Developing a Trading Plan
You must have a plan if you intend to trade and be successful. Everyone tells you this. You hear it in seminars and read it in books, but most often the specifics are lacking. That leaves a trader learning the profession, to wonder what kind of plan he or she should develop and what that should involve. But finding no real specific guidance, he is left to wonder what to do. So.....most often, the trader will fall back to the approach he or she has used before, NO PLAN.
It is not that you intend to NEVER develop a trading plan, it is just that you are unsure of how to go about this development, and thus you put it off. You can develop a plan next week, or next month, or who knows when, but right now you don't know how to do that, so you put you mind on pushing ahead with your trading. The plan can come later
Unfortunately, this is true all too often. It has been true with me too. You want a trading plan, you know you need a trading plan, but right now you don't even know where to start. So you put it off. In this section I want to discuss what a trading plan is, why you need one, what elements are essential and how it should be used.
What is a Trading Plan and Why do I need to Develop One?
The idea behind a trading plan is quite simple. It is a guide for the trader. It is nothing more than a set of rules that the trader himself has decided are essential to his success. He has decided on these elements, through a period of careful consideration, during which he was not exposed to the stresses of the market. His guide therefore should be based on a logical consideration of important elements, not emotional feelings. The hope is then that when the trader is exposed to trading situations that cause fear and anxiety, he will STILL follow these elements which he deemed essential, and in so doing, steer away from making grave errors.
As stated, a trading plan is a set of rules. These rules then act as a guide for the trader, a roadmap that will keep him from diverting into unwanted behavior. What type of rules should we include? That, of course, is up to the trader. But lets start with understanding why these rules are necessary.
Sun Tzu was a warrior, an ancient Chinese military general. He was a leader. He left this earth many centuries ago, and yet his treatise on battle,
THE ART OF WAR, is still selling briskly. He wrote of military ideas after leading successful campaigns himself. He is credited with the following:
TACTICS WITHOUT STRATEGY IS THE NOISE BEFORE DEFEAT!
The stakes in trading are not quite the same as those in battle. Yet the confrontation is quite similar. You are up against another whose intentions
are quite opposite from yours. Your goal is to defeat him and his to defeat you. (The futures markets are a zero sum game.....for you to win, someone
must lose). However silly it may sound to liken trading to battle, I assure you the two are similar. The idea that you must defeat your opponent, the need
for planning ahead, the stress of confrontation when things do not go as expected which brings anxiety and fear, these are all elements of both trading and battle.
Sun Tzu realized long ago what Grant, Sherman, Patton, Rommel would find out much later. To succeed you must plan.
Why?..... It should be obvious.
A general who goes into battle without first acessing his adversary, planning his strategy and tactics, and making considerations for the unexpected, will
find himself trying to make those decisions under considerable duress when things do not go as expected. The same is true in trading.
Consider the stress that accompanies a new trader who is trading off his personal savings. He may not have shared this with his wife or family, and knows that should he fail (which most traders do) it will affect his family's lifestyle considerably. It may even make it difficult to pay bills. But even if the effects are not so drastic, the trader stands to lose his hard earned money should he fail. He makes the trade he believes will succeed (why else make a trade?), but things do not go as expected and the trade quickly is underwater. This trader had no plan. No trading plan and no plan for the specific trade. So now he is confronted with a very stressful situation, and he must compile a plan from here, under conditions of duress, in a setting in which we know his subconcious will filter information, not allowing for objectivity. I have been there. It is not fun and rarely ends with a good outcome.
A trader must try to avoid this situation at all costs, once there, he will fail again and again.
There are two important safety precautions to prevent a trader from falling into the stress of making difficult decisions under duress. The first is an overall trading plan. The second is a specific plan for each trade. Together, this amounts to the traders Strategy and Tactics.
So we know that a trading plan is a set of rules to guide us. We know why we need those rules. But what specific rules are we talking about?
The specific rules a trader incorporates into his plan are determined by him. He knows what his flaws are and the rules should be quite clear in addressing his greatest area of risk. For example, I know that my biggest flaw is overtrading, both volume and dollar amount. I have rules that limit how much (in percent of capital) I can risk, and how many trades I can take per unit of time. Another trader may have other issues like trading with no preparation, trading on advice from others, trading too many markets or markets that are too thin, trading in volatile markets (like bond markets after a major economic announcement, trading without stops, etc. Each trader needs to make sure his trading plan addresses his general approach, and his biggest flaws. Some of the things a trading plan should address include the following:
- What markets a trader will trade?
- when the trader will trade those markets? (day only...not after major news...etc)
- How often he will trade?
- How much he will risk (per trade / total at one time)
- How he will handle drawdowns on his acount, and increases in the value of his account? (will he stop trading, reduce trading during drawdowns....will he withdraw money with success?)
- How will he decide when to trade?.... what tactics will he use, specific trade set ups, subjective assessment, etc.
- How long will the trade duration be? minutes, hours, days, etc.
- How will he exit trades? scaling, specific exits, stops, etc.
- Under what circumstances will he trade? certain days, only when he can devote full attention, only when healthy, etc.
- Under what circumstances will he stop trading?..excessive losses, stress, family issues, etc.
- What will the trader do to improve?..review trades, study what, who? replay markets? etc.
It will probably not surprise you to find out that many traders are smart enough to develop plans, but then lazy enough to not follow the plan. You need to incoporate punishments so that if you fail to follow your plan, you cannot trade for x days.
PLANS FOR SPECIFIC TRADES
We have addressed the fact that a trader needs to develop a general trading plan. That should incoporate some or all of the above. But there is another aspect to being a good trader. For each and every trade, there must be a specific plan, and the trader must follow it.
Well, how is this different from the general trading plan, you might ask. It is quite different.
The general trading plan is meant to address all things involved in getting you to a trade, but it does not address the specific aspects of any single trade.
That does not, however, mean that those specific aspects are not addressed. They must be addressed.
A trader may follow all his general rules, find a specific set up, and be prepared to trade, but he must then set up a very specific plan for that individual
trade. For example:
I will enter long at this price because of this set up and with this expectation
I will exit at this point with this profit.....(or scale out here and here).....OR
If the market does this or this, I will recognize that my idea is no longer valid and exit the trade in this manner.....relative stop? absolute stop?
If the market does this.....I will add to my trade, ....OR ....I will allow my trade to continue to run with this exit strategy...(trailing stop?)
The specifics of the plan for an individual trade may vary. The important aspect is that you have a specific plan.
Trading is tough. It is as mentally stressful as warfare and must be approached that way. You may choose not do this, but at least be aware that you will up against others who choose to approach trading with discipline. They will be better prepared than you. The smart trader will not allow himself to be thrust into difficult situations that cause him to make tough, quick, decisions under duress. The smart trader knows that those decisions will likely lead to failure, but following plans developed ahead of time, will lead to success.