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Trading plans and why you need one

A trading plan involves understanding price action in the markets and how to build a robust trading system to take advantage of opportunities you have identified.

All trading involves risk. Losses can exceed deposits.
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Source: Bloomberg

Like most endeavours in life, the art and game of trading will require some effort to learn the markets and the associated tools available to trade them.

Many self-directed investors and traders often take on trading with the same mindset used when they actually accumulated the wealth in the first place.

Consider in life, the work skills you have acquired to stay employed and advance your career took many years to craft.

To create a position of inner knowledge in a career requires dedication and sacrifice to study and learn and apply.

Trading is often the same as starting a new career. However, many bring the skills they learnt in life, expecting them to be applicable to the markets.

The way we deal with interpersonal problems in private and public life will not apply to trading and investing.

For example, to lose money on a purchased product, say a new kitchen appliance that did not meet expectations, opens up many doors for recourse. The product can be returned or exchanged, or a refund obtained.

In the markets, this simply does not apply. Buying a share or commodity future and finding it’s worth less than the purchase price often invokes the same stress as buying a faulty product. However, in the markets we have no recourse for a refund; our only course of action is to sell at the reduced price and accept the loss.

Building a trading plan will give you direction on developing skilled observations of the market. The second outcome of building a trading plan is to give you a measure of your weaknesses and strengths and take advantage of them. Your “trading plan” will give you an edge over the markets and allow you to filter out the market noise and other distractions.

Trading plans are the business end of trading for online traders, investors and retail traders

Consider the professional trader that has to answer for his trading actions to his employer. This professional end of the market has a trading plan to adhere to and the trader is in a position where deviating from the plan brings in unlimited risk for his/her employer and the trader. Professional traders do not treat the trading game as a discretionary decision-making process. It is real. The outcome is real. And the process is controlled and monitored over time to make sure there are no deviations from the plan.

The building blocks for the trading plan are:

1. Understand the price action

Each market has different characteristics so study the market you are interested in.

Price patterns in the FX markets can differ to the equities markets.
This also applies to the implied volatility of each market. This, associated with using leverage, must be understood before placing a position.

2. Understanding the win-loss ratio

The first element in developing a trading strategy, from identifying a repeatable entry condition. The win-loss ratio can be ascertained by simply using a pencil.

Backtesting a trading plan does not require a computer program to complete. The backtesting can be done by printing a chart out and drawing pencil mark entry points based on your observation of a repeatable criteria. In this technique, the win-loss ratio is developed. The potential follow through of price action can be expressed as probability.

3. The position sizing

Position sizing to control risk is the key to any great trading plan. Professional traders understand this important factor. It’s not the profit that gives results, it’s the control of losses that give a trading plan the real edge.

Position sizing defines the risk of each position to known value should the market move to the predetermined stop loss level.

4. Stop losses

This is the key to trading successfully. Many trading plans have win-loss ratios considerably less than 50 / 50. A win-loss ratio of 80 losses to 20 winners can still be a very viable outcome as long as the winners’ return is far larger than a series of small losses.

From here, success is measured as the ability to stick to your own developed trading plan. That’s the game.

This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.

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