What is a trading plan and how to create one?
As someone new to trading, it can be quite confusing how to begin. I would recommend that all new investors read the guide to forex trading before they think about crafting their first trading plan. If you already have, the next step is to understand what a trading plan is and how to create your trading plan. Some experienced traders may still not fully utilise a trading plan, so this article can also benefit them and help them increase their proficiency in the market.
Whether you are going to start forex trading, index trading, or cryptocurrency trading, a trading plan is essential to get your journey started on the right track. This article will follow a 4-step process that will help new traders understand just how important a trading plan can be and what different aspects they will need to consider. Firstly, let's discover exactly what a trading plan is.
What is a trading plan?
A trading plan is a strategic process for investors to follow when identifying and trading in a particular market. There is a set of variables a trading plan includes such as goals, risk, strategy, and trade management.
The trading plan should be created and used by a single person but it’s a good idea to get an understanding of how other traders approach their plans. Some traders have different attitudes about the way they approach risk and capital, guiding the decision-making and process of their plan.
How to create a trading plan using a 4-step process
- Step 1: Why do I need a trading plan?
- Step 2: Goals and risk management
- Step 3: The trading plan strategy
- Step 4: Trade entries and trade management
Why do I need a trading plan?
The common question often asked is why would one need a trading plan. To exemplify its importance, here is an example.
Trading plan example
Imagine opening a business - say, a cafe. Instead of selecting a location randomly, the standard approach would probably be to draft up a business plan with the following considerations:
- In-depth research of the market environment
- What the competition is doing
- What is the unique selling point and how to get an advantage in the market
- The cost-benefit analysis of running the cafe
- Various financing options to get started
There definitely is much more to it but to sum it up, there is plenty to do before the first cup of coffee is sold.
When it comes to starting up a business, developing a plan to serve as a framework is seen as essential. However, in trading, there are unfortunately plenty of traders who think that it is not necessary to have a trading plan despite the numerous benefits!
Identifying expected outcomes and setting realistic goals
First, a trading plan will present a trader with the question of why they are trading in the first place. It is critical to know the answer as it will help determine their expected outcome from this endeavour. For example, there will be some who want to make a living from trading to help their financial situation, while others will take it as a hobby to get some extra income. Whichever view you adopt, there is no right or wrong answer! More importantly, the investment plan is there to help the trader realise what it is exactly that they want out of the market, so realistic goals can be set.
Thus, a trading plan should be treated as a personal roadmap, which outlines all the goals that one wants to achieve. While the hobbyists might be satisfied with a couple of hundred dollars per month, there will be others who might expect much more. The hobbyist’s roadmap will probably be centered around getting some extra income while working toward steadily increasing it. Others might aspire to become professional traders and thus will have bigger goals, which makes it crucial to have a detailed plan and a clear vision to achieve it.
Therefore, every trader will benefit from having a trading plan regardless of skill or interest level as it makes it easier to identify what type of trader one is, which then determines what risk tolerance and strategy suits them best.
Avoiding emotional pitfalls
The second benefit of a trading plan is that it can bring order and structure into your trading. Trading may be stressful and emotional at times. It happens to traders all the time and results in them overreacting and taking a trade purely based on emotions, instead of facts and figures. Although having a trading plan will not negate this entirely, being organised will give the trader a clearer picture of what they are looking for in the market.
As a result, this reduces the probability of ending up with losses due to impulsive revenge trading. Moreover, a trading plan makes it much easier to analyse the trader’s results. Imagine operating without a clear strategy and relying on the intuition of what is the best move. The strategy involved will wildly fluctuate, constantly shifting from trading continuation and reversal patterns on the hourly chart, to scalping the Aussie Dollar on a five-minute chart or trading the news. While a statistical analysis of the performance can be performed, the results will not provide any valuable insight because of how often the person skips from one trading system to the next in such a short time.
On the other hand, by developing a concise strategic plan and sticking to it for a while, only then will a trader be able to effectively analyse their performance and gather valuable information to help them improve as a trader.
What kind of trader are you?
Lastly, a trading plan will help you identify what your trading preferences are. Are you more comfortable trading short-term or do you prefer medium-term to long-term trading? Understanding what style is best suited for each individual, allows traders to learn more about their risk appetite. One does not need to know the answer immediately, and preferences can change with time. Therefore, this is a situation where a demo trading account can be very helpful, as a trader can practice without using real money.
Understanding one’s own risk profile is fundamental to trading as everyone has different approaches. Some are natural risk-takers, and when they hear the word “risk”, they start associating it with “opportunity”. However, there are others who are more risk-averse and prefer to limit risks to the lowest possible level. Knowing and understanding one’s own risk level will allow each trader to adjust their risk management techniques accordingly.
Furthermore, this helps in identifying other personal traits that can make an individual a successful trader; in other words, knowing their edge as each trading style is defined by each individual’s own strengths and weaknesses.
How does a trading plan help with trade performance?
Simply put, a trading plan helps by identifying expected outcomes, setting realistic goals, and understanding a risk profile, which in turn determines a trading strategy and style. This helps to eliminate emotional pitfalls that might be present when one is trading.
However, formulating a trading plan is just the initial step. What comes next is evaluation. It is important to note that a trader must constantly analyse each and every individual trade undertaken and its following results closely. Was the plan followed, and if not, why? The frequency of evaluation differs from trader to trader. Intraday traders should do a daily review of their trades, while for long-term traders, it might be sufficient to do a weekly review.
Having a trading plan also allows an individual to track whether there have been improvements made. After each analysis of the trader’s performance, they can discover where things went right or wrong. No one can be a perfect trader as losses are part of the game. However, by constantly analysing performance, errors, and weaknesses can either be eliminated or reduced, whereas, winning streaks can be further built upon.
Now that you understand why and how a trading plan is beneficial, it’s time to put this into action and start crafting the basis of a trading plan in step 2, by setting goals and adopting risk management techniques.
Goals and risk management
Any strategic plan needs to have a set of outcomes to achieve. By setting these goals and preparing yourself with risk management in place, the process of following the plan becomes clearer.
Is a trading plan static?
It is important to mention again that a trading plan is a personal document. There is no correct or incorrect way of creating one. It should at least cover some key topics, but the structure and style of the trading plan depend on the preferences of each trader. Therefore, the content of this article should merely be considered as examples that might help in the process of creating a trading plan. Furthermore, please keep in mind that a trading plan changes continuously, as you might switch to a different strategy or increase/decrease your risk appetite. A trading plan is not something that is written once and then left in its original form.
Setting goals in the trading plan
The first step of every trading plan is to set goals to achieve. It should explain what the purpose behind trading is and what an individual wishes to achieve with it. Some traders have a certain number in mind – such as a certain percentage of return per month. Others prefer not to have specific numerical goals but rather evaluate their overall development as an investor. Again, there is no correct or wrong method here. Every trader should use what they feel most comfortable with. Stating the reason for being in this business and what the goals are will help with focusing on the bigger picture, and serve as a reminder of why the trader is investing so much time and effort into becoming a successful one.
Adopting risk management measures
The second part is all about risk management. To keep it simple, let's assume that the following example revolves around one single trading strategy. In the picture below, there are certain risk management criteria listed. The first is about defining the maximum risk a trader is willing to take per trade, and involves calculating the percentage before an order is executed. To avoid overtrading, it may be prudent to set a maximum of trades to take in a single day. A limit can be set by defining the maximum number of consecutive losses before trading should stop. To elaborate, should there be an event when there are more than three consecutive losses, follow the 3R rule. This is an acronym for Rest, Reconsider, and Restart.
The 3R rule
The purpose of the 3R method is to help a trader calm down and prevent emotional trading. After a series of consecutive losses, it is natural to feel upset and to have the urge to make up for the losses as quickly as possible. Unfortunately, this may result in even larger losses. If the 3R rule has been followed, there will be time to think about what went wrong and to look at the market objectively again, instead of having skewed perceptions.
There is another approach to the 3R rule, which is for a maximum drawdown. This is the largest loss that a trader is willing to tolerate. It is important to note that this is not meant for each trade, but overall. For example, in a situation where a trader might be down 5 percent on their account, they might want to rest for at least 48 hours and analyse what went wrong exactly. It is easy to overtrade and to get emotional if there is a lack of clear perspective and no rules in place.
Please be mindful that the numbers in the table above only serve as an example. An active trader who has i.e. 20-30 transactions a day might not see three consecutive trades as a major issue. A day trader might be looking at a higher number of trades. However, for someone who trades off the daily chart and has only a couple of trades per month, three consecutive losses might be considerable. Therefore, every trader needs to define their own level of risk undertaken.
Calculating the risk-reward ratio
Finally, there is the minimum risk-reward ratio. This is when a trader decides to stop and take profit orders in advance, which is very simple to calculate. Some traders set their minimum risk-reward ratio as 1:1. This means that if they are considering opening a trade that - according to their analysis - might generate 60 pips in potential profit, they are not willing to risk more than 60 pips either. If the trade would require a larger stop, the trader may decide not to take the trade. The idea behind this is not to risk more than the expected return.
Goals and risk management are critical to having a strong trading plan. In the next step, we will cover more areas needed to build a trading plan, including the trading plan strategy.
The trading plan strategy
It is important for a trader to ensure that their strategy is as detailed as possible. While some portions of it can be discretionary and difficult to define, the general rule of thumb to follow is to include as many details as possible.
A trader’s edge
Each trader should try to identify their own edge. This might be a set of skills that the trader possesses. For example, some traders might have a short attention span but are quick with numbers and can handle the stress of intraday trading extremely well. Whereas a trader with a different trading style may not be able to function efficiently in this kind of environment, but could instead be a skilled strategist who can always keep sight of the bigger picture.
For beginner traders, it is especially important to identify what skills they may have and tailor the trading strategy according to each individual’s personality, not the other way around.
What does a basic trading strategy look like?
- Example 1: Buy if the 5-day moving average crosses above the 20-day moving average and the RSI is below 70.
- Example 2: Sell if the 5-day moving average declines below the 20-day moving average and the RSI is above 30.
This is a simplified example that contains two of the most popular technical indicators. The trader who uses this strategy could potentially see the moving average crossover as a sign that momentum is building – either to the up or downside. They might have added the RSI (Relative Strength Index) as an additional filter, as the trader wants to avoid buying a currency pair when the RSI is showing overbought conditions or selling a currency pair when the indicator is showing oversold conditions.
They could even come up with the idea to add further indicators to prevent trades in a low volatility environment, like the Average True Range (ATR) or the Bollinger Bands.
The logic behind this could be the following: The 5-20 DMA crossover may signal that the current trend could extend further as momentum is accelerating. However, the trader does not wish to take trades in a low-volatility environment as this may decrease the quality of the signals.
The above example shows a very simplified take on what a trading strategy may look like. However, there are other requirements for a trader to take note of.
Outline of a trading strategy
The outline of a trading strategy consists of the following areas:
- Logic - (the thinking behind the strategy and why you think it will work)
- Objectives - (your goals)
- Characteristics - (e.g. you decide you only want to trade during the Asian trading session as your tests showed the strategy performs the best at that time of the day)
- Risk Management Rules
- Entry Rules - (when to enter a trade)
- Trade Management Rules - (stop-loss and/or take-profit - fixed or trailing)
- Exit Rules
Very few traders find the right strategy straight away. The majority will spend a significant amount of time testing various strategies in a demo environment and/or backtesting. Even if a trader gets to the point where they find a strategy that has promising results and feels right, it is unlikely that they will stick with that exact strategy for an extended period of time. The financial markets are evolving constantly, so traders must make changes too.
Trade entry and trade management
For the last step of this process, we will discuss three important topics:
- Trade Entry
- Trade Management
- Trade Analysis
Trade entry
How a trader manages their trade entries will mostly depend on their trading style. Scalpers will not have much time for planning and will make many intuitive decisions. This is different for people using a swing trading strategy, as they may end up never using market orders and instead, rely solely on limit orders. As with the trading plan, there is no correct or incorrect way of entering a trade – much depends on the trading style and strategy of each trader.
However, it may prove beneficial to define the entry criteria carefully and add filters. You can start by defining your trade signal, trade entry, and additional rules if needed.
A simplified example might look like this:
- Trade signal: Buy if the 5-day moving average crosses above the 20-day moving average and the RSI is below 70.
- Trade entry: Buy on the next candlestick open following the crossover.
Examples of Additional Rules:
- Only enter the trade during the European trading session (for example, if the strategy has statistically been proven to be most successful during this trading session)
- Only enter the trade if there is no major holiday in one of the countries where the currencies are issued (e.g. avoiding Japanese Yen during Japanese public holidays)
Trade management
Scalpers might need to manage their trades with a lot of discretion, but in general, a lack of proper trade management rules can lead to emotional decisions such as closing out a trade too early or adding to losing positions.
The simplest method is to add a fixed stop and take a profit order at the time you are opening a trade. If you see that the market has turned and the reason for entering the trade is no longer valid, you may decide to close it earlier. However, for beginners, it might be difficult, as they could end up closing trades too early. In a worst-case scenario, the trader might constantly take profits too early, but leave the losing positions running in the hope that the market will turn in their favour again.
Therefore, beginners might find it easier to set stop and take profit levels in advance, and stick to them. If you get stopped out way too often, you have to review where you place your orders and/or if your strategy is still functioning properly.
Trade analysis
A trading journal can be a good addition to a trading plan. There, you can log all of your trades and add comments – e.g. what went well or what went wrong. With time, you may discover valuable information and learn from your constant observations.
When analysing a trade, you want to look at how you entered a trade, how you managed it, and how it was closed (manually or triggered by a stop/take profit order). Furthermore, you want to identify if you have made any trading mistakes or have broken your own trading rules. However, do not focus only on the negative parts – it is important to make note of your success as well, as you may learn new things and can utilise them to improve your strategy.
It is best to review your trades and update the journal during quieter periods. For example, if you trade during the European session, you may do this after the session has closed.
To summarise:
- Determining a trade entry should help you identify the right conditions to enter a trade according to your own rules.
- Trade management could prevent traders from making emotional decisions and closing trades too early or too late.
- Trade analysis is an efficient way to identify your weaknesses and build on your strengths.
Now that you've crafted your own personal trading plan, it's time to monitor the market conditions and start to achieve your trading goals.
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This information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. It has been prepared without taking your objectives, financial situation, or needs into account. Any references to past performance and forecasts are not reliable indicators of future results. Axi makes no representation and assumes no liability regarding the accuracy and completeness of the content in this publication. Readers should seek their own advice.
