The trading plan is a key component in successful trading. Without a plan, it’s pretty hard to know where you have been and where you are going. In 2009 I wrote an article for Stock & Commodities magazine, called “The Trading Plan”. It provided an outline for what a basic trading plan should include: entry rules, exit rules and risk management rules. These general categories contain information on when it is appropriate to trade and when it isn’t, and how big those trades should be.
Shortly after publication of that article I did a ratio interview on a beautiful Saturday morning, on AM560 WIND, with the Director of Trading with the Online Trading Academy in Chicago, Craig Weil. Here is the transcript of that radio interview, where we discuss the trading plan more in-depth. Even though this interview originally took place in early 2010, the concepts are timeless.
Trading Plan Interview with Cory Mitchell
Criag Weil: When people ask me what the number one thing that all successful traders and investors have in common, it doesn’t take me long to come up with an answer. Now, you have heard me say hundreds of times that there are many ways to skin this cat, as there are literally thousands of methodologies and strategies are employed every day by successful traders. There are strategies for all asset classes, for all time frames and for all kinds of markets….up…down or sideways. Now some of you may say, its technical analysis, but of course the fundamentalists would scoff at that notion. Some of you might say patience or discipline, and that would be true to a degree. No one is going to succeed without it, that’s true. But, you can display great patience and discipline and still not make money.
You may have even discovered the greatest investing strategy since Warren Buffett was in diapers and back tested it thousands of times to eye-popping results, but unless you can implement that strategy properly, and have a plan for it, you will fail.
And just as no business will get funding or succeed without a business plan, no trader or investor will consistently make money in the markets without a trading plan.
Joining us now for a discussion on trading plans is someone who knows a lot about the topic. Cory Mitchell is an independent Trader and founder of Vantagepointtrading.com, a free educational website devoted to helping traders learn about and succeed in the markets.
Cory has written numerous articles for several publications including Investopedia and Technical Analysis for Stocks and Commodities Magazine, and it was his featured article in their March issue that compelled me to invite him to the show today. The title of Cory’s article is simply “The Trading Plan” and in it Cory has artfully articulated why I think this is an extremely important topic. I am thrilled he could join us today. Cory, welcome to Traders Talk Live!
Cory, before we get into our topic today, let’s get a little background on you and your trading experience…
1. Where did it all start for you? How did you get hooked on Trading?
CORY: I have been trading since 2005 full-time, and what probably hooked me was when a professor I had in university introduced me to technical analysis. The idea of looking at charts and visually trading based on actual price levels appealed to me much more than dealing with a lot of numbers. I went on to work for 2 proprietary trading firms in Canada… trading stocks… and then a year ago I also began trading the Forex Market as it is open 24 hours and allowed me more freedom to trade at night which is when I prefer to trade. I am also a Chartered Market Technician, member of the Canadian Society of Technical Analysts and the Market Technicians Association and definitely love the technical side of trading.
CRAIG: OK Cory, there are many components to a successful trading plan and we don’t have much time so we had better get going.
Now, as I alluded to in your introduction, I feel having a plan may be the single most important ingredient for success. So much so that at online Trading academy we actually have a one day class dedicated to it.
Now, a trading plan is not just reading some books and opening an account, and sometimes…the new trader succeeds at first without a plan… and thus don’t think they need one…
Ex-floor traders are especially guilty of this when learning to trade electronically.
2. But we shouldn’t fool ourselves right? You call it random reinforcement… What is that?
CORY: Random reinforcement it prevalent in many things…including life in general…it means that we can do something wrong, and be randomly rewarded for it simply because the market is so dynamic. This misleads people into believing they can beat the market without a plan simply because they win on a trade every so often–but it is a short-term phenomenon. This random element reinforces bad habits because it gives an occasional profit while emptying out the trading account over the longer term. It baits a lot of people into losing a lot of money who don’t take the time to really think through their plan.
3. So where should someone start? Do we need a methodology first, or does the plan come first? The chicken or the egg? We really have to have some idea of what kind of trader we want to be, right?
CORY: Yeah. We do not need some idea of what kind of trader we want to be. It is likely best to start out by balancing our personality and desire to trade in a certain way …with our current circumstance. By this I mean…it is very hard to be an active day trader… if the person also has a full-time job. So we need to be realistic about what and when we will trade. From there…we can begin to develop strategies that cater to our lifestyle, personality and the particular market we have chosen to trade.
CRAIG: Cory, You have broken the trading plan down into 3 parts: Money Management, Entry rules and Exit Rules, so let’s address each of these specifically…and how our plan will not work without mastering them all.
First off, you call it Money Management, I call it risk management.
It seems obvious that we should be concerned about this, but so many traders overlook it. First, we have to determine what our maximum loss will be on each trade, but every trader has different risk tolerances and equity.
In fact our primary goal shouldn’t be to make money, our primary goal should be capital preservation. Our secondary goal should be to make money.
4. what is a good rule of thumb as far as what to risk on a trade?
CORY: Many traders think of a dollar amount first when considering risk. And I think that can be dangerous. It is better to gauge risk as the percentage of the entire trading account which is being risked on each trade. The amount that is risked on any given trade should be 1-3% of the trading account. From my experience, traders that last it seems lean toward risking a very small percentage of total capital on each trade…therefore, we should risk only about 1 % of our capital on a trade.
Although, as our accounts grow we will find that we risk less and less percentage wise. A $500,000 account trader does not risk $5000 on every trade [especially on a day trade]…no way…the risk may be only a couple hundred. So when this occurs, and percentages are no longer useful, a trader will normally use a dollar risk,, less than 1%, such as $300, $500/trade or whatever the case may be. [For more on this topic see Proper Position Sizing]
CRAIG: And speaking of rules, rules are really what this is all about right, Cory?
5. Can we have a trading plan without written rules?
CORY: We can’t articulate our plan if we have none.
The rules should to be written down. If they are not written down we have no idea what has made money and what hasn’t, because we can’t remember what exactly we did on each trade over the last month or year – and chances are, if someone doesn’t take the time to make a plan, they aren’t going to take the time to write down each trade in detail either…but if we have a plan we will know what is working and what isn’t…and we can fix it by altering the trading plan.
6. And our rules have rules. Don’t we need a contingency plan for every situation?
CORY: Yeah…We need to know how we, personally, are going to respond to a situation. The market can go crazy and we don’t need predict every movement, but if we have a well laid out plan we will know how to handle our current trades based on current conditions. So yes, our trading plan takes all the guessing out of what to do while in a trade – it lays out our course of action no matter what occurs.
CRAIG: Lets talk about entries and exits, your other two keys (See Forex Strategies and Stock Trading Strategies). Most people concentrate on entries and don’t really consider exits right? But that is where our profits or losses lay. Anyone can get into a trade, but it is getting out that is really going to carry the day.
7. In your opinion…what are the most important rules or steps we should have for exits?
CRAIG: The first thing is we should always have a stop loss in place. This stop is what limits our risk to a very small percentage of our total account mentioned earlier, the 1-3% or less, or our set dollar risk per trade, mentioned earlier.
CORY: We can also exit a trade with profit targets. Profit targets based on logical technical analysis allow the trader to see exactly what they can expect in return for the amount of risk they are taking on. If a reward likely won’t outweigh the risk…the trade should be avoided.
I generally use multiple profit targets and exit part of our position at each different target [I don’t typically do this as much anymore…I usually just get out all at once, but occasionally I still get out in stages]. Using stops and profit targets lets me know exactly what my risk to reward ratio is before the trade even takes place, and I will talk a bit more about this when we talk about position sizing.
CRAIG: OK Let’s talk about position sizing is and why this is so important. I think this is a difficult concept for a new trader to get. Most people think that they should have a default quantity on every trade but that is dangerous, especially if you trade different equities every day.
People think they can make up a stop “I only will risk 10 cents or 50 cents” or whatever, but not all trades are the same. A stop should be based on some data or criteria like time right? And once you determine a proper stop, that will dictate your positions size.
8. Can you give us an example of proper positions sizing works and what kind of exits you use in your trading?
CORY: Sure, First let’s assume we have a $10,000 trading account. I will try to keep the numbers simple. Risking 1% of 10,000 on this trade means we can risk $100. And let’s say we want to buy a stock at certain price – we look and see at what price this trade would be proven wrong. Let’s say there is a support level 30 cents below our entry, and this is where we place our stop. Since we know our stop is 30 cents, we divide the $100…the total we can risk on the account… by our 30 cent risk on the trade to give us our position size. In this case we can buy 333 shares, or 300 when rounded down. We now have a logical stop in place and an ideal position size…
From there we need to look at our charts and determine a proper profit target. For me to actually take this trade there would need to be some chart formation or something logical and tangible (not emotional) which would indicate this trade would make me at least 1.5 to 3 times my risk level. In other words, I need to reasonably expect that I will make 45 cents or more (preferably 60 or more), for my 30 cent risk. [for day trading I expect at least 1.5x, and for swing trading I expect 2x or greater].
We can do this by having one target, but generally I set multiple profit targets because we can take a quick profit on part of the position but the last portion of the trade can be left to really ride for a bigger profit….of course it does not always work out as planned, and that’s ok, that’s why we try to make more on profitable trades than we lose on the ones that go bad.
CRAIG: Having a trading plan will allow us to review our trades and correct our problems. But many students, especially those that have been trading a while, don’t really care to put in the time to review their mistakes and reinforce their rules.
9. What do you say to those people who don’t want to take the time to write down their rules and review their mistakes?
CORY: It may sound harsh but the financial markets require that there are winners AND losers (see: Why Most Traders Lose Money and Why the Market Requires It). The people who lose over the long run are the ones who don’t put in the time to plan out and review their ventures in the markets. If you do plan and review, you have a much better chance at success.
CRAIG: Thanks, Cory Mitchell, for joining us on Traders Talk Live today.
After Thoughts to the Trading Plan Interview
To me, the concept of random reinforcement is one that deserves repeating. The market moves so much that we are bound to be right some of the time, even with no plan. But without a plan, over the long run we will lose, and may end up making the same mistakes over and over again because we have no record of how we were trading in the past. Don’t let the market lure you in. If you are making trades by the seat of your pants, and it seems to be working, enjoy it, because it won’t last. Isolate what is working, and then solidify a trading plan by writing everything down. If things aren’t working, and you don’t have a plan, make one!
Question 6 also deserves a bit of extra attention. I talk about knowing what to do in every situation, because pretty much anything that can happen (big drop, big rally, little drop, little rally, moves sideways) has been planned for and we know how we will act if any of those situations arise. This is where some new traders get stuck. They think trading should be exciting and highly emotional. Most of the time, trading is pretty boring, especially with a trading plan. When trading doesn’t feel like how it looks on TV or in movies, the new trader thinks something is wrong, and starts gambling to create some excitement. Overall, emotions should be pretty subdued when it comes to successful trading and following a plan. It is still fun, I love it, but if you are chasing emotional highs, trading is not the proper place for that. The market will give you plenty of highs…and even more lows if you are chasing a rush and gambling (no plan).
Craig’s comment in question 8 is also very important, saying many traders “don’t really care to put in the time to review their mistakes and reinforce their rules.” This is true, and every trader is guilty of it at some point. May be things are coasting along, we get cocky and stop doing our work or slack off on our rules…and WHAM! The market will let us know we are off our game. It our responsibility to asses the situation and get back to our winning ways. No one is going to do it for us, and the market rarely allows us to just coast along for long. To trade successfully takes regular work and sticking to our trading plan. And when our trading isn’t working (and we are sticking to it) it is our job to fix it. For more on trading plans, see Learn How to Make a Trading Plan.
By Cory Mitchell, CMT
My Stock Market Swing Trading Video Course has everything you need to start swing trading stocks effectively and efficiently. Learn the patterns to look for, how to find those patterns, what to trade and what not to trade, how to get in and out, and how to manage your risk. More than 11 hours of video shows you all this, and more.