What is a trading plan?
Contrary to popular belief, you do not need to know where the market will top and bottom to make money in the markets. In fact, that is where most people go wrong.The best traders in the world realise that neither they nor anyone else knows what is going to happen. Sure, everyone can point out tops and bottoms after the fact, but no matter what anyone tells you or tries to sell you, no one can pick tops and bottoms consistently before the fact.
So how do you make money without picking tops and bottoms?
Plan your way to success
Have you ever really thought about why companies like McDonald’s are so successful? It’s certainly not the taste of their burgers.It’s because they follow a well-tested methodology the world over. The staff in Sydney is following the same regimen as the staff in Singapore. The burgers in Auckland are made the same way as they are in Athens. We can all learn a lot from this approach.
To be successful, you need to treat your trading like you would any other small business. If you were about to invest $50,000–$100,000 to start up a café or a lawn-mowing service, wouldn’t you research the market carefully first? Wouldn’t you write up a business plan? Of course you would.
Trading should be treated the same way – given the same respect if you like.
Your trading plan
A trader’s business plan is known as a trading plan – it defines her approach to trading. A properly constructed trading system will leave no room for human judgement because it will define your plan, given any circumstances that may arise. It is a distinct set of rules that will instruct the trader what should be done and when to do it.The importance of a trading plan cannot be overstated. Without a consistent set of guiding principles to govern your trading decisions, you will most likely hop from one trade to the next, impelled by emotions. By not having a plan, you are planning to fail.
Proof it works
All successful traders that I have come in contact with have written down their exact trading methodology, at one point or another.Have you ever heard the story about one of the most famous system traders of all time, Richard Dennis? In mid-1983 Dennis was having an ongoing dispute with his long-time friend Bill Eckhardt about whether great traders are born or made.
Dennis believed that trading could be broken down into a set of rules that could be passed on to others. On the other hand, Eckhardt believed trading had more to do with innate instincts and that this skill comes naturally.
In order to settle the matter, Dennis suggested they recruit and train some traders and give them actual accounts to trade with to see who was right.
To cut a long story short, Dennis taught his trading methodology to a group of students he named ‘The Turtle Traders.’ This group of traders later became some of the most successful traders of all time, proving that a thought-out and well-documented trading plan is the key to success.
A trading plan is simply a set of rules that addresses every aspect of a trade such as entry and exit conditions and money management. Regardless of how complex it may be, a good test for your trading plan is to hand it to someone else to read thoroughly and then see if they have any questions about it.
If they can easily understand all the rules and requirements of your strategy with little to no questions, then you have compiled a sound trading plan.
*Side Note: It must be recognized that Dennis’ trading method isn’t suited to everyone, with over 60% of all trades taken by the system resulting in a loss. It wasn’t the system that made these traders so successful, it was that Dennis showed them the importance of having a plan and following it
Write it down
Why is it so important to write your trading plan down? Something magical happens when you commit it to paper and, believe it or not, this will be one of the most important things you can do in your endeavour to becoming a successful trader.When you take time to sit down and spell out how you perceive the markets, you are beginning to take responsibility. If the market does not behave according to what you wrote, the only conclusion you can arrive at is that your perception is wrong. Accepting that possibility is a huge step towards maturing as a trader.
When you write down how you are going to enter a trade, based on certain events, you are eliminating any possibility of placing the responsibility on anything else but yourself. Now when something goes wrong, as it inevitably will when you’re learning a new skill, you’re the one to fix it!
Trading plan format
Again – to draw on the business plan analogy – just as there is a standard format for designing any business plan, there is also a format for designing a trading plan.There are three major components within any trading plan: entry, exits and money management rules. Here’s a quick summary.
- Tested entry rules. Entry rules should be a precise set of rules that a tradable instrument must pass before you enter a trade. Entry rules should be simple, direct, and leave no room for human judgement.
- Tested exit rules. Entering a trade is all to no avail if you do not know when to exit your position. Having a set of rules that define your exit is equally as important as a set that defines your entry.
- Strict money management rules. Perhaps the most important and least addressed aspect of trading is the ability to manage risk. A profitable trader is one who has the ability to manage the risks associated with trading. This is achieved with strict money management rules.
The perfect trade entry
Every trader needs a trade entry system. But within each market, there is a plethora of trading opportunities to choose from – I call this the universe of securities. So how do you choose from this vast universe? Simple. Predefine your entry rules.Trade entry rules are a stringent set of conditions that you develop, document and then apply, to decide when you are going to enter a trade. It doesn’t matter what securities you’re trading, you just need a consistent method of entry. Like sifting through a bucket of sand trying to find pieces of gold, the same approach is used to reduce your universe of securities to a shortlist of those that meet your criteria.
Developing your trade entry rules
As in all aspects of trading, there are many theories on trade entry and how to exit trades. I believe the best way to approach entries should be simple, direct and leave nothing to human judgement.This is contrary to the philosophy of many traders who buy stocks based on media reports, ‘expert’ opinion, rumours and/or gut feel. The good news is that by acting contrarily, you will do what most traders never do… make a profit.
Reinventing the wheel
Let’s revisit the example of Richard Dennis and his Turtles. Dennis’ protégés were successful because they were under his direction at all times. Every trade was heavily scrutinised and made according to his strict rules. The students had to follow these rules or be dropped from the project.
The fear of loss forced the traders to follow the system no matter what. In the real world, most people would not have the discipline to do this. And nor should they; it wasn’t designed for them.
Furthermore, the Turtles were trading with someone else’s money. When it’s your own money on the table, you need to be completely comfortable with the decisions you make, and you can’t do that unless your system suits your personality.
Dennis’ students went on to become successful traders in their own right because they learnt discipline from their mentor, not because they continued to trade his system out of the box. They adapted it to suit themselves. And that’s what you should do.
Think of it this way: how many people do you know who have stayed in a job or field of work just because it’s what they’re used to? They may not love it, but they persist just the same.Maybe you’re one of those people. But, while these people might be able to do that job with their eyes closed, they will never excel at it if they’re not passionate about it. Their heart needs to be in it.
Trading is the same. If you’re not 100% behind your trading system, chances are you won’t be able to stick to it, and if you can’t stick to your system, you will never reap the benefits you are hoping for.
Keeping trade entry rules in perspective
Most traders believe the key to success is being able to pick the bottom of the market. This is why 99% of traders spend most of their time fidgeting with the entry; they are looking for that elusive secret, That one setup that will ensure ongoing success.But let me tell you from experience – that setup rule doesn’t exist. And, in actual fact, it’s not that important. Spending countless hours optimising your trade entry rules, trying to find that ‘perfect’ indicator, can actually do more harm than good. Over optimisation based on historical data actually decreases the profitability of your trading system when trading in real-time. Typically, the more you optimise, the less robust your system tends to be.
). He said that the trading system, which includes your trade entry rules, accounts for only 10% of what it takes to be a successful trader. That means, there is another 90% of ‘stuff’ you should be concentrating on, such as money management .
Amazingly, a system can have a very random entry signal and still be profitable as long as money management is in place. Take the following real-life example from Tharp.
Example:
Tom Basso designed a simple, random-entry trading system … We determined the volatility of the market by a 10-day exponential moving average of the average true range. Our initial stop was three times that volatility reading.
Once entry occurred by a coin flip, the same three-times-volatility stop was trailed from the close. However, the stop could only move in our favor. Thus, the stop moved closer whenever the markets moved in our favor or whenever volatility shrank. We also used a 1% risk model for our position-sizing system…We ran it on 10 markets. And it was always, in each market, either long or short depending upon a coin flip… It made money 100% of the time when a simple 1% risk money management system was added… The system had a [trade success] reliability of 38%, which is about average for a trend-following system.
Although a little convoluted in its explanation, this example illustrates that an entry strategy as simple as a coin toss can turn solid profits.Most traders spin their wheels trying to get in at the ‘best’ price, even though this is not where the money is made.
So what’s the take-home rule here? It is easier to copycat your way to success than to try to re-invent the wheel. According to Anthony Robbins, the way to become as healthy as possible is to find the healthiest person you know, ask them how they do it and copy them.
Similarly, the way to select your trade entry rules is to find the best, proven entry system you can for your selected market and model your entry on that system..Sure, you can waste months and spend thousands of dollars testing different methods, but why put yourself through that? Would you rather be a wealthy copycat or a broke trailblazer?
Trading is one of the few industries where people actively share their methods. In other areas of business, people tend to keep their success secrets to themselves; in trading, there are innumerable proven systems and models out there that you can access. Admittedly, you have to pay for most of them, but they are readily available.
So now you have two choices: you can design your own trade entry rules (which includes appropriate back testing) or you can apply a ready-made entry system, confident that someone else has done all the hard work for you.
The better choice seems obvious to me, but I’m not here to make your decisions for you. I’m here to pass on as much information as I can and help set you on a course that will suit your situation.
Going it alone
If you have decided to give it a go yourself, here are a few good rules of thumb to follow. Your trade entry rules should address each of the following:- trend
- liquidity
- volatility
Trend
The cornerstone of technical analysis is the trend. Remember ‘the trend is your friend’ and you always want to trade with it, not against it. I believe this to be the most critical component of any trade entry system. You need a way to measure the trend.There are many ways to identify trends, and as with most things in trading, there’s more than one way to skin a cat. The key is to have a method in place.One of my preferred methods for identifying trending securities is to find securities trading at their recent highs.That is to say, the highest high price must have been achieved in the past x number of days (where x is the variable depending on the timeframe you are trading). The longer the timeframe, typically the higher the variable.
Example:
If I were to trade a medium to longer term approach I might want the highest high price in the past 200 days to have occurred in the past 20 days.I use a charting package called MetaStock
Using MetaStock, the formula would look like:
HHVBars(H,200) < 20
HHVBars(H,200) < 20
Liquidity
Liquidity is an important determinant because you want to be trading securities that you can buy and sell quickly and without moving the market.You never want to be caught in a position where you want out but there’s no one to buy.With liquid instruments, such as the forex market that trades billions of dollars each day, trades are happening constantly, so your activity alone will not move the market. In short, avoid illiquid securities.
Example:
Depending on the size of your float, you might want the average daily trade volume to be greater than $400,000. This could be achieved by requiring that:
The 21-day average of volume multiplied by the closing price be greater than $400,000.
Using MetaStock the formula would look like:
Mov(v,21,s)*C > 400000
Mov(v,21,s)*C > 400000
Volatility
Volatility is simply a measurement of how much a security moves. Not whether it goes up or down, just how much it fluctuates.It is important to trade securities that move enough for you to make a profit. Of course you don’t want securities that are so volatile you can’t get to sleep at night.On the other hand, you don’t want something that moves at such a snail’s pace that it is not delivering the returns you are after.One of my favourite ways to identify volatility is using the ATR method,[1] which indicates how much a security will move, on average, over a certain period.
Here’s how I might use this method. A $10 security might have moved fifty cents per day on average over the past 21 days. I can simply divide this value by the price of the security to calculate the average percentage movement of a security over the past 21 days. With this value, I can stipulate a minimum and maximum volatility value.
Example:
If I were a reasonably conservative trader I might want a security to trade between a band of 1.5–6%. That is to say, I want the ATR divided by the average closing price, over the past 21 days, to be greater than 1.5% and less than 6%.
Using MetaStock, the formula would look like:
ATR(21)/Mov(C,21,S)*100 > 1.5 and
ATR(21)/Mov(C,21,S)*100 < 6
Tip: A great place to start when researching your entry rules is to print out all the trading candidates you would have liked to have traded in the past. Next, mark on the charts themselves where you would have ideally liked to have entered. Finally, look for common characteristics among those entry points – these similarities can form the basis of your entry rules.ATR(21)/Mov(C,21,S)*100 > 1.5 and
ATR(21)/Mov(C,21,S)*100 < 6
Documenting your entry
Finally, as with everything we do, it’s important to document your new trade entry rules. As I’ve said, a good set of entry rules are simple, direct and leave no room for human judgement.Take the trade entry rules discovered through your own research or from your selected program and write out exactly how you will enter a position.This simple act of documentation puts you among the top 10% of traders.Trading money management
Who knows if the market will go up or down? How much will it move? And for how long a trend will continue? In reality, risk management is the only thing you really have control over. That’s why it’s so vitally important to your trading money management strategy.The perfect indicator
Sadly there are no entry criteria that will pick winning trades 100% of the time.As you’re about to find out, it takes more than a good entry to make money in the market.Nevertheless, most novice traders undertake a determined search to find the perfect indicator(s) that will lead them to trading success. Even though the idea of this ‘holy grail’ is obviously far fetched, I too have searched for it.
So why do almost all market traders search for the perfect entry? I believe the reason is a subconscious one. Focusing on an entry point gives traders a false sense of control.
The point at which you have chosen to enter the market is the point at which the market is doing exactly what you want it to do. This can create a sense that you are not only controlling the entry, but the trade itself.
Unfortunately, this couldn’t be further from the truth. The market is going to do what it’s going to do – it doesn’t care for your well-thought-out entry criteria. Repeating what I said just a moment ago, in trading money management risk management really is the only thing you have control over.
In Jack Schwager’s book Market Wizards, Schwager interviewed some of the world’s top traders and investors, nearly all of whom emphasised the importance of money management. Here are a few of my favourite excerpts:
‘Risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade is my second piece of advice.Whatever you think your position ought to be, cut it at least in half. ’-Bruce Kovner
‘Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.’ –Larry Hite
‘You have to minimize your losses and try to preserve capital for those very few instances where you can make a lot in a very short period of time. What you can’t afford to do is throw away your capital on suboptimal trades.’ –Richard Dennis
The difference between winning and profiting
Despite the importance of risk management, I believe traders still under appreciate it. You see most people look at trading as a game of odds. You may be guilty of this too. True, it does involve odds, but odds alone do not tell the whole story.When you look at trading systems, are you someone who only looks at the ratio of wins to losses? After all, it seems logical that a system that generates eight winning trades out of ten is better than one that only has four out of ten… right? Not always.
Let’s take Richard Dennis’ Turtle trading system as an example. This system won 40% of the time and lost 60% – but it was still hugely successful.
You see, it’s not about how often you win, but also about how much you win. Winning and profiting can be two completely different things.
Here’s what I mean: if your system had an 80% chance of winning $100 and a 20% chance of losing $1,000, in the end you are bound to lose everything, despite the fact that you may experience many winning trades. Stringing together eight winning trades, valued at $100 each, followed by a couple of $1,000 losses will guarantee a trip to the poor house.
On the flip side, a couple of $1,000 wins is far better for your wallet than eight $100 looses, as demonstrated in the following scenario about system biases, commonly referred to as expectancy.
Expectancy is just a fancy name for what I have just described.
Expectancy Is Calculated As:
(% of wins x average win size) – (% of losses x average loss size)
So in our example we can see that:
(80% x $100) – (20% x $1000) or $80 – $200 = –$120
A trading system with these metrics has what is known as a negative expectancy. Compare that with our second example where the system has a positive expectancy and you could lose 80% of the time, yet still be profitable.
(20% x $1000) – (80% x $100) or $200 – $80 = +$120
This loses 80% of the time yet shows a profit of $120 per trade. Which situation would you rather find yourself in?This is just one example, but learning to roll with the small losses as part of an overall strategy is something that would-be traders find difficult.And it’s one reason why they are never truly successful.As mentioned previously, humans will instinctively take profits the moment they appear and ride losses until they are unbearable.
Unfortunately, this is exactly what an 80:20 negative expectancy system looks like: taking lots of small wins, and losing all those profits – and more – to a few very large losses. Without clearly defined risk management rules, you too will fall into this very large trap of trading.And it’s not only traders who apply these rules to their work – all the best professional poker players apply risk management rules to the way they play.
I was once speaking to a player who told me that one of the risk management rules he applies is to never risk more than 2% of his entire gambling float in a single hand. In this way, he knows it is okay to lose a game here or there because it’s only a small part of his overall purse.
At the time I thought, ‘Isn’t that interesting? That’s one of the rules I follow when trading’. Of course, there’s more to it than that.
What is trading risk management?
Good trading risk management is simply a set of rules you follow to keep your risk at a level with which you are comfortable. There are essentially four components to setting excellent trading risk management rules:Let’s look at each of them in turn.
- Trading float
- Maximum loss
- Initial stops
- Trade size
Trading float
Determine how much money you set aside for trading. Remember, the more you trade with, the more you stand to win or lose.This decision needs to be based on your overall trading goals, while recognising your other financial commitments outside of trading.
Maximum loss
Determine the maximum amount of capital you are prepared to lose in one trade.Like the professional poker player I met, you might set your limit at 2%. InMarket Wizard Larry Hite recommends not going beyond 1%. Other professional traders say 0.25%. You need to find the sweet spot to match your trading float.
Initial stops
Set a predefined point at which you admit defeat and exit the trade.When you enter a position, you never know where you are in the trend. The trend might be in the middle of its run or at its end. That’s why you must set your initial stop.It’s like saying, ‘If a particular trade doesn’t do what I thought it would, I’m going to get out.’Generally, short-term traders will set their stops closer to the price, while longer term traders tend to give their trades a little more room to move.
Note: by setting your stop losses too tight, you’ll decrease the reliability of your system because you’ll get stopped out more often. Plus, the more you’re in and out of trades, the higher your transaction costs.
There are many ways to set initial stops, such as technicals, indicators, percentages and more.Whatever you choose, the important thing is to just have something in place. Sure, you can always drive through that red light, but you risk getting wiped out by a semi-trailer!
Trade size
After setting your initial stop, you need a method for calculating your position size so you never risk more than your predefined maximum loss.There is a simple formula for calculating this:
maximum loss / initial stop size = number of units to purchase.
A basic but very powerful equation!
Trading secrets revealed
These four areas are the foundation of any excellent trading money management strategy.I learnt much of my trading money management and risk management through reading Van Tharp’s work. Tharp can, at times, be somewhat over-complicated in his language, making it hard to master his strategies.
Part of my process for fully understanding Tharp’s theories was to write them down in my own words. I believe Einstein had it right when he said, ‘Make everything as simple as possible, but not simpler’.
I later published these articles for my private clients in a course calledTrading Secrets Revealed. You might find it helpful for deciphering what seem like complex and sophisticated concepts. Remember, money management really is the most important aspect of any trading system.
By documenting this step, you have put yourself among the top 5% of traders.
The perfect trade exit: profit management
Identifying a good trading opportunity and setting your maximum loss is all to no avail if you don’t know how you’re going to. Typically, in most trading books, trade exit is covered in the discussion on risk management.To me, profitable exits deserves its own category, more aptly called profit management. Before you enter a trade, you should always know how you will exit it.
There are at least two possible trade exits for every trade:
- How you will exit a losing trade
- How you will exit a profitable trade.
Why stops are so important
As human beings, we are hardwired to fail as traders. What we need to do to be profitable traders really is counter intuitive.Here’s what I mean.
The intuitive reaction when a trade goes against you is to hold on until it turns around.In so many other areas of our lives we are taught to be patient and hang on… All good things come to those who wait. But in trading it’s different.
Unfortunately, and most likely, if you hang on, these losses will be compounded as time passes. The counter intuitive reaction is to cut losses short and move onto the next trade.Similarly, the intuitive reaction to a trade turning profitable is to sell.
Our human nature is to crystallise this profitable trade and come out a ‘winner’. Clearly, this is in direct conflict to the rule of letting your profits run.The counter intuitive (and correct) response is to let your profits run.
Trailing stops
So how do you know when to implement your trade exit plan? By using a trailing stop.In short, trailing stops are typically set in a very similar method to your initial stops, that is, based on technicals, indicators and/or percentages.The only real difference is the price at which you calculate.
Your initial stop is calculated from your entry price whereas your trailing stop is calculated from the highest price since entry. In this way, this stop ‘trails’ price… as price moves up, so too does your stop.
Trailing stops will allow you to ride the trend for longer, while locking in profits should the trend reach its end.The trick is to find the balance between giving your trade enough room to move, while also having the stop tight enough to not give back too much profit.
Generally, short-term traders will set their stops closer to the price, while longer term traders tend to give their trades a little more room to move.
Setting your exits
Think of setting your trade exits as an ejector seat when things go wrong and a seatbelt to strap you in when things go right. As with entry conditions, exits should be precisely defined and 100% mechanical, with no room for emotional intervention.Part of becoming an experienced trader is not only learning the markets and developing a discipline for sticking to your strategy, but also preparing yourself to take a loss.
Once you start trading, you will learn to not get so attached to individual trades – not to sweat the small stuff. You will be better able to see the big picture and see how small losses are a real and unavoidable part of any successful trader’s system.
You are now ready to document your trade exit rules. By documenting your trade exit rules you have just put yourself among the top 1% of traders.
