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1. Why Do You Need a Trading Plan?
In this article, we will explain how having a trading plan could help you in your journey to become a successful trader and discuss some of the major components – from risk management to the strategy and trade management.
We will begin with the question “Why do I need a Trading Plan?“. Before we go into the details, let’s take a simple example.
Imagine that you are opening a business – say, a coffee shop. It is likely that you wouldn’t open a coffee shop at a random location just because you happen to like the place. You would probably first ask yourself at which location the demand for a new coffee shop could exist. After that is established, you would create a business plan and conduct an in-depth research of the market environment, what the competition is doing and how you would get an advantage. What follows is the cost analysis, financing options and so on. To sum it up, there would be plenty of planning and analyzing before you sell your first coffee.
People take it for granted to do those things before they start their business. In trading however, there are unfortunately plenty of traders who think that it is not necessary to have a trading plan. There are numerous benefits of having one though.
First of all, a trading plan will confront you with the question why you are trading in the first place. It is important that you know the answer before you start this endeavor. Some people want to make a living from trading, while others just do it as a hobby and to get some extra income.
There is nothing wrong with that either. It is just important that you realize what it is exactly that you want out of the market, so that you can set realistic goals.
Look at the trading plan as your personal roadmap. It outlines all your goals that you have in your trading. The hobby traders might be satisfied with a few hundred dollars per month. Their roadmap would be how to get to the point of having a decent extra income, and perhaps, how to incrementally increase it.
Other traders aspire to become professionals, and have bigger goals. For them, it is even more crucial to have a plan and a clear vision of what they want to achieve.
The point here is: Every type of trader will benefit from having a trading plan. Perhaps it will be a bit less detailed for the hobby traders, and more complex for the one’s aspiring to become professional traders.
Nevertheless, having a personal roadmap makes it easier to identify what kind of trader you are and what risk profile and strategy suits you best.
A few key benefits of having a trading plan:
- It can bring order and structure into your trading
- It can help you manage emotions better
- It helps you analyze your results more efficiently
- It helps you make better observations about your behaviour / skills / strategy
Another important question to ask yourself is: What kind of trader am I? Are you more comfortable trading short-term or do you prefer medium-term to long-term trading? It is important that you find out what suits you best.
Of course, you don’t have to know the answer immediately, and your preferences can change with time. This is a situation where a demo account can be very helpful, as you can practice there without risking any money.
Ask yourself – what is my risk profile? You don’t even necessarily need to have trading experience to answer that question. Some of us are natural risk takers, and when we hear the word “risk” we associate it with “opportunity”.
On the other hand, there are people that are risk averse, and prefer to limit their risk to the lowest possible level. It is important that you recognize your risk profile. Then you can adjust your risk management techniques accordingly.
The next question is about your trading strategy. You must be able to explain your strategy in detail and know its strengths and weaknesses.
But it is not only about strategy – it’s also about your edge. What are the personal traits that can make you a successful trader? Identify your own strengths and build your trading style based on that.
Further, you must evaluate your results constantly. Analyze every individual trade you took. Did you follow your plan? If not, why?
How often you need to evaluate your results depends on your trading style. Intraday traders should do a daily review of their trades, while for long-term traders, it might be sufficient to do a weekly review.
The last question is – what will I do to improve? After you have analyzed your performance, you should know what you did right and what you did wrong. You cannot be a perfect trader.
Losses are part of the game. However, by analyzing your performance, you can identify some errors and weaknesses that perhaps can be eliminated or reduced. The same applies for winning streaks – build on your strength.
2. Structuring A Trading Plan
After covering the importance of having a trading plan, we will now discuss its structure.
It must be mentioned again that a trading plan is a personal document. There is no correct or incorrect way of creating one. It should at least cover some key topics, but the structure of the trading plan depends on the preferences of each trader.
Therefore, the content of this article should merely be considered as examples which could help in the process of creating a trading plan.
Furthermore, please keep in mind that a trading plan changes continuously, as you might switch to a different strategy or increase/decrease your risk appetite. A trading plan is not something that is written once, and then left in its original form forever.
- Explain why you are trading and what you wish to achieve with it
- You may express your goal as number (x amount of profit) or something else (e.g. being financially independent, building a business)
- Remind yourself why you are investing so much time and effort
- Set some important risk management criteria for yourself
- Define the maximum risk you are willing to take per trade
- To avoid overtrading, you may set a maximum number of trades you want to take per day
- To avoid an excessive drawdown, you may limit it by defining the maximum number of consecutive losses you are willing to take
- You may apply the RRR rule in this case (Rest, Reconsider, Restart)
The purpose of the 3R method is to help you calm down and prevent emotional trading. After a series of consecutive losses, you may feel upset and want to make up for the losses as quickly as possible.
Unfortunately, this may result in even larger losses. If you follow the 3R rule, you will have time to think about what went wrong and to look at the market objectively again, not as your enemy.
Keep in mind that the numbers in the table above only serve as an example. An active trader who has i.e. 20-30 transactions a day might not see three consecutive trades as a major issue. A day trader might set a higher number of trades for this purpose.
However, someone who trades off the Daily Chart and has only a couple of trades per month, three consecutive losses might be high. Every trader needs to define for him/herself what level of drawdown he/she is willing to risk.
Finally, there is the minimum risk-reward ratio. If you decide your stop and take profit orders in advance, this is very simple to calculate. Some traders set their minimum risk-reward ratio as 1:1.
This means that if they are considering opening a trade that – according to their analysis – might generate 60 pips in potential profit, they are not willing to risk more than 60 pips either. If the trade would require a larger stop, the trader may decide not to take the trade. The idea behind this is not to risk more than the expected return.
3. Building Your Trading Strategy
Each trader should try to identify his/her edge. This might be a set of skills that the trader possesses. Some traders might have a short attention span but are quick with numbers and can handle the stress of intraday trading extremely well.
On the other hand, a different type of trader may not be able to function efficiently in this kind of environment but could be a skilled strategist who can always keep the bigger picture in his/her mind.
For beginners it is especially important to identify your skills and suit your trading strategy to your personality, not the other way around.
How could the description of a basic trading strategy look like?
- Example 1: Buy if the 5-day moving average crosses above the 20-day moving average and the RSI is below 70.
- Example 2: Sell if the 5-day moving average declines below the 20-day moving average and the RSI is above 30.
This is a simplified example that contains two of the most popular technical indicators. The trader who may use this strategy could potentially see the MA crossover as a sign that momentum is building – either to the up- or downside.
He/she might have added the RSI (Relative Strength Indicator) as an additional filter, as the trader wants to avoid buying a currency pair when the RSI is showing overbought conditions or selling a currency pair when the indicator is showing oversold conditions.
They could even come up with the idea to add further indicators to prevent trades in a low volatility environment, like the Average True Range (ATR) or the Bollinger Bands.
The logic behind this could be the following: The 5-20 DMA crossover may signal that the current trend could extend further as momentum is accelerating.
However, the trader does not wish to take trades in a low volatility environment as this may decrease the quality of the signals.
The example above is a simplified one. A more detailed description of a trading strategy may include:
Very few traders find the right strategy straight away. The majority will spend a significant amount of time testing various strategies in a demo environment and/or back testing. Even if a trader gets to the point where he finds a strategy that has promising results and feels right, it is unlikely that he/she will stick with that exact strategy for an extended period of time. The markets are evolving constantly, and so are traders and their preferences.
4. Managing Your Trades
After having explained the importance of having a trading plan, given an example of the structure and looked at building a strategy, we will discuss:
- Trade Entry
- Trade Management
- Trade Analysis
How a trader manages his trade entries will mostly depend on his trading style. Scalpers will not have much time for planning, and will make many intuitive decisions.
On the other hand, swing traders may end up never using market orders and solely relying on limit orders. As with the trading plan, there is no correct or incorrect way of entering a trade – much depends on the trading style and strategy of each trader.
However, it may prove beneficial to define your entry criteria carefully and add filters. You can start by defining your trade signal, trade entry and additional rules if needed.
A simplified example might look like this:
Trade signal: Buy if the 5-day moving average crosses above the 20-day moving average and the RSI is below 70.
Trade entry: Buy on the open of the next candlestick that follows after the crossover.
Examples for Additional Rules:
- Only enter the trade during the European trading session (for example, if the strategy has statistically proved to be most successful during this trading session)
- Avoid certain days (for example, not trading JPY during Japanese Public Holidays)
Scalpers might need to manage their trades with a lot of discretion, but in general, a lack of proper trade management rules can lead to emotional decisions such as closing out a trade too early or adding to losing positions.
The simplest method is to add a fixed stop and take profit order at the time you are opening a trade. If you see that the market has turned and the reason why you entered the trade is no longer valid, you may decide to close earlier.
However, for beginners it might be difficult, as they could end up closing trades too early. In the worst case, a trader might constantly take profits too early, but leave the losing positions running in the hope that the market will turn in his/her favor again.
Therefore, beginners might find it easier to set stop and take profit levels in advance, and stick to them. If you get stopped out way too often, you have to review where you place your orders and/or if your strategy is still functioning.
A trading journal can be a good addition to a trading plan. There, you can log all of your trades and add comments – e.g. what went well or what went wrong.
With time, you may discover valuable information and learn from your constant observations.
When analyzing a trade, you want to look at how you entered a trade, how you managed it and how it was closed (manually or triggered by a stop/take profit order).
Furthermore, you want to identify if you made any mistakes or broke your own trading rules. However, do not focus only on the negative parts – it is important to make note of your success as well, as you may learn new things and can use it to improve your strategy.
It could be useful to review your trades and update the journal during the quiet times. For example, if you trade during the European session, you may do this after the EU session closes.
- Having a trading plan is important if you are serious about trading
- It will help you become more organized and help you with analyzing your results
- You should have a strategy ready and describe it as detailed as possible
- You should have personal goals and know why you are trading
- Manage your risk with risk management rules that suit your strategy
- Analyze your trades – sometimes you might find clues that could help you fine-tune your strategy
- Don´t forget – a trading plan is not something you write in one day and stick to it indefinitely. It will change, just as you will change as a trader.