At Trade Nation we don’t set out to educate. We know there are plenty of people out there who can do that better than us. But if you’ve spent any time on our website, you’ll know that we talk about the importance of a trading plan. So, we thought we’d save you some time by putting down our thoughts on why it’s so important, and what should be in it.
Why have a trading plan?
Having a trading plan is like reading a map before starting a journey. It will help you get to your destination. There’s nothing to stop you setting off without knowing your route. But it does make life a lot harder.
In contrast, a trading plan provides a framework to help you identify which markets to trade, when to take profits and when to cut your losses. It instils discipline and so helps take emotion out of trading. Once discipline is lost, you’ll be much more likely to trade emotionally. Fear, greed, hope and anger can cause havoc and lead to disastrous trading decisions. But if you’ve planned your trades in advance you can stay composed, no matter what the market circumstances.
What’s in a trading plan?
The starting point is deciding what kind of trading would suit you best. For instance, day traders will never hold a position overnight and are likely to trade multiple times during a session. They are constantly watching the markets to spot short-term trading opportunities and may be in and out of a market multiple times in hours, or even minutes. They will be quite happy to risk $50 to make $50, operating on a low risk : reward ratio. Day trading is certainly exciting, but also time-consuming. So, it’s not for everyone.
In contrast, trend traders may keep a position open for weeks or even months. They study charts to identify a major trend in a market, whether up or down. Then they look to trade in the direction of the trend until there’s an obvious change in direction.
Swing traders are similar, although they are prepared to initiate trades that go against the underlying trend, hoping to profit when markets correct after a significant move. Both would hope to make maybe three to five times as much profit when compared to their risk.
Meanwhile, position traders are really long-term investors. They tend to ‘buy and hold’ company shares, looking to build a portfolio and reinvest dividends. They don’t trade on margin, so they don’t employ leverage. Consequently, spread trading and CFDs are of little interest to a position trader, unless they’re looking to hedge an existing position.
Now let’s turn to money management. This is a fairly simple consideration with the first action being to identify how much risk capital you have. This most certainly is not money for day-to-day spending, or for the mortgage, or for your pension, or that put aside for emergencies or even for holidays. Risk capital is money that you can afford to lose.
Once you’ve decided how much you are prepared to risk, it’s important to divide up this capital into smaller packages. After all, you don’t want to hazard everything on just one or two trades. Some traders say you shouldn’t risk more than 5% on a single trade. A few say the percentage can be higher, but most would recommend that it’s lower, maybe 2% or even 1% per trade. Whatever you decide, it’s important to keep any losses at manageable levels. In this way they won’t hurt you, emotionally or financially, even if you have a series of losing trades.
How you decide to split your resources will depend on the amount you have to trade as well as your own attitude to risk. The more risk capital you have, the more you can divide it up. This in turn will give you more trading opportunities. Overall the aim is to keep losses manageable, so you still have enough risk capital to continue trading. Then you will find it easier to run your winning trades and look to lock in bigger profits. Doing this consistently over time is the key to successful trading.
It will also help with another essential part of your trading plan - developing clear instructions for the size of your trades in relation to the amount of money in your account. Once you’ve decided on how much you’re willing to risk on each trade, you have to apply this limit every time you discover a trading opportunity. We’ll illustrate this point with an example:
Let’s say that you have trading capital of $5,000 and you decide that the maximum you’re prepared to risk per trade is $100, or 2%. Now, perhaps you have been following the UK 100 market - it’s trading around 7,355 and trending upwards. You do want to buy the index just not at current levels.
Instead you identify a buying level around 7,320 while a good selling opportunity comes in around 7,400. You believe that is an area of resistance, marked by the inability of the index to break above this price. You now have the potential for a trade. You decide to put on a limit order to ‘buy’ at 7,320, you aren’t buying at current levels but setting a limit at the price you are prepared to pay. You also attach a sell order to your limit order which will be a take profit at 7,400 – potentially an 80-point gain.
You have already decided that you will risk no more than $100 on the trade, so you could simply put an order to buy $10 per point at 7320 with a stop 10 points below for a risk of $100. But this takes no account of how the UK 100 may swing around even if the overall upward trend remains in place. In fact, the chart tells you that the UK 100 could fall back to 7,300 where there is a major support level, and the upward trend would remain in place. You decide to put a stop in at 7,295 – 25 points below opening level. To make sure your risk is around $100, this would mean opening a trade of $4 per point, at the most. You may decide to be more cautious and limit it to $2, hopefully keeping the potential loss to $50 (assuming no slippage).
Now you have a limit to buy $2 per point to open at 7,320
You have attached a limit to the opening order to sell $2 per point, to take an 80-point profit, at 7,400
And you have attached a stop loss to sell $2 per point at 7,295 should the UK 100 move against you.
You have decided to trade $2 per point, so your risk is around $50 with a profit target of $160
This gives you a risk : reward ratio of around 1 : 3.
So, you have used risk and money management together with some technical analysis to plan a trade.
Bear in mind, that while in this example you’re risking $50 of your $5,000 risk capital (or 1%), you will use $732 of your trading capital (7,320 x $2 x 5%) as initial margin on the position. Consequently, there will be a limit on the number of trades you could have open at any one time even with a healthy $5,000 of risk capital.
Choosing your levels
Good risk management involves using orders such as stops and limits to help you plan your trades. But how do you decide where to place these orders? This is important. After all, these are the levels that you’re choosing to open and close your positions which will determine whether your trade is profitable or loss-making.
You need to be able to identify significant price levels, and this is why it’s important to have some knowledge of charts, drawing tools and technical indicators. Charts will help you identify areas of support and resistance which will be invaluable in helping you decide where to enter and exit a trade. If these terms are all new to you then it is worth putting in some study at this point. This is an enormous topic and well beyond the scope of this blog. But here are a few pointers to help you get started.
Charts will help you identify if a market is trending or ranging. A market can trend upwards or downwards, and it’s generally believed that it’s never a good idea to trade against the prevailing market trend. However, ‘swing’ traders look for trading opportunities that can go against the major trend if they believe the market is ‘overbought’ or ‘oversold’.
If a market isn’t trending, then the chances are that it’s stuck in a range. This means that it will tend to fluctuate between two price levels which can be close to each other or far apart. As the market approaches the higher end of the range, known as resistance, then traders look to sell. When it falls towards the lower end of the range, known as support, then traders look to buy.
Trading the range can be very profitable, and it’s also useful in identifying market tops and bottoms so you can avoid buying or selling at the wrong time. Identifying these areas of support and resistance is vital in deciding where to place your stop losses – that is, orders to close a position when the market falls below significant support or rises above significant resistance.
The Trade Nation platform has charts for all available markets and a host of technical indicators and drawing tools. These can help you decide whether a market is ranging or trending, while highlighting significant areas of support and resistance. All this will help you to decide on suitable trading opportunities that fall within your risk appetite.
Keep a trading diary
When you start trading it’s vital to go in with your eyes open. Nobody speculates with the aim of losing money. But it does, and will happen, even to the best traders. It’s a good idea to write down all the elements of your trading plan and what you did every time you trade. Why you chose a particular market; were you trading with the trend or within a range; how you chose your opening, take-profit and stop-loss levels; was the trade profitable or not and if this wasn’t your first trade, did you do something different this time? This will give you something to refer back to when you are trading.
Keeping a diary will help determine what went right and should be repeated, as well as what went wrong and should be avoided. By documenting the process, you learn what works and what doesn’t, and this will help you avoid expensive mistakes.
A trading plan which includes strict rules for money and risk management is the cornerstone of a long and profitable trading career. Trading may not be for everyone. But you can only know if you do some basic research and take the time to trade, perhaps beginning with a practice-and-learn account.
Study the charts while keeping abreast of fundamental factors that can influence markets. The latter will include economic and geopolitical events. Don’t risk too much on a single trade and never trade with money you can’t afford to lose. Having a trading plan and employing solid money and risk management techniques will help you maintain your mental as well as your physical health. This in turn could help in opening up the really exciting, and hopefully profitable, world of trading to you.