Trading is a business. As in any other business, a well thought-out plan can make the difference between success and failure. A trading plan is a pact you make with yourself. It is your personal blueprint for success. It must include not only your goals but must also detail how you plan to achieve them. Traders work alone, and so do not need to deal with many of the organizational issues confronting other business plans. But traders need a business plan (trading plan) just as much as any other business.
The three important factors that need to be strongly engrained into our minds and ultimately into our trading plans are Trading Psychology, Discipline, and a Trading System.
Trading Psychology:
Your mind is your main trading asset and must be guarded. How do you plan to protect yourself throughout your trading career? How will you guard against burnout? When and for how long will you take a vacation or a break from trading? (Remember, it's ok and it's healthy to take a break from trading). What is your plan in the event of an unusually large loss? Are there things outside your trading which heavily influence you emotionally? How do you plan to deal with them? Emotional decisions are the most destructive factor to the bottom line. Your trading plan is your protection to guard against these!
Perhaps the single most important aspect of trading and yet the one that is paid little attention to by the average trader is the psychology of trading. Traders must remain emotionally detached from the market; this is easy to say but often difficult to do. A new trader will experience a gauntlet of emotions as they enter the markets for the first time - fear, anxiety, panic, joy, even greed - these are all emotions that the greenhorn trader should not only expect but be prepared to face. You need to remain emotionally detached and act according to your trading plan. Emotional imbalance impairs your ability to make intelligent decisions.
Of course, there are other things to consider besides your emotions. Do you know why you are trading? Are you trading for the thrill, for the challenge, or to make a steady income? Whatever the reason, you will enjoy the experience more and trade better if you know your purpose. Many new traders approach the market with unrealistic expectations. Instead of seeing trading as a business which requires both time and some hard work, they see the market as nothing more than a place to make "quick and easy money." At first they may do well but without any kind of plan in place invariably their inexperience and overconfidence catches up with them.
You must accept the fact that the market is always right and that at times you're going to be wrong. There is no shame in being wrong, even the best traders can be in error. If you don't admit your wrong and do something about it, fear, greed and hope can cloud your vision of the market and can cause emotional responses harmful to your trading. Do not become in love with a losing position. If you're wrong - admit it, get out, salvage your trading capital and wait for the next trading opportunity. Conversely, congratulate yourself and feel good about a trade when you have labored according to your trading plan, regardless of the profit or loss.
Acknowledge that you are the person responsible for your winning and losing - do not blame the market, do not blame a hot tip that did not plan out, and do not blame a newsletter or financial advisor. Losses give us the chance to focus on where our plan fell short and to instantly correct it.
Discipline:
Like most things in life, you will not succeed without discipline. Discipline is adhering to your established trading plan, including entry points and stops. To become consistently profitable, we must have a high level of self-discipline with a well-defined trading strategy that effectively maximizes profitable trades and minimizes losing trades. Creating a trading plan is relatively easy but it is the discipline to follow that plan that will differentiate capable traders from all others. During periods of profit, adhering to a trading plan is comparatively easy. However, during periods of loss the same trading plan will appear rigid and constricting and it is at such times that a trader will be tempted to stray from the plan. At times you might want to deviate from your trading plan, but doing so invalidates the reason for preparing it in the first place. Remember the purpose of the plan was to provide guidelines to follow. Breaking from it will often lead to risk exposure that you were originally unprepared to take.
Besides abandoning your trading plan, a lack of discipline can lead to other troubles for the trader. If you abandon your trading plan you may be tempted to impatiently rush into or out of trades without considering the consequences. You might also start to ignore price charts or start falling victim to your emotions. And most assuredly you will not utilize your stop-losses. Once you ignore your stop-losses it is only a matter of time before you make your last trade. How can you make money, if you don't have any money to trade with? The most important trading rule is to cut your losses. Even though your primary motivation is to make money and you consider this important, protecting your trading capital is even more important.
One of the best ways to manage your risk when trading is to limit how much money you put into a single position. This is to guard against the possibility of something unpleasant occurring. What is the maximum percentage of your trading capital you are prepared to commit to a single trade? If you have had three losses in a row, the likelihood that you are going to have a profitable trade doesn't automatically swing in your favor. Don't increase your trade size thinking your next winner is just around the corner. Instead, after a few losses, your trade size should be decreased slightly to reflect your reduce trading capital. You also have to ask yourself, "What happens if you keep losing money?" Are you prepared to lose all of your trading capital before you are forced to stop, or do you think you would like to hold on to some of the money and place it somewhere else, with the plan of either not trading again for an extended period of time or giving up altogether?
There is a lot to learn about managing your money in trading. Telling you to cut losses is one thing but executing it ruthlessly and without delay can be another.
Trading System:
Having a routine makes it so much easier to follow your plan. Why is this critical? Well, why do most traders fail? Simple, they don't have a plan. A trading plan will often follow a trading routine that the trader consistently exercises over and over again. The routine should bring together most of the parts of your trading plan into a methodical and deliberate process for each and every trade.
When you do not have a written trading plan, even though you have developed a plan in your head, it is too easy to drift away and go back to old habits. Having the written plan will guide you to making the right decisions. Consider the difference between knowing what has to be done and what you want to do. In trading, what has to be done is always the right choice, yet if you do not have a trading plan, you can easily decide with what you want to do, instead.
In your routine you'll likely be sorting through large amounts of information in the form of websites. A routine will help you manage the information flow, it is important to identify what information you need and where you will find it. What information do you really need to trade and what information is for interest only but does not effect on your decisions?
Decide how you will categorize the industry/economic sectors in the market. Will you use any form of sector analysis in your method? If so, how will you use it? Will it be the starting point for your trade selection process or will it be a final filter to ensure you don't enter stocks that belong to poorly performing sectors? If you are going to use fundamental analysis, what items are of most interest to you? For example, are you interested in earnings, dividends, growth, acquisitions? If so, how will you use that information?
Write down your trading methodology. Start by talking in very general terms about how you are going to approach your trades. As examples, are you going to trade only heavily traded stocks that are trading at new 52-week highs? Or are you going to trade more speculative stocks and trade breakouts and/or chart patterns? Are you going to use technical analysis? If so, will you be looking at trends? Over what time frame and how are you going to identify them? Are you interested in reversals of short-term or medium-term trends? If so, how will you identify them and then what will you do once you identify them? How about technical indicators? Will you use any of them? What are your conditions that you look for in all of your trades? What setups will you use and do you have printed examples in your trading plan to go back and review. Finally, what triggers will you use? Usually following specific trading rules and keeping it simple works best!
Write down your trading methodology. Start by talking in very general terms about how you are going to approach your trades. As examples, are you going to trade only heavily traded stocks that are trading at new 52-week highs? Or are you going to trade more speculative stocks and trade breakouts and/or chart patterns? Are you going to use technical analysis? If so, will you be looking at trends? Over what time frame and how are you going to identify them? Are you interested in reversals of short-term or medium-term trends? If so, how will you identify them and then what will you do once you identify them? How about technical indicators? Will you use any of them? What are your conditions that you look for in all of your trades? What setups will you use and do you have printed examples in your trading plan to go back and review. Finally, what triggers will you use? Usually following specific trading rules and keeping it simple works best!
It is essential that you monitor your performance for a variety of reasons. The most basic of these is to ensure you protect your trading capital. Further, monitoring your performance allows you to review your past trades and learn from your mistakes. This is an approach used by some of the best traders in the world. They will periodically review all of the trades they have conducted, both winners and losers, and learn from them. How will you go about conducting a review of your trading activities and how often will you do this? A trading diary should detail all of your trading decisions, including reasons for starting a trade, your emotions when opening the trade, trend direction, as well as daily adjustments of exits. A trading diary provides you with a methodical way of maintaining a clear focus. It can also assist you with learning from your mistake.
A written trading plan is the only way to go. It is critical that you create your plan when you are thinking clearly and then trade your plan. By planning each trade from beginning to end you are forced to follow a disciplined and methodical approach to the markets.
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