Without a trading plan, we’re just gambling in the markets. Learn how to make a trading plan, and put the edge in your favor.
Before taking on an endeavor, it is wise to have a plan. A plan is critical, and when trading there are multiple reasons for having one. One of the best reasons for having a trading plan is it requires you to educate yourself about the market, acquiring knowledge on trading basics and strategies before a plan can be written. Additionally, having a plan takes much of the emotion out of trading…you know exactly what to do, how, and when. We can’t get rid of our emotions entirely, but the plan helps us control them so they aren’t destructive.
The plan also gives us objective feedback on whether our style of trading is working or not. If there is no plan it is very hard to determine what was profitable and what wasn’t after many trades. You may find yourself asking “Why did I take that trade?” With a trading plan, you always know why you took a trade.
Making decisions randomly means there is no research behind what we are doing, it is just an impulse or whim. Trading in such a way is like taking out a boat out with no paddles and hoping the current takes us to the right location. It is gambling. There is no defined “edge” which is proven to make a consistent income. Each whim has a chance to work out, and may even work out several times in a row, but luck eventually runs out. We need a plan we can test rigorously and practice. The trading plan gives you your edge. Before making a trade, make a trading plan.
What’s a Trading Plan?
A basic trading plan is composed of three basic sections: Entry Rules, Exit Rules, and Money Management. All three aspects work together to create a system that suits your personality and that you can actually adhere to. Rules that you continually (or even occasionally) break are useless. Therefore, before delving into the entry, exit and money management rules take a “personal inventory.” It is upon these decisions the rules of your trading plan are built
Entry rules tell you why, how, where, and when to enter a trade. Exit rules determine how, why, where, and when you exit a trade (for profit and loss). Money management is the most important aspect, as it controls risk. Superseding the other two elements, if a trade is too risky based on the money management rules, don’t take the trade. It doesn’t matter how much money you make if you are willing to lose it all on a few trades.
How to Make a Trading Plan: Money Management
In creating a plan it is easiest to start with Money Management rules. The trading plan is built from the ground up based on your personal financial situation. A potentially winning strategy that involves too much risk means the strategy is useless. Strategies must be tailored to individual needs and resources. Therefore, start out by stating how much capital you have to trade.
No more than 1% of capital should be risked on a single trade. Once a strategy is proven profitable, this can be increased to 2%, but typically successful traders (who last) keep risk below 1% per trade. If a trader has $25,000 in trading capital, $250 is the maximum risk per trade ($500 if risking 2%). This is accomplished through position sizing…a key element to understand in trading
This is why money management supersedes entry and exit rules. If the risk is too large the trade can’t be taken. The amount of capital at risk is determined by the number of shares taken (for the stock market), multiplied by the price difference between the entry point and stop loss price for the trade
A forex account with a $700 balance can only risk $7 per trade. To keep the risk to that level requires trading micro lots (the smallest unity of currency available for trade), likely on a short time frame (day trading) until the capital grows
Money Management rules may also include trading “curbs”, such as daily stop losses or a “loss from top”. A trading curb is a provision you create which stops you from trading if a certain amount of money is lost in a single session (hour, day, week, month, etc). A “loss from top” requires you take a break if you have lost or given back a significant amount of profit. Daily stops and loss from tops are typically used in day trading, but not so much in swing trading or investing.
What if you are in a trade and you see another one? The money management section of your trading plan should provide a detailed description about having multiple positions and how these positions are managed. Can you have multiple unhedged positions, or only multiple hedged positions? How do you determine if a trade is considered a hedge? How is your trading capital determined when you already have multiple positions on the books – do you still calculate 1% of total capital (balance), or only non-exposed capital? Think through all these scenarios and write down how you will manage your funds before, during and after trades are completed.
No matter how you set up your personal rules, remember the goal is to limit risk. So taking a bunch of trades in highly correlated stocks or assets, is the same as risking huge amount in one stock/forex pair/future. Create guidelines to avoid that scenario
How to Make a Trading Plan: Entry Rules
Once you know what your maximum risk is per trade, develop entry and exit rules.
Entry rules thoroughly outline what has to happen in order for you to enter a position. This sequence of events may include specific price movements, chart patterns, statistics, indicators or any other variable that you feel puts you on the right side of the market. Include in the entry rules section whether you will trade one side of the market or both (long and/or short); what overall market conditions have to be present (or not present) to enter a trade; are there times you will not take a signal? Are trades taken as soon as a signal occurs, or is there a delay such as taking the position at the end of the day, the following morning, or when a price bar completes? What chart time frames will you monitor
Ask all these questions and then incorporate the answers into a detailed entry plan
How to Make a Trading Plan: Exit Rules
Exit rules meticulously outline exactly what has to happen for you to exit a position you are already in. Such rules may include price movements, chart patterns, indicators or a reversal of the original signals which triggered the entry. This section outlines how and where a stop loss is placed. A stop loss is an order that gets you out of a losing trade if a certain price is reached. In this section also decide if you’ll use profit targets–an order that gets you out of a profitable trade when a fxopen low commissionscertain price is reached.
Additional factors to consider: Will you use trailing stops (move stop loss as the price moves favorably in your favor)? How? Under what conditions will you exit a trade before the price reaches your stop loss or profit target (this is called “active trade management”)? Why and How? Will you exit your trade at end of bar/day/week or the instant a trigger occurs? On what chart time frame will your exits be based?
Ask yourself all these questions and then incorporate the answers into your exit rules.
Revising Your Trading Plan
As you begin implementing and practicing your trading plan in a demo account, you will realize you have overlooked certain things. Your trading plan tells you what to do, and situations will arise where you are questioning what should be done. When this occurs it’s because there is a hole in your trading plan…you’ve missed something. Define what you are missing and then state in your plan how you will handle that situation should it occur again.
In the initial few days and weeks there could be lots of revising before you come up with something that is functional. Once you have something that is functional, avoid excessively revising it. Instead, trade it for a month or more and see what the results are. Based on the results, you can then make some revisions. Then go through the same process again with the revised plan. If you opt to do this on your own, it can be quite time-consuming. Using someone else’s strategies and formulating a trading plan for them may speed up the process…but you still need to test out the plan to make sure it is profitable for you.
How to Make a Trading Plan: Summary
A trading plan is a way for you to objectively trade the markets in a way that suits your individual personality and financial situation. It outlines everything that needs to happen for you to enter a trade, as well as everything required to exit the trade. Both these elements are governed by money management rules that keep the risk on each trade below 1% of your trading balance.