What is a trading plan?

What is a trading plan?

Trade plan
Photo by @mikeygl

 

A trading plan is the consistent steps you take to analyse a market and decide to take a trade. They can be complex or they can be simple but the key things that they should include are:

  • Determination of the market direction
  • A trigger to execute the trade
  • A strategy to manage your risk exposure

There are additional things that are also good but keeping it very simple, you should have a strategy that does the above points.

How do trading plans work?

Trading plans or trading strategies are a detailed guide and methodology to analysing the markets and taking trades. Consistency is key to a successful trading plan.

They work by using the law of averages. A trading strategy might not be successful if you only take 10 trades, however, if you take 500 then it might be. 

It’s important that you give your plan enough room to prove to you that it either does or does not work. You don’t want to give up on a plan that fails over the first 10 trades but succeeds over the next 500.

Test your trading plan

As we’ve mentioned, being consistent with your strategy is important because it is being able to look back at those results which will help in refining and improving your strategy.

Testing a new strategy is also important. You won’t be able to say for sure if a strategy works straight away, which is why we would always recommend that you test any new plans on a demo account first.

A demo account is a great environment for you to practice and tweak your strategies. As well as finding the ones that suit you better.

Your trading plan results

Your trading plan or strategy results are a great place to improve your trading. It is a place where you can see in black and white how your strategy has performed. There is no hiding behind excuses, your profit and loss will determine how your plan performs.

Your trading plan will differ from other people but if you are thorough in keeping a diary of your trades, you can analyse each one to understand where you are going wrong and where you are going right.

Understand your weaknesses can help you improve them while seeing your strengths, gives you confidence to keep doing those tactics.

A quick example might be that you notice you keep getting stopped out yet the market eventually goes in the direction you had predicted. The solution would be to give yourself a bigger stop to account for unexpected price movements before it continues in your direction.

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Why are trading plans important?

Trading plans are so important. They give you a framework to execute your trades and ensure that you use a consistent process that leads to success.

You will almost never hear of traders that do not have a trading plan, successful traders anyway. This is because they have found something that works for them and so they repeat it. When something works and makes you money, the logical step is to keep doing it.

Trading plans also keep you focused on your objective and remove the element of judgement and psychology from trading.

Trading plan and emotions

Trading can be a very emotional activity, following a plan removes the emotion from your trading (assuming you follow it perfectly). 

Emotions can cause you to take bigger trades, larger risk and simply make poor decisions. If you follow your plan, you won’t find yourself doing these things. In fact, following a plan is boring because you should be doing the same thing each time. Your losses should be consistent and your wins should be relatively consistent.

You start running into problems when you notice your losses aren’t consistent. If you have some small and some large losses, you’re likely not following a risk management strategy.

How To Create A Trading Plan

Everyone’s trading plan is different. People find their own ways of doing things and like to stick to them, understandably. Therefore creating a trading plan can be a personal affair.

Within your trading plan, you can have several trading strategies. For example, you might have a strategy for trending markets and a separate one for ranging markets.

Creating one takes some determination, some testing and some realisation about what you like and what you don’t. You need to take a look at yourself to figure out what will work for you. 

Do you get anxious when holding trades overnight? Then probably worth sticking to day trading. Or can you only look at the markets a couple of times a week? Then perhaps a longer-term strategy is needed.

There are key things that you should include in your strategy, we take a look at them below.

What are the key things to consider in a trading plan?

At the start of this lesson, we highlighted three of the main components you need to address when creating a trading plan; market direction, trade execution, and risk management. However, there are more things that we recommend you look at when creating your own plan.

Trading hours

What hours are you going to trade? What hours do you have available? You need to understand your own time table. If you are working a 9-5 job, then you can’t be watching the markets during this period, therefore you might have to analyse and place orders in the evening.

Also, what time zone are you in? Are you going to be trading the American session, the London session, or the Asian session?

If you’re a stock trader, this is important because stock markets open during the day in that time zone. 

  • London is open from 8:00 am to 4:30 pm (London time)
  • New York is open from 9:30 am to 4:00 pm (NY time)
  • Tokyo is open from 9:00 am to 3:00 pm (Tokyo time)

So what do you put in your plan? Just make sure that you put the times that you will be trading and analysing the markets. If you find yourself trading outside of these hours, then it’s worth asking yourself why. If for good reason, then make a not in your plan that you can trade during those hours.

 

Photo by @wanaktek

What to trade

While this my change, it is worth noting down what markets you will be trading. The more you trade one market the more you get to know it. It sounds a bit funny when you say that but the more you watch and trade a market, you start to understand how it works and how it moves.

You can obviously trade what you want but there are some markets that are more popular with beginners than others. Namely, the FX market and some of the commodity markets, like gold and oil. This is because they’re liquid and easy to enter and exit your trade.

It’s important to understand how a market moves because they all move differently. For example, if you were to buy GBPUSD and BTCUSD and decided to use the same size stop loss, you will find that the bitcoin market is a lot more volatile and therefore much more likely to stop you out quicker.

You would therefore use a larger stop loss when trading BTCUSD (bitcoin).


Cryptocurrencies
Photo by @9_fingers_

Goals

It’s important to have objectives and goals in your trading. If you’re not working towards something then you won’t get the accomplishment feeling you should get when you succeed at something.

Depending on what you want from your trading, it might be a career or some extra income, you should have targets to look toward. 

It could be a monthly return rate. Normally anywhere between 3-5% return a month is considered a good return, especially if you’re managing your risk properly. If you’re targeting a larger percentage than that then there is a good chance you are risking more than you probably should and therefore it is worth you re-evaluating your risk parameters.

Establish your trading strategy and style

This is a combination of things that we’re looking at in this lesson. You have to ask yourself a few questions:

  • How long do I want to hold a trade for?
  • How many trades can I have open at any time?
  • How much time do you have available?
  • Do you get anxious in certain circumstances?

These are the types of questions you need to understand. You can then start to think about the trading style that suits you:

  • Scalping
  • Position and swing trading
  • Day trading
  • Long term investing

We’d recommend that beginners start by looking at position and swing trading and perhaps day trading. Although day trading is time intensive so it would depend on other commitments.

Risk Limits

Risk, risk, risk. This is one of the most important parts of your trading plan. Ensuring you know how much you have at risk at any one time. 

This will include how much you are allowed to risk on each trade, how much exposure you have at any one time and how much is the maximum you can lose over a day, week, and month.

Risk per trade

A common practice is that you do not risk more than 1% of your trading account on one trade. This way, you will need to lose 100 consecutive trades to blow your account. The chances of that happening are slim.

You can go smaller than this but it’s not recommended to go any bigger.

To do this, you need to ensure you know where you are going to place your stop loss, from there you can figure out the size required to ensure you stay within the 1% bracket.

Risk exposure

You also need to know how much you have exposed to the markets at any one point. We mentioned above that you shouldn’t have more than 1% on a single trade. This is true but you should also not have excess amounts of trades on at once. 

If you have 50 trades open at 1% each, you have half of your trading account at risk. The worst-case scenario is that you will blow half of your account, that is not something you want to happen!

Therefore the recommendation is that you do not have more than 2% of your account at risk at any one time. This means a maximum of:

  • 2 x 1% trades
  • 4 x 0.5% trades
  • 8 x 0.25% trades
  • You get the idea

This way, in the worst-case scenario, you will only lose a maximum of 2% of your trading account.


Screenshot of MT4

 

Keep an online journal

Keeping a journal is a great way to analyse your trades and forces you to be honest with yourself. One common feature of new traders is not admitting to losses and not taking any accountability for their trades.

This is dangerous because you can ignore mistakes you’re making.

Using a trade journal puts in black and white how you and your trading plan are performing. You can also analyse your results.

A great example as mentioned above is if you find you’re getting stopped out frequently but the market then goes in the direction you predict, then you should consider giving yourself a larger stop loss. You wouldn’t know this if you didn’t keep a journal.

What to include in your journal

Here are a few things you should consider keeping a record of in your journal:

  • Date and time of the trade
    • Open and close
  • Open price
  • Close price
  • Initial stop loss 
  • Initial take profit
  • Risk to reward ratio
  • Percentage at risk
  • Where you moved your stop loss to
  • Market you traded
  • Profit and loss
  • Trading style and strategy

Financial News and Events

Financial data and news is released every day. They have differing impacts on the markets but it is a regular occurrence. You need to decide how you manage your trades through these releases and whether you trade around them.

This is most notable around high impact news. Items like interest rate decisions, non-farm payrolls or quarterly company results.

Will you take a trade an hour before an important announcement? Will you hold a position through a data release? Will you manage your risk when approaching news or events?

You should have the answers to these before you reach the point where you need to make a decision.

Often it will depend on your trading style. For instance, a scalper will probably be actively trading through these periods while a day trader who doesn’t like big spikes in the price, might look to avoid these or exit their trades if the price is not in the place they expected it to be.

An example might be if they are running a position into non-farm payrolls and the price is where they originally bought but their stop loss is close and at risk of getting spike out, then you might look to close the position and re-enter once volatility has reduced.

Circuit breaker/disaster recovery plan

It’s important to have a backup plan, this again comes down to risk. You need to know when to call it a day.

Before you start trading, you should have only put into your account what you can afford to lose, therefore you shouldn’t worry about that.

The event you should be ensuring you’re prepared for is when you have a bad day, week, or month. This simply means that after a certain amount of losses that you stop trading until the next period.

We tend to advise the following circuit breaker:

  • 2% per day. If you lose 2% in a day, stop trading for that day and take a rest
  • 5% per week. If you have lost 5% in a week, then stop trading until the following week
  • 8% per month. Stop trading for the month if you lose 8%.

This is to make sure you don’t blow your account quickly. Taking time away can refocus you and make sure that you’re adhering to your strategy.

The same actually applies to your profits. Sometimes it is good to call it a day if you have had a good day or week. This way you don’t give anything back to the market and are ready to start the next day, week, month on the positive.

Trading Plan Summary

One of the key takeaways from this lesson should be that you definitely should have a trading plan. And that it is valuable in helping you to remove emotions from your trading.

You can have one trading plan with several strategies in it but it’s important that you are consistent with your trading. Give your strategies a chance to be successful, even if you have to test them on a demo account first.

In our next lesson, we look at what your trading style is.

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