Planning and risk management

Lesson 1 of 8

What is a trading plan?

Having a suitable trading plan is one of the most important aspects of trading. It's there to act as your own personal decision-making tool, helping you answer vital questions like what, when, why and how much to trade. Your plan should cover your personality, attitude to risk, trading goals, risk management rules and any trading strategies you intend to follow.

It is vital for your trading plan to be personal to you. It's no good copying someone else's plan, because that person will very likely have different goals, attitudes and ideas to you. They will also almost certainly have a different amount of time and money to dedicate to trading.

What's the difference between a trading strategy, a trading plan and a trading diary?

You'll hear these terms used a lot in the industry, often interchangeably, but for the purposes of this course we'll be talking about specific things when we refer to them:

  • A trading strategy defines precisely how you should enter and exit trades. For example, 'Buy gold when it drops below $1250, sell when it reaches $1350' would be a very simple trading strategy.
  • A trading plan is a comprehensive blueprint covering everything from your goals, motivation and attitude to risk, through to risk management rules and analysis of past trades. It can (and should) include both your strategies and your commitment to keeping a diary.
  • A trading diary is a written record of everything that happens when you trade, including entry and exit points, profit/loss, trading statistics and even your emotional state before, during and after each trade.

Why is a trading plan important?

It makes trading easier

A trading plan gives you guidance on when and how you should trade. Without a plan you might be constantly worrying about which market to trade, whether to take your profits early, let your losses run, or if you're missing out on other opportunities in different markets. With a trading plan you've done all the thinking upfront, so you can wait for the right market conditions and trade according the parameters you've set for yourself.

It helps you trade without emotion

A plan can remove emotional decision-making in the heat of the moment. You should already know your desired profit, and acceptable loss, on every trade before you place it. This means you'll be able to cope with any dramatic changes in the market price as your trade is in progress. Realistically, markets can only go up or down, so you should be able to plan for every eventuality beforehand.

It helps you to maintain discipline

Discipline is an extremely important trait for a trader. Anyone can get lucky on a few trades, but a disciplined trader is much more likely to be profitable in the long run. And if you have a solid trading plan, discipline is much easier to maintain.

Say you start using a simple trading strategy – for example, you go long on the S&P 500 every time it goes up more than 0.5% in one day, with the expectation it will continue to rise.

However, after a couple of trades your strategy doesn't seem to be working very well and you've lost some money. Do you abandon it immediately?

Depending on your circumstances, you might decide to stick with it. You can then find out if there's a fundamental flaw with the strategy, or if you were just unlucky with the first few trades.

If it's the former, is there a way you can tweak the strategy based on the results of your trades? By maintaining discipline and sticking to your plan, you could potentially turn a losing strategy into a winning one – or at least discover how and why it wasn't successful.

It enables you to improve

By following a trading plan, and maintaining a trading diary, you can keep a record of what works for you and what doesn't. This is useful for analysing your own performance and improving as a trader. A full record of every trade makes it much easier to learn from your mistakes, and to evaluate which trades you won (or lost) by luck or by judgment.

Lesson summary

  • A trading plan is your own personal decision-making tool, helping you answer questions like what, when, why and how much to trade
  • It should provide a blueprint of how to trade in any given situation, which:
    • Makes trading easier
    • Helps you trade without emotion
    • Helps you to maintain discipline
    • Enables you to improve
Lesson complete