Stock Trading Plans: The Secret To Trading

When someone had first suggested I create a trading plan before I started trading, I laughed. Why would I need to write down on paper what I already knew. I dont need a plan to know how to breath, so why would I need one to trade?

Eventually, I did try and put together a plan. Problem was, every trading plan template I saw was boring. Most situations didn't apply to me, and I never really understood the benefit.

Until last year. After the markets dropped, I decided I had to do things differently. So, I started all over. With pen in hand, I started writing out some thoughts - these thoughts became the basis of my current trading plan.

Get Emotional - Just Not When You Are Trading

What many people don't realize is that the real secret to successful trading isnt in the stocks you pick, or the exit strategy you employ or even what markets you trade.

Its how you handle yourself when your emotions start to get the better of you.

How many times have you sold because you were fearful of additional losses? How many times have you held on too long because you got greedy. It happens more often than you think.

Trading is 80% psychology, and 20% stock picking.

By creating a mechanical market timer, you can remove the element of “interpretation” from your trading, therefore, removing many of the psychological challenges that lead to poor results.

With a mechanical timer, I no longer predict where the market is going to, but instead, continue to trade with the trend, while managing my risk more effectively.

The end goal is to develop a trading system that is easy to follow, easily repeatable and mechanical so that all of the trading decisions are made for you.

Creating a mechanical trading system, with a well written trading plan as its foundation is the key to increasing your profits.

Its surprisngly easy to create a trading plan!

Get Personal

The reason most trading plan samples fail is because they were written by someone else, reflecting their trading plan.

If you want to create a plan you can refer to when stuff starts hitting the fan, its has to be meaningful to you.

Ideal Trading Plan

• Simple, clear and complete – a complex plan leads to confusion
• Trading rules much be easy to use, objective and actionable
• Able to be back tested
• Within my comfort level
• Is 100% mechanical in design, allowing for little interpretation of the rules
• I should be able to hand this trading plan to anyone, and they should be able to follow it and achieve the exact same results.

3 Common Trading Errors:

• Failing to pre-define the portfolio risk and failing to set the consequent position sizes.
• Not using stops
• Failing to automate the trade as much as possible

Now we've laid the groundwork for the trading plan, lets start looking at the main parts of the plan

1. My Vision

This sets out the high level vision of what you want your trading plan to accomplish.

Example: During 2010, I will strive to obtain consistent gains with specific attention paid to capital preservation. Through the use of a mechanical timer, and execution of this trading plan, I will outperform the S&P 500 index.

By outperforming the S&P500 this year and in future years, I will achieve the future objectives I have set forth.

2. Major Objectives:

Now outline your personal and financial objectives. This is where you want to dig a bit deeper. You want to make it personal for you:

Example: Financial Objectives 2010:

• Annual Rate of Return: 60% or more
• Maximum Drawdown: 25% or less
• Maximum Portfolio Risk: 2% or less per position

Financial Objectives: 2011 and beyond

• 2011-2015: reinvest all profits
• 2016+ - begin trading full time, drawing 80% of the profits, while reinvesting the remaining 20%

Personal Objectives:

To create a steady cash flow to allow my wife to continue to stay at home and raise our beautiful1 year old daughter without having to worry about her working.

By setting specific goals, you can remind yourself each time you read the plan why you're doing all of this in the first place.

3. Major Strategies

So now we have established why we're doing this, and what we're aiming to accomplish with this plan. Next is how we're going to do it.

A couple of things to ask consider:

• timing the market - what will you use to determine if you are on the right side of the market? Will it be a moving average crossover? Will it be a specific market timing service like MarketClub VectorVest
• trading mistakes - how many mistakes will you allow yourself to make? A general rule of thumb is fewer than 10%. A trading mistake is caused by not following the plan precisely, or an operational error such as entering a trade order incorrectly. A trading mistake is not a trade that didnt work out. How will you record your trading mistakes and how often will you review them? How much money could you have made if you had just followed your trading plan?

4. Trading Rules

List each step you will follow with as much detail as possible. Remember, you should be able to hand this trading plan over to someone else and they should be able to trade the plan and get the same results as you.

Example:

• Update market timer (mine is calculated by Excel so that the numbers provide the direction, not me)
• Based on the signal, run the applicable scan
• Update stops
• Place orders
• Watch TV

You should also state if you will use margin, what position sizing strategy you will use, what your maximum portfolio risk will be and the maximum position size.

Each of these variables, if not defined can be open to interpretation. Define them so that there is no room for interpretation.

5. Confidence Building

This is where you state what type of testing has been done to establish your trading rules. For example, if you say in your trading rules that you will go long when the 5day moving average crosses over the 35day moving average, what type of backtesting have you completed to ensure this strategy work? What were the results?

If you have confidence in the trading rules, you'll have an easier time trusting your market timer when emotion starts to get the better of you.

6. Contingency Plans

These are your what if scenarios that aren't covered in your trading rules.

You'll want to address your portfolio stop (what will you do if your portfolio drops by x% in a given month), your signal stop (what if your market timer isnt working - what will you do to protect your portfolio), and equipment contingencies (what if your internet connection goes down).

These will help to address potential risks to your portfoliol.

7. Routines

Its much easier to follow a plan if it follow a routine. Personally, I do all of my trading at 8pm. I do my monthly reviews on the last Saturday of the month between 9am-10am as I enjoy my morning coffee.

8. Beliefs

Van Tharp says that we trade our beliefs. I used to think this was garbage, until I wrote out my beliefs:

• I am a trend follower
• I cannot predict the future and fully accept that I cannot control the markets. I can only control what I can do.
• I believe the more mechanical the system, the better
• I can be overly critical and notice only the negatives in my trading
• I consider success to be fleeting and fear that it will not stick around

This is where your trading plan truly becomes YOUR trading plan. My trading plan addresses my beliefs (as a trend follower, I dont trade during the day) and helps to re-enforce the reasons why you developed the plan in the first place.

Thats It

These 8 steps can be adapted to any trading methodology or trading style. It doesn't require a specialized tool - you can make it as complicated or simple as you feel necessary.

The trading plan is highly individual and will be based on your skill and temperment.

Of course, completing the trading plan isnt enough - you have to trade the plan.