This is the first article in the “Essentials of a Trading Plan” series. We will explain why it is important to have a trading plan and what questions you should ask yourself.
We will begin with the question "Why do I need a Trading Plan"? Before we go into the details, let's take a simple example. Imagine that you are opening a business - say, a coffee shop. It is likely that you wouldn't open a coffee shop at a random location just because you happen to like the place. You would probably first ask yourself at which location the demand for a new coffee shop could exist. Then you will create a plan and do an in-depth research of the market environment, what the competition is doing and how you would get an advantage in the market. What follows is the cost analysis, financing options and so on. To sum it up, there would be plenty of planning and analyzing before you sell your first coffee.
People take it for granted that you do those things before you start your business. In trading however, there are unfortunately plenty of traders who think that it is not necessary to have a trading plan. There are numerous benefits of having one though.
First of all, a trading plan will confront you with the question why you are trading in the first place. It is important that you know the answer before you start this endeavor. Some people want to make a living from trading, while others just do it as a hobby and to get some extra income. There is nothing wrong with that either. It is just important that you realize what it is exactly that you want out of the market, so that you can set realistic goals.
Look at the trading plan as your personal roadmap. It outlines all your goals that you have in your trading. The hobby traders might be satisfied with a couple of hundred dollars per month. Their roadmap would be how to get to the point of having a decent extra income, and perhaps, how to incrementally increase it. Other traders aspire to become professionals, and have bigger goals. For them, it is even more crucial to have a plan and a clear vision of what they want to achieve.
The point here is: Every kind of trader will benefit from having a trading plan. Obviously, it will be a bit less detailed for the hobby traders, and more complex for the one’s aspiring to become professional traders. Nevertheless, having a personal roadmap makes it easier to identify what kind of trader you are and what risk profile and strategy suits you best.
A trading plan can bring order and structure into your trading. Trading may be stressful and emotional at times. It happens to all traders that they overreact and take a trade purely based on emotions instead of facts and figures. It can happen even with a plan. However, having one will make your trading more organized. You will have an idea what you are looking for in the market, and it will reduce the probability that you will end up with losses due to impulsive and emotional trading.
A trading plan makes it also much easier to analyze your results. Imagine a trader who has no clear strategy and just does what he thinks is best at that particular moment. Yesterday, he was trading technical patterns on the hourly chart, today he is a news trader, and tomorrow he is scalping the Aussie Dollar on a five-minute-chart. He can do a statistical analysis of his performance as many times as he wants. The results will still be worthless, because he is skipping from system to system in a short time.
On the other side, let’s say you have developed a strategy, have a clear plan and stick to it for a while. Then, it makes sense to analyze your performance. You will probably gather some valuable information based on those statistics and observations.
Another question is: What kind of trader are you? Are you more comfortable trading short-term or do you prefer medium-term to long-term trading? It is important that you find out what suits you best. Of course, you don’t have to know the answer immediately, and your preferences can change with time. This is a situation where a demo account can be very helpful, as you can practice there without risking any money.
Ask yourself – what is my risk profile? You don’t even necessarily need to have trading experience to answer that question. Some of us are natural risk takers, and when we hear the word “risk” we associate it with “opportunity”. On the other side, there are people that are risk averse, and prefer to limit their risk to the lowest possible level. It is important that you recognize your risk profile. Then you can adjust your risk management techniques accordingly.
The next question is about your trading strategy. You must be able to explain your strategy in detail and know its strengths and weaknesses. But it is not only about strategy - it's also about your edge. What are the personal traits that can make you a successful trader? Identify your own strengths and build your trading style based on that.
Further, you must evaluate your results constantly. Analyze every individual trade you took. Did you follow your plan? If not, why? How often you need to evaluate your results depends on your trading style. Intraday traders should do a daily review of their trades, while for long-term traders, it might be sufficient to do a weekly review.
The last question is - what will I do to improve? After you have analyzed your performance, you should know what you did right and what you did wrong. You cannot be a perfect trader. Losses are part of the game. However, by analyzing your performance, you can identify some errors and weaknesses that perhaps can be eliminated or reduced. The same applies for winning streaks - build on your strength.
Part 2 of the series will be published tomorrow.