June 21, 2018
A properly developed trading plan is the first step to becoming a successfully consistent and profitable trader. Yet, you and most retail traders like you don’t have a well written and thoughtful trading plan until you’ve blown a few accounts. Even then the grueling task to write a plan often gets pushed aside and procrastinated upon.
So why do most traders avoid taking the chore of writing a plan if it’s so important?
The answer for most traders is simply, “We don’t like rules”.
Think about it, why choose day trading as a career? Because trading offers you the freedom of being your own boss, allowing you to call the shots and live your life on your own terms. Free from the shackles of a 9-5 job and the dream of making as much money as you possibly can without limitations! Without rules.
Now enter the world of trading, a limitless environment without many rules. Other than the ones impose by your broker, you’re free to do whatever you wish. A dangerous environment for rebellious traders to be in who don’t have any sets of rules or guidance to go by.
I point to this one phenomenon as to why so many traders fail – they can’t handle having any rules to follow or they take it upon themselves to set rules.
In this lesson, I’m going to go over what a proper trading plan needs, and why it’s critical to enforce rules to your trading to achieve the success you are seeking.
A trading plan is your own list of guidelines for everything you do as a trader written in the most precise and personalized way possible. Your trading plan should answer questions like, what are you looking for to enter a trade? what is your edge? How do you manage your trade? What do you do after your trade? And so much more.
Writing your own trading plan should be a personalized self-discovery period where you reflect on the type of trader you are, by answering the questions of how you will prepare trades, execute trades, manage trades and review trades. The challenging part of writing your own trading plan is summing up in fine detail, how you will approach each step of your trade.
However, writing your trading plan is not the difficult part. The difficult part is writing the plan in as much detail as possible while keeping it as concise as possible, preferably to a single page so that you pin it to a wall near your trading desk and see it every day.
After all, a trading plan that that is eight pages long and takes fifteen minutes to read isn’t likely to be referenced often – which is why your trading plan should include summarized notes.
Lastly, a trading plan needs to be revised as your trading skills improve. Please don’t make the mistake of thinking that your trading plan is set in stone and you simply have to make it work. Be open to revisions as you move along in your trading career, just remember to always follow the most up to date version. Otherwise, you will find yourself drifting through the market trying many different “things” without knowing what works well and what doesn’t work so well.
In a nutshell, a trading plan keeps you on the path to your goal and helps enforce disciplined. Trading is like any other business, and as traders, you must treat it as such. All successful business has policies, procedures, and operating standards to ensure that they comply with their business practices. So as traders, we must enforce policies, procedures and operating standards to our craft to help us remain disciplined and focus towards our goals.
As previously mentioned, the market is a limitless environment without many rules. Therefore, your trading plan needs to serve as your rule book to help keep you out of trouble.
The trading plan is also a great way to test what works and what doesn’t. A successful experiment always involves one control and multiple variables by which the control can be tested against. Your trading plan becomes the control by which you test variables (entry and exit methods, various price action patterns, etc.)
Now that we covered the importance of having a trading plan, its time for you to start organizing together with some key components of your plan. Below is my opinion of what I feel are some of the most important pieces you need in a good trading plan along with some helpful tips.
Everybody’s plan is different so by all means, personalized your plan to fit your own style.
All traders must state clearly what they are trying to achieve from the markets. Plain and simple. You must make sure that your goals are realistic enough that you can put in place some steps and procedures to help you achieve it. For example, if you are an inexperienced trader and you say that you want to make $1 Million dollars in three months’ time, you may be setting yourself up for failure as your experience does not match your expectations. A more realistic goal would be for an inexperienced trader to say “I want to make $1,000 per from trading stocks, 6 months from now” and build on by breaking down all the steps you need to complete to help you reach your goal.
Your goals must be straight forward, defined and have deadline to be accomplished by. This will ensure that the plan that you created is either one that’s keep you on track to achieving your goals or its flawed and needs to be modified.
Its important that when you trade that you have some understanding about financial markets basics that drive prices in the market, whether that is a solid understanding of fundamentals or technical, we all need a starting point as to which we will begin our analysis and thought process. This will help us develop a trading bias as to which side of the market we want to be on and why.
For some, fundamental drivers are a good starting point. Having an understanding of the broader implications of the global economy and how businesses practices, trade balance, economic data, and central bank monetary policies can drive the stock market, bond market, currency market, and commodities market up and down on a daily basis will help us make a decision.
Furthermore, traders can also use the micro fundamentals of an economy, a company, a sector or industry as preliminary focal points to begin their research on formulating a direction bias. Using these economic factors can provide you with the edge you need to develop a trading idea.
For others, learning to read charts and develop intuition around technical patterns is another way of developing your own understanding of where prices will go and ultimately having a directional bias for an asset. This can include understanding technical patterns like head and shoulders, wedges and rounding top/bottoms or other charting patterns to formulate your trading decision.
Additionally, technical traders may also use leading or lagging indicators to help them make trading decisions as to when to enter the markets. By understanding the patterns of price action, volume and time, you can instinctively know when its time to get in and out of a market and which side to be on!
Regardless of whether you prefer technical or fundamentals, we all need a starting point to begin our trading analysis. These two common subjects provide a guideline as to how we can build a strategy or a trade around using technical or fundamental or both. Now I know some traders only use technical and trade very well doing so. I also know traders that only rely on fundamentals and do very well just trading with that. The point is either can function independently of the other and that’s what makes trading so unique. However, most successful traders use a combination of both technical and fundamentals to provide the most optimal trade setups that make the most sense.
It will take a lot of work and you must put in the time to learn how to approach it properly. The market is filled with people who have studied for years and trade at an institutional level. You must be aware of this and give yourself time to learn and hone your craft. The worst thing a trader can do to themselves is to expect to take more out of the market than their experience would allow them to.
Understanding time frames fall into two categories of trading. One, you must know how different charting time frames affect the way you see the market and ultimately, how you set up your trades. And two, you must have some sense of how long a potential trade may take to play out.
All too often I encounter traders who are unable to understand how looking at different time frames on a candlestick chart affects the way they perceive how a market is moving. For example, you could look at a daily chart and see a clear uptrend with a bull wedge pattern forming and you would believe that a break-out may come soon. However, when you zoom in on that particular daily candle into say, a 3-minute chart, you could see an intraday downtrend with a bear wedge pattern being formed. This conflicting information will affect the way new traders perceived the markets and set up their trades if you don’t understand that candlestick patterns can be distorted once the time frame is changed. Having the ability to see the bigger picture with a broad time frame and the knowledge to know that the more you zoom into a candle, the more that information will change will put you in a better position to make an educated decision as to whether or not to enter a position.
Additional, you must also have some sense of how long it will take a position or trade to play out, in order to eliminate the issues of turning a trade into an investment and an investment into a trade. Before entering any position at all, a good trader with a plan will have a sense of the path that a trade will take and how long it will take to reach its destination. Anybody can make a call like “I think Apple will reach $200 a share”; it seems like anybody can make a call on exactly where any share price will be. But the real question these so-called analysts never ask is, when will it get there and how will it get there? What happens if Apple sells off to $100 a share and then rebounds in one year from now and eventually trades at $205 a share. Your so-called analysts were ultimate “right” but not after having to endure being offside by a large percentage and holding for a year. The point here is that, when you trade the markets, you must have a sense of how and when a particular asset will get to the price (where) before you enter a trade as this will ensure that you will stay on course to achieving your goals or at least allow you to bail out of a trade when something unplanned has happened.
Rule of thumb, it always important to look at the bigger picture because this gives you an understanding of where a particular market is going. Then you must understand whether you are taking a short term intraday position or a longer swing trade position, as this will affect the holding time you may be in the market. Finally, when you enter a trade you must have a general understanding of which path it will take to get to your target, how long it will take to get them and where it will go. This will help traders avoid the issue of turning a trade into an investment and an investment into a trade!
As part of your trading plan, you must define all the products that you trade. These will become your handful of go-to assets that you will look at on a daily basis and become an expert on. By narrowing down to several tradable assets, you will be able to spend more time to understand the price action, the longer-term trends, the behavior of the asset, how it effects by fundamentals, how it effect by the news, etc. You should be able to create a trading career around several assets and trading styles. It’s preferable to trade a handful of assets that you are comfortable with while having the knowledge, experience and confidence to execute them properly with consistent strategies rather than to jump around from product to product.
Some strategies call for trading different assets such as event and news-driven products and this requires the ability to do proper research and trade what’s hot in the market at the moment. However, if your plan is not built around this style of trading, then its best to avoid the hype and trade what has consistently worked in the past from your small watch list.
It’s important for traders to have a consistent routine to achieve consistent results. Developing a routine of activities that could help you perform better should include things such as doing research about the market before you trade. Ensure that you are physically and mentally prepared by eating and getting proper rest. Having a balanced life that allows you to disconnect from the markets should be a part of your preparation as well.
You should consider the following steps before you begin to trade every day. One, have you given yourself time to research the markets and catch up with what is happening around the world before you trade? As global markets operate 24 hours a day, it’s important to understand if there are any significant events that took place on the other side of the world that could impact the markets while you were asleep. Two, did you get enough rest the previous night so that you can perform at your peak? If you were out partying the previous night, the chances of you being able to perform at your peak may be limited in this game without rules so it may be better to take the day off. Three, are you physically and mentally fit to take on the markets today? Have you eaten breakfast or had your morning coffee? These common routine steps will affect the way to approach the markets and in a game without rules, its important that you don’t overlook these basic tasks as you prepare to trade the markets. Finally, once you have closed out of all your positions, are you giving yourself some time to disconnect from the markets. Having proper work and life balance critical to your success and those who are most prepared will be well ahead of those who are not.
How will you enter a position that suits your defined strategies when you trade? For example, if you see an asset that meets all of your criteria, how will you enter the trade so that you get the best possible risk-to-reward ratio? What market environment will allow this trade to move in your favor? What technical pattern must you see before you set up the trade? Are you going to use a market order or a limit order?
Trade entry is so important that you would know instantly the moment you enter the trade whether or not a trade will play out in your favor. In addition to this, having proper entry prices will ensure that you will never be holding a losing position or that your drawdowns on the trade remain minimal.
Exiting a position is just as important as entering a position. All to often, new traders will only think about an exit in terms of profit targets and forgetting to plan the exit if the trade went against them. Good traders must plan for all possible scenarios before entering a position, which includes knowing where your profit target will be as well as your stop loss. Furthermore, you can elaborate on how exactly you will exit positions if you are inside of your trade. Will you exit all of your positions once it hits your target or exit half of your position and let some ride-on for glory?
One of the most critical aspects of any good trading plan is to establish how you will manage your risk. At the end of the day, all good traders are essentially risk managers and your ability to clearly state how you will manage positions and take on risk will ultimately determine whether or not you will succeed as a trader. When entering any trade, you must ensure that all your rewards are greater than the risk you are taking on. A good rule of thumb here is to only take on trades that will profit a risk-to-reward ratio of a minimum of 1:3 or better. Placing a trailing stop loss once you are onside by X amount of dollar, cents, pips or ticks. Whatever the case may be, a good trader with a proper plan to manage risk will be around the game much longer than those with no conceptual idea of risk management.
This is where you will take time to reflect on how your trades played out and analyze what went right and what went wrong. By logging down information into a journal, overtime you will be able to see whether or not your trading plan is working base upon your performance. From here you will be able to modify your plan and tweak it into something that makes more sense. Is your plan working? If so, how will you continue to build on the success of past trades? If it’s not working, what will you need to change in order for you to succeed? Is your profit target unrealistic or are you holding onto trades for too long? Remember, no trading plan is ever set in stones and good traders will constantly tweak and modify their plan as they grow and gain more experience trading.
The hardest part about writing your trading plan is not just about defining the rules and guidelines in which you will trade by, but to include enough detail information so that your trading plan is effective and concise enough that you will actually use it.
The whole idea of creating a trading plan is so that it could be read and reflected upon daily. This means having a summarized format that you can hang somewhere that’s visible from your trading desk.
I hope this article has given you practical advice about how to write a proper trading plan so that you can be well on your way to becoming a more consistent and successful trader. If you feel like you need a guideline in helping you create your own day trading plan, click here.