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12 Steps Toward A Winning Trading Plan

05/11/11 11:04:15 AM PST
by Barry McCarthy

One step at a time: That's all it takes to build a trading plan you can profit with.

Developing, refining, and adhering to a detailed trading plan is one of the most rewarding decisions you can make as a trader. You are running your own business, whether part time or full time, and trading should be treated as such.

Most business failures occur due to poor or a lack of planning, and trading is no different. Imagine how insane it would sound if the CEO of a profitable business told you he no longer felt the need to keep company accounts of revenue and costs, that he felt there was no point in thinking about current or future strategy, that he had decided that the company would open in new markets without doing any research or cash flow projections, and that from that point on there would be unlimited blank checks available for all new projects. Insane? Yes! Yet that same insane thinking is brought into the financial markets by the majority of traders. Is it any wonder so many fail?

A trading plan is a business plan for your trading. It maps out every aspect of your trading journey. Every trader will have a unique plan that evolves for as long as he or she chooses to be in the markets. Only 5% of traders ever create a written plan, estimates show. Is it any wonder that most studies conclude the failure rate in trading can be over 90%?

A well-defined and implemented plan has numerous benefits. It results in a dramatically higher probability of success, better decision making, less stress, reduced errors, more effective risk and money management, improved risk/reward ratios, enhanced performance analysis, and greater overall discipline and professionalism.

It can be difficult to create a trading plan, as there is a lot of subjectivity involved in the process. To help with the design and development of your plan, I have created a 12-step approach to guide you.

Step 1: Conduct an overall analysis of your current resources, capabilities, and beliefs about trading

1A Conduct an inventory of your resources

  • Do you have an adequate amount of capital with which to trade comfortably?
  • Can you commit enough time to trading? Can you commit regular time to research/study and trading -- for example, can you give trading your full attention from 7 pm to 8 pm on weekdays?
  • Are you mentally committed to do what it takes to become a profitable trader? What are your greatest skills and strengths to help you achieve this goal?
  • Are there any possible challenges, limitations, or conflicts that may make trading more difficult for you? How will you overcome those?

1B List your current beliefs about trading. Remember, you don't trade the market; you trade your beliefs about the market.

Step 2: Define your trading goals and objectives

2A What do you want out of trading? Be clear on the bigger-picture reasons why you want to get involved in trading.

2B Make a list of the trading goals that you will work toward achieving. These can include process-oriented goals and results-oriented goals, such as:

  • Process-oriented goals. I will follow all my trading signals and not break any of my top five trading rules; I will develop a low-risk trading system that produces consistent profits.
  • Results-oriented goals. I will target a trading profit of $85,000 this year.

2C Make a list of your trading objectives toward achieving your goals. Some examples would include improving your risk/reward ratio from 1:3 to 1:4, improving your win/loss ratio, or reducing the number of times per month you break your trading rules.

Step 3: Decide on your activity level and trading style

3A How actively do you plan to participate in the markets? Will you be daytrading, scalping, swing trading, position trading, medium- to long-term trades, spread trading, or using arbitrage? Make sure your system is adequate for the time frame you plan to trade and the actual time you have available for trading.

3B What trading style fits your personality and resources? Mechanical or intuitive? Look at the way you make decisions in everyday life, and that will help you decide on your trading style. Always match personality to your style! If you need lots of information and analysis before making decisions, then a rapid-fire intuitive style may not be appropriate for you.

Step 4: Trade execution and other software

4A How will you execute your trades? Will it be via telephone or online, contract for difference (CFD), spreadbetting, or direct market access? Conduct a thorough analysis of your options and determine a method of execution that best suits your requirements. Compare your options under various criteria that are important to you and only then make an informed decision.

4B Decide if you will need any other software. Does your trading style require premium charting services, technical analysis systems, high-end data, or analytics -- that is, Bloomberg, Audio Squawk services, commercial trading newsletters?

Step 5: Gain the market knowledge required to make effective trading decisions

5A Invest the time to learn about the macro factors affecting the markets. Interest rates and monetary policy, central bank announcements, the yield curve, inflation, economic reports, geopolitical events, major overnight news stories, and risk on/risk off. Integrate these concepts into your plan.

5B Develop the required specific knowledge for the product you wish to trade. Conduct a full analysis of any product you are planning to trade. You should discover all the possible factors that influence the movement of its price or have the potential to do so, study it technically and work out its price patterns, find out what its typical daily trading range is, know where it is traded and how it is quoted, what hours it trades, what its price limits up and limits down are, conduct a scenario analysis for various events and decide how the price may be affected and what your action would be, find trading edges for the product that will allow you to have a higher probability of successful trades, and find any other indicators you think may lead the price of the product.

5C Learn and understand how to conduct technical analysis on the trading product you have chosen. Decide if you want to use any technical indicators to signal your trade entry and exits.

Step 6: Decide on your weekly routine and trading tasks

6A Routine. Whether you plan to trade for an hour a week or 12 hours a day, it is important to write down your routine and aim to keep to it. Successful trading is all about developing consistency in your approach to the markets. This allows you to learn and improve much faster. Even if you only have one hour a night, try to maintain the same hour consistently. Then break down the hour into what you actually will be doing -- your trading tasks.

6B Trading tasks. These are unique and specific to the individual trader. They are the list of procedures you need to do in order to trade successfully. For example, you may spend 15 minutes analyzing the charts looking for areas to work your limit orders the next day, or you may spend 30 minutes a day analyzing your trades and keeping a trading journal.

Step 7: Define your system of trading

7A Describe the system and justify why you believe it can be profitable.

7B What product(s) will you trade?

7C What time frame are you planning to trade?

7D What signals will cause you to enter the trade?

7E What are your trading edges?

7F How will you decide where profits need to be taken?

7G Where will you place your stop-loss on each trade?

7H What risk/reward ratio are you aiming for in each trade?

7I What is your expected win/loss ratio per trade?

7J What are your five golden unbreakable trading rules?

Step 8: Develop a robust risk and money management plan

8A Preserving and maintaining your trading capital is the most important factor in your trading. Without capital, you don't have a business. How many dollars or percentage of your equity are you willing to risk per trade/per day/per week/per month/per year? For example, I will not lose more than 4% of my account equity in any week. If you plan to trade daily, then have a strict maximum daily downside limit. If you are a part-time trader, the same should apply but on a weekly basis. Sticking to these limits is arguably the most important thing you can do as a trader.

8B What happens if you keep losing money? Decide at what point you will have to conclude your methodology is flawed and needs redevelopment. Remember, without trading capital you don't have a business. At some point it may be best to go back to a risk-free demo account until you have refined your methodology into a profitable one.

8C Many great traders feel profit retracement limits help them keep trading profits. When on a good run of profitability, traders can move away from their trading plan, overtrade, become too aggressive with position size, ignore rules, and suffer a general breakdown in discipline. Having a maximum percentage retracement limit or maximum dollar amount to retrace will act as a protective measure on profitable runs.

8D Always know your worst-case risk scenario. If a major geopolitical event or market crash occurred and all your positions were stopped out, what would your worst-case exposure be? Are you happy with the level of risk? Would you have enough capital left to continue trading?

8E Managing your trading account balances. Know in advance what your maximum limits are. In addition, some profits should be drawn out of the account as a protective measure. Anything can happen.

8F Emergency procedures. What would you do if your computer crashed or your broker's system crashed? Do you have a set of procedures in place for all possibilities?

Step 9: Develop an effective position sizing plan

  • Position sizing refers to the part of your plan that controls how much you want to trade. An effective size rotation plan is a core component of any profitable trading strategy. Many of the greatest traders tend to rotate their trading size based on opportunities that present themselves. Many brilliant traders spend 90% to 95% of their time trading one to three units of risk per trade and then rapidly increase this to 10 or even 20 units of risk when the time is right and the probabilities are stacked in their favor. It's important to state what your position sizing plan is in advance of trading. Mismanagement of position size/leverage is one of the main reasons that traders get wiped out! So give some serious thought on this point if you want your trading business to be profitable over time.

Step 10: Design the metrics to measure your trading performance

10A Keep a trading journal or diary. This will help you learn from your mistakes and give you a clearer focus. Make notes in the journal as you trade and then summarize those notes when you finish trading.

10B Develop a system to review your performance over certain time intervals. It can be daily, weekly, or monthly, depending on how actively you trade. It may be helpful to record all your trades in a spreadsheet. This way, you can easily aggregate your data and measure your performance based on your own metrics.

10C Generally, the more profitable you are, the more time you spend on analysis of your performance. New or unprofitable traders spend next to no time looking at what they did and why they did it. The very best traders may spend up to a third of their allocated trading time to analyzing their performance. There is a strong correlation between the level of profitability and how much time you are willing to spend on analysis and improving your trading performance.

Step 11: Research, innovation, and new trading edges

  • No system, indicator, or edge will last forever. A crucial part of running a successful trading business is to accept this fact and commit to a constant search for new edges, better indicators, and innovative ways to make low-risk profits in the financial markets. It may be helpful to write down your research goals as this will allow you to focus on what's important.

Step 12: Conduct a regular review of your trading plan

  • A trading plan is never finished. It will always be a work in progress as long as you trade. It can always be improved and refined. It is vital to conduct a periodic review of every part of your plan. I would recommend that at the end of each month you carry out a full review of your performance and trading plan and make improvements where necessary.

Congratulations! That is, if you have committed to developing an effective trading plan. You are in the estimated 5% of traders who actually do! Your chances of long-term profitable trading have been given a dramatic boost. I wish you happy and profitable trading!

Barry McCarthy

Barry McCarthy is an independent futures trader and senior lecturer in financial trading at Independent Colleges, Dublin.

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