Having a Trading Plan is Fundamental in this Business

Q. What constitutes a good trading plan?

It seems that the general view on trading is that there is a lot of stress about money management and being able to remain calm under pressure/stick to a plan? But is this sufficient? Don't we read that we need the edge to come out ahead? What constitutes a good trading plan?

A: To be successful in trading controlling your losses is even more important than hitting more winners than losers. A good trading plan is crucial to your success as a trader. Face it - without a plan and a rules-based approach to trading, you are simply trading by the skin of your teeth. It may seem to work for a while, but self-doubt and/or greed will ultimately get in the way of being consistently successful. The good news is, it’s fairly easy to create. The following steps may help you get started.

A good trading plan is simply one where you make money. It doesn't matter two hoots what system you use, a pin thrown at the FT is fine but if you run your losses and cut your profits you will lose money. Money management is 75% of the game, finding a system that works is the other 25% but there's nothing wrong with 'gut' and fundamentals do not rule of technical analysis or vice versa. Until you can grasp how to play the odds in your favour, stay out.

In this it is simply a case of shifting your odds in your favour:

If you can get a system of indicators that is gives better than 50-50 results you have an edge.

If you can play each trade by cutting losses and letting wins run such that an average winning trade makes more than an average losing trade loses you have a bit more edge.

In this instance the use of stops and limit orders will help you stick to your trading plan. If you can manage your money such that the losing runs don't knock you out of the game you can continue trading and probably make a profit.

Money management (for me at least) is a massive key to trading, working with an auto stop (set on entering a trade), each trade being only allowed to take a set % of account capital i.e 1% to 3 %.

Each trade should have a plan with pre-defined entry/stop/target (target has to take into account the risk-to-reward ratio...something that seems a tad harder at the moment) and obviously a reason why any possible trade (which may or may not be taken) should be short listed onto your watchlist in the first place.

Sound Business Plan

In any other business, a person makes out a sound business plan. They calculate the gestation period for the business plan, anticipate the cash flow requirements for the next five years, calculate the depreciations, project sales or incomes and anticipate the expenses, contingencies, adjust for inflation and so on. Why can the same principles not be applied to trading?

After all, trading is a business. You invest money, either in buying or shorting a stock. Take the view that the small losses that you would incur are part of expenses like your brokerage. If the reader steels his heart to accept this loss, his attitude to the business of trading will change.

Unfortunately, the human ego is unwilling to accept a loss, simply because the mind is not prepared to take a loss willingly. Losses that a person suffers are never attributed to a sound business decision, but always to bad luck. The day a trader accepts in his mind that a stop loss is a business decision that day, his or her attitude and approach will change.

Constructing a Trading Plan

In order to succeed in trading you need a trading plan, in other words you need a business plan. Here are the necessary elements of a good trading plan:

Mission Statement and Objective – What is your purpose, what are you trying to achieve, and why is that important?
Strategy Description – Describe your trading strategy and process.
Strategic Market Analysis – Portfolio Selection, what markets are going to trade and why?
Competitive and Feasability Assessment – Who are you competing against? Do you have an edge and what is it?
Psychological Analysis and Emotional Plan – Can you psychologically handle the volatility and uncertainty inherent in your strategy. Are you aware of the psychological implications of implementing your strategy? Do you have a plan to deal with your emotions?
Operating Plan – What do you need to implement your strategy and how do you intend to carry out your plan?
Financial Plan – How much money do you need to trade? Is it money you can afford to risk? What is your worst case scenario? Do you have a stopping point?

If you put in the time, energy, and effort to answer all of these questions to formulate a trading plan your chances of success increase dramatically.

EXAMPLE ONLY PLAN - BUY

When constructing a trading plan ask yourself:

Will I trade only one specific market or many?
Will I trade on a daily basis or hold my positions for days or longer?
How much do I want to make?
How much am I willing to lose per trade?
If I trade on a daily basis, how many consecutive losses will I tolerate before I stop for the day?
How will I analyse the markets? Will I look at news and other events? Will I examine charts and price movements?
How will I use stops to help control my risk?
Will I have one profit target or multiple targets?
What kind of profit can I reasonably expect to gain?

Using your answers, write out a short but detailed plan of action. Stick to your plan. Here, it helps to keep a diary of all your trades as it will force you to follow your rules and avoid impulsive trading as much as possible.

A Trading Plan Example

EXAMPLE ONLY PLAN - BUY

If the 10 and 40 day moving average are both in a clear uptrend.
When the stock has two consecutive closes above the 10 day moving average - buy.
Hold the position until there is a close below the 40 day moving average.

A sell example would be the opposite to this. A person using the trading plan above would know what they would be doing before having entered the trade and they would know exactly what to do while in the trade.

Having said this, there is no type of trading that doesn't carry an element of risk. I have never known of anyone who knows where the markets are going. Through sound technical and fundamental analysis a trader can make a more informed judgment on which way price will go, but the market has a way of frustrating even the best of traders. After sound analysis, the only way a trader can combat the risk that is presented on each trade is through discipline and money management with the best trades being the ones with a favourable balance of risk and reward.

P.S. Don't forget to define your nature as a trader. Are you patient, tranquil, careful, knowledgeable, and realistic? How much capital do you have? What are you profit and loss targets based on your capital? What is your entry and exit strategy? Is your capital sufficient to allow you to enter multiple trades to gain experience? Do you adequately understand the markets you are trading? Do you treat trading as a business? How much time do you have for trading?...etc Once you make this self-assessment, recognise your weak spots and work on correcting them. Yes, this may take you sometime but it is absolutely necessary.

Q. Most traders devise a 'trading plan' based on nothing more than a couple of 'indicators'....

Most traders devise a 'trading plan' based on nothing more than a couple of 'indicators', a basic grasp of money management and an idea in their head that they should stick to the plan. But is there any logical reason in the first place that buying based on just the fact that one line crosses the other will work?

A: Ok indicators...I've spent a lot of time in the past testing/making logic of various ones and believe in some cases they can be helpful but alone they are not the key, in some cases they can provide a good confirmation, a lot are very simple to understand how they are calculated so that allows one to understand the logic which I think is fairly important.

Using the example of moving average crossovers (which I like) they are super when they do work, I've had some great runs with that simple tactic, of course (like most trading tactics) this will not work all of the time. Inspecting your past trades will also reveal a lot of valuable information on what has worked and what has failed to work and helps you identify times in the market when your indicators have a better possibility of working - it is this sort of research that I believe helps one become a more experienced trader.

Q. When making a trade, how much background research do you do? Have you got a strategy?

A: I have several strategies, rules, and principles which I try my best to adhere to when trading. You need an edge in the markets - research a market which interests you until you notice patterns, and then devise rules for trading those patterns. Back test and paper trade your system until you are confident that it has a positive expectancy, and then trade it. Remember, you do not need to know what will happen next to make a profit on a trade.

Also, you will never know the outcome of any trade with any certainty. Just remember that if you are trading a system which has an edge over time, trade the system correctly and over a large enough sample size (i.e. enough trades) you should make a profit corresponding to your edge. A casino has an edge in roulette, but it has no way of knowing the result of any given spin. It does know that over a long enough time period and a large enough sample size (i.e. bets) it will make a profit according to the size of its edge.

...Developing a Trading System/Strategy

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