The Importance of a Trading Plan
The topic of Trading Plans is not a small one.
There is a lot to consider. This article will be about the broad reasons why developing a plan is so important, and an outline of the major things to consider when developing a plan.
That’s the first lesson; you have to write it down. Any good trader should be able to hand someone a document, written in simple language, defining how they engage with the market. There is no point having it in your head… that’s where the problems are in the first place. Unless you are a robot, you – like everyone else – are subject to emotions of fear and greed, which cloud judgment at precisely the time you cannot afford it. A trading plan’s purpose is to remove those emotions so that when the market conditions push you to peak emotion, rather than make a decision on the fly you have a playbook for how to deal with the situation. It’s all written down, or coded into your trading software, and it takes care of itself. Ultimately, a trading plan is designed to allow the calm, rational you, to override the emotional, irrational you when the heat comes.
“If you fail to plan, you plan to fail.” – Benjamin Franklin
For all of you out there looking for the ‘secret’ to trading or for that one thing that will give you an edge, well, here it is; unless you have a detailed and clearly defined trading plan that you stick to, you will not achieve long-term success in the market.
In order to survive, in order to give yourself a better than even chance of not losing all your money, you must have a plan and you must stick to it. That piece of advice was given to me by my trading mentor Stuart McPhee. It changed the game for me and now I am passing it to you.
The funny thing about it, is that most people are already aware of this information. All worthwhile trading literature emphasises the need for a trading plan, yet most people don’t develop a plan in any case. New traders often come to the market without any sort of plan and subsequently have little regard to their risk and profit objectives, other than to say ‘I want to make money’. This is NOT a plan people!!!
Developing a plan seems like a lot of work (and it is) and is probably one of the major reasons why people don’t bother. Unfortunately, too many people these days come to trading with the mistaken belief that they will just be able to wing it. The trader without a plan tends to rely upon gut feeling, hunches, tips and even dumb luck. For these traders the experience is usually a nail-biting, stressful, rollercoaster ride that more often than not ends up with a decimated trading account.
Just as no one in their right mind would start a business without a detailed business plan, no one who is serious about trading should begin (or continue) trading without a detailed trading plan. Once you have completed your plan, you will have gained extremely valuable insight into both what type of trader you think you are, as well as what type of trader you want to become.
What is a trading plan?
Before we go any further, I should outline exactly what I mean by a trading plan. I define a trading plan as a detailed set of rules that govern every aspect of your trading, including (but not limited to) your entry and exit decisions, your trade management, your position sizing and your trading psychology.
Trading is essentially about decision making. What most people lack, however, is a framework within which to make those decisions. They find themselves in a situation in the market that they haven’t prepared for, fear and/or greed kick in, and they end up making a poor decision. A trading plan seeks to eliminate the impact of fear and greed by clearly outlining what will be done in each and every situation that you encounter. If someone who has a trading plan ever encounters a situation, they do not know what course of action to take, and fear and/or greed start creeping into their decision making, it is fair to say that their trading plan is not detailed enough.
If it sounds to you like I am suggesting you become mechanical when dealing with the market, essentially I am. In the past I have had a lot of clients say to me, ‘but Chris, this is not why I wanted to start trading, I did not want to follow rules and have it be boring’. I’m sorry to disappoint all of you who have this notion of trading being exciting and easy. It is hard work, it requires a significant amount of discipline and, yes, I’m afraid some of you might even consider it to be boring if you don’t like following rules.
What is not boring, however, is achieving positive results and making suitable returns. The last time I checked these were the ONLY reasons why anyone would start trading. It stands to reason therefore, that you would want to give yourself the greatest chance of achieving those goals and the best way to do that is by having a plan and sticking to it.
Benefits of a trading plan
The key benefit of a trading plan is that it will help to remove the emotions of fear and greed from your decision making. The other major benefit of a trading plan is that it provides you with an ability to monitor your performance, reflect on outcomes and refine your approach. The best real-life example I can provide is that of a science experiment. Think back to when you were in school, conducting science experiments. The idea was to test a hypothesis in a controlled environment, measure the results, and then either confirm or reject the original hypothesis.
With a trading plan, it is a similar process to the science experiment. Your trading plan acts as your hypothesis, the results are the same, and then you can either confirm your trading plan if the results are positive, or, reject it if the results are negative. The key, in both situations, is that you have a controlled environment and a measured set of results that allow you to make informed decisions.
If your trading is going badly, there will be either one of two reasons why; something in the plan is not working, or, you are not sticking to the plan. If the plan is a good one that has been back tested and paper traded (or forward tested with a small amount of money) then the fault is likely that you are not adhering to the plan. If you are adhering to the plan, you can go back and do further testing. Rather than completely chuck out your trading plan, you can make adjustments, fine-tuning it until you achieve the desired outcomes.
This is the part of the process which can take a lot of time. A trading plan will naturally evolve and may, in fact, never be complete if you continue to try to improve your performance.
By comparison, if you are losing money whilst trading without a plan, you have almost no way of distinguishing what you are doing well from what you are doing poorly. You have no way to measure your results and, as an extension of that, no way to figure out the problem and correct it without going through the time-consuming process of trial and error.
Trading plan versus trading strategy
Before going any further, I want to clarify the difference between a trading plan and a trading strategy. A trading plan is a detailed set of rules governing every aspect of how you engage with the market. You may even go so far as to outline the amount of time you will commit to doing research.
A trading strategy, however, usually only considers the entry and exit criteria. These are merely elements of a trading plan and, as we will go into further detail later, not necessarily the most important ones. Traders will often include more than one trading strategy within an overall trading plan.
When I say ‘your trading plan’ I mean exactly that; it will not be anyone else’s plan because it will reflect your personality traits, biases, risk tolerances, abilities, and resources. That is indeed one of the catches when it comes to trading plans, no one else can write it for you.
You must develop it for yourself because what I trade, how I trade it, the amount of risk I am willing to accept, etc, will likely be different to what you want to trade, how you want to trade it, and the amount of risk you are willing to accept.
The questions are designed to stimulate your thoughts and get your mind tuned into what you will have to decide upon. Furthermore, the plan is something that you can, and should, come back to later. The best traders will review their trading plans regularly, even though they might not change anything.
Chris Conway has been working in the financial services industry for more than 10 years, primarily as an equity analyst. He is passionate about both fundamental and technical analysis, believing that a combination of the two yields the best performance returns. A regular market commentator, Chris appears frequently on Ausbiz and is regularly quoted in The Financial Review, The Age and Sydney Morning Herald, Reuters and The Australian.
With his rules-based approach to markets and passion for technical analysis, Chris looks after the Technical Trades section of the Marcus Today Newsletter.