No one would open a restaurant or start any other business without having a plan in place. They would want to know the costs, define the risks to the business and find their edge over the competition. Trading the financial markets successfully is no different, it’s a business.
A trading plan is a set of principles or rules that a trader will follow during his or her trading journey. It is designed to provide a set of core objectives, a positive expectancy and therefore confidence in the markets.
Ten key questions and considerations:
- What do I genuinely want to achieve from my trading account?
- Do I understand the risks around leverage and market volatility and how to use it to my benefit?
- How will lifestyle, personality and circumstance affect my system and how active I can be in the markets?
- Am I a technical or fundamental trader, or both?
- Should I use a discretionary or systematic (mechanical) system?
- How do I manage the risks around my capital?
- How do I manage my positions around key event risk?
- What tools, research and resources do I need to make a success of trading?
- How can I assess what is working and what is not so I can continuously improve?
- Does the plan or system provide an edge, and if so how disciplined will I be adhering to the guidelines?
My core objectives for my own trading account are two-fold; I want to take a measured, balanced approach to growing the capital in my trading account and I want to manage the risks around this. How I go about achieving these objectives will be defined within my plan and subsequent actions will be unique to my personality and ambitions.
Lifestyle, employment and circumstance will play into an individual’s plan and shape the parameters of any strategy. These factors will influence how active they can be in the market and the timeframes they will trade. It is also important to consider whether the trader is more influenced by statistics, probability or has a tendency to act more reckless or conservative.
Traders are managers of risk
Traders have to be a managers of risk. There is a saying that professionals go broke by taking a small profit, while retail traders go broke taking a large loss. There is real meaning behind this and the moment when a trader is no longer phased by the notion of being wrong and taking a small loss is the moment they truly understand trading. The ability for a trader to admit they are wrong and cut a positon is a key component in creating an edge as the trader defines their risk. The saying ‘there is nothing wrong with being wrong, just don’t stay wrong’ is very true. In life, if something is not working we tend to do less of it. But in trading, there’s a temptation to hold onto losing trades in the hope they’ll turn, even though it makes us very uncomfortable.
A stop loss represents the point at which I can admit that my analysis is incorrect and I no longer want to be in the trade. It’s an essential tool, although the exact point of placement can often be a point of great frustration. As humans we are often wrong, but society makes us believe we have to be correct. This is why you will often hear traders talking about holding a losing position ‘until it moves back to breakeven’. That trader has to satisfy that need to be correct. However, the best traders will cut back on losing trades and reward winners by letting the position run and even adding to position size if the market moves in their favour. Do more of what works.
Knowing I don’t have to be right every time is something that takes time to understand, but mathematically if my strategy has a low win rate then I have to target a higher risk-to-reward ratio to compensate. For example, even if I get 25% of my trades right I can still be profitable if I make three times what I make on winning trades than what I lose on a losing trade. By targeting the highest probability set-ups and also a higher risk-to-reward outcome I am putting the odds in my favour.
Trading with the underlying trend and following the money flow is a great starting point for identifying higher probability outcomes. Having a strong understanding of price action analysis is also something I would highly recommend and this doesn't mean placing 30 different indicators on a chart, but just looking at candlestick analysis and basic supply and demand. Question who is in control of a move in markets.
As described, it is essential to do more of what is working and less of what isn’t, so continuous improvement should be a core component of any plan. Keeping a trading journal is often a low consideration for new traders, but it is in some ways the most important factor in driving future success.
Psychology is another important ingredient, especially once a plan is in place. How a trader adheres to the rules set out in the plan will separate discipline from recklessness. Emotion is often a traders’ worst enemy and breeds irrationality. It is often what causes traders to increase position size after a run of successful trades, or cut back after a period of drawdown. But it is the number one reason why traders cut back on profitable positions if the market has even the slightest move against them.