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Creating a trading plan

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Last updated 3/5/2010 5:59 PM EST (GMT -5) 8 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 (8)

spunky

March 06, 2010 at 09:38 PM ET

Great article; need one on patience next, one of my big weaknesses. I am not sure why pips wouldnt count though ?

regards
Brad

bgareiss

March 08, 2010 at 01:26 PM ET

In my opinion, measuring results by pips implies poor risk management. It is better than nothing to track "pips", but tracking the equityl profit/loss and percentage gains are far more important. How many large, successful funds have you seen advertising how many pips they win? They all use percentage gains because pips don't provide much information. I could go into this for quite a while. I strongly believe individuals should be tracking their results by measuring equity p/l and percentage gains/losses.

Brad

FXDragon

March 07, 2010 at 02:36 AM ET

I have the same problem. I think greeds somewhat related to impatience. You just wanna take that money its right there right. Why wait!
I go by the strategy that if im long and the trade is in my favor. I would take profit close to around where i would want to start shorting again. Since i dont have exact target. Still yet to succeed though:)

Sincerely
Vulcan

Derekis

March 07, 2010 at 09:28 PM ET

Hi Brad,

Thanks for another well written article on a topic that is key to a trader's long term success.

Regards,
Derekis

bgareiss

March 08, 2010 at 01:27 PM ET

You're welcome. I am glad you enjoyed the article.

Brad

spunky

March 09, 2010 at 06:59 PM ET

Brad:
If every pip is that same amount ie dime, 1 dollar , 10 dollars ; it tracks the same. I like to use the data to learn about my stop loss settings as well as targets.

Regards
Brad

bgareiss

March 09, 2010 at 08:35 PM ET

Only currency pairs that end in "USD" are worth $10 for 100,00 unit lot. Every other pair is a different amount. These differences may seem trivial, but they can really add up over many trades. Furthermore, if you measure by pips, losing 10 trades with a 20 pip stop would be the same as losing one trade with a 200 pip stop. Assuming those eleven trades had a 1:1 risk:reward, and you won all ten of the 20 pip trades while losing the 200 pip trade. You would be at break even with a 91% winning percentage. This is why we weigh all trade equally by adjusting the position size according to the distance between the stop and the entry (and the pip value). Otherwise you are putting a random variable (trade magnitude) in your results. Also, 100 pips gained on a $1,000 account with 5 100,000 lots is very different from 100 pips gained on a $100,000 account with 1 10,000 lot. I am not suggesting ignoring pips completely, but there are far better ways to track results.

Brad

bgareiss

March 09, 2010 at 09:43 PM ET

Please note the typo above where I wrote "100,00" in the first sentence when I meant "100,000".

Brad

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