Every trader should devise a trading plan before they place their first trade. A trading plan is basically a set of guidelines that the trader will follow to enter, exit and manage their trades.

Without a trading plan emotions take over and can wreak havoc on even the best trading idea when the market does not proceed exactly as expected. Trading on emotion in most cases results in losses, as emotions are triggered at points where you feel panic, a sense of loss or greed. A trading plan, while it does not totally eliminate the emotions of a trader, will provide the ground rules with which to act in all situations. Thus the trader will not be acting emotionally but following the guidelines of a well prepared plan that has been prepared and tested while the mind is calm and rational.

A trading plan also provides critical data on where money is being lost or made. If trades are randomly made, it becomes very hard over time to gauge with accuracy which entry, exit, and money management techniques work and which ones don’t. A trading plan, if followed, will allow the trader to quickly see where weaknesses are and correct them.

Developing a Simple Trading Plan

There are 3 basic components to a trading plan and they are: Entry Rules, Exit Rules and Money Management. Entry rules are guidelines as to how you will enter trades. The rules will stipulate you only enter a position when a certain combination of price action, volume, indicators, or time factors occur. Exit rules are basically the same, except that they apply to exits. The rules will stipulate that trades are exited when a certain price or maximum loss is hit, a trailing stop (a stop that moves up as the security moves up in price) is triggered, a profit target is reached, or a certain combination of price action, volume, indicators and/or time factors occurs. Money Management deals with how much you will risk on each trade and your position sizes.

Creating Your Trading Plan

All areas of the trading plan must work in harmony with one another. Entry rules should provide the trader with a reasonable expectation of profit for the risk taken on. And the exit rules will limit the risk of any trade so that no greater than 1% of capital is lost on a single trade. Entry and exits are tied to money management which allocates how much of the traders capital will be placed on each trade and how the amount of capital used will change as the traders account balance changes.

Entry rules are the simplest and normally the most focused on aspect of trading, but are probably the the least important. A great entry is only as a good as the exit and how the position is managed. Much information can be found on entering positions so it will not be focus on it here. Refer to the Strategies sections of this site for some trading ideas.

Exit rules can be very simple or quite complex. Each trader will have to decide for himself which approach is best. There are basically four ways to exit a trade – stop, trailing stop, profit target, or a combination of indicators (includes price, volume, indicators, and time). Exits are designed to keep you from taking too large of a loss or giving back too much profit. A maximum loss point should be thought out before the trade and a stop loss put in place at the time of the trade. This is the most you are willing to lose on trade. Once the trade is placed, under no circumstances should you pull your stop or make it larger. If a long position is entered based on technical analysis, quite often a stop is placed just under a previous support level. For shorts a stop is placed just above a previous resistance level.

If the instrument you are trading becomes profitable then you have several options on how to exit with a profit. A trailing stop is used by many traders and can be quite effective. Lets say you had a original stop loss of 30 cents. Once the instrument has moved up by 30 cents from your purchase price, you move your stop to your purchase price. You continue to move your stop up behind the price of the security, trailing it by 30 cents. In this way, if the stock moves up a dollar and then falls back down, you will lock in a profit of 70 cents. This is a simple approach and can be implemented on almost any trading platform.

Other exit strategies might include a profit target. Profit targets can often be estimated, especially if you use chart patters in your entry signals. Profit targets can also be used using fundamental data. For instance, if you buy a stock that has a lower P/E than the average in its sector and you believe it is undervalued, you would take profits when the P/E of your security reaches the average of its sector. If you choose to use profit targets, simply place an order to offset your trade at the price you expect the instrument to go to. A guide to establishing profit targets based on chart patterns can be found in the Technical Analysis section of this site.

The trader may also choose to use a series of indicators to exit a position. If an entry is based on a certain set of condition, then one could exit when those conditions no longer exist. Although, this does not have to be the case. An exit based on indicators can be used no matter what the reason for the entry.

The bottom line is develop rules that limit your losses to a small amount of your capital on a per trade basis, and once you have a profit, give it room to continue to move in your favor but lock it before things turn back around.

Money management is the most often overlooked aspect of trading. Thus it is no wonder most who try their hand at trading go broke – they simply fail to manage their money. Your money management rules will dictate how much of your capital you will use on each trade and thus the amount of shares/contracts you will take on a given instrument. One major money management rule, is don’t risk more than 1% of your capital on a single trade. That does mean you can’t use all your capital, it just means you need to have a stop in place. Keeping this in mind, the trader must also keep his/her money management rules in sync with the other rules. For instance, if a trader has a $10,000 trading account the most he/she would wants to lose on any give trade is $100. This seems small, but since not all trades will be winners, keeping losses small will keep the trader in the game even if a trading system has a string of losses (which can happen even with the best trading systems). This $100 is the maximum stop that the trader will use for his/her exit rules. An exit point must be placed at or before this amount of a loss is taken. As the capital in the account grows and shrinks, so will the maximum loss allowed. This will keep keep losses very small small during bad times, and allows more room during times of prosperity.

As an example, using the $10,000 account from above, you could purchase 200 shares of a $40 stock ($8000 + commissions). Maximum loss is $100. A different stop could be placed based on proper support levels, but $100 is the maximum loss. The trader uses the maximum loss as his stop. If the stock falls $0.50 to $39.50 the trader will exit his trade, as -$0.50 X 200 = -$100 (not including commissions).

Other Notes

Here are a few other things to keep in mind:

-You should aim for your reward being 3X your risk. If you are willing to lose $100 on a trade, you should reasonably expect it to make you $300 if it works out. If there is too much risk and not enough reward, don’t make the trade.

-Write your plan down and keep it by you when trading.

-Even great trading systems can have strings of losses. Don’t change your plan after every losing trade. Analyze the trade and see how the plan could be improved, but don’t start making changes until you know the plan is flawed. Not every trade will be a winner.

-Keep a journal of your trades. This will make it easy to spot weaknesses in your trading plan over time.

-A trading plan is only good if the trader is disciplined enough to use it. Actually follow your trading plan. The more work you put into it, the more confident you will be in it and the more likely it will be that you stick with it even when things are tough.

© Cory Mitchell 2007

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