How to build a trading plan?

A trading plan consists of a defined set of parameters that outline your trading strategy.

Possessing a well-structured trading plan holds equal significance to any other factor. Regardless of your expertise or intelligence, the absence of a robust trading plan will hinder your chances of success. This concept is straightforward and undeniable.

You are engaging in trading against some of the most intelligent and wealthy individuals globally. To navigate this, it’s imperative to enter the arena with a well-structured strategy. This trading plan should be documented on paper and meticulously refined. This precaution is necessary due to the influence of emotions that arise during trading. When emotions take over, logical thinking becomes compromised, even if you believe otherwise. Therefore, the key is to formulate your trading plan in writing and adhere to it when the time for trading arrives.

Therefore, for every trading strategy you intend to execute, it is essential to establish a corresponding trading plan. This plan will precisely outline the execution of that strategy.

Your trading plan should be established during periods outside of active trading hours, when your mental state is steady and rational.

What are the essential components of a trading plan?

Strategy:

Essentially, it’s primarily a label, which can also provide insight into the fundamental idea behind your trading plan. For instance, it might describe concepts like the dividend cut model, market opening gaps, or SMA crossovers.

Trading style:

Does your approach involve swing trading, day trading, or long-term position trading? This essentially categorizes your trading style. This distinction is crucial because, for example, if you’re in a day trading position that starts moving unfavorably, emotions might influence a shift from day trading to swing trading. Instead of cutting losses, there’s a tendency to hold onto the trade, potentially resulting in greater losses. This highlights the significance of clearly defining your strategy’s style. If it’s a day trading position, it needs to be closed by the end of the trading day.

Strategy type:

In our earlier lessons, we familiarized ourselves with the primary categories of strategies: mean-reverting strategies, momentum strategies, and event-based strategies. These descriptions outline the nature of each strategy. To elaborate further, a mean-reverting strategy involves capitalizing on price fluctuations that oscillate between upward and downward movements, while a momentum strategy focuses on price consistently moving in a singular direction.

Holding period:

This pertains to “how long should I maintain my position,” where you establish both the shortest and longest allowable durations for holding a position. For instance, in day trading, you might hold a position for a minimum of a few minutes and a maximum of three hours. Consider a scenario where three hours have passed, the trade has yet to reach the desired take profit level, but it’s still progressing positively. It’s crucial to exit the trade upon hitting the three-hour mark, even if the trade remains favorable. This discipline in adhering to your predetermined strategy is paramount. Regardless of circumstances, you must exit as directed by your trading plan, even if it means missing potential opportunities.

Asset selection:

Which stocks or assets will you be choosing for this strategy? As we are aware, there is a multitude of stocks available, but not all of them are equally compatible with every strategy. Some perform more effectively with specific strategies, while others do not. Therefore, you need to carefully screen your assets to identify the most suitable ones for your strategy and establish the criteria for this selection process. For instance, criteria could include factors like high institutional ownership, low P/E ratios, or recent 52-week highs. The process of screening stocks is contingent upon the specific characteristics of your strategy.

Entry signal:

Essentially, this represents the trigger that prompts you to enter a trading position for the given strategy. For instance, if a stock breaches its 52-week high, there’s a crossover of moving averages, a reversal in the RSI, or the emergence of certain chart patterns, these could all serve as signals to initiate a trade. The specific signals vary depending on the strategy employed. so entry signal can be anything.

Entry style:

What method do you use to enter your trading position? Do you execute a single market order, place a limit order, or opt for multiple entries? You need to define the approach for entering a position, considering the strategy you’re employing.

Take profit signal:

At what point do you exit the trade to secure your profits? For instance, this could involve the trade reaching a specific percentage gain, encountering support or resistance levels, or when a trend undergoes a reversal, among other factors. This decision is, once again, strategy-dependent.

Take profit style:

How do you exit your trade to realize profits? Do you employ a limit order, execute a single market order, or opt for multiple exits? This approach is also contingent on the specific strategy you’re using.

Position sizing:

What is your approach to entering a single trade? Is it a singular entry or do you use multiple entries, incorporating scaling in or averaging in techniques? Additionally, what level of risk is associated with each individual trade? Moreover, if you’re employing multiple entries for a single trade, how does the risk for each entry within that trade compare?

Learn more about Position sizing.

Stop loss:

At what point do you decide to cut your losses if the trade goes against you? What is the upper limit for potential financial loss on a single trade?

What is your strategy for managing losses, and what are the exit criteria you’ve established for your positions? For instance, if the trend is disrupted, you choose to exit the trade, or if support or resistance levels are breached, you opt to cut the loss. In accordance with these rules, the stop loss price is then determined.

Bail out indicators:

“Bail out indicators” refer to specific triggers that prompt you to exit a position, irrespective of whether you’re in a profitable or losing situation. These triggers could be related to fundamental events or news that unfold in the market.

Below is an illustrative game plan for a Forex strategy based on Bollinger Bands:

Conclusion

Through this approach, you can observe how each strategy formulates a tailored game plan optimized for its specific requirements and the manner in which you intend to execute it. Consequently, it becomes necessary to create a game plan that aligns with both the strategy’s nature and your personal trading style. This game plan should cater to your individual type of trading and suit your lifestyle effectively.

In this field, sticking to a trading plan is the key to long-term success. Jesse Livermore, a renowned trader, achieved significant wins and losses due to lapses in his own rules. He acknowledged this in his own words, as detailed in the book “Reminiscences of a Stock Operator.”