Learn How to Make a Trading Plan
Without a trading plan, we’re just gambling in the markets. Learn how to make a trading plan, and put the edge in your favor.
Before taking on an endeavor, it is wise to have a plan. A plan is critical, and when trading there are multiple reasons for having one. One of the best reasons for having a trading plan is it requires you to educate yourself about the market, acquiring knowledge on trading basics and strategies before a plan can be written. Additionally, having a plan takes much of the emotion out of trading…you know exactly what to do, how, and when. We can’t get rid of our emotions entirely, but the plan helps us control them so they aren’t destructive.
The plan also gives us objective feedback on whether our style of trading is working or not. If there is no plan it is very hard to determine what was profitable and what wasn’t after many trades. You may find yourself asking “Why did I take that trade?” With a trading plan, you always know why you took a trade.
Making decisions randomly means there is no research behind what we are doing, it is just an impulse or whim. Trading in such a way is like taking out a boat out with no paddles and hoping the current takes us to the right location. It is gambling. There is no defined “edge” which is proven to make a consistent income. Each whim has a chance to work out, and may even work out several times in a row, but luck eventually runs out. We need a plan we can test rigorously and practice. The trading plan gives you your edge. Before making a trade, make a trading plan.
What is a Trading Plan?
A basic trading plan is composed of three basic sections: Entry Rules, Exit Rules, and Money Management. All three aspects work together to create a system that suits your personality and that you can actually adhere to. Rules that you continually (or even occasionally) break are useless. Therefore, before delving into the entry, exit and money management rules take a “personal inventory.” It is upon these decisions the rules of your trading plan are built.
- Which market will I trade? Stocks, options, futures or forex? All are viable, but not the same. Each market has different starting capital requirements/recommendations and when they are open for trade varies (what time of day can you trade?). Pick one, and stick with it. Don’t try to learn all markets at once. Put some thought into it now, so you don’t feel you wasted your time later.
- What are my time restrictions? If you work during the day, day trading will likely be difficult (but not impossible). It may be better to focus on a trading strategy where you can look for trades in the evening and put your orders out for the following day. This is called swing trading. Decide when you will look for trades and/or when you will place trades. Build your plan around it. Forex and futures trading are open around the clock, making them a more flexible alternative than stocks.
- What are my capital restrictions? As indicated above, markets have different starting capital requirements/recommendations. Stocks tend to be the most capital intensive for trading. Trade the market you are interested in. Capital is a factor though. Don’t trade a market if you are under-capitalized (where the smallest position will result in too much risk). Under-capitalizing will become clearer when we discuss money management in the next section. If you are under-capitalized for the market you want to trade, wait until you have more capital (you can still build your trading plan and practice it in a demo account, though).
- Preferred time frame, goal, and personality? These may seem like different questions, but they are all linked. Consider all three when deciding what you want to achieve, how long you want your trades to last (approximately) and what style of trading likely suits your personality best. Here are some things to consider. Successful day traders (open and close trades within the same day) and swing traders (trades lasting one day to a few weeks) have greater income potential than longer-term investors. This because capital can potentially grow each day, resulting in rapid compounding. That said, short-term trading can result in rapid losses if you don’t know what you are doing…but that is why you are making this trade plan!
What you want to do and your personality may not align. If you like the idea of long-term investing but are constantly looking at stock quotes and strategizing short-term trade setups, you may have a problem when it comes to the more “hands off” approach of longer-term investing. If you want to actively trade, then do so, and build your plan around it. If you don’t want to be active, and taking a hands-off approach aligns with your goals, then build your plan around that.
With the decisions about how and what you will trade out of the way, we can move onto the rules.
Entry rules tell you why, how, where, and when to enter a trade. Exit rules determine how, why, where, and when you exit a trade (for profit and loss). Money management is the most important aspect, as it controls risk. Superseding the other two elements, if a trade is too risky based on the money management rules, don’t take the trade. It doesn’t matter how much money you make if you are willing to lose it all on a few trades.
How to Make a Trading Plan: Money Management
In creating a plan it is easiest to start with Money Management rules. The trading plan is built from the ground up based on your personal financial situation. A potentially winning strategy that involves too much risk means the strategy is useless. Strategies must be tailored to individual needs and resources. Therefore, start out by stating how much capital you have to trade.
No more than 1% of capital should be risked on a single trade. Once a strategy is proven profitable, this can be increased to 2%, but typically successful traders (who last) keep risk below 1% per trade. If a trader has $25,000 in trading capital, $250 is the maximum risk per trade ($500 if risking 2%). This is accomplished through position sizing…a key element to understand in trading.
This is why money management supersedes entry and exit rules. If the risk is too large the trade can’t be taken. The amount of capital at risk is determined by the number of shares taken (for the stock market), multiplied by the price difference between the entry point and stop loss price for the trade (covered in next sections).
As capital grows, the dollar amount risked on each trade will grow. This is because 1% of $30,000 is greater than 1% of $25,000. So your percentage risk always stays the same from trade to trade, but as capital grows the dollar amount you risk becomes more, potentially resulting in larger dollar gains as well. If capital shrinks due to losses, the dollar amount risked on each trade will diminish (although the percentage of the account at risk stays the same).
It is common for professional traders to risk less than 1%, especially once the account grows large. A $1,000,000 account holder may not want or need to risk $10,000 (1% of capital) on a trade and therefore only risks $2,000. In this case, the maximum risk is not a percentage of capital, but rather a fixed dollar amount which is less than 1% of total capital.
A forex account with a $700 balance can only risk $7 per trade. To keep the risk to that level requires trading micro lots (the smallest unity of currency available for trade), likely on a short time frame (day trading) until the capital grows (see: Forex Day Trading with $1000 (or less).
Money Management rules may also include trading “curbs”, such as daily stop losses or a “loss from top”. A trading curb is a provision you create which stops you from trading if a certain amount of money is lost in a single session (hour, day, week, month, etc). A “loss from top” requires you take a break if you have lost or given back a significant amount of profit. Daily stops and loss from tops are typically used in day trading, but not so much in swing trading or investing.
What if you are in a trade and you see another one? The money management section of your trading plan should provide a detailed description about having multiple positions and how these positions are managed. Can you have multiple unhedged positions, or only multiple hedged positions? How do you determine if a trade is considered a hedge? How is your trading capital determined when you already have multiple positions on the books – do you still calculate 1% of total capital (balance), or only non-exposed capital? Think through all these scenarios and write down how you will manage your funds before, during and after trades are completed.
These may seem like inconsequential (or overwhelming) questions, but if you plan on trading for a consistent income, or to build your account over the long run, they are important. There is no right or wrong answer, but I will provide some guidance on what I do.
I will take up two highly correlated positions, risking 1% in each. Highly correlated means assets that move together. So buying Ford stock and GM stock would be considered a highly correlated trade (when they are moving together; they don’t always). I could buy both (if my entry rules provided signals to do so–discussed next), risking 1% in each, but I would avoid any other trades that move like Ford or GM.
No matter how you set up your personal rules, remember the goal is to limit risk. So taking a bunch of trades in highly correlated stocks or assets, is the same as risking huge amount in one stock/forex pair/future. Create guidelines to avoid that scenario. To see if stocks are correlated, you can punch them into this correlation tracker tool.
As for how I calculate my capital, I use my Balance for calculating my 1%. So if you have a $10,000 balance calculate the 1% based on the $10,000, even if you have 4 or 5 other trades already in play. While some of those open trades will end up being losers, some should likely be winners, helping to keep the overall balance at (or near) $10,000 or higher, just as an example.
How to Make a Trading Plan: Entry Rules
Once you know what your maximum risk is per trade, develop entry and exit rules.
Entry rules thoroughly outline what has to happen in order for you to enter a position. This sequence of events may include specific price movements, chart patterns, statistics, indicators or any other variable that you feel puts you on the right side of the market. Include in the entry rules section whether you will trade one side of the market or both (long and/or short); what overall market conditions have to be present (or not present) to enter a trade; are there times you will not take a signal? Are trades taken as soon as a signal occurs, or is there a delay such as taking the position at the end of the day, the following morning, or when a price bar completes? What chart time frames will you monitor (see Forex Trade Time Frames and Trend Strategy)?
Ask all these questions and then incorporate the answers into a detailed entry plan. For some ideas on entering trades see Engulfing Candle Strategy, the Daily Range Strategy, Day Trade Trending Strategy, and How to Spot Trend Trading Opportunities.
I personally gravitate toward similar style strategies. They may change a bit based on whether I am day or swing trading (you can do both, just stipulate how you will do both in your trading plan), but the theme is usually the same. I prefer trading pullbacks to an area I can see. This could be a trendline, Fibonacci retracement area or the mid-band of a Keltner Channel. I would classify myself as a trend trader and price action trader. All my entry signals come from actual movements in price, not indicators (even if an indicator is on my chart, it never actually signals the trade). The Forex Strategies Guide eBook covers many of these price action entry techniques, as does the Stock Market Swing Trading Video course.
Keep it simple and easy to remember; in the heat of the moment you have to be able to act on your plan. If it is too complex you’ll have a tendency to freeze or make mistakes.
How to Make a Trading Plan: Exit Rules
Exit rules meticulously outline exactly what has to happen for you to exit a position you are already in. Such rules may include price movements, chart patterns, indicators or a reversal of the original signals which triggered the entry. This section outlines how and where a stop loss is placed. A stop loss is an order that gets you out of a losing trade if a certain price is reached. In this section also decide if you’ll use profit targets–an order that gets you out of a profitable trade when a certain price is reached.
Additional factors to consider: Will you use trailing stops (move stop loss as the price moves favorably in your favor)? How? Under what conditions will you exit a trade before the price reaches your stop loss or profit target (this is called “active trade management”)? Why and How? Will you exit your trade at end of bar/day/week or the instant a trigger occurs? On what chart time frame will your exits be based?
Ask yourself all these questions and then incorporate the answers into your exit rules.
My main exit rules are relatively straightforward. I always use a stop loss order. For most strategies ,it is placed just below a recent swing low when going long, and just above a recent swing high when going short.
I pick a price target that is within reach based on normal market movements. I then check to make sure that the profit target I’ve chosen is more than my risk. I look for profit potential to be at least 1.5x times the risk or more (for day trading) or preferably 2x or more (for swing trading). Notice the order of those events–I pick my target first and then see if it is larger than my risk.
I do incorporate active management into my trading. I set a stop loss and target at the outset of the trade, but I won’t always let the price reach my profit target or stop loss. I may close out the trade early, or allow the trade to make more profit. This is also planned out beforehand, using a concept I call “trading beyond the hard the right edge.” That concept is discussed in the later sections of the How to Day Trade the Forex Market (concept applies to all markets).
How to Make a Trading Plan: Tying it Together
Your basic trading plan is complete. Now it is time to practice implementing. To pull all together means you will likely need to a do some experimenting and research before you can even a compile a plan. Once the plan is complete, test the plan for profitability in a demo account, before trading real capital. Let’s look at a trade example you may come across as you begin testing your trading plan.
You have chosen the stock market and can risk a maximum of $250 per trade based on your $25,000 in capital (adjust accordingly). You see a trade setup that aligns with your entry rules in stock ZZXX which trades at $20.00. The charts, your analysis and your exit rules determine that you should place a stop loss at $19.50, thus exposing you to a potential $0.50 downside move in the stock. At this point you may also want to look at what your potential profit is, to make sure the potential profit even warrants the trade. Say you determine a reasonable profit target is $21. If the target is reached you’ll make $1 per share, and only risked $0.50 to get it. Your reward is 2x your risk, so the trade is a go.
From this, you can then determine how many shares to buy (your position size) so your risk remains below $250. By purchasing 500 shares, if your stop loss is hit, you will lose $250 plus commissions and fees (if applicable). If commissions/fees are a factor reduce your position size slightly.
The trade is then managed by monitoring the exit rules. If an exit rule is triggered, exit in the way outlined in your plan. If other trades come along they may or may not be entered based on the provisions provided in the trading plan.
How to Day Trade Stocks looks at a number of these factors for day trading the stock market. It describes entries and exits and is best used in conjunction with only risking 1% of account capital.
Revising Your Trading Plan
As you begin implementing and practicing your trading plan in a demo account, you will realize you have overlooked certain things. Your trading plan tells you what to do, and situations will arise where you are questioning what should be done. When this occurs it’s because there is a hole in your trading plan…you’ve missed something. Define what you are missing and then state in your plan how you will handle that situation should it occur again.
In the initial few days and weeks there could be lots of revising before you come up with something that is functional. Once you have something that is functional, avoid excessively revising it. Instead, trade it for a month or more and see what the results are. Based on the results, you can then make some revisions. Then go through the same process again with the revised plan. If you opt to do this on your own, it can be quite time-consuming. Using someone else’s strategies and formulating a trading plan for them may speed up the process…but you still need to test out the plan to make sure it is profitable for you.
How to Make a Trading Plan: Summary
A trading plan is a way for you to objectively trade the markets in a way that suits your individual personality and financial situation. It outlines everything that needs to happen for you to enter a trade, as well as everything required to exit the trade. Both these elements are governed by money management rules that keep the risk on each trade below 1% of your trading balance.
By Cory Mitchell, CMT.