A trading plan is an indispensable tool to reach your goals: it makes you better organized and allows you to operate efficiently and effectively. Most importantly, a trading plan is a convenient way to measure success. Let’s discuss the fundamentals of trading plans so you can start making yours.
What is a trading plan?
When it comes to trading, blindly following someone else’s piece of advice, or worse, not having any plan at all, are surefire ways to burn through your capital. We have different circumstances in life — personal views, thought processes, market experiences, and risk tolerance levels must be considered when assembling your trading plan. Ultimately, how you will trade will be determined by your preferences and lifestyle.
A trading plan makes trading simpler and smarter. In essence, a trading plan defines what you’re supposed to do, why, when, and how. It integrates your personality, expectations, trading system preferences, and risk management rules, so you become your own trader.
It is important to know clearly why you chose to become a trader, as your motivation determines the type of trading style and the kind of plan you will adopt. If you’re looking to top up your retirement fund, yet lack the time to day trade, position or swing trading may be for you since longer-term swings, and less micromanagement might be attractive to you.
Also, be aware that emotions may cloud judgment. Life gets in the way sometimes, and things happen that impact our ability to make sound decisions. With a trading plan, we reduce the impact of these situations so we can make trading decisions as rationally as possible.
What are the elements of a successful trading plan?
Crafting a successful trading plan involves more than just keeping your emotions in check. As we go in deeper into this topic, we must explore the different elements that could help mitigate your losses and maximise your profits.
Overall market risk
Risk and money management are a staple of any trading plan. Investing in the forex market has inherent risks. This is why, before trading, you must set for yourself an amount of capital that you are comfortable risking. This defines overall market risk.
For instance, if the overall market risk in your account is 3% of your total account equity, you can execute two possible trading strategies: three open trades with 1% risk each will put you at your ceiling. On the other hand, two open trades risking 1.5% each also reach your threshold.
Stop-loss orders are placed for your protection and are included in your trading plan. Risks are contained to prevent large-scale losses when you hit the set level. If you’re currently in a long or buying position at a demand area’s top edge, the price action approach will tell you that stop-loss orders are best for a few points in the south.
Risk and reward
Each currency that you risk in trading has a potential financial reward for you. This is measured by the risk/reward ratio. If you are trading US dollars and your ratio is at 1:3, you expect a three-dollar return for every dollar that you will invest.
In relation to this, your success ratio must be considered as well. Your success ratio is your number of winning trades in proportion to the number of losing trades.
Knowing when to exit is as important as when to enter the market and is a good risk management principle that many tend to overlook. This curbs greed and helps eliminate revenge trading or the emotional response that compels traders to attempt to recuperate from any loss. Here are two examples you may use:
On a profitable trading day, stop when your daily targets are achieved. Shut down your computer when that happens.
When your permissible daily loss of 3% is hit, shut down your computer as well and begin again tomorrow.
In case your smartphone or computer malfunctions in the middle of a trading session, do you have a plan to deal with this? What if your internet cuts out; do you have a back-up plan? These are contingencies you need to plan for. You should also have your broker’s contact details for emergencies.
The amount you can afford to lose any time must always be the limit of your trading capital. Exceeding your limit may drain you and negatively affect your financial capacity. Thus, your trading plan should have a cut-off point. For example, if a downtrend causes your equity to fall below your preset limit of 25%, you should temporarily halt trading until you identify the reasons behind it.
Constantly modifying your position size, whether upward or downward, could negatively impact your trading stability, and could lead to some of the less rational decisions that losing traders make. Sticking to your position size is another way to curb both excessive greed and the impulse for revenge trading.
Trading plans help you stay the course and are crucial when starting in the forex market. Having a set of rules to guide you will limit the likelihood of a big downturn. You can always work with your broker to create your trading plan.