That planning and trading are two essential ingredients for success is borne out by the saying, “planning without action is futile, action without planning is fatal.” This could not be truer than in stock market investing where you need to know where your last dollar went and where you next dollar will likely come from.
How do you create a trading plan? All trading plans should at least include the basic requirements covered by the acronym C-P-R.
The CPR Trading Plan
Before you start buying and selling stocks, you need to consider three key areas: Core rules, Psychology, Risk management. Your core rules are the trading triggers and setups that you use to trade. Psychology refers to having the right mindset. Risk management relates to how you manage your capital or money.
How do these 3 components work together to create a trading strategy? Let’s find out.
Core Rules
When it comes to trading rules, most websites focus on entry points. You will see newsletters and advisors screaming that ‘now is the time to buy before the explosive upside’. People trying to hawk their trading system might show charts outlining how triple digit profits were made in record time. What is the truth? Getting a timely entry is a difficult at best.
A timely entry may be based on any of the following events:
- a positive announcement or reported event in the news
- some fundamental change in the company such as higher profit margins and an increase in revenue
- technical indicators that track volume, momentum, and trend
More important than your entry will be your exit point or when to sell. Even if you pick an amazing entry, it is meaningless if you let profits slip away. Exits can be triggered from the following:
- a negative news item
- a negative fundamental change such as a decrease in earnings or drop in sales
- technical indicators that signal a downturn in price, increased volatility, or performance weakness
- selling points based on trailing stop-losses or support and resistance levels
- selling automatically after a set period of time
Your exits also relate to risk management that we will cover a little later on. The entry and exits you use are largely dependent on the specific strategy you use (short-term swings or long-term trends) so it is not possible to cover every possible combination. That being said, your plan must have well-defined rules to buy or sell – anything less is wishful thinking and emotional trading.
Psychology
You can have two traders that are using the same set of technical indicators and the same strategy on the same stocks with one person being wildly profitable and the other losing horribly. Why? It all has to do with emotions and trading psychology.
What are the attributes that make a successful trader?
One key area not to be overlooked is self-discipline. No matter how good a trading system is, it will never make you money unless you can follow it when trading. What if you lack self-discipline and find yourself frequently trading based on fear or losing money or chasing stocks that seem to be getting away?
- One method to help you improve is to trade with a partner and use them as a sounding board before your trade
- The second method is to write your entry and exit requirements down for each trade before investing. This may not be possible if you are in the high frequency trading category
- If you find yourself going against your trading rules – have a punishment system where you shut down live trading for the day and stick to simulated trading.
- One other method is to lower your trade value to a small amount and increase it slowly as your nerves allow or when your discipline returns
Another needed quality in a trader is patience. An impatient trader may make hasty trades simply because he wants the market to do a certain action. If you lack patience, your losing trades will skyrocket as your emotions now make the decisions.
- Patience is needed when making a trade and not jumping in a stock before your signals confirm the move.
- You need patience as you wait for the stock to react after buying – they will not typically shoot straight up the moment you enter.
- You also need patience to make your annual profit target. If you have a 30% profit goal, you are hoping to gain 2.5% every month and not 10% a month for the first 3 months. It takes patience to wait for the long-term rise.
Having or developing the ability to make a sound decision with a clear mind and see it through with self-discipline and patience is mandatory if you plan to be a successful trader.
Risk Management
Risk management is the most important aspect of your trading plan. Winning systems will go through rough periods where little money is gained. If your strategy does not have any risk controls in play – you could lose despite having some of the best trading rules. As a simple example, if you bet all your money on the toss of a coin, eventually you will lose 100% of your money despite having the ability to guess the toss correctly 80% of the time.
How can you manage risk? There are a few ways you need to consider:
Diversification is one risk control. You can diversify in many different ways. Assuming you have a large list of shares all meeting your buying criteria, you can choose from a variety sectors and industries. You may choose some larger stocks and some smaller stocks to diversify market capitalization. Diversification can include domestic or foreign shares. Deep value and growth stocks are two broad categories that add to diversity. One aspect of diversity that is important to understand is that the products need to be different and independent from each other as much as possible; 4 oil stocks – even if some are big and some are small – do not give much in the way diversification.
Another way to control risk is by limiting the amount you put into each trade. Assuming you have a decent amount of capital to start with, you should limit your loss to no more than 2 – 5% of capital on any one trade.
(i.e. if you have $100,000, no more than $2 - $5K should be loss on any one trade.) Peter Lynch advises trading roughly 10 - 20 stocks, but no more than 5 at any time are necessary if you have a higher cash position. This will make sure you do not have too many eggs in one basket when a trade goes South.
Another way to determine risk is to look at the underlying option value if they are available. If implied volatility is high there is higher volatility risk associated with the stock. The less the implied volatility the lower the known risk exists, although the profit expectations will likewise be less.
Risk can be managed by how you allocate your assets according to broad markets like options, bonds, cash, mutual funds, shares, FOREX, and CFDs. Even if you are trading leveraged markets, you can lower risk by parking much of your idle capital in other products of lower risk.
Other risk management techniques can include stop orders that have you selling your shares if thresholds are met. For instance, William O’Neil – founder of CAN SLIM – recommends selling when share prices fall 7 – 8% below your purchase price. Other sell points can be when a technical price resistance is nearing. Trailing stop orders are exits the move with you on the upward climb but they keep their footing as an exit order when shares fall. The percentage below the price you make a trailing stop-loss is largely dictated by the type of trading you do.
Some try to lower risk by picking low beta stocks, or ones that historically move with less market-based volatility. Think of these as companies that are de-leveraged against the market.
Point-form Considerations of a Trading Plan Template
Core Rules
- What markets are you trading? CFDs, FOREX, shares, options, or some other product?
- What are you entry signals? Technical analysis of trend, swings, or momentum? Fundamental analysis of earnings, dividends, and revenue?
- Will you include broad market data including sector and industry information or trade each stock like an island?
- What order types will you use: market or limit? Does your broker give you rebates for adding liquidity?
- Have you backtested your core rules or did you derive your strategy from some book written 30 years ago?
Psychology and Mindset
- Do you have a location where you can trade with a clear mind with little distraction?
- Do you have the discipline and patience needed to carry out this specific type of trading; is the strategy too tedious and does it emotionally wreak havoc?
- Does this strategy play up your strengths while downplaying your weaknesses?
- What checks and balances do you have in play should you start to emotionally trade as opposed to sticking with the plan?
Risk Management
- Do you have proper exit orders that utilize absolute stops, trailing stops, market changes, company fundamental changes, increased volatility, technical indicators, or support and resistance levels?
- Have you diversified according to broad asset classes, markets, sectors, industries, size of company, value or growth, countries, or other products that do not have a high degree of correlation?
- Have you analyzed implied volatility in option premiums or considered the volatility risk associated with the beta value?
- Are you trading enough companies – possibly 10 to 20?
- What is the maximum loss you are willing to take on any one position, or on your entire portfolio?
These are just a few examples that you can use when developing your very own trading plan. Remember that trading without a plan to reach your goal is like a dream – is feels good but rarely meets with reality without a lot of hard work. For more here is a sample trading plan [coming soon].