The Importance of Having a Perfect Trading Plan
The Importance of Having a
Perfect Trading Plan
When approaching a field like forex trading where personal decisions translate into profits or losses, having a well-outlined and easy-to-follow plan can make the difference between success and failure.
Having a plan to be successful in any field of endeavor is highly recommended, but trading the forex or any other financial market without a plan is almost a sure recipe for failure. Having goals set in advance and knowing when to get out of a trade make up an important part of successful forex trading. Remember, a trade must be liquidated in order for a profit to be realized. Virtually every successful trader in the markets depends on some sort of plan or guidelines for their success. Here we’ll go through the basics of a forex trading plan, the advantages with one and the importance of keeping it.
If you want to know how to develop a forex trading plan, read this.
Advantages of Forex Trade Plans
Having a trading plan before starting to trade is much like having a map before starting to travel. Would you take a trip without knowing how to get where you are going? Trading in the forex without a trading plan, even if you have experience trading in a demo account, can be a challenging experience once real money is on the line.
Basically, having a trading plan helps traders treat trading forex more like a business. Most people interested in forex trading already know that anyone running a business generally requires a business plan in order to have an organized basis from which to achieve greater success.
Furthermore, the objectivity and clarity that a good trading plan provides can be a real boon when needing to make quick trading decisions to take advantage of opportunities that may arise in the often fast moving forex market.
However, the main advantage of having an objective and well thought out trading plan stems from the fact that it gives the trader an opportunity to trade objectively and therefore with greater confidence and less emotional involvement. When engaging in a risky endeavor such as forex trading, having enough confidence to return to the market after taking an emotionally-draining loss can ultimately be the determining factor between success and failure. Read more on self confidence and forex trading here.
Emotions Can Create Havoc When Trading Forex
Rules in the trade plan help traders keep trading psychology and emotional responses to trades at a minimum. One sign of a successful trader consists of an undaunted attitude regardless of market direction or lack of it. The savvy trader seems to be composed no matter what the market circumstances.
Common human emotions like greed, fear and hope can cause serious trouble when trading, so having a good way to manage them when they inevitably arise can help you overcome many common forex trading pitfalls. Read more on trading psychology here.
Many traders have lost their entire account because of the lack of discipline to follow their trading plan. Once discipline is lost when trading, the trader will then be much more likely to trade emotionally and can potentially incur devastating losses as a result. We’ll come back to this later in this article.
Accordingly, for the best chances of success when trading, remember to prepare yourself before you begin to trade by planning your trades objectively and then proceeding to trade your plan as strictly and calmly as possible.
Both successful Forex and Futures Traders Use Trade Plans
How successful traders behave becomes most readily apparent on the floors of the major futures exchanges where thousands of people trade a multitude of different financial instruments, currencies and commodities in a central location or trading pit. Traders of all types find themselves on these exchange floors – day traders, scalpers, spreaders, option traders, as well as brokers executing orders for clients.
The frenetic activity, which appears chaotic, in reality occurs in quite an orderly fashion in the transacting of trades. The wild gesticulating actually arises from traders and clerks using hand signals to communicate with each other and to service the off-floor traders on the phone or out of earshot.
Yet very few, if any of the successful traders on those floors trade without a trading plan. The plan helps them make sense and order out of the apparent chaos.
Not only does this fact generally hold for exchange floor traders, but it applies to off floor traders too. Basically, the market does not play favorites and can be equally unforgiving to all participants, so those who have a proven trade plan tend to survive, while those without one do not.
Overall, a good trading plan will help you
- Identify your goals
- Organize your market research and trading activities
- Decide when to take a position and in what direction
- Manage your emotions and trading risk once you enter a position.
The Trading Plan
A trading plan to a trader is much like a road map to a traveler. The road map shows a traveler where they are and how to get to where they are going and it gives them an overall trade strategy to follow.
While some trading plans seem complex, developing a trading plan does not have to be difficult, and the complexity can be decided by the developer. A basic plan which is easy to follow and incorporates clear technical trading signals is what most traders attempt to achieve when developing a plan.
Elements to Incorporate Into a Trading Plan
Most trading plans typically contain certain important elements. These might include such things as:
- Profitability goals
- How to determine the size of positions
- How to manage positions once taken
- Objective criteria that the trader will use for selecting, entering and exiting trades
Also, the trading plan should provide for an adjustment in trading strategy depending on the type of market conditions observed.
Avoid Circumventing Your Trading Plan
The aforementioned benefits to having an objective and proven trading plan can more than compensate over the long run for the time it takes to develop, test and then implement a decent forex trading plan.
Nevertheless, even armed with this understanding and a good plan for trading, some forex traders find themselves short circuiting their own potential trading success by circumventing the decision making process laid out in their plan.
Such a failure on the part of a forex trader to follow their own trading plan can easily be a cause for the eventual demise of their trading account.
Circumventing the protections placed into your trading plan might arise from the emotion of greed, especially in the case of failing to take profits appropriately. Alternatively, it can be influenced by hope in the case of failing to cut losses when the plan advises that the right time to do so has arrived.
Since your trading plan was developed to protect you from losses in the process of maximizing your potential profits, failing to implement your trading plan faithfully can cost you a considerable amount of money – perhaps even your whole trading account.
Stick to Your Trading Plan For Optimal Success
In essence, if you went to all of the time and trouble of developing a decent trading plan in the first place, the least you can do is follow it when trading.
Not following your own trading plan that is intended to protect both you and your trading account would tend to beg the question of “why are you trading to begin with?”
Losses of trading discipline may also be a sign that you are not yet consciously or unconsciously psychologically prepared for trading forex. Basically, forex traders generally require considerable personal discipline for the best chances of success in the long run.
Accordingly, for the best chances of success when trading, remember to prepare yourself before you begin to trade by planning your trades and then proceeding to trade your plan.
Keeping a Trading Journal
In addition to the trading plan, a daily journal of trades makes up another extremely useful tool for a forex trader to help them further hone their talents.
Keeping a journal of all of their trading activities allows the trader to look back at both winning and losing trades to determine what went right with the winners and hence should be repeated, as well as what went wrong with the losers and hence should be avoided.
Building the Perfect Master Plan
No two trading plans are the same because no two traders are exactly alike. Each approach will reflect important factors like trading style as well as risk tolerance. What are the other essential components of a solid trading plan? Here are 10 that every plan should include:
1. Skill Assessment
Are you ready to trade? Have you tested your system by paper trading it, and do you have confidence that it will work in a live trading environment? Can you follow your signals without hesitation? Trading the markets is a battle of give and take. The real pros are prepared and take profits from the rest of the crowd who, lacking a plan, generally give money away after costly mistakes.
2. Mental Preparation
How do you feel? Did you get enough sleep? Do you feel up to the challenge ahead? If you are not emotionally and psychologically ready to do battle in the market, take the day off—otherwise, you risk losing your shirt. This is almost guaranteed to happen if you are angry, preoccupied, or otherwise distracted from the task at hand.
Many traders have a market mantra they repeat before the day begins to get them ready. Create one that puts you in the trading zone. Additionally, your trading area should be free of distractions. Remember, this is a business and distractions can be costly.
3. Set Risk Level
How much of your portfolio should you risk on one trade? This will depend on your trading style and tolerance for risk. The amount of risk can vary, but should probably range from around 1% to 5% of your portfolio on a given trading day. That means if you lose that amount at any point in the day, you get out of the market and stay out. It’s better to take a break, and then fight another day, if things aren’t going your way.
4. Set Goals
Before you enter a trade, set realistic profit targets and risk/reward ratios. What is the minimum risk/reward you will accept? Many traders will not take a trade unless the potential profit is at least three times greater than the risk. For example, if your stop loss is $1 per share, your goal should be a $3 per share in profit. Set weekly, monthly, and annual profit goals in dollars or as a percentage of your portfolio, and reassess them regularly.
5. Do Your Homework
Before the market opens, do you check what is going on around the world? Are overseas markets up or down? Are S&P 500 index futures up or down in pre-market? Index futures are a good way of gauging the mood before the market opens because futures contracts trade day and night.
What are the economic or earnings data that are due out and when? Post a list on the wall in front of you and decide whether you want to trade ahead of an important report. For most traders, it is better to wait until the report is released rather than taking unnecessary risks associated with trading during the volatile reactions to reports. Pros trade based on probabilities. They don’t gamble. Trading ahead of an important report is often a gamble because it is impossible to know how markets will react.
6. Trade Preparation
Whatever trading system and program you use, label major and minor support and resistance levels on the charts, set alerts for entry and exit signals and make sure all signals can be easily seen or detected with a clear visual or auditory signal.
7. Set Exit Rules
Most traders make the mistake of concentrating most of their efforts on looking for buy signals, but pay very little attention to when and where to exit. Many traders cannot sell if they are down because they don’t want to take a loss. Get over it, learn to accept losses, or you will not make it as a trader. If your stop gets hit, it means you were wrong. Don’t take it personally. Professional traders lose more trades than they win, but by managing money and limiting losses, they still make profits.
Before you enter a trade, you should know your exits. There are at least two possible exits for every trade. First, what is your stop loss if the trade goes against you? It must be written down. Mental stops don’t count. Second, each trade should have a profit target. Once you get there, sell a portion of your position and you can move your stop loss on the rest of your position to the breakeven point if you wish.
8. Set Entry Rules
This comes after the tips for exit rules for a reason: Exits are far more important than entries. A typical entry rule could be worded like this: “If signal A fires and there is a minimum target at least three times as great as my stop loss and we are at support, then buy X contracts or shares here.”
Your system should be complicated enough to be effective, but simple enough to facilitate snap decisions. If you have 20 conditions that must be met and many are subjective, you will find it difficult (if not impossible) to actually make trades. In fact, computers often make better traders than people, which may explain why nearly 50% of all trades that now occur on the New York Stock Exchange are generated by computer programs.
Computers don’t have to think or feel good to make a trade. If conditions are met, they enter. When the trade goes the wrong way or hits a profit target, they exit. They don’t get angry at the market or feel invincible after making a few good trades. Each decision is based on probabilities, not emotion.
9. Keep Excellent Records
Many experienced and successful traders are also excellent at keeping records. If they win a trade, they want to know exactly why and how. More importantly, they want to know the same when they lose, so they don’t repeat unnecessary mistakes. Write down details such as targets, the entry and exit of each trade, the time, support and resistance levels, daily opening range, market open and close for the day, and record comments about why you made the trade as well as the lessons learned.
You should also save your trading records so that you can go back and analyze the profit or loss for a particular system, drawdowns (which are amounts lost per trade using a trading system), average time per trade (which is necessary to calculate trade efficiency), and other important factors. Also, compare these factors to a buy-and-hold strategy. Remember, this is a business and you are the accountant. You want your business to be as successful and profitable as possible.
10. Analyze Performance
After each trading day, adding up the profit or loss is secondary to knowing the why and how. Write down your conclusions in your trading journal so you can reference them later. Remember, there will always be losing trades. What you want is a trading plan that wins over the longer term.
Successful practice trading does not guarantee that you will find success when you begin trading real money. That’s when emotions come into play. But successful practice trading does give the trader confidence in the system they are using, if the system is generating positive results in a practice environment. Deciding on a system is less important than gaining enough skill to make trades without second-guessing or doubting the decision. Confidence is key.
There is no way to guarantee a trade will make money. The trader’s chances are based on their skill and system of winning and losing. There is no such thing as winning without losing. Professional traders know before they enter a trade that the odds are in their favor or they wouldn’t be there. By letting their profits ride and cutting losses short, a trader may lose some battles, but they will win the war. Most traders and investors do the opposite, which is why they don’t consistently make money.
Traders who win consistently treat trading as a business. While there is no guarantee that you will make money, having a plan is crucial if you want to be consistently successful and survive in the trading game.
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