loss order–an order which will close your trade and limit the amount you can lose. Where the stop-loss is placed must be determined before any trades are made, because without it, you don’t know how much you are risking on the trade. Once the trade is in motion, you may choose to implement a trailing stop. A trailing stop moves with your trade, reducing your risk or potentially locking in a certain profit once the trade moves in a profitable direction.
You’ll also need to outline if any profit targets will be used. Profit targets are pre-established price level or percentage-return levels at which you close your position (or part of it) to realize a profit.
You may choose another exit method, such as exiting simply when the criteria that got you into the trade disappears. If you entered because a trend was in place; when the trend breaks that could be your exit.
Outline your method for exiting profitable and losing trades, in fine detail, for any scenarios that may arise.
Money or risk management is the most important aspect of the plan. A basic rule for money management is that you shouldn’t risk more than 1% of your trading capital on a single trade. This is why you must determine your stop-level in the Exit Rules section. Once you set a stop-level, you know what your risk is.
Once you know your risk, you can determine how many contracts or lots you can buy. Managing your position size is crucial, as buying too much can create additional risk, while buying too little may make it difficult to reach your objectives.
In this section also consider whether you can take on multiple trades, or only one at a time. If you take on multiple trades, can they be correlated? If two assets are highly correlated, and you buy both of them, you are essentially taking the same trade, and doubling your position size. Consider these factors, and outline exactly how you will manage your money, risk and positions in order to reach your objectives.
Creating a trading plan will take time, but is well worth the effort. It should be very detailed, and at absolute minimum contain the sections discussed above. As you trade, things you didn’t consider will occur, and you’ll need to go back and tweak your plan. Once your plan is profitable though, avoid tinkering with it. The point of the plan is make your trading systematic, so you see what works and what doesn’t. If you constantly change the plan it won’t have time to show you if it is really working or not. Take the time to make a plan, because lack of planning leads to trading failure.