Follow a Trading Plan to Increase Your Personal Wealth!
What do all successful traders have in common—they follow a simple trading plan!
This is a document you create to help you trade. It should include your objectives for trading, the type of setup you need before you trade, a way to screen for the types of positions you want to trade, entry and exit signals, and a methodology for deciding how much to buy.
It’s important because without a good plan, it’s hard to make money. If you would like to see an example of a Trading Plan click on this link Example of a Short Term Trading Plan
Speaking of money, how much do you have set aside to trade? This is a very importance issue to address upfront. DO NOT TRADE MONEY YOU NEED TO LIVE ON!!!! If you do not have any money set aside, take time to save some additional money before starting to trade.You can find more information on what to do about trading capital in Trading Basics
Once you have set aside your trading capital and you understand and follow the few simple techniques I’ll teach you, and you follow them diligently, not only will you increase your personal wealth, but you’ll have more time in your life to spend it with those people important to you!
Six Simple Steps to Become a Successful Trader!
Trading Objectives – Begin with the End in Mind
The first part of the trading plan is to decide on your personal objectives. Trading objectives are the goals you want to achieve through trading, such as putting your kids through college, buying a bigger house, or retiring earlier than you ever thought. Based on your goals, you’ll need to decide what type of securities you want to trade, because your trading objectives will determine your strategy.
The strategies discussed below mainly focus on trading stocks, but the sky’s the limit; you can trade ETFs, Futures, Option, Stocks or Currencies. This decision should be based on the securities risk return parameters and your financial objectives. It’s very important you have an understanding of what type of securities you want to trade before moving on. This will ensure you develop the right trading plan to fit your financial expectations.
Here are a few questions to get your mind thinking about Trading Objectives:
What type of securities do you want to trade? This will be based on how much capital you have to trade, and how much time you want to spend. Trading stocks will tend to take more capital than trading options, but options trading has additional risk/return parameters to consider, and could take more time to trade. All types of securities will have their pros and cons. If you don’t already have an understanding of your trading options, then you need to take time to read through additional trading system resources to get a better understanding. Make sure and record this information in your Trading Journal so that you can go back and review it as you are building your Trading Plan.
What type of returns do you want to achieve?
Other than returns, what personal goals do you want trading to accomplish for you?
How much time do you want to spend trading? Is your goal to do this 40 hours a week, just 30 minutes a day, or anywhere in between?
These are just a few of the important questions you need to answer before you start building your Trading Plan. Click Here to See an Example of a Short Term Plan It’s critical to set clearly defined time and goal commitments so you can build a trading plan that fits your objectives.
Once you do that, the next step is the setup. This is designed to help you decipher the “big picture” of the markets in general, and whether to take a long or short position. This is a very important part of the Trading Plan. Quick Note: A long position is when you buy a security with the hope it’s going to go up so you make money. A short position is when you borrow a position from your broker and sell it with the thought it will go down so you make money.
Trading Setup – How Do You Know What to Do?
A trading setup is the research and work you do to make decisions on what position you want to trade, and what direction you want to trade.
Let’s say you’re interested in building a swing trading system. You want some way to help you decide whether to take a long or short position, or a combination of both. So you do some research. You find out there are many ways to create your own trading setup—from using moving averages to following new highs and lows. Here are a few examples of different types of setups.
Relative strength indicator setup – This is an indicator where you can put to use all the ETFs on the market to help you identify the strong or sub-sectors. You can build different types of algorithms to calculate what you want to see. For example, you want to buy stocks within sectors that have a RSI of greater than 50. So you decide to calculate the RSI (relative strength indicator) for each ETF for a side-by-side comparison. Then you develop a range for when you think it’s most appropriate to trade. You can use this to tell you when you should be looking to take long or short trades for your system.
Moving average indicator setup –This is where you use a short and long term moving averages to help you identify the most appropriate time to take a long or short position. For example, let’s use a 20 and 40 day moving average. When the 20 day is above the 40 day, you’re looking for long positions. When the 40 day is above the 20 day, you’re looking for short positions.
There are many ways to get a read on the market by using other people’s work. For example, the Investor’s Business Daily does a great job of identifying the current type of market. You can use their “big picture” to help you decide what type of positions to trade.
There are also many newsletters and economists that publish their opinions on the market. If you find a service you like, and will work for the type of system you’re trying to build, use it!
You decide to build a swing trading system. Based on your market beliefs [this is how you think about the market], you decide to use moving averages. A simple moving average is formed by computing the average price of a security over a specific number of periods. Most moving averages are based on closing prices. For example, a 5-day simple moving average is the five day sum of closing prices divided by five, and this will continue to change as you add the current day and drop the fifth.
Here is a chart to help you understand the example above. This chart is the S&P 500, which would represent the broad market indicator for a short-term swing trading system.
HINT: I have found it is best to start with a broad market index, such as the S&P 500 Index, to monitor whether I should be looking for long or short positions. Drill down a little further and find the specific sector ETF that currently meets the same criteria. Then find the stocks within the sector that meet the setup criteria. The success rate of my Trading Plan goes way up if all the stars are aligned.
Trading Screen – You Catch More Fish If You Go Where the Fish Are
The screen is your “net” to scoop up a large amount of potential positions to trade. This can range from a very broad screen, where you trade any stock that meets your technical criteria, to as specific as following a list of stocks, like the Investor’s Business Daily Top 50. Either way, you need to have a thought behind choosing your positions before you build your trading plan. Some stocks work better with different type of indicators, so it’s important to create a screen that fits your trading plan.
Here are some examples of what successful traders use to build their stock screens.
Fundamental screens – These are screens that focus on the balance sheet or income statement of a company. The examples, below, are from screens I have seen work, and can be used in a number of different ways to find where the FISH are hiding.
Free Cash Flow per Share – This is the operating cash flow minus the capital expenditures. A lot of traders believe that if the company has good, free cash, it will outperform over the long term.
Price/Earnings to Growth – This fundamental screen can help you find growth companies without significantly over-paying. This is much more important for a long term trend and reversal trader than for a short term trader.
Earnings Yield – These are the past 12 months’ earnings, divided by the current market cap, to give you what the yield would be if you distributed the earnings. This measurement is typically used to compare the position to a risk free rate to see if it is over- or under-valued.
There are many more ways to do fundamental screens. These are just a few to get you thinking about how to build your Trading Plan.
Technical Screens — These help you narrow down your list based on some type of technical pattern or indicator, such as a trading box, cup and handle pattern, or price channel pattern.
Trading Box – A Trading Box is a technical pattern modified from the Rectangle. A Rectangle is a continuation pattern that forms as a trading range during a pause in the trend. The pattern is easily identifiable by two comparable highs and two comparable lows. The highs and lows can be connected to form two parallel lines that make up the top and bottom of a rectangle. Rectangles are sometimes referred to as trading ranges, consolidation zones, or congestion areas. The difference between the Rectangle and Trading Box is the use of support and resistance. The Trading Box does not have to have only two comparable highs or lows to be formed. It can have as little as one, or as many as five highs and lows before it’s formed. The more times that support or resistance is held, the stronger the pattern. This is a continuation pattern, and once the consolidation is broken in either direction, you should have the momentum to keep the stock going in that direction.
Below is an example of this chart pattern.
Cup and Handle – This pattern signals a continuation of the previous advance. It’s a rounding basing pattern and consolidation followed by a breakout, developed by William O’Neil, founder of Investor’s Business Daily. In 1984, Mr. O’Neil designed and launched Investor’s Daily (later to be renamed Investor’s Business Daily®), the first national business newspaper to compete successfully with The Wall Street Journal. Mr. O’Neil used his years of experience in economic and business research and his massive historical database to fill a daily information gap that existed for the individual investor and business community.
Below is an example of this chart pattern.
Price Channel – This denotes a pattern of the trend, either up or down. The pattern is signified by having a lower trend line support and upper trend line resistance. Price channels with upper slope are bullish, and lower slopes are considered bearish.
Below is an example of this pattern.
There are several ways to develop the optimal screen for your trading plan. You can either use Fundamental and Technical indicators by themselves, or build some type of combination. There are so many different ways to build a screen that you’ll need additional research to find indicators that fit your market beliefs. Remember, the screen is to help you narrow down your universe to potential positions that will work for your trading plan.
Okay, so now we have worked through our setup. We know how to decide which direction we are going to trade based on our broad market views and beliefs. Then we narrowed down a list of stocks that we think are great opportunities. What’s next? ………
Trading Entry Signal – How Do You Know When it’s Time to Set the Hook?
There are many different signals people use to let them know when it’s time to actually set the hook and take a position. Here are a few examples of the signals for your Trading Plan.
The first signal is for a long-term trend trading system. It is a breakout/breakdown from the Trading Box with volume. This is a good signal for getting the long-term trend right, and can be used for long or short positions. Sometimes you get a corresponding move in the opposite direction after the break, so you have to be patient. This can be a weakness of the signal. I have found the signals that continue the momentum directly after the break usually make up for those that take longer.
Here’s an example of buy signal on a breakout.
Here’s an example of a sell signal (short) on a breakdown. Notice there is no volume increase on this chart. Increased volume on the downside is not necessary for this signal.
This next signal is for a short term reversal system to take long or short positions. It’s a very easy signal, can be used many different ways, and is called a Pivot Point. Basically, what you’re looking for with this signal is for the stock to stop going up or down, and then have a sequence of either higher highs (for a long position), or lower lows (for a short position).
Some traders like to have three consecutive moves in the direction they are trading. I have found that if you have good support or resistance, you can make the trade once the bar has made a higher high or lower low.
Here’s an example of a buy signal.
Here’s an example of short signal.
This last signal for your Trading Plan is based on Japanese Candlestick Charts. There are a lot of traders that use these charts because they believe it gives them more information based on what the body and wick/shadow of chart looks like for that bar.
The Hammer is a bullish reversal pattern that forms after a decline. The low of the long, lower shadow implies that sellers drove prices down during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. This pattern alone is not enough to give you a signal to buy. If you add high volume on the sell-off, or a follow through move over the next couple of days in addition to the hammer, then you would have a better confirmation of a buying opportunity.
Trading Signals Exits – Know When to Hold’em…. Know When to Fold’em……
It’s very important to take your time and work through the exit signal in order to make sure it’s accomplishing what you want in your Trading Plan. The exit signal alone can change your system from short to long-term. It’s one of my beliefs that the exit signal is much more important than the entry signal.
There are many different ways to exit a position, and you don’t have to have just one exit point. The exit strategies below are just a few I use in my trading plan.
Trailing Stop is my favorite exit signal. A trailing stop is what it sounds like; you have entered a position, and calculated the most you would be willing to lose (more on this in Position Sizing) by setting a bailout price below your entry price. As the price of the stock goes in your favor, you move the stop, allowing it to continue to trail the price.
The second type is an Extreme Exit. This is when a stock has moved very quickly in your favor and you don’t want to risk the profit. Again, in this example, I use the Average True Range (ATR) of the stock. The formula for this exit is when the spread between the 20 day moving average and the price of the stock exceed five times the ATR. Then it’s time to at least take some profit off the table.
Here’s an example of this exit.
IMPORTANT NOTE: There are many different types of exits. Over time, you’ll find that different exit/entry signals work better or worse in different market conditions. So as you are working through your Trading Plan, be sure to study the market and stock charts. You’ll find that after going over hundreds of charts, you’ll have a better feel for what will work for your Trading Plan.
Position Sizing – The Art of Controlling Risk
This is the most important part of the trading plan. There are two areas of trading I think are very important…… POSITION SIZING and TRADING PSYCHOLOGY
There are many ways to build a position sizing model—from very complex to very simple.
What is position sizing? In its basic form, position sizing is the percentage of your account value that you’re willing to risk on each trade. Here’s the basic formula to help you understand the concept.
The percentage of your account value you’re willing to risk divided by difference between Current Price and Stop Price equals the amount of shares you can position.
Account Balance: $100,000
Risk Amount: 1% or $1000
Current Price: $36.78 – Stop Price: $32.14 = $4.64
Risk Amount: $1000/$4.64 = 215.52 shares (rounded 216 shares)
Total Amount of position = 216 shares * $36.78 = $7944.48
Here is a page dedicated to Click here to go to Position Sizing. There are also several resources from Dr. Van Tharp that we’ll discuss to help you decide what type of position sizing model works for you.
The information was mainly about how to create a discretionary trading system, but you can also apply everything discussed into a mechanical trading system.
Let’s Recap What We’ve Done…………
You worked through and decided on your objectives for your Trading Plan. Click here to find an Example of a Short Term Plan.
You built a setup based on your market beliefs to help you decide what markets and which direction to trade.
You built a screen that will narrow down your positions to a manageable list of potential trades.
You built an entry signal to let you know when it’s time to get in the position.
You built an exit signal to let you know when to get out of the position.
You built a position sizing model to calculate the size of the trade and help you achieve your objectives.
Congratulations! If you have completed all of this work, you are light years ahead of most people trading in the market.
Don’t stop now; the next step on your journey is to develop a Trading Journal to help you keep up with your daily tasks, trades and mistakes so you can become a better trader.