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Creating a trading plan

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Last updated 12/24/2009 6:36 PM EST (GMT -5) 10 Comments

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Bradley W. Gareiss

Technical Analyst, GFT

A trading plan is a must.  I would be will to bet that virtually all successful traders have one.  However, most new traders have no plan.  In fact, I bet most new traders barely even have actual reasons for entering a trade.  Imagine that you are planning to loan money to a new business as an investment.  Could you picture yourself lending money to this person if they had no business plan and said they were going to start their business based on "their gut"?  Of course a person would never be able to start a business by relying only on their gut.  However, plenty of new traders start trading in exactly that manner.

Creating a trading plan is actually relatively easy.  There are several core requirements that make up the plan.  In my opinion, the main components of a trading plan are:

First, we have to define our trading objectives.  Why are you trading?  What is your end goal?  Most new traders have completely unrealistic goals.  For instance, a new trader might wan their $10,000 investment turn into $100,000 in their first year.  While this is possible, it is highly improbable.  These unrealistic expectations kill off a lot of traders before they ever had a chance.  I think breaking even in the first year is an admirable goal; many traders do not do that.  If a trader makes 20-30% on their initial investment in their first year, that is outstanding.

Next, we have to determine the basic outline of how to get there.  What currency pairs (or other financial instruments) will you trade?  This sounds simple, but it is easy to get off track by not defining this.  I am in favor of utilizing as many pairs as you can comfortably manage, but I would not waste time with illiquid, choppy pairs.  Other traders love choppy pairs.  It's up to you.  You also have to determine when you will trade and how often you will trade.  Are you going to be a day trader or hold positions for a longer period of time?  Your schedule and responsibilities may have some impact on that.  But it is important to define these basic ideas to begin to form some consistency.

Money management is probably the most important aspect of trading.  Would you rather have a fund manager who was a great analyst, but used poor money management?  Or would you rather have a manager who was an average analyst, but used perfect money management?  I think the answer is obvious.  Even the best analyst will eventually blow out their account if they don't manage their risk properly.  First, you need to determine how much risk capital you have to fund you account.  Then you must determine how much you will risk on each trade.  Most traders risk 1-3% of their account balance on each trade.  This may sound low to the inexperienced, but after you blow our your account while risking too much, you will see why 1-3% is appropriate.  It is also important to determine what your minimum risk:reward ratio will be.  This could vary based on your overall trading strategy.  Then calculate what your break-even winning percentage is.  For instance, if your minimum risk:reward ratio is 1:2, you must win one out of three trades to break even.

Along with money management, it is vital to have an "edge".  An edge puts the probabilities in your favor and allows you win more than you lose in the long run.  Without an edge that makes you money over time, proper money management will only delay the inevitable as your account dwindles.  There are many different methods to acquire this edge, but it is important to find one that is compatible with you.  Also, back-testing may offer some help in determining an edge, but I think its value is overvalued.  I think the true test of an edge is actually using it for future to trades, which will expose flaws in your execution of the strategy that back-testing won't.

The final step is to keep track of your results.  I typically have a spreadsheet that has the following fields at the top of the page:

This format makes tracking results very simple.  Please notice I track everything in dollars because that is true unit of measure, not pips.  This format also makes it very easy to plot your account equity curve on a chart.  There are a ton of statistics we can draw from this information that would take too long to write on this feature.  However, the biggest perk of tracking your trades is that you look at the big picture.  If you don't write down this information, you will weight the past 3 trades very heavily and maybe be able to remember the past 10 trade results (but I doubt it).  This spreadsheet will allow you to identify problems with your overall plan and trading strategy so you can fix them.

This is a pretty basic start to having a trading plan.  Experienced traders know that many more details are eventually inserted into this template to prevent mistakes and encourage good habits.  However, I feel the above is the bare minimum required to developing a viable trading plan.

The information, including Commentary and Trade Ideas, provided on FX360.com should not be relied upon as a substitute for extensive independent research which should be performed before making your investment decisions. Global Forex Trading and FX360 .com is merely providing this information for your general information. The information and opinions presented do not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision and should tailor the trade size and leverage of their trading to their personal risk appetite. Any projections or views of the market provided by FX360.com may not prove to be accurate.

The views of the authors and analysts are not necessarily those of Global Forex Trading, its owners, officers, agents or other employees. FX360.com and the currency research team will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained on FX360.com. Global Forex Trading and the currency research team do not render investment, legal, accounting, tax, or other professional advice. If investment, legal, tax, or other expert assistance is required, the services of a competent professional should be sought.

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Comments (10)

FX4Sure

December 24, 2009 at 11:52 PM ET

I'm very conscious about money management, also I feel as I'm under capitalized that creates more pressure on me, making me to try to push harder to the market, I'm brand new to the world of trading.

However I feel the market is very different across the time, I think one trading plan is not enough, you could miss many opportunities and maybe get more losses.

phi

December 27, 2009 at 01:00 PM ET

Bradley,
I have a question about the recent USD/JPY trade. You posted two different invalidation points one at 88.25 on 12/14 followed by 89.00 on 12/17. On 12/17 it went below 89.00 but you still recommended the trade after the price went back up. Roger also recommended the trade. Could you explain why you thought this trade was still valid? Also, in the closed trade section of the trade recommendations it shows 0 pips as an outcome. I entered this trade and was stopped out at -54 pips. I think the criteria you use to invalidate trades are a tremendous trading edge. Did I make a mistake entering this trade after it went below 89.00?
Thanks

bgareiss

December 28, 2009 at 07:30 PM ET

The pattern was still valid because a secondary ABCD pattern formed within the primary CD leg. Since Roger and I both posted the trade, I believe he moved his stop break even. I can see how that could be confusing, and usually we don't post the same basic trade for that reason. Regardless, it seems you didn't miss anything or make a mistake. Brad

mynextgig

December 28, 2009 at 01:28 AM ET

Bradley,

A question for you relating to money management.

As you state, a fixed percentage of your account (1-3%) should be risked per trade. However there are 2 ways to manage this.

Options would be :-

1. Determine a starting balance and trade consistently at 1-3% risk per trade on this starting balance
2. Apply 1-3% risk per trade as of the balance at the time of each trade

Issues with 1. is that during a bad run the risk per trade can increase from 1-3% and could hit 10% or more during a particularly bad period. However, issue with 2. is that by readjusting the risk per trade means recover from a bad run takes much longer and may in some cases become unacheivable.

Keen to hear your thoughts. Personally, i use option 1 and base my analysis on x number of losing trades wiping me out.

Thanks,

bgareiss

December 28, 2009 at 07:32 PM ET

In my opinion, 1-3% of the current balance should be risked rather than 1-3% of a set amount. Brad

bshakespeare

December 29, 2009 at 04:41 AM ET

Brad,

Similar to FX4Sure, i am new to FX. I have been hammered over the last two weeks with the ups and downs, and I have noticed that a trading plan is the best way to go. But I have not been diligent to the limits trying to 'outplay' my position - inexperience. So my questions is do you make notes as you go and look at those, or after the session and when do you review them? I am trying to work out when I should alter my plan based on a trend that is appearing on my pairs.

Your thoughts would help.

Cheers,
B.

bgareiss

December 29, 2009 at 03:48 PM ET

I think it is worthwhile to take notes after each trade about what went right and what went wrong. The key is to make a consistent system and tweak it after a decent sample of trades. Brad

jamc

January 05, 2010 at 06:46 AM ET

Hi,

Early November I've set up a strategy that produced to this day 90% of winning trades, turning my initial amount of 5000 USD into 100'000 USD (with 70+ trades)

In your opinion, should I go live ? or, in other words, after which number of trades should I consider my strategy as viable ?

Cheers
J.

alexjbrandt

January 05, 2010 at 06:57 AM ET

In my opinion a strategy is viable when your account survives a draw down for an extended period of time.

bgareiss

January 05, 2010 at 02:35 PM ET

I would definitely start trading live. However, keep in mind it is likely your results will be worse because your emotions may come into play. But if you are getting really good results on the demo, you won't learn anything else by trading fake money at this point. Brad

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