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.
The percentage of day traders that quit within two years, according to a 2010 paper titled “Do Day Traders Rationally Learn About Their Abilities” by Barber, Lee, Liu, and Odean.
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.