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Making a Trade Plan: The Importance of a Trading Plan

Trading Plan
Written by Andy

Once you’ve learnt all the fundamentals about trading, and are ready to get on with it, you have to take one more step and that is to make a trade plan. If you’ve failed to plan, you plan to fail. There’s no substitute for a clear and simple trading plan. If you see a successful trader who doesn’t appear to have a plan, there are two things you should know – he paid a lot for his knowledge, and he does have a trading plan, it’s just in his head and not written down. This is where and how you put into action what you learned about technical analysis applied to price charting. Developing a good trading plan will provide you with a solid base to improve your trading.

You need to devote as much time and effort as necessary to develop a comprehensive trading plan and to test it. The plan includes what type of market you’re going to trade on, and what timeframe you want to look at, and you need to pick the approach which is best for you personally. There is no one best way to trade, although people who have found something that works for them will probably be big advocates of their market and methods. The initial step to devising a trading plan is to define your particular goals and a time frame to achieve them. Successful trading is a by product of adhering to a sound plan that addresses your entry and exit strategies, risk and money management.

The point of a trading plan is that it is consistent, and can help you reduce your emotional attachment to the money in your trading account. If you fl y by the seat of your pants, the latest lesson in the market has taught you will be the one uppermost in your mind, and unless you’ve invested a lot of money and time over the years you are unlikely to trade profitably.

It’s really not difficult to plan your trading, although you may find psychological and emotional problems executing it – each trader will have a different personality and trading a method or system which suits your personality is the key to successful trading. Trading simply consists of finding a good trade, putting down your money, and then closing the position which may be for a profit or a loss. The basic actions are easy to do, and the simpler you keep the process, the better.

The underlying principles you should follow in your plan include -:

  • go with the trend
  • cut your losses
  • let your profits run
  • exercise money management in position sizing

If your plan includes the four points listed above, you have a sound basis from which to proceed. Don’t forget that you always want to keep a check on how your plan is performing, and look for possible improvements, but you don’t need to micromanage it. You should schedule some time away from the markets at intervals to review it.

First, to make your trading money work the hardest, you need to be trading a leveraged financial product, and the most ubiquitous one is the contract for difference. The CFD allows you to trade in most if not all markets, and is very efficient in terms of how much money you need to deposit versus the potential profit. You need to understand the principle of leveraged trading, and that losses are leveraged too, but dealing with this downside is simply a matter of money management and suitable stop loss positions.

It’s usually advised to trade with the trend, as this is relatively low risk, which means it is more likely to work out in your favour. Often you can tell whether a trend exists and in what direction it is going just by inspection, but there also some technical analysis tools which quantify this. However you do it, your task is to narrow down to the financial security where you will actually place your trade.

A good trading plan will take into account an individual’s goals, education, risk tolerance and money management amongst others.

Making a Trade Plan -:

  1. Study the overall trend of the market.

  2. Consider the macroeconomic indicators in relation to the fundamentals.

  3. Use technical analysis (trends, tools, support and resistance levels) to set precisely your entry and exit points (limit order and stop loss using OCO).

  4. Trade only the best potential setups where the potential reward is much higher than the risk. Do appreciate that not all trades will be winners but the profits should offset the losses.

With so much choice, this is often done by choosing first a market, selecting one exhibiting the best trends, then choosing a sector in that market, again evaluating which of several have a solid trend in place. You can repeat this selection procedure down to an individual stock or security, or you may prefer to trade on an overall index. CFDs allow you the flexibility to choose this, and also to select whether you want the price to go up or down, that is trade long or short.

Trade Entry and Exit Criteria

Your knowledge of technical analysis and/or fundamental analysis will help in determining the best opportunity for placing the trade, and should also be used to check the reward/risk ratio so that you can see the potential for gains is much greater than the possible loss. Traders often look for at least 2 to 1 or 3 to 1 for this factor. There are a various methods that are used to determine your entry including ‘buy low, sell high’, ‘buy high, sell higher’ or ‘buy high, sell low’ for short selling. A good trade entry price will usually account for about 10 – 20% of your trading performance.

The amount you place on the trade is important, as no matter how well you research the product, the markets can turn against you and result in a loss. You shouldn’t trade a greater amount than that which will restrict your possible loss to, say, 2% of your trading account, as otherwise a succession of losses could cripple your ability to continue trading.

As soon as you enter the trade, you should have a stop loss position to exit if it starts losing money, and then set up an exit for profit, which may be when a certain target price is reached, or a trailing stop following the price. Either way, this element completes your trade plan.

Trade Your Plan -:

  1. The trade entry and exit price levels of the trade should be determined prior to entering a trade. The exit point is an important element of the position sizing methodology and predetermining your trade exit level allows you to make a decision when you have no capital at risk (where you don’t yet have an emotional attachment to the trade).

  2. Once the price hits your entry point do not hesitate to take the trade. Another opportunity may not be available later on. When the entry point is within your sights, take it. Wait too long and you may miss it.

  3. Set up your one cancels the other order (limit order and stop loss for your trade). This protects your trade whatever happens in the market and helps remove the stress attached to the position leaving only any of two choices: either liquidate for your profit or a predefined loss.

  4. Trade and stick to your rules as defined in your trading plan with strict discipline.

Experienced traders can pick suitable entry points with a good level of accuracy, and even though overall they might have more losing trades than successful ones they are still able to trade very profitably, through utilising good risk and money management strategies and techniques.

Watch Your Leverage

If you mentioned to someone that you are investing or trading in stocks or mutual funds, then it’s no big deal. But if you tell someone that you are considering futures trading, then they may look to you as though you are crazy. Somehow there is a reputation surrounding futures and other derivatives that makes the general public consider them highly risky, particularly following the latest financial meltdown.

The fact is that futures markets aren’t usually any more volatile than stocks. In fact, with daily limits, they can be less volatile. Derivatives of all types can give you an excellent way to multiply the effectiveness of your trading account, as long as you have a full understanding of them. Volatility is not the issue, most of the problems come from the incorrect use of leverage.

Leverage works both ways, magnifying both wins and losses, and this can make a few people very rich but is a danger to the unaware. It all comes down to position sizing and money management. As with all types of trading, you must choose the amount you put in any particular trade so that the possible drawdown with a losing position is small enough that a succession of losses won’t cause you to stop trading. Part of this calculation must include the size of your initial account, or the capital requirements for you to start trading in the first place.

Many would-be traders are attracted to the markets that offer leverage by tales of how you can get rich quickly with a small investment – the incredible boom in interest in Forex trading is an example of this. Leverage without responsibility is a recipe for a short term trading career, and even if you have come to trading with that intent, this course will set you on the right path for a successful trading career.

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