T 2 UNIVERSITY
Developing a Trading Plan: 1. Introduction BEFORE YOU BEGIN TRADING - Plan your trade and trade your plan. Before you even consider trading it is important to take the time to seriously question your intentions in the market. Do you see Forex as the means to a quick profit? Are you trading for excitement or a rush? Are you interested in trading because you seek satisfaction on a purely intellectual level? Do you see trading as a hobby or as an additional avenue of investment? Are you looking for a way to fund early retirement or do you see trading as an opportunity to augment your savings? Do you need the profits that trading might bring to cover debts or other financial commitments? Many traders do not know why they want to be in the market. By taking the time to honestly evaluate your reasons for trading, not only will you learn more about yourself but you ll also be forced to justify your commitment of hard earned capital to the market. Remember if your rationale is floored so too will be your trading. For those contemplating a career in Forex trading, the following provides a useful list of issues that should be covered prior to entering the Forex market and the pitfalls that all too often cut short the career of an aspiring Forex trader. 2. Developing a written trading plan When someone decides to start a business, the first task usually tackled is drafting a business plan. Most people would see this as mere common sense; however it seems the same logic does not apply to MOST new traders. Rather than planning how and where their capital is to be allocated, many new traders will launch headlong into a trading career with little regard as to their risk and profit objectives. By failing to have a trading plan, a trader will not know what to do when the market goes in their favor or worse still, when it moves against them. Without the structure that a trading plan provides, you will find yourself not only at the mercy of changing market conditions but also of your own conflicting emotions -a sure recipe for disaster. Many surveys reveal that successful and experienced traders use a plan that is consistent with their temperament and the amount of money they have in their accounts. While a plan will not prevent losses, at least it provides you with some guidelines to follow. You can and should make minor adjustments to your initial trading plan throughout the trading period, but do not let the ups and downs of the market affect your overall game plan. Do not abandon your original objective, unless the market conditions that led you to place your trade change. The trading plan therefore imposes the disciplined structure that is essential for long term success. A written trading plan helps keep you from making poorly conceived, spontaneous, thoughtless, emotional trades. An unwritten plan often gets changed when the trader s mood changes. A written plan keeps you from many trading pitfalls such as greed, fear, boredom, a need to be right, a need to be a victim, and masochism. 2
While a trading plan may contain many elements, at minimum it should at least contain the following characteristics: 1. Select your investment universe (i.e. Futures market and the contract/s FX markets and contracts) 2. Appropriate account size (capital you can afford to lose. Allow for diversification). UNIT allocation based on the trading model 3. Define your style of trading (aggressive, medium, conservative) 4. Define your time frame (day / short / medium / long term trader) 5. Have specific Rules Of Engagement (DIV CTS 3) 6. Add risk management parameters stop loss (fixed dollar, trailing, swing) 7. Outline your money management 1. How much to risk - percentage based on capital 2. Percentage of money to risk on each trade 3. Where to place stops 4. When to add to a winning position 5. When to liquidate part / all of a losing position (Stop Placement) 6. When to liquidate part / all of a winning position (Profit Target 1,2,3) 7. Profit objective for trade / week / month / year (including MM) 8. Impact of commissions and fees on trades individual and overall Slippage Continuing Education Subscriptions 9. Are you overtrading? (How many SIGNALS did your model generate this week? How many TRADES did you take?) 8. Back test the system as well as forward testing (referred to as paper trading) 9. Performance measurement (risk / reward ratio) 10. This will help you to determine your expectations (REASONABLE) 11. Determine your necessary requirements (resources to get the job done) 12. When should I start trading 13.Is trading for me? A good trading plan is always complimented by a diary of your trading successes and mistakes. What you learn from your mistakes is more important. You paid for them; you may as well learn something from them, if you don t remember them you are bound to repeat them. It often takes courage and cold hard unemotional judgment to stick with your trading plan. 3. Risk Management The most common mistake made by Forex traders is the lack of any systematic risk-management. The high leverage and high volatility of the Forex markets usually have a strong influence on a trader s emotions. This emotional volatility results in a lack of objectivity and poor decision making. Have RESPECT for leveraged markets. The MARKET IS ALWAYS RIGHT. The aim therefore, is to devise a systematic approach and define in detail, parameters of a risk-management system. Under such a system, profits, and in particular losses, are defined and stop-loss orders are placed. 3
ALWAYS USE STOP LOSSES! Its purpose is to attempt to limit your loss. However you must be aware that there is no guarantee that your stop loss order will be filled at your price. Don t use mental stops - mental stops get moved. Absolutely, positively do not remove or move your stop-loss father away. Place stops on the basis of how much money you are willing to lose on each trade. This amount is always a percentage of the equity in your account. Most professional traders never risk more than two - three percent of capital on any given trade. Figure your stop losses ahead of time when you have a clear head and are not thinking crazily because the trade is going badly. Do not move your stop loss unless you have a profit and then move it only as a trailing stop. Design your exit strategy up front, before the trade is even initiated. When you put on the trade, use an OCO (One Cancels the Other) order and enter both a protective stop and a profit target stop. Placing a money management order such as this in a quiet time of contemplation stops you from making emotional decisions during the heat of battle. If you hear yourself saying I promise I will liquidate the position of this loser when it comes back to where I bought it then it is probably to late. The market doesn t know or care where you got in! Some traders fall into the trap of getting married to a position finding it hard to unwind the position when it goes against them. Respect Price - Price is a loaded gun that can go off in either direction. Don t get caught up with what a trader, a report or a news item says it should be doing. You must respect what price can do! Never buy just because the price is low or sell because the price is high. 4. Diversification Diversification is the key to any trading plan. Look at a number of markets with one program or have a number of different programs for one market allowing for increased versatility in varying market conditions. It s well documented that dividing capital among unrelated markets can reduce risk. For example Program A, may only provide signals in a certain market type, whereas Program B may provide signals in other market types. Strict control of trading capital is possible with the application of basic common sense principles. Concentrate and focus on a few select markets and completely master them - this is the tendency of professional traders. You should not have a trading plan that calls for putting on multiple contracts if that means you have to use most of your money for margin. Your first trading rule should be to protect and preserve your trading capital. The name of the game is to survive so you are around to take advantage of any market opportunities. 5. Money Management The principles of money management and risk control are 4
perhaps the most important issue that any trader will face. Put simply, unless traders know how to manage their money correctly and keep their losses to a minimum, their career as traders are sure to be short lived. Money management is mandatory. Money management is critical to not only succeeding in the market but also staying in the market. Like all aspects of trading there are no hard and fast money management rules. Money management can simply be defined as `how much capital to risk? and `how many contracts to trade?. This is one of the most crucial concerns a trader faces; it determines your risk and profit and is often a technique neglected by traders. The belief is that the markets will reward us with profits in due course and that we cannot force profits from the markets in the interim. You cannot predict the future, merely enable yourself to align with the current `line of least resistance and therefore increase the overall probability of success. Losing trades are inevitable to any trading plan and it s the ability to manage these losing periods and the your primary role of preserving capital that will enable longterm survival and capital appreciation. You must anticipate losses, expect them, plan for them, embrace them, grab them. Your first loss is your least loss. Most importantly do not take losses personally. They are an integral part of successful trading. Sound money management philosophy and skills are absolutely fundamental to success to keep losses small. Successful Forex traders work according to probabilities, aiming to win on average more than they lose. Whatever the approach, money management reduces the need to find the perfect system. Large loss of capital If your account equity declines by 50% at any stage, trading should be halted immediately and indefinitely until you reassess your trading goals. Is Forex trading for you? It is imperative to keep your individual losses small. The table below shows you the returns you will need to generate based on the loss of your original capital. If you lose 50% you need to make 100% return just to break even. Losses Return to Recover 5% 5.3% 10% 11.1% 20% 25.0% 30% 42.9% 40% 66.7% 50% 100.0% 60% 150.0% 70% 233.3% 80% 400.0% 90% 900.0% Smart money management starts with the trader starting with enough capital to 5
withstand several losing trades. The trader must also conserve enough money to be able to add and keep adding to the infrequent, substantial, profitable move. 6. Discipline Like most things in life, you won t succeed without discipline. Discipline is adhering to your established trading plan, including stops and entry points. This is the most difficult yet most important rule of them all. For Forex traders to become consistently profitable, they must have a high level of self-discipline with a well-defined trading strategy that essentially maximizes profitable trades and minimizes losing trades. Drafting a trading plan is relatively straightforward - but it is the discipline to follow that plan that will distinguish capable traders from all others. During periods of profit, adhering to a trading plan is comparatively easy. A speculator, no matter how knowledgeable, capitalized, or confident will never be consistently successful without discipline. During periods of loss, however, the very same trading plan will appear rigid and constricting - and it is at such times that a trader will be tempted to depart from the plan. Although you might want to deviate from your trading plan, 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 invariably lead to risk exposure that you were originally unprepared to take. The difficulty in maintaining the required level of discipline is one of the main reasons many traders adopt a system driven trading approach. These traders include professional hedge fund managers and Commodity Trading Advisers who use computer models to generate their buying and selling orders (ie there is no discretionary or gut feel trading done). The equity, futures and Forex markets are unpredictable in nature and thus cause a natural amount of inherent anxiety among the participants. The speculators ultimate success depends upon quickly identifying a losing trade, admitting the mistake and having the discipline to get out of the trade with a minimal loss rather than being stubborn and compounding a loser into an even bigger loss. The lack of discipline can cause a trader to: 1. Abandon their trading plan. 2. Rush into or out of trades without enough information. 3. Be impatient and trade impulsively. 4. Trade too many markets with too little information and capital. 5. Ignore charts. 6. Fall victim to your emotions. 7. Not utilize stops. By planning every trade from beginning to end you are forced to think about how far the market might move against you or with you. You can t control the markets and most traders do a good job of trying to control themselves. A written trading ithe only answer. It is critical that you create your plan when you are thinking clearly. 6
is the only answer. It is critical that you create your plan when you are thinking clearly. 8. Testing a trading Plan Before they begin in the market, some traders find it helpful to paper trade the market for a while. This involves taking hypothetical positions in the market and then monitoring these to see what the outcome will be. Before doing any physical Forex trading at all, the first move is to start by paper trading. A trading plan must be able to be measured. I ll risk no more than 2% of my capital on any given trade. It can t say I won t use too much of my equity for margin. Traders whose systems are more technical in nature will back test their system against historical market data to determine the success of the system in that particular market. A trading system can be as simple as a few rules or as complex as a Black box technical analysis package. The key is that the system matches your personal trading style. You can either create a system from scratch or buy a readymade package. Either way it is advisable to test the system with dummy trades before doing the real thing. Some experts recommend 10 years of back testing with historical data (black box systems) where as others recommend a shorter time span for the testing of a simpler system. It is very important to perform your own testing on any off the shelf systems, and not rely purely on the seller s recommendations. While all of these techniques are beneficial, prospective traders need to be aware that simulated trading - no matter what its form, does have its pitfalls. Experienced traders will often say that there is no substitute for having real money in the market. Depending upon traders own discipline, the way they react in this circumstance could be very different compared to when the trade was purely hypothetical. In addition, while a market s past performance can provide some general clues as to its price behavior, there is no guarantee that this will be repeated in the future. Individuality Trading plans are individualistic, based on such factors as personal experience, education, risk capital and tolerance toward risk. For this reason, trading plans may differ greatly from one trader to another. A trading plan may work better with some people than others. Consequently, you must develop a trading plan that works best for you. Among other things, this requires patience, rigid adherence to the rules that you establish, meticulous record keeping of trading performance (which provides valuable feedback) and an open mind to try new methods. There are no guarantees of profitability in the world of Forex investing, but the discipline of a trading plan goes a long way toward making you a successful Forex trader. 7