Lesson 2 - The Importance of a Trading Plan
“A trading plan is just words until you act on it.”
This lesson will also introduce you to the key topic of risk management and stop losses.
A trading plan is a very simple document, a piece of paper or card on your desk that gives you a list of exact rules that you are allowed to trade by. It defines what you can do, when you can do it and how you should do it.
It doesn’t have to be too detailed, but it should at a minimum cover several key components:
- Entry and exit rules for trades
- Risk / reward (where your stop losses and take profit targets go)
- What you need to be wary of
Often, a trading plan might look like a series of diagrams and example charts with a set of rules and a checklist for entering a trade depending on the strategy.
The point of a trading plan is to add discipline to your trading, to remove some of the emotional subjectivity and to ensure that you follow the rules you know work for you.
Your documented plan will change and adapt as you learn more and change your style accordingly. Throughout this course, you will probably add to the document, change it and modify it. But for now, the most important thing is that you must ensure you have that document, be it on a piece of paper (even if it’s currently blank), an accessible document on your computer’s desktop or even a tattoo on your hand. Just make sure you have something.
If you already have a strategy, then you can complete a draft of this document now (and congratulations: you are already better organised and have more chance of success than most retail traders).
This trading plan document should be a roadmap to trading, defining what you do and how you trade, so treat it well. Make sure it stays by your side at all times, and never trade without it.
Finally, two rules about a trading plan:
- Don’t ad lib - if it’s not on the plan you can’t do it!
- Don’t make it up – nothing goes on the plan until it’s been tested thoroughly!
Below is an example of a trading plan
Example Trading PlanWhy am I trading?
What is my approach?
What are my goals?
- Long Term
What markets will I trade?
What timeframes will I trade?
What setups will I trade?
Where will I place my stops?
Risk Management rules:
Pre-market activities or routine:
Post-market activities or routine:
What tools will I use for my trading business?
Continuing education/ adaptations:
My Trading Rules:
Introduction to Psychology
The first point, which cannot be stressed enough, is that it is vital for traders to find a strategy that suits their personality, rather than trying to change themselves to fit a particular strategy. A number of strategies will be outlined in later lessons.
Too many traders fail initially because they are trying to operate in an unnatural environment. It’s vital to stick to what you are good at. For example, a trader with a short attention span is not well suited to scalping on 15 min charts, as this requires a serious amount of concentration throughout the day. Likewise, a trader who is working full time and only has evenings free is unlikely to do well with intraday trading, as they will miss entry and exit points, and a trader who gets anxious about trades and is liable to stress about them during the day should avoid swing or position trading.
This may sound odd, but a good place to start as a new trader searching for a strategy is to conduct a version of a SWOT analysis on yourself.
This means going through your strengths, weaknesses, opportunities and finally any threats to you achieving your goals of becoming a successful trader.
If you are truly honest with yourself, then this in itself will be a challenge. Just remember that no one needs to see this assessment but you, and you must ensure you are brutally honest with yourself.
Can you genuinely learn complex and complicated techniques for trading? Do you have the necessary time? Does the fact that you need to walk the dogs first thing in the morning threaten your ability to log into the computer? If you made tomorrow’s lunch early in the evening instead of watching TV, could you free up 30 more minutes to study?
This is a great way for traders to paint a picture of themselves and get an idea of what they can realistically achieve. The next step is using this to build a profile and a set of statements that will start to define how, when, where and what you will trade.
Four Types of Traders
ScalpersFirstly, there are Scalpers. These guys (and girls) are in-and-out of the market in rapid timeframes; they are often going for less than 10 pips on a trade. It usually requires the ability to stare at monitors all day and repeat the same process religiously. In many cases, a lot of this style of trading is now part automated. At 10 pips a trade, a key concern for scalpers is cost-per-transaction.
Intraday TradersNext up are the Intraday Traders, characterised by the fact that they seldom hold positions overnight. A normal trade for them is on the 15-minute to hourly charts, with somewhere in the region of 30 to 80 pip targets. They often use alert systems to highlight potential entries or warning signs for exits. These traders are looking for patterns, but will also be focused on more general market sentiment, and are likely to exit a position based on their ‘gut’ feeling for when the market is turning.
Swing TradersThird are the Swing Traders. These are individuals looking to hold positions normally for a couple of days or more, and are therefore running much wider stops and profit targets of typically upward of 100 pips. They tend to be more focused on the daily and 4-hour charts and as always are looking for patterns, though they tend to be a little more rules-based than some intraday traders. A swing trader’s focus is on capturing large movements in the markets and parts of key trends.
Position TradersFinally, Position Traders. These are the guys that will hold large positions for weeks at a time, sometimes technically based, but more often than not based on fundamental reasons. Due to the cost of carrying long-term trades, they are looking for hundreds of pips profits from their positions. Such a trader will also look carefully at carry trade potential.
Knowing these basic personal descriptions of the types of traders above and understanding your strengths and weaknesses should help you to understand where you ought to be focusing your energy.
A big issue for new traders is a lack of understanding about themselves. Often, they try to fit themselves to a strategy that isn’t right for them. Instead, they should embrace who they are and find a strategy that works around that.