It takes time, effort, and research to develop an approach or methodology to trading that works for you. There’s no guarantee of success but developing a detailed trading plan and following it without fail eliminates many of the biggest causes of failure by investors.
A reasonable plan has just 10 steps. Refine your plan as you go along if you don’t get it right the first time.
Key Takeaways
- It’s essential to stick to your plan but you should be prepared to adjust it for changing market conditions.
- Knowing when to sell is as important as knowing when to buy.
- Build stop-loss prices and profit targets into your plan to identify specific exit points for every trade.
- Factor in the overall market condition.
Disaster Avoidance 101
Trading is a business and you have to treat it as such if you want to succeed. A plan should be written with clear signals that aren’t subject to change while you’re trading but they should be subject to reevaluation when the markets are closed.
Your plan can change with market conditions and might be adjusted as your skill level improves.
Important
A plan for day trading is much the same as a plan for long-term investing in the markets but sticking to the plan becomes even more critically important. Invest only as much as you can afford to lose. Set target prices for gains. Build in stop-loss orders. Above all, don’t let impulse guide you during the trading day.
Building the Perfect Master Plan
No two trading plans are the same because no two traders are exactly alike. Each one’s approach will reflect important factors like trading style as well as risk tolerance but there are 10 essential components that a solid trading plan should include:
1. Goal Definition
Determine your financial objectives, risk tolerance, and time horizon if you’re new to trading. These factors must be clearly articulated in advance to ensure that your trading activities can be achieved.
2. Trading Style Selection
A trading style must be identified. It should reflect your personality, culture, and preferences. The plan can include day trading, swing trading, position trading, or long-term investing. The chosen style should align with your goals and timeline.
3. Strategy Development
Your strategy is your approach to the markets. You could rely on technical indicators, fundamental analysis, or a combination of both.
Entry and exit tactics, risk management techniques, and position sizing rules must all be specified when you’re building a strategy.
4. Realistic Expectation Setting
Trading always has inherent risks. Realistic expectations for returns should be set and the potential for losses should be recognized. Avoid the trap of chasing quick profits or risking too much on a single position or trade.
5. Comprehensive Market Analysis
Conduct a thorough market analysis to identify potential opportunities. Analyze charts, study market trends and news, and monitor the appropriate economic indicators if you’re considering a stock and then take a step back and consider the overall market condition.
6. Risk Management Rule Development
Allocate a percentage of your portfolio for each trade and don’t ever go above the amount you’ve determined is right for your account. It should be equivalent to the amount you’re willing to lose per trade.
Make use of stop-loss orders to avoid big losses and establish clear profit targets to secure gains.
7. Trade Management Plan
Determine how you’ll manage your open positions. You should determine when to adjust your stop-loss orders, take partial profits, or exit the trade entirely.
8. Trading Discipline Maintenance
Stick with your trading plan when you’ve written it down. Avoid situations where you abandon your trading plan impulsively because the market is doing something that elicits an emotional response from you like fear or greed.
Train yourself to embrace discipline and consistency when executing and exiting trades.
9. Monitoring and Trade Evaluation
Keep a detailed record of your trading activity, including entry and exit points, your reasons for taking the trade, and the outcomes.
A frequent review and evaluation of trades is necessary to becoming a good trader. The evaluation and review of your past trades will allow you to identify patterns, strengths, and areas for improvement.
Fast Fact
It’s been reported that more than 80% of day traders give up and quit within two years because they lack comprehensive strategies.
10. Continuing Education
Stay updated on market trends, economic news, and new trading techniques. Read books, attend seminars and webinars, follow reputable financial news sources, and interact with experienced traders to enhance your knowledge and skills.
Why Does a Trader Need a Plan?
Traders must maintain a disciplined and systematic approach to their trades. A well-defined trading plan helps remove subjectivity and impulse from trading decisions. It incorporates risk management strategies such as setting stop-loss orders and determining position sizes based on risk tolerance. Traders are exposed to excessive risk without a plan.
How Do I Determine My Risk Tolerance?
Key factors when traders assess risk tolerance are their financial situations, personal investment goals, risk appetite, and experience and knowledge of the financial markets.
A risk tolerance questionnaire or even a meeting with a financial advisor will help you determine your risk tolerance.
How Can I Evaluate My Trading Performance?
Not surprisingly, most methods of evaluating trade performance come down to adding up your wins and your losses. A few common methods include calculating the total return of your trades, determining the profit factor, and using the Sharpe ratio.
Other metrics include analyzing the win rate, the average win amount, the average loss amount, the drawdowns, and the recovery rate. The recovery rate in this case is the percentage of the drawdowns that the trades recovered.
The Bottom Line
Practice trading is a useful exercise before you start trading real money in the markets but it doesn’t help a new trader understand how emotion can sway decision-making. That’s one reason why a plan is important. You won’t be prone to impulsive moves and uninformed guesses if you make a plan and stick to it.
Traders who win consistently treat trading as a business. There’s no guarantee that you’ll make money but having a plan is crucial if you want to be consistently successful and survive in the trading game.
Disclosure: Investopedia does not provide investment advice. Investors should consider their risk tolerance and investment objectives before making investment decisions.