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Having a trading plan seems like a no brainer, yet many traders fail to create one. It’s like starting a business without a business plan.
“I’ll just wing it and hope things work out.” That’s clearly not a plan that will set you up for success. It’s more like a recipe for disaster.
Why You Need a Trading Plan
Regardless of your experience level, you should have a practical trading plan. Here are some key reasons why you need one:
- Trading is not easy. Having a plan makes it less complicated.
- A plan limits the emotional destruction that often happens when trading.
- It takes out the guesswork on how to act in different market situations.
- A plan keeps you organized and allows you to stay focused.
- Creating a trading plan shows that you’re serious and that you’re treating trading like a business.
Key Steps for Building an Effective Trading Plan
How does one create a trading plan? Well, it’s going to take some effort to build a well-defined trading plan. You should know now that having one will boost your success as a trader. So, it worth the effort!
Each individual trading plan will be different, but there are some crucial components needed in every plan. Let’s go over the key elements necessary to create a practical trading plan.
Define Your Trading Strategy
What kind of trader are you? What are the main types of trades you will make, and what kind of securities will you be trading? A trader that narrows his or her focus is more likely to succeed. If you try to do too much, you’ll get overwhelmed and confused.
It’s common to use more than one trading strategy. However, beginners should focus on one system at a time. Once you gain more experience, you can begin using multiple methods.
For instance, an experienced day trader may hold positions longer than a day to maximize profit. This crosses into swing trading and can involve more risk. Be sure to outline the predominant type of trades you will be making.
Estimate Your Trading Knowledge
Part of building your plan is assessing what level of trading experience and knowledge you have. You may need to take a trading course or read some books to get the basics down before starting.
You’ll want to be confident in your ability to follow a trading plan. This comes from a good understanding of how the market and trading works. Consider paper-trading for a little while if you are just starting.
Define Your Goals
I am sure your goal is to make money. That’s the case for every trader. However, you need to be more detailed than that. Define your overall trading goal.
Are you trading part-time to make a side income that will help support you or your family? Maybe you are going at it full-time to escape the life of working a 9-5.
Envision how much you want to make monthly and how you will use the income.
Next, you should create a goal for every trade that you place. Calculate the risk to reward ratio and make sure the trade makes sense. Define where and how you will take profit (if the trade works) and where your stop loss will be (if it doesn’t).
Determine Your Risk Tolerance
You need a plan that centers around proper risk management. This includes setting a limit on how much of your portfolio you will risk on each trade. A rule a thumb is that you should never risk more than 5% of your portfolio on a single trade.
Risk tolerance will vary from trader to trader. Beginners should consider only risking 1% to 2% of their portfolio on a trade.
You must preserve your capital and live to trade another day. Never risk blowing up your account. If you cannot participate in the markets, you can’t gain the experience needed to become a successful trader.
Make Some Rules
A trading plan needs some clear rules. Here is a list of some rules you can incorporate into your trading plan:
- Risk level (how much you are risking on each trade).
- Min acceptable risk/reward ratio for a trade.
- Entry rules. The parameters that must be met for you to enter a trade.
- Exit rules. How will you exit a winning or losing trade?
- Market condition rules. When will you sit on your hands and not trade?
- Emotional control rules. Are you in an acceptable emotional state to trade?
- Max loss rules. Taking a break after losing a specified amount in a single trade.
- Trading methods or financial securities that you will or will not use.
Create a Trading Schedule
A schedule will keep you organized and ensure that you are putting in the work. Set up a schedule that allows you to devote at least 10 hours a week to the markets.
You do not always have to trade, but you can always be charting, researching, and looking for set-ups.
A lot of part-time traders just trade randomly when they feel like it. With a schedule, you’ll be regularly monitoring markets, doing homework, and making better trades.
Keep Track of Your Trades
A trader should track all of their trades. I suggest using a spreadsheet. By keeping detailed records, you can easily monitor your performance.
Incorporate a Journal
A journal should be a part of your trading plan. Taking notes on all of your trades will help you review your reasoning behind them. You can reflect on your logic, what was going on in your head, and more.
Review Performance Regularly
Keeping track of your trades and journaling make it easy to assess your performance. Over time you will begin to see what works and what doesn’t.
If you just try to keep all this in your head, it will be nearly impossible to point out your strengths and weaknesses.
Each trader is different. One method may work well for some but not for others. By reviewing your performance, you can identify what your winning strategies are.
While it is essential to make a trading plan, don’t go overboard. Your plan should be detailed but simple. If you overcomplicate things, your trades will likely suffer.
Creating a practical trading plan is not difficult but does take time and effort on your end. To sum everything up, make sure your plan has the following:
- Risk Tolerance Rules
- Defined Trading Strategy
- Exit/Entry Rules
- Trading Journal
- Thorough Trading Records
- Defined Trading Goals
There are several tools you can use to make a trading plan. You can use a Word document, a note program, a paper notebook, etc.
I recommend using Microsoft Excel and creating a spreadsheet. This way, you can organize all of your trades and determine your profit/loss.
Once you’ve pieced together a plan, you’ll need to review it often. You’ll make changes as you become more experienced and grow as a trader.
Always remember that trading should be treated like a business.