Trading plan and its role in trading
Quote on the topic
If you fail to plan, you plan to fail.
Benjamin Franklin is one of the Founding Fathers of the United States
If you make a mistake while trading in the market, then you directly pay for it in the literal sense. For this reason, planning in trading is not just an option, but also a required point of the strategy for achieving a goal. In this article we’ll talk about what a trading plan is supposed to be, in other words, a set of rules according to which a trader acts.
These rules determine the principles of entering the market, the rules for calculating the position size and determining the targets around which it is necessary to exit the market, as well as the role of technical analysis indicators, news and other methods of market analysis when making trading decisions.
If you have a definite trading plan where all possible response options to different market movements are specified, then you will not doubt the correctness of your trading decisions, and the probability of making harmful and emotional trades for a trading account will decrease greatly.
A trading plan along with a trading diary and a trading list will help a trader become more disciplined and it will allow him to use his time, money and nerve cells efficiently.
- What is a trading plan?
- What does the trading plan consist of?
- Point 1. Is it possible to trade in the market now?
- Point 2. In what direction to trade?
- Point 3. How to determine the market entry point?
- Points 4 and 5. How to limit risks and determine the target? How to determine the optimal position size?
- The example of a trading plan for medium-term trading in the market
- Information noise
What is a trading plan?
If a trader does not have a trading plan, then in the long term the probability of losing money in the market tends to 100%. I saw a lot of confirmations of this rule while working in the brokerage business. My first trading accounts also became a vivid confirmation of this. Traders who regularly lose money in the financial markets, most often do not have a trading plan. They open and close transactions by intuition. Or they have a trading plan, but it is ignored at the most inopportune time.
I’d like to note that one of the greatest difficulties of this type of business is to follow a trading plan with discipline. It is enough to ignore it once to destroy trading results of the past weeks or even months. The discipline is the basis of trading, but it will have no sense without a strong plan of actions that determine what can be done or not.
Quote on the topic
Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.
Paul Tudor Jones is a founder of hedge fund Tudor Investment Corporation
A trading plan is a document you have to fill out yourself. It can be in a paper or an electronic form and has to be at hand while trading in the financial markets. It’s very convenient to use Google Docs as your trading plans as well as trading lists and diaries will be available on any device.
Perhaps you are simultaneously trading several trading strategies on trading accounts. For example, medium-term pullback trading on the Daily timeframe is carried out on the first account and trading within a week on the H1 and H4 timeframes is carried out on the second one. In this case it is necessary to make up two trading plans. This will allow you to make each trade decision as carefully as possible and after the trade has been closed, it will let you understand how much this trading operation was consistent with your trading system.
What does the trading plan consist of?
A trading plan must consist of at least five elements. At the same time each of them can be represented as an answer to the question:
- Is it possible to trade in the market now?
- In what direction to trade? (If trading is directed)
- How to determine the market entry point?
- How to limit risks and determine targets?
- How to determine the optimal position size?
This is the «skeleton» of a trading plan, each point of which needs to be specified in detail individually in accordance with the applied trading approach, appetite for risk and the specificity of markets that can be traded. (The example of a trading plan for medium-term trading in the market is presented below).
Not all points of a trading plan are equally important. Some need to be adjusted to your trading style (Points 1, 2 and 3), others can’t be ignored or changed significantly in any case. Otherwise trading on this account will end very quickly and sadly. (Points 4 and 5).
Quote on the topic
— What advice would you give someone in regards to being successful in the markets?
— I think the single most important element is to have a plan. First, a plan forces discipline, which is an essential ingredient to successful trading. Second, a plan gives you a benchmark against which you can measure your performance.
Howard Seidler is a fund manager, TurtleTrader
As a rule, the need to determine clearly your trading system becomes evident when a trader loses the second and rarely the first trading account. In most cases the trading plan is considered as an option: «I already know when to enter and exit the market, I will determine the rules later». After a while, a trader, as a rule, loses the first money and then the «later» (time for thinking about the causes of failures) comes.
In contrast, any professional trader has a definite trading plan. Any book, a podcast or an interview with famous managers is a vivid confirmation of this (excellent materials on this topic have been collected in books of Jack Schwager «Market Wizards» and «The New Market Wizards»).
Let’s examine each element of a trading plan in more detail.
Point 1. Is it possible to trade in the market now?
The first point of the trading plan is the answer to the question «Is it possible to trade in the market now?»
It allows you to understand if it makes sense to analyze this financial instrument. If you can’t trade in the market, then in this case it makes no sense to determine market entry points, keep an eye on smaller timeframes and corresponding news flows or calculate the position size. This is a waste of time.
This can happen when there is no directed trend in the market or it evolves very actively and it’s too late to open a position. When the market fluctuates in a triangle or a flat, it is undesirable to trade (if you just start studying trading in the market and see a triangle or a flat, then it means you can’t trade).
Quite often there are situations when it’s impossible to trade in the market. You had better wait than enter the market just because the trading terminal has already been open and some time has been spent on analyzing the market situation.
The first point of the trading plan must give a clear answer to the question: is it possible to trade now? Your resources pay for its ignoring, namely:
- Time. A trader analyzes in detail the instruments that are basically unworthy;
- Money. If the market is not good for trading now, the probability of negative result increases.
Point 2. In what direction to trade?
If the first point of the trading plan is performed and it is possible to trade in the market, then the following question arises: in what direction is it necessary to trade and what trend prevails in the market – bullish or bearish?
Price patterns allow you to determine the trend direction in any markets and timeframes during a few seconds.
Point 3. How to determine the market entry point?
The third point of the trading plan implies an answer to the question: at what point is it necessary to open a position? What exactly has to happen in order to have a noteworthy signal?
The principles of determining market entry points and trading tactics is a reflection of your vision of trading in the market process. The entry point can be searched on one timeframe or you can use the data of several ones. You can also apply volumes, price and option levels, candle patterns (price action), etc. Each trader gradually accumulates a set of signals and methods of market analysis that are trustworthy and let strictly specify the principles of entering and exiting the market.
Why to specify the rules for entering the market? This allows you to discipline yourself and trade in accordance with the set of rules that is specified in the trading plan and is noteworthy in your opinion.
In directed trading there are two basic principles of searching for market entry points:
- pullback trading indicates the search for a market entry point at the most likely time of a market correction completion
- breakout trading indicates the search for a market entry point at the time of a confident update of the next maximum, an entry in the middle of the impulse wave
Over the past 100 years, thousands of new names for these trading tactics have been born in the directed trading on the timeframes ranging from the Daily to the M1. They often contain any surname or inappropriate words such as «secret» or «author’s». Nevertheless, the basic principles of searching for market entry points do not change. It’s a breakout, a pullback and their combinations.
Points 4 and 5. How to limit risks and determine the target? How to determine the optimal position size?
The fourth and fifth points of a trading plan are combined for a reason.
These are money-management and risk-management rules. They contain the calculation of the optimal position size when entering the market and the principles of determining profit potential and risks in each trade (the risk-reward ratio).
Ignoring these principles in the long term leads to the guaranteed loss of funds in the market.
I have been lucky to work in companies related to trading and to communicate with traders since 2007. During this time I’ve concluded that most traders lose money because they ignore risk and money-management rules (usually out of fear).
Quote on the topic
And then at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.
Paul Tudor Jones is a founder of hedge fund Tudor Investment Corporation
Most traders lose money in the market and most traders do not follow risk and money-management rules. These statements are interrelated. If you analyze actions of new traders, you will see that most often they don’t have points No.4 and 5 in their trading plan or a trader does not follow them. It is enough just once to open a position with extremely big size or not to limit risks with the help of stop order to destroy the fruit of a trader’s painstaking work, in other words, trade statistics and/or capital.
Money-management is the principle of determining a certain position size as certain percentage of capital. Risk management is the risk-reward ratio. Money management and risk management are two most important points of a trading plan, at the same time most traders ignore them or do not realize their importance.
Instead of this, the issues of finding an ideal trading concept occupy the traders’ minds. This concept may allow them to enter and exit the market at the reversal points. This is a search for the so-called «trading Grail».
I’d like to note that the «Grail» exists and it lies in the following a trading plan and risk and money management rules.
It’s almost impossible to destroy a trading account following risk and money-management rules even if you really want it. If the risk per trade is fixed as a percentage of capital (rather than in dollars or contracts) and does not exceed 1-2% per trade, and the average risk-reward ratio in each trade is 1:2 or lower, then destroying the trading account will be an extremely difficult task.
Is it hard to believe? Try to open a demo (!) trading account and try to «crash» it using the parameters described above. You will get tired much faster than the account will be destroyed even if the direction of entering the market is chosen by using an absurd principle that is coins, «heads» and «tails». This will make it clear that the risk-reward ratio and the correct calculation of the position size are more important than the rules according to which you enter the market.
Professional traders pay special attention to risk-management and money-management. This is the basis of trading. If you look at the statistics of traders who lose money in the market, you will see the opposite mirror image. These rules are ignored, but special attention is paid to the first three points of a trading plan (or one of them, most often it’s point No.3). In the search for the Grail a trader often tends to believe that the most important thing in trading in the market is to find the ideal entry point, whereas money and risk management is not necessary. Moreover, I’m sure that this viewpoint destroyed more trading accounts than forex brokers, which do not put customers’ trades into the real market.
The most important thing in trading in the market is not to find the ideal entry point, but to trade following risk and money-management rules. If you just start studying financial markets and accept this as a fact, you will save a lot of time and money.
The example of a trading plan for medium-term trading in the market
- Is it possible to trade in the market now? Is there a triangle or a flat on the Daily timeframe? If so, then we analyze the next financial instrument. If not, we pass to point 2.
- In what direction to trade?
- We plot a market marking. These are key support and resistance levels on the timeframes ranging from MN, W1 and Daily.
- What price pattern has been formed on the Daily timeframe? Is there a bull or a bear trend?
- What do professionals think about the market? We analyze COT net position indicator. If the professionals’ opinion is not combined with the technical picture, the position size is reduced by half in point No.5 (in conservative version of this trading plan the position isn’t open at all).
- Market entry points determination:
- level breakout (Daily)
- pullback from the level (Daily)
- Determination and calculation of risks and profit potential:
- market exit points determination (targets and fixing the risk according to the Daily levels)
- Are risk management rules met? (P:L >= 2:1)
- The position size calculation by the formula. The risk is limited by a stop order or a vanilla option.
The more sources of information surround us, the greater the risk of the negative impact of information noise on trading results is. A trading plan is an effective tool to deal with this problem. Let us take a small example.
Suppose you’ve opened a buy position in the US dollar market. An hour later, you read an analytical review the author of which describes 10 reasons for rapid stop of this currency existence.
You agree with many arguments and begin to worry. The question arises if it is necessary to close a position. The answer is no.
If your trading plan has been made up correctly, then you have recorded entry signals and exit market signals in it. It’s unlikely that such signals will include exit from the market after reading the tapes on Twitter or Facebook.
First of all, the author of the review could talk about the prospects for the next 5-10 years and your position is open for 2-3 days.
Secondly, the author is not the ultimate truth and you should think for yourself. The guide to action is a trading plan.
Thirdly, do not forget that often authors of analytical reviews write them in view of their obligation to write something (this is the work). As a consequence, the author may be glad not to write about the dollar today, but it is necessary as the topic is popular and it is necessary to write something, and the negative always attracts more attention than the positive.
Fourthly, the more actively the market grows, the more pessimists will be in the market. The crowd is more often mistaken than it acts correctly. It is enough to look at the ratio of short and long positions from retail brokers. Often in the bull market, when the price updates the highs during several months, there will be more sell positions than buy positions.
Private traders act like hedgers. Isn’t it an absurd? No, it isn’t. The crowd just acts emotionally, most traders do not have a trading plan and the average risk in each trade exceeds the profit (sometimes several times). Apart from this, private traders are more often averaged in an attempt to guess the market reversal point than they trade the trend, like professional speculators do.
All options for reacting to changes in the market situation should be justified in a trading plan. In this case, you will be no longer concerned about force majeure. Sharp market movements as well as losing trades will certainly occur. However, the risk of negative trends formation will be taken into account in a trading plan and it will not cause default of the trading account. Stop orders do not guarantee transaction execution at the explicit price. Trade risks are fixed most strictly with the help of vanilla options.
Most often, nothing extraordinary happens in the market. And if a trader loses his capital due to the fact that the market has grown or fallen by 5-10%, then the problem is probably associated with the trading plan and ignoring risk and money-management rules, but not due to the performance of one or another Fed official.
Heads of Central Banks and CEO of companies periodically deliver unexpected statements and companies sometimes publish unexpectedly poor statistics. This happens and if such events lead to the destruction of the trading account, this is the reason to think about. Two first books of Nassim Taleb describe very fully the problem of ignoring money-management and risk-management. Traders often stubbornly refuse to see it. The books are called «Fooled by Randomness» and «The Black Swan. The Impact of the Highly Improbable». I strongly recommend them as they really shift the paradigm.
It is necessary to determine in advance where you enter and exit the market. Then force majeure and strange market movements will not have an unforeseen negative impact on your capital. Everything will be pretty clear. This is normal if you are in search and such tools is not available. I recommend you to start studying trading tactics with the classics, that is a breakout trading and a pullback trading.
The first goal of any new trader is to stop destroying trading accounts. And this goal is realized by gradual developing of a qualitative trading plan and following risk and money-management rules.
- Formula for calculating the position size
- Option or stop-loss? Position size calculation when trading options.
- Horizontal levels in traiding – free online course
- Trading with professionals: CFTC reports for private traders