The Basics of Trading:Part 2

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Mark Williams

20 Jan, 2005

in Getting Started and 2 more

The Trading Plan

Building and using a trading plan is an essential part of trading. Without a suitable plan of action, it is highly unlikely that you will be able to create consistency in your trading.

Your plan should be clearly written, so that at any point before, during and after a trade, you should know what to do. This will make trading a lot easier and a lot less stressful - there can be nothing worse than looking at a losing position and not knowing where to get out, or how big the loss is going to be.

There are a number of elements that make up a good trading plan and it will be different for every trader. Here are the most important elements:

Which markets?

It may sound obvious, but which markets are you going to trade and are you able to trade them? Itís no good deciding to trade the UK markets on a day-trading basis if youíre doing a full-time job during the day. You also have to ask yourself "What advantages does this market have over the other options I have available?".

Who am I going trade through?

How are your trades going to hit the market? Will you use a spreadbetting company, a CFD account or a traditional broker? Which has the greatest advantages and do they have the level of service you require? Some people might find that spreadbetting offers the best deal for trading, but it might not be best for everyone.

Entry criteria

This is where things have to be detailed:

  1. Are you looking to buy low and sell high (swing trading) or buy high and sell higher (momentum trading)? What will get you into the market?
  2. Are you looking for a test of support to hold price up, or are you happy to get in mid-move? What will be the factor that confirms whether you take the trade or not. For example, you might be looking for the general index to be moving higher, or might be looking for some sort of indicator to signal a move in your favour is imminent.
  3. Does the trade you are about to take have a good risk / reward ratio? I would be reluctant to take any trade with less than a 3:1 R/R ratio.
  4. How are you going to place your trade? Are you going to use limit orders or market orders to get you in?

% Risk of capital on any trade

I make sure I do not risk more than 1-2% of my trading capital on any single trade. Any more than that and you risk a large drop in your account if you hit a bad patch or drawdown in your trading. Are you prepared to have more than one position open at any one time? Having more than one position open can get confusing on a short-term basis but for longer-term traders itís the most efficient way to trade.

Exit Criteria

As I mentioned earlier, there can be nothing worse than looking at a losing position and not knowing where to get out, or how big the loss is going to be. The exit criteria can take many forms:

  1. Are you going to set a stop-loss in the market or use a mental one? I would always advise using a stop in the market if you can.
  2. Are you going to use a trailing stop and lock in profits when you can or take them off the table when offered?
  3. Are you looking to exit at your price target or just tighten the stop?
  4. Are you going to scale the position out (selling out bit by bit) or take everything off the table in one go?
  5. How long are you looking to hold the trade open for? Are you looking to sell in hours, days, weeks, months or years from now?

What charting set-up

Which time-frames are you going to be looking at. This table will give you an idea of what charts you should be looking at:

Type of Trader

Holding Period

Chart to Trade Off

Tick Trader

Minutes

Tick / 1 minute

Day Trader

Less than a day

1-5 minute

Position Trader

Hours / Days

15-60 minute

EOD Trader

Weeks / Months

Daily

Long Term

Years

Weekly / Monthly / Yearly

Are there any indicators you look at?

Testing

Are you going to test the above strategy by paper trading, simulating or are you happy to go straight in and trade from the start. I would advise paper trading any strategy to make sure it works. Some look great on paper, but when it comes to actually trading they are not actually workable.

Time to change the trading plan

How long will you give the trading plan before you start to amend it? If you start changing a plan too early, you will risk not giving it a chance. Give it too long though, and you risk draining your account with a plan that isnít working.

The question above are ones that you SHOULD WRITE DOWN. Iím sure you can think about them in your head, but when it comes to the crunch, you need to be able to look at a piece of paper that tells you what to do Ė it shouldnít need much thinking about. These questions are the minimum that I would have as part of a strategy, you might find that there are other areas that I havenít talked about, but you still want them in your strategy. Great, the more detailed you can make it the better.

Iím often asked how long should you paper trade for? The answer is, itís a balancing act. You are balancing the need for understanding a trading plan with the need to trade for real. There is no getting away from the fact that real trading is very different to paper trading, for a start the emotional difference is massive and the risk with paper trading for too long is that you can get into a comfort zone, which makes the next step to real trading significantly harder. How long is really up to you, but my†advice would be that as soon as you are happy with the plan, plan a couple more trades and then start trading for real.

When it comes to trading for real, make sure you start small. As Iíve mentioned before, your aim in the earlier stages of your trading career should be to stay ďin the gameĒ, there will be plenty of time to increase the stake size once you have traded profitably at the lower stakes for a time.

In Part 3 of the article we'll look at a basic trading plan that I have successfully traded in the past.

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Thanks - very interesting, I use Proquote at work and was just wandering with regard to what you say about paper practice trading using historical data if you had any ideas on how to advance a chart on a day by day basis using this programme? It does not seem possible unless you know any better? Also I have started trading stocks (3-4 at a time) on the AIM that exhibit a high degree of short term momentum, (SBT etc) therefore support lines are steeply inclined and less consistant than in your barclays example, in such cases would you still recommend setting the stops just a few percent below the inclining resistance trendline?
Lastly and on an unrelated point what do you think of trading brand new issues?Tthe upside potential seems huge and obviously losses can be limited with stops, I saw one treble in value within 2 hours of market opening last week (forget the name now sorry). The lse website gives a list of forthcoming issues as does investors chroncle, but I cannot find anywhere that gives advance opinion on likely market reaction to the listing. Any ideas on this? Thanks

Feb 16, 2005

Newbie (3 posts)

Perfect for me!

Feb 07, 2005

Newbie (1 post)

Thanks to all of you for your kind comments. They are very much appreciated and it makes the whole thing worthwhile :cool:

I believe that part the 3rd and final part will be published this week (all being well).

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Hi Ale

Need to sort out the link on page 2 to Sierra - it sends you to the top of page 1.
Thanks for that, I completely missed that one :o

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Hi jimmy1jag

Instead of paper trading, however, I have just opened an account with Finspreads, where, for the first 8 weeks you have the option to join their (from memory) "Trading College". If you sign up to the trading college, you can trade at as little as 1p per point (for the first 8 weeks), instead of the standard minimum of 50p per point. The minimum you can put into the account at start up is £100. So £100 max. exposure and an opportunity to put the theory into practice for a low initial outlay. But trading for real money.
Excellent. The Finspreads trading college was designed for this very purpose and well worth doing.

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Hi tulaine

It's good to get confirmation of 'common sense' while I'm still gathering information and learning the ropes. Not sure I agree with the figures though. Setting a maximum risk at 2% of the bank and 1 open trade at a time means it could be ages before any significant profits are visible. Another advisor suggests 4% and 12 open trades, still risking less than half the bank at any moment. Of course exposure to risk is a personal thing, so no arguments can ever resolve such an issue. I may not be comfortable with 48% out, but I don't think 2% would satisfy.
I can understand your thinking, however before you think about going above 2% risk, then please please make sure that you can trade profitably below this level before moving above it.

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Jan 31, 2005

Member (1518 posts)

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