The Basics of Trading:Part 2

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? It’s no good deciding to trade the UK markets on a day-trading basis if you’re 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 it’s 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:

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 isn’t working.

The question above are ones that you SHOULD WRITE DOWN. I’m 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 – it shouldn’t 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 haven’t talked about, but you still want them in your strategy. Great, the more detailed you can make it the better.

I’m often asked how long should you paper trade for? The answer is, it’s 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 I’ve mentioned before, your aim in the earlier stages of your trading career should be to stay “in the game”, there will be plenty of time to increase the stake size once you have traded profitably at the lower stakes for a time.