How many successful business out there do you think made it without a well thought out business plan? That’s right, very, very few. If they did succeed it was probably a fluke or fad. The businesses that are most successful, most certainly had a business plan that was followed, that evolved, that set about principles that ensured its success.
Here’s another poignant question. How many successful traders out there are operating without a business plan? The answer is very few, if any. Virtually all successful traders have a trading plan. So, what makes you think you’re different from all the successful traders? Someone once said, “If you want to be a millionaire, then do what the millionaires do.” And the extension to that saying is, “If you want to do anything well, then do what the successful people do.” The winners have discovered how to be a winner, you can benefit from their experience, their knowledge, their wisdom.
Here are some of the questions that a trading plan will address:
- How will you differentiate yourself from the all the unsuccessful traders?
- How will take the emotion out of trading, and be objective and focused?
- What type of environment do you need to develop your strategies and trades?
- What is your plan for educating yourself, keeping current with tools, technique and information?
- What are your strengths and weaknesses, how will you exploit your strengths, minimize your weaknesses?
- What type of trader are you, how does your lifestyle, job, responsibilities play into the type of trader you are?
- How will you size your positions? What is your money management strategy?
- What are your personal and/or professional goals, what do you want to accomplish with trading?
Every one of these questions should be addressed in your trading plan. Or, at the very least, there should be a well defined process that identifies the problem, outlines a resolution, defines the risks, and presents strategies that mitigate the risks.
In general, all the issues involved in defining your trading venture, can be distilled down to these basic categories:
- Your Mindset
- Your Methodology
- Money Management
Who likes to lose? Nobody. Yet, most traders are experts at losing. They don’t know when enough is enough. They fail to exit profitable trades in time, and they hang on to losing trades, sometimes doubling down with the failed thinking that they’ll make up for the losses they’ve already accumulated. No one likes to lose, yet the psychosis of losing can, and does, consume most of us.
So, it’s obvious that successful traders develop a mindset that avoids losing scenarios. They focus on maintaining the right attitude, those characteristics that ensure the greatest possible chance for success. The winners mindset. Learning how to be a winner, to think the way a winner thinks, first involves understanding yourself so that you understand where you need to concentrate your efforts. What are your strengths, your weaknesses? Are you a grounded person, or are you highly emotional? And most importantly, do you possess the discipline necessary to carry out your plan?
The stock market is an ever changing medium. It can challenge your sensibilities one day, then bore you to death the next. Therefore, patience is a necessary component to achieving the proper mindset. But even more important than patience, is your overall attitude to dealing with adversity and change. Change in the stock market is a given, the one universal constant that you can count on. Therefore, you must counteract that change by staying level-headed, you must be composed and deliberate, act with forethought, and without emotion. Only in this way can you use your best judgement, you’ll take profits accordingly, and you’ll accept losses because they were within the limits of the risk mitigation strategy your employed.
Getting to this level of objectivity only happens when you have confidence in your abilities and your plan. You develop that confidence through experience, and understanding what works, and what doesn’t. You gain confidence from the trust you have in your trading plan, and your ability to execute that plan. You have the knowledge, developed the skills, obtained the experience, and can exercise the judgement to be a winner.
Your methodology has mostly to do with the type of trading style, or styles, you feel confident and comfortable employing. But it also has to do with how you develop your theses, how you decide the proper point of entry, and what your plan is for exiting the trade. But even more important than those critical factors, is what size of a position do you plan on taking.
The size of your position is dictated by your tolerance and capacity for risk. So, what you need to understand, is precisely how much risk your willing to, and are capable of, taking on. First off, let’s define the difference between risk tolerance vs risk capacity.
- Tolerance– Risk tolerance is how you feel about taking on risk. Do you have the stomach for dramatic swings in the value of your portfolio? If you do, then you’re relatively risk tolerant. On the other hand, if dramatic swings in your portfolio keep you up at night and Tums are a major food group for you, then you’re probably risk averse.
- Capacity– Unlike tolerance, which measures how much risk you wantto take, risk capacity is a measure of how much risk you needto take in order to reach your goals. Your risk capacity will determine the optimum size of positions you take, that will allow you to reach your goals, in the time horizon you have chosen for yourself.
Another crucial part of your methodology plan, as I mentioned earlier, is the type of trader you are. Are you primarily a Day trader, Swing trader, or are you a Position or Trend trader? Each of these styles requires a certain amount of acuity in various analytical skill sets, as well as congruence with your life style. Here’s a breakdown of the various trader types:
Advantages: No overnight exposure, more opportunities, cut losses quickly.
Disadvantages: Greater transaction costs, greater need for advanced resources (computers, advanced software, feeds, etc), constant attention required throughout trading day.
Advantages: Potential for larger gains per trade, more time to analyze and setup trades, not nearly as intensive as Day Trading.
Disadvantages: Increased risk per trade, overnight exposure, requires more work to setup trades, Swing Traders tend to follow markets closely throughout the day, even if they don’t take positions.
Advantages: Requires the least amount of time preparing for trades, potential for huge gains, less likely than Swing Trading to get stopped out due to fluctuations in the market.
Disadvantages: Losses can be much larger due to much more liberal stops, tendency to miss out on short term opportunities, requires great patience to allow trade to develop, capital tied up for long periods of time.
As you can see from the type of trader you are, that will determine the disciplines, or analytical methods, on which you need to focus. It’s these disciplines that will tell you when taking a position has the highest potential to be a profitable trade. There are essentially three types of analysis that you’ll perform. I will expand upon these, and provide links to future articles. They are:
- Quantitative Analysis
- Technical Analysis
There are several other very important skills you must acquire. A fundamental understanding of the industry sectors is very important, as well as access to current financial information, and the ability to understand it in the context of the potential positions you derive. Other important aspects of your trading methodology that you should define in your plan include, your routine, whether it’s a pre-market routine, or some periodic routine in which you gather necessary data, evaluate it, manage your investments, etc. Developing a routine is a powerful technique to taking a lot of uncertainty out multitude of variables you must deal with, day in and day out.
Under the Methodology section I described the different types of risk you must consider. Well, the management of money is all about mitigating that risk through managing how you allocate your money. This all centers around a fundamental guiding principle that can be stated succinctly as:
- Capital Preservation First, Maximum Profits Second
So, the inexperienced trader will say that this is in direct opposition to my primary goal, and that’s to make money. Well, that’s what the INEXPERIENCED trader will say. The professional, on the other hand, will embrace this philosophy as the fundamental reason why they make consistent profits.
So, capital preservation isn’t just about when to exit a trade, it’s also about whether to make the trade at all in the first place. One of the biggest reason traders lose money is that they exit trades too late, or put another way, they don’t take profits early enough. The other big reason for losing money on trades, is that many people simply trade too often. There’s a fear that if they don’t stay in the game, they’re somehow losing out on potential profits. This is simply wrong-headed. You need to select your trades based upon your plan’s criteria. If the trade doesn’t meet your criteria, then you don’t make it.
Here are some of the aspects of money management. I’ll list them here, then link to future articles where I’ll explore these topics in greater depth.
- Position Sizing
- Exit Strategies, Stop Losses
- Asset Allocation
So, to wrap up this post on having a trading plan, it is imperative that you have not only considered these aspects of trading, but that you have a detailed strategy on how you are going to handle them. A comprehensive trading plan is a key to being a successful trader.
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