It is human nature to plan things ahead of time. Despite the thrills we get at times by being spontaneous, in most cases and especially in the day to day aspects of life, humans tend to prefer order to chaos.
It is not surprising then that in almost all aspects of life we are governed by some kind of a plan. Take for example a new washing machine that you have just bought. Chances are that it comes with a manual. The technical manual is nothing but a plan of action, which tells you what to do when something happens.
Whilst there is a debate in the world of human psychology as to whether chaos or order is better, one thing that stands out for order is that with a plan you are prepared for the eventualities. This puts you in better control of things.
So, going back to the example of a washing machine, if the spinner is not working, you know what to do. And surely when things go wrong, your manual no doubt comes to the rescue. The world of financial trading is no different from the above example.
What is a trading plan?
In the world of financial trading just about every trader and money manager worth his salt is most likely to have a trading plan. There is a well known saying, fail to plan and plan to fail! It might be clichéd but the truth of the matter is that when it comes to trading, it is only preparation that can help you to survive.
A trading plan might sound complex at first and could be overwhelming for beginners, but think of it as a blue print or a manual that prepares you for most of the eventualities that you might face when trading.
A trading plan is of course the result of having or following a trading strategy. Say for example if you want to buy EUR/USD targeting 20 pips in profit.
A trading plan will tell you:
• How much money to risk in the trade • How many units or contracts to trade • How to manage your trades
Thus, a trading plan is a culmination of various aspects of trading, starting from money and risk management to trading strategy and trade management.
Let’s explore these in a bit more detail.
A trading plan makes you focus on money management
Whilst it is relatively straight forward when you are placing just one trade, the moment you add a few trades, or even multiple positions to the same trade, you can expect things to become complex.
At the very core, money management tells you how much money you can afford to risk based on your trading capital and the risk reward ratio of your trade.
Whist money management is an entirely different and vast study in trading, it ties in perfectly with a trading plan. By following a trading plan and starting with money management, you are essentially starting off on a firm footing, controlling your risk right from the start.
A trading plan makes you focus on risk management
Risk management is often confused with money management. It might be similar to money management but only to a certain extent.
Risk management essentially deals with how to manage risk. Risk management is all about what you should do in case the markets behave erratically, or different from what you perceived that markets would do.
Risk management is all about contingency and how to deal with certain events. For example, advance risk management techniques can be even hedging the currency pair, or looking at inter-market correlations to minimize risk, or perhaps the most widely used risk management techniques, using derivatives.
With a trading plan, risk management helps you to deal with any eventualities or surprises that the markets can throw at you. It might shake your confidence but with robust risk management techniques you can quickly get on top of your trades.
A trading plan helps you in trade management
Trade management is all about how you nurture your trades. For some traders, trading is very basic. Enter at price A, exit with a profit at B, or exit with a loss at C. But trading is more complex than that.
Sometimes using multiple contracts traders can focus on just one trade but manage multiple positions. Position management as it is often referred to, requires a lot of focus and discipline and deals with managing multiple positions simultaneously.
A good trade management incorporates all aspects of this including telling you when to partially exit your trades, where to move your stops to break even, when to lock in the profits and so on.
What are the benefits of using a trading plan?
There are a number of benefits of using a trading plan if one wants to run with it. It might sound time consuming but a trading plan helps you to consistently keep learning by providing feedback on your trades.
Most essentially, a trading plan will help you to keep your calm when things go south!
As the famous John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent.”
A trading plan is what it takes to remain solvent in such instances, be it from either protecting you from taking on more losses, or ensuring that you book profits regularly so the markets do not take back the money left on the table.
With the above said, let’s finally take a look at how to get started with a trading plan.
Getting started with a trading plan – the 5 steps
Here are five brief steps to help you get started with a trading plan.
1. Analyse the markets
Spend some time to understand what the markets are telling you. Focus on the fundamental events that could shape the markets during the day or during the week. Based on your analysis and the trading system that you follow, pick a few assets/instruments that you want to trade.
2. Set a goal
Having a goal is important as that is the destination you are heading towards through your trading plan. A goal can be either to make a certain amount of profits during the week or the day, or to limit your losses to not more than a certain percentage of your capital.
3. Set a risk level
Set a global risk level for your account, or specific risk levels for each of the trades that you intend to take. Also take into consideration how you want to trade, should you just keep it simple with fixed entry/exit levels or do you want to make use of position management.
4. Have your triggers ready
Having a plan is one thing, but you should know when to pull the trigger, also known as timing the market. Knowing when to enter a trade is just as important as knowing when to exit. Focus on solid good trade management to fully capitalize on your plans.
5. Stick to the plan
Despite all the preparation, it can be very easy to throw the plan away and trade with your guts. Sticking to a trading plan is probably the hardest thing, but can give you immense rewards that can be quantified. With enough practice however, it should become second nature. So, to summarize, a trading plan is an essential aspect of trading that is required which will help you to keep your emotions in check and to approach the markets objectively. While a trading plan will in no way guarantee you from taking losses, it will certainly help you from taking on more losses that what you can risk or tolerate.
If you want to succeed in trading and want to build consistency in your trading skills, a trading plan is your best tool.