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Stocks & Commodities V. 27:3 (44-49): The Trading Plan by Cory Mitchell

Never Trade Without One

The Trading Plan

When creating a trading plan, you have to take into account trades too early or not at all because of anxiety, staying in
LISA HANEY

all the possible contingencies. Here are the steps you should
go through when designing your game plan.
by Cory Mitchell
trading plan is your carefully thought-out and
trades after profits should have been taken due to an emo-
tional attachment to a tradable, or exiting too early and for a
minuscule profit when it should have been left open longer.
THE BENEFITS
Having a trading plan will allow you to navigate different

A tested way of approaching and beating the market

over the long term. It is the course of action for
entering, exiting, and managing your trades so
that all contingencies are considered before a
trade ever takes place. With such a plan, emotions
are left out of the trading equation, and only tangible criteria
are used to make trades. Emotions can cause many problems
in trading, including entering trades out of boredom, entering
Copyright (c) Technical Analysis Inc.
circumstances methodically and logically. This process can
be repeated, tested, and then altered if results are not up to
your standards. If you trade based on emotion, you will not be
able to go through this process because your emotions will
always get in the way and you will react accordingly. Prob-
lems can be avoided by not having to trade on reactions to the
moment. The market is in constant flux, which in turn means
emotions can be in constant flux. Well-laid-out trading plans
Stocks & Commodities V. 27:3 (44-49): The Trading Plan by Cory Mitchell

Scalper

Frequency Of Trades
will allow traders to avoid this trading style that allows you to
Trading Style Day
barrage of emotion as they will make more trades, such as
know in advance how to handle daytrading or swing trading. If
each situation as it arises. you are impatient, you probably
Swing
Designing a trading plan gives want your trades to be quick and
you ground rules by which to more frequent. If you worry about
trade and a consistent basis for Position positions or money, you may
which your results can be com- want to take on several positions
pared using different trading cri- Less Aggressive More Aggressive for the longer term, but with small
teria. If you lose money and you amounts of capital on each.
are still sticking to the plan, you will know it is your plan that Looking at your personality and the way you react to
needs to be worked on. If you don’t have a plan, you have no stressful situations will give you a good idea of the trading
real idea what is causing your losses, since they are not based style that will be the best fit for you. Then fine-tune the style
on anything other than your thoughts and emotions at the time you choose. The trading style you choose should fit your
of the trade. Having a plan will save you time and money as goals and objectives as well as your personality.
you pursue consistent profitablility.
On occasion, the markets do reward bad trades (or, at WHAT TO TRADE
least, trades that have not been thought through). This is Deciding what market to trade will ultimately be determined
known as random reinforcement — believing you have a by your capital position and personality. Certain markets
winning trading system when you do not. Due to the sheer require more funds than others due to leverage restrictions
number of transactions possible, some trades will randomly and legal requirements across different countries. Some
work out when no forethought was given to the trade at all. markets are historically more volatile than others as well. The
The true trader strives for consistency over the long term. It stock market, the stock index futures market, and the better-
is essential to have a trading plan so that over the course of known commodity markets are the ones that most traders
many trades you will be able to see if your success (or should stick to. Trading those markets with sufficient volume
failure) is related to sheer, dumb luck. to enter and exit your positions easily is recommended.
In order to develop a trading plan, there are several steps Once you know how and what you are going to trade, you
that we should go through. The plan should not leave room for can start to develop your trading plan. Your plan will be a set
traders to question what to do during a trade. All possible of rules, written down for easy reference, which you will use
questions must be looked at before trades are made, so that to execute every trade you make. If you deviate from the plan,
when money is on the line, traders will know that they can rely then there is no point in having one. That is why it is worth
on their plan because it was well thought out and all pertinent taking the time to develop a plan that you believe will be
questions were asked and scrutinized during the making of profitable, so that you will not sway when the market goes
the plan. against you. You know your plan will be successful over the
long term, but if it is not, you know it is your plan that needs
THE INITIAL QUESTIONS adjustment.
Before you place a trade, you need to know why you want to
trade, what your objectives are, and what type of person HOW OFTEN TO TRADE
you are. Is it extra income, a main source of income, or Deciding how often to trade will be based on your personality
capital growth that you want to generate through trading? and your trading objectives. A trading plan can be created for
Are you going to do it full or part time? How much money any style of trading and followed by any personality type, but
do you have to work with, and what type of return do you sticking to the system will be easier if the plan is designed
expect from your money? around a trading style that reflects the trader’s personality.
Once you have answered these questions, you will have a Trade a style that would not reflect your personality only if
rough idea of what you want to do with your trading and you you have no choice. This might include believing you would
will be able to build a trading plan. You will want to stipulate be well suited to daytrading even though you have a full-time
all your objectives in regards to trading, not just answer the job and thus cannot daytrade. In this case, developing a
questions. trading plan for a different method of trading would be
suitable as long as you realize it may go against some of your
PERSONALITY basic tendencies, and you decide to commit to the system
There are many forms of trading and even more types of anyway.
trader personalities. It is crucial to build a trading plan based The style of trading chosen will have a direct impact on
on a trading style that complements your personality; select- how often trades are made. Daytraders make many trades in
ing a style at odds with your personality is a sure way to lose one day, swing traders make a trade or several trades every
money and ultimately burn yourself out. few days or weeks, and investors make trades (or invest-
If you don’t like to sit idle, then you may want to look at a ments) over many months or years. Since the style of trading
Copyright (c) Technical Analysis Inc.
Stocks & Commodities V. 27:3 (44-49): The Trading Plan by Cory Mitchell
TRADING TECHNIQUES
determines the number of transactions made, it will also
reflect commissions and the amount of fees paid to a broker.
This should also be considered in any trading plan.
A trading plan must be profitable when accounting for
commissions and other costs, and the extent of profitability
over fees should be estimated using backtesting of old market
data to determine if the trading plan is even worth implement-
ing. While testing a plan on old data does not guarantee
profitability today, you can be fairly sure that something that
has never worked in the past is not likely to start working all
of a sudden tomorrow.
Trading objectives will also determine how often trades
are made. Having your objectives in sync with your plan is
important for you to be able to stick with it for the long term.
Having unreasonable objectives for your plan will only lead
to problems and possible abandonment of your plan. Realis-
tic objectives must be based on your current circumstance,
how much time you dedicate to market study, current level of
market understanding, capital available, and any other fac-
tors related to your situation.
There are three main parts to a trading plan — money
management, entry rules, and exit rules. After creating a plan,
it will be important to test it on old market data for profitabil-
ity, and then in real time. Constant monitoring of the trading
plan is advisable.
MONEY MANAGEMENT
Money management should be your first concern. This is the
most overlooked area, and ignoring it is why many traders go
broke. Not every trade will be a winner, so controlling losses
using position sizing and stops is crucial to maintaining
profitability over the long term.
The basic rule of money management is that no more than
1% of capital should be risked on any one trade. This does not
mean that a trader should only utilize part of his or her capital.
Rather, the trader can be fully invested in a single instrument
(or several), but a stop in place will keep the potential loss to
approximately 1% of trading capital or less. Stops should not
be placed at random levels such as placing a stop at the 1%
loss of capital level. Instead, you will use your money
management combined with your entry signals so that you
can enter trades and implement stops at reasonable technical
levels.
To give an example, if a trader has a $50,000 trading
account, he or she will not risk more than $50,000 x 0.01 =
$500 on a single trade. Therefore, if a stock is purchased at
$30, the most the trader should lose is $500 if all capital is
employed. The trader has the option of using all his or her
capital and buying 1,600 shares (rounded down from 1,666),
or buying a smaller amount. If the trader purchases 1,600
shares at $30, their maximum stop would be at $29.69. At this
price, the trader would have lost just under $500, or 1% of
trading capital on the trade. Each trader should use his or her
own variation of this rule and decide if he wants to risk 1% of
capital on each trade, or just 1% of capital in use.
In the example, if a trader buys 1,000 shares of the stock at
Copyright (c) Technical Analysis Inc.
Taking time to make a trading plan will
give you a greater chance of beating
the market over the long term.
$30, he will have used $30,000. The maximum loss on this
trade is $300 for the entire position, based on risking 1% of
used capital. The trade will be exited based on an exit
strategy, which will be discussed shortly, or when $300 has
been lost on the position. The exit price would be $29.70
(1,000 x ($0.30) = -$300) or at a reasonable technical level
above this price.
By maintaining a 1% risk level on each trade taken, it will
not matter if only a portion or all of the trading capital is being
utilized, for at no point will all outstanding trades with their
potential losses exceed 1% of total capital. It is better to stick
with the 1% stop of capital used for shorter-term trading such
as daytrading (don’t lose more than 1% of capital per day).
Since trades are exited in a timely fashion, the smaller stop
based on 1% of capital used for the trade (as opposed to all capital
available) should not cause too many whipsaws, which can
deteriorate performance. With volatile stocks that present a good
opportunity, it may be prudent to take fewer shares than your
capital would allow but use a maximum stop that is 1% of total
capital. This is also useful for the longer-term trader to avoid
being whipsawed out the market too often.
Finding the ideal position is easy once you know the
maximum loss on the trade you are willing to accept, the price
of the stock, and a proper technical stop level. Using our same
example, if $50,000 is available and a stock is trading at $30,
you know that you do not want to risk more than $500 on the
one trade.
Let’s assume that the stock has shown strong price support
at $29.50. Based on technical levels, you would place your
stop at $29.40, just below the support level. This means that
you are willing to risk $0.60 a share. If your maximum loss
is $500, you can determine how many shares (or contracts) to
take based on this information. In this case, the trader could
take $500/$0.60 = 833, or 800 shares. By taking 800 shares,
you can use a proper technical support level/stop for your
trade and also not risk more than 1% of your capital.
The main thing to remember is that losses need to be
controlled. Write down your money management rules, and
when in a trade or preparing for a trade, use the rules and do
not deviate from them under any circumstances.
ENTRY RULES
How to enter a trade is probably the most discussed topic
among traders. Every trader is looking for a new piece of
information that will allow them to get into a bull market right
before it happens. While a good entry is important, most traders
focus on it way too much. Trying to find the perfect entry is
hardly worth the time. Most commonly known entry signals
will do fine as long as proper money management and exit
rules are implemented.
Getting into trades will not be the focus of this article.
Stocks & Commodities V. 27:3 (44-49): The Trading Plan by Cory Mitchell
Elements Of A Plan

There are plenty of entry

1Money
2Entry
3 Exit because you can lose that
systems out there includ- Management Rules Rules amount does not mean that
ing buying/shorting on old • Amount of capital • Based on trading • Stops you should. Often, stops can
highs/lows, moving aver- • % Per-trade risk personality • Trailing/protective be placed much closer to the
age convergence/diver- • What % of capital • Trade length — • Profit target entry price than the maxi-
gence (MACD), and sto- is acceptable loss long term? Swing? • Combination of mum stop-loss allows.
chastic crosses and mov- • Control losses Day? Scalp? indicators
ing average crosses. You Stop-loss: The exit is known
can find one or several you like, then customize and filter before the trade is placed. Whether mental or automated
them. Pick or create an entry system that goes along with how stops are used, the stop is known and the trader must enter a
you would like to trade. stop order to monitor the position so that he does not lose
If you want to trade long-term trends, entry signals should more than he determined he would. When a stop is deter-
be based on long-term indicators so you are not whipsawed in mined before a trade, it is never altered once the trade is
and out of trades. If you want to daytrade, the entry indicators executed.
or criteria should be based on short-term movements so Dealing with losing trades is easy; a stop is set and the
potential profits are not outweighed by large losses that may trade is left alone. When a trade becomes profitable, that is
result if stops were based on long-term criteria, such as when the trader has several options on how to exit the trade.
weekly support and resistance areas, for example.
The bottom line is finding an entry criteria that works for Trailing or protective stop: Trailing or protective stops are
your personality and provides for adequate reward based on common and an excellent way to lock in a profit. A trailing stop
your stops and money management rules. A potential entry is where the stop is increased as the price increases, assuming
signal for a long-term trader might be: the trader is holding a long position. If a trader is using a stop
■ A Standard & Poor’s 500 stock rises above its 200- of $0.50 on a trade, if the stock moves up by $1.00, the trader
day moving average would keep his $0.50 stop below the current level, thus locking
in a $0.50 profit if the stock were to retrace some or all of its
■ Overall market is trending with an average direc- gains. If the stock continues to rise, the trader would continue
tional movement index (ADX) above 40 to move up the trailing stop to $0.50 below the price.
■ Volume is rising A trailing stop can be based on a daily close, intraday
■ The stock must have a positive increasing money fluctuations, or be moved only when the price rises by the
flow indicator amount of the stop. A trailing stop is never backed up; for
long positions, it is never moved back down if the price
■ The stock is over $10 falls, and for shorts it is never moved back up if the price
■ The stock trades more than two million shares a day. begins to rise.

This is just an example and is not meant to be used for trading
purposes. It can be, but all criteria should be validated by
backtesting the criteria for profitability on past market data on
the same time frame. If the trade is expected to last for several
months or a year, the entry criteria should be tested on daily,
weekly, or monthly charts.
Write down your entry rules and only enter trades when a
given instrument matches those criteria. You can have differ-
ent criteria for different trading styles, but only trade by rules
you have written down and tested.
EXIT RULES
Knowing when to exit a good or bad trade is a crucial part of
trading. It will not matter how good your entry is if profits are
not taken off the table in a timely manner. Exits can be simple
or quite complex. There are basically four ways to exit a
trading instrument — a stop, trailing/protective stop, profit
target, or a combination of indicators (including price, vol-
ume, indicators, and time). This part of the trading plan is
designed to keep losses from getting too large or giving back
too much profit on profitable trades. The maximum loss on a
trade will be determined by your money management, but just
Copyright (c) Technical Analysis Inc.
Profit target: Profit targets are another way a trader can exit
a trade. Profit targets allow the trader to see the potential risk
and reward of a trade before it is placed. Profit targets are
especially useful if chart patterns are used for entry signals.
Information on common profit targets can be found in most
technical analysis trading information. Profit targets do not
have to be based on chart patterns; instead, they can be based
on company ratios such as a price/earnings ratio. If a stock is
purchased because its P/E ratio is lower than the average for
its sector and believed to be undervalued, profits could be
taken when the company’s P/E reaches the sector average.
Using chart patterns is more objective, but if a trader
prefers using fundamental data, it can be used. When using
a profit target, simply set an offsetting order at the target price
to which you expect the instrument to go.
While profit targets are excellent for managing risk and
reward ratios and capturing a good piece of a stock’s move,
traders sometimes feel as if they are leaving money on the
table if the price continues to move in their direction after
they have exited at their target. The solution to this is to trade
multiple units and exit half or a part of the position at the
target price and then implement a trailing stop on the rest of
Stocks & Commodities V. 27:3 (44-49): The Trading Plan by Cory Mitchell
TRADING TECHNIQUES
the position. This will lock in a profit but also allow the trader
to capture additional gains that may occur while still limiting
risk of loss.
Combination exit: A trader may also employ a series of
indicators to exit a position. The same criteria used for the
entry can also be used as an exit once the original criteria no
longer exists. Other indicators can be used to show when the
instrument is losing steam.
One example of using indicators to exit a position may be
to exit:
■ When the price moves back below its 200-day
moving average, or
■ When there is a close below a former swing low or
a close below a major trendline, or
■ The stock at the end of the day if no other exit criteria
has been triggered.
Exits should be tested for profitability given entry and
money management criteria. Coming up with your own
signals and testing them will give you confidence in your
signals, and the likelihood that you will stick to the plan is
greatly increased.
THAT’S A PLAN, STAN
Money management, entries, and exits all work together. All
three areas must be focused on to come up with a profitable
trading system. All areas must work in synergy with each
other. The trading plan should always be written down for
easy reference so the emotions of trading do not cause the
trader to deviate from the plan that was created while the
mind was clear and the plan tested for profitability. The more
confident a trader is in his plan, the less likely it is that the
trader will make foolish mistakes.
Copyright (c) Technical Analysis Inc.
It is also important that everyone realizes that trading
losses do occur, and a string of losses does not necessarily
mean that a trading plan is not valid. After several trades have
been made, the trader can analyze the trades and see how they
could have been improved. But it is important not to keep
tinkering with a trading plan once time has been taken to test
it and write it down. Give the plan time to work.
Market conditions do change so continually analyzing and
adjusting may be required over the long term, but making too
many changes could change a winning a plan into a losing one
just before it is about to become profitable. A rule of thumb
is that if you have experienced 10 or more losses in a row in
spite of following your system, you may need to make
changes. If you are sticking to your money management
rules, then you will not have lost more than 10% of your
capital. That can be made back with a thorough analysis and
some changes.
When making a trading plan, it should account for all
contingencies that may occur in trading. Money management
rules should explain exactly how much is risked on each
trade. Entry and exit rules should be laid out and only when
a trade matches that exact criteria should it be entered or
exited.
Taking time to make such a plan will allow you to approach
the market with confidence and give you a much greater
chance of beating the market over the long term.
Cory Mitchell is an independent trader specializing in short-
to medium-term technical strategies. He is the founder of
vantagepointtrading.com, a website dedicated to free trader
education and discussion.
S&C
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