In trading, you have two choices: follow a methodical plan or fail. Any trader who consistently makes money in the market will tell you that unless you create and follow a plan, you will fail.
If you are one of the few who have written a trading or investment plan, you are off to a good start for success.
Having a plan is certainly no guarantee for success; however, it does get you over a major hurdle. If your plan has a few shortcomings or it lacks sufficient preparation, it will take you a while to start seeing success.
But when you have a plan in front of you, it gives you something to work with and modify. Documenting your process won’t prevent you from making mistakes, but it will keep you from repeating them.
This tutorial contains some ideas for creating a plan.
If you want to succeed at trading, you need to treat it as a business. Successful businesses always have a plan. Many people in business often boast about using a seat-of-the-pants model for business. They arrive at a destination, but they don’t always know how they got there. In other words, reading a few books, learning a little about the industry, and opening a brokerage account could all be a recipe for disaster.
The market has the potential to pause or reverse. When you know where either will occur, you will be in a position to act accordingly. This is where having a concrete plan is necessary. But even with a plan, you will need to re-evaluate it after the market has closed. You will adjust your plan as you sharpen your expertise and as the market changes. This is why as a trader you need to develop your own plan. You need to consider your own trading style, skill level, and goals. If you use another person’s plan, you won’t be able to accurately account for these factors and you will do yourself a disservice.
Building your master plan
The following are 10 essential components of a good trading plan:
This is where you determine if you have tested your system, have confidence that it works, and you are ready to trade. Are you prepared to unwaveringly follow your signals?
Trading is an activity of give and take. If you have a plan, you will avoid the costly mistakes that those who don’t have a plan will make.
Trading is a mental game. This means that you need to be alert and attentive to the task before you. Are you rested? Are you up to the challenge?
You don’t want to risk a big loss because you are not mentally, physically, and psychologically ready to face the markets. If you have had a bad night, are hungover, sick, or just not emotionally prepared, you should skip the day.
Some traders recite a mantra before facing the market. This is a good way to help you get mentally prepared. Find a mantra that is motivational and puts you in a good trade mood.
Set your risk level
Before you go into a trade situation, you need to determine how much of your portfolio you should risk on any one trade. Your risk can be between 0.1 percent up to 1.5 percent for every position. Anything above this is really skirting with disaster in my opinion.
Establishing this ceiling compels you to get out and stay out in the event that you lose that amount at any point throughout the day. In your plan, you determined your trading style and risk tolerance so you have already made this decision before going in. Stick to this risk level if you want to continue trading on another day.
Set your trading goals
Part of your trading plan involves setting realistic profit targets and risk-to-reward ratios. What are you willing to accept in terms of risks and rewards? Some traders refuse to take a trade unless that trade’s profit has the potential of being at least 3 times greater than the risk.
As an example, if your stop loss is $3 dollars per share, your profit goal should be $9 dollars. This is a goal that you need to set and reset often (weekly, monthly, and annually). Best to set percentage of your portfolio increase goals as actual dollars can distort your thinking due to relating how much you can buy with such an amount.
Do your homework
You can’t expect to successfully trade in a vacuum. Therefore, before the market opens, be aware of what is going on around the world. What are the overseas markets doing? Are the pre-market S&P 500 and Nasdaq 100 exchange-traded funds up or down? One way to gauge the market before it opens is to review the index futures. Also, learn what the economic or earnings data is and when that information is due out. Rather than taking an unnecessary risk, it’s best to wait until that report is released. Professional traders are not gamblers — they trade on probabilities.
Prepare for trading
Keep your trading area distraction-free because distractions can be costly in the trading arena. Whichever trading program you use, label the major, minor, and resistance levels and set alerts that you can easily see (or hear if you use an auditory signal).
Set exit rules
Your exits are far more important than your entries. (See the next section for a discussion of entries.) Many traders devote 90 percent of their attention looking for buy signals and almost no attention to when and where to exit — this is a mistake. Traders cannot sell if they are down because they don’t want to risk taking a loss. You need to overcome this thought process or your trading will be short-lived. Professional traders commonly lose more trades than they win. However, by limiting their losses and effectively managing their money, they still earn a profit.
Know where your exits are before you enter a trade. Every trade has at least two exits. Also, before you enter a trade, write down what your stop loss amount is if a trade goes against you. Profit targets for each trade are optional as market conditions change that regularly. Remember with any trade never risk more than a pre-set portion of your portfolio.
Set your entry rules
You want your trading system to be just complicated enough to work but simple enough to enable you to make snap decisions. For example, an entry rule might say, “If signal C fires and the minimum target is four times as high as the stop loss and you are at support, buy x number of contracts or shares.”
If you have 15 conditions (many of which are subjective) that need to be met, it will be nearly impossible to actually make trades. More than half of al trades that occur on the New York Stock Exchange are generated by computer programs. This is because computers are better traders than humans. Computers don’t have the emotional component involved in trading decisions. With computers, each trading decision is based on probabilities. Computers make the trade if the trade meets certain set conditions.
Keep good records
Good traders always want to know why and how they win or lose a trade. Keeping good records helps you recognize what goes into a successful trade. They also prevent you from repeating mistakes. Your trading records should contain the following information:
- Entry of each trade
- Exit of each trade
- Resistance levels
- Daily open range
- Where the market opened and closed for the day
- Notes about the trade and what you learned
Your trading records need to include as much detail as possible so you can analyze the information you recorded about the trade. This report lets you evaluate the profit and loss for a particular system, average time per trade (important for calculating trade efficiency), draw-downs (amounts lost per trade based on a trading system), and other factors that help you see the overall picture of your trade so you can compare your information to a buy-and-hold strategy. Think of this report as you doing accounting for your business.
The post mortem
It’s important for you to keep a trading journal to write down your assessment and conclusions of a trade. At the end of the day, knowing why and how the trade went the way it did is more important than calculating the profit and loss which is nothing but a by-product of your processes.
The bottom line
Before you begin trading a new system, be sure to test your preparation by doing paper trades for at least the first month or two but not too long as nothing beats real market trading experience and having real risk capital on the line. This process doesn’t guarantee that you will have immediate success when you start trading real money, but it will help boost your confidence that the system you use will actually work. It is more important to gain skill in making trades without hesitation than it is to decide on a trading system.
Your chances of winning in the market are based on your level of skill and your trading system. Nevertheless, you cannot expect to win without losing. Skilled traders will not enter a trade unless they know that the odds of winning are in their favor. Skilled traders will always lose some battles, but if they cut their losses short and let their profits ride, they will win bigger than they lose.
Treat your trading efforts as a business and you will survive in the trading game. Successful traders who win consistently do this. Your next step is to create a concrete trading plan using what we have discussed in this tutorial.
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