Developing Your Trading Plan

While the old adage “If you fail to plan, you plan to fail” might be cliche’, it is certainly true when it comes to trading.

Do you have a specific trading plan? Can you outline exactly what types of setups you’re looking for, how you will enter those trades, and how you will exit those trades?

I can. Every successful trader I know can do this. If you can’t, then you should.

It doesn’t have to be fancy, but it should have at least three components. The first is “Setups”, which identifies specifically the type of setups you’re looking for. The second is “Entries”, which identifies entry signals for each type of setup. The final is “Exits”, which identifies exit strategies, including both profit targets and stop losses.

If you can’t write out a clear and concise plan which includes detailed descriptions of the setups you’re looking for, how you plan to enter those setups, and how you plan to get out, then you’re trading randomly.

If you can’t write out a clear and concise plan which includes detailed descriptions of the setups you’re looking for, how you plan to enter those setups, and how you plan to get out, then you’re trading randomly.

If you don’t have a clear plan, you’ll have no idea how to improve if you’re not having success. You’ll have no clue as to what changes you need to make. You won’t be able to hone in on where the problems are. Are the problems with you, or are the problems with your plan? For example, if you DO have a trading plan, and you’ve been following it consistently but you’re not having success, then your plan needs to be modified or scrapped for a new one. However, if you have a plan and you’re not following it, or if you don’t have a plan at all, then the problem is with you.

…if you have a plan and you’re not following it, or if you don’t have a plan at all, then the problem is with you.

There are a number of things you’ll want to keep in mind when developing your trading plan. Here’s some of them:

1. Do what works FOR YOU

Just because a certain trading style or strategy works well for one trader doesn’t mean it will work well for you. For example, some people really like to trade the day-ranging 2x and 3x ETFs like SCO, and they can do it well. I’ve tried trading these and I often get burned. I just can’t seem to establish any sort of consistency with them, and I have trouble recognizing good setups. It’s a niche that just doesn’t work for me, so it’s not something that is part of my trading plan. Yes, you can make a lot of money off of those ETFs, and it makes them tempting, but if you can’t do it with consistency, then you either need to modify the way you play them, or try something else altogether.

Trading near the open is another good example. Some traders enter trades right as the market opens. I’ve found I usually get burned when I do that. There’s only a few setups that I have where I will do that. For most of my setups, I’ll wait at least 15 minutes after the market open before I consider a trade entry. This allows me to better assess what is happening.

While I do have a few good long strategies, going long isn’t a major portion of my trading. I just have never been great at it, so I don’t do it a lot. I’ve found a niche (shorting) that works well for me and I stick with that niche.

Some people are good at scalping. I’ve found that I can’t do that with any consistency, so I don’t do it.

2. Learn From Other Traders, But Develop Your Own Style

This relates to #1. I’ve learned a lot from other traders, and have picked up bits and pieces of things they do and applied it to my own trading. Over time I’ve been incorporating aspects of various traders’ strategies that seem to work for me, while throwing away the aspects that don’t seem to work for me. I then incorporate some of my own things based on what I’ve been observing as I trade the market. The result is my own trading plan which is a hybrid of other successful trading strategies, with some of my own twists.

3. Market Conditions Change, and Be Ready to Adapt

Many trading strategies may not work in all market conditions. Thus, you need to be ready to adapt or change if the market changes and your strategy stops working. Thus, you will need to be ready to change your strategies to the changing market conditions. Most of the strategies I use have been tested over a variety of market conditions.

4. Don’t Be a Jack of All Trades and Master of None

If you’re a beginning trader, or even if you’re seasoned, if you try to trade too many strategies, it may interfere with your success. You won’t be able to master any particular strategy, and you may miss a lot of good plays because you’re trying to follow too many strategies at once. I had that problem early in my trading career. I had too many watchlists, I had too many variables I was trying to consider, and I had too many types of setups I was looking for. I overtraded and I lost money.

Don’t try every strategy under the sun

To start with, it’s better to focus on mastering one or two setups. Once you’ve done that, you can slowly add more setups to your trading arsenal. Don’t try every strategy under the sun.

5. Make Small Adjustments to Your Trading Plan As Necessary

Sometimes your trading plan will require small adjustments to improve profitability. To this day I’m still making small tweaks to my trading strategies when I discover weaknesses. For example, recently I had a string of losses on a particular long strategy. I went back through my trades on that strategy, and found it would be better if I maintained a certain daily volume requirement. Most of my losers were on stocks where the daily trading volume was too low. So I adjusted my scans to filter out stocks where the volume was too low.

Trading journals that track your trading statistics can help with this. I use Edgewonk to help me fine-tune my trading systems. You can input various custom trading statistics to help you. For example, I’ll put in things like a company’s market cap. I’ve found that I tend to have losing trades when I trade companies with extremely low market caps (<$6 million), so I no longer trade those.

You can also use plain Excel spreadsheets for this. While it can be a bit tedious, it is very useful. I have dozens of Excel spreadsheets where I’ve analyzed different trading strategies. I’ll usually put in columns for the date, the ticker symbol, the entries and exits, the stop loss, the profit/loss, and then whatever characteristic I’m trying to analyze. I can then sort based on profit/loss or the characteristic, and determine if there’s a particular threshold where the strategy no longer works very well. That’s how I identified the minimum volume requirement for the long strategy I mentioned earlier.

6. Your Profit Targets Should At Least Be Equal to Your Risk

If you enter a short trade at 3 with a stop loss at 3.50, then your profit target should be around 2.50. This gives you a 1:1 risk/reward ratio. If it’s much less than this, then you need to have a really high winning trade rate to make money over time. However, most traders don’t have winning percentages that exceed 70-80%. I typically hover in the 60-70% range. Having at least 1:1 risk/reward ratio ensures you’ll make money over time if you have a decent winning trade rate. If your winning trade rate is about 50/50 or less, then you need your profit targets to be greater than your risk. You can be a profitable trader with a winning trade rate of less than 50%, but your winners need to be much bigger than your losers. This also demonstrates the importance of risk management and keeping losses small. If you take losses that are too big, you’ll eventually lose all your money because your losses will exceed your wins. Personally I never risk more than 2% of my capital per trade. Van Tharp has recommended 1% in the past. Sign up for my email list here to get a calculator that will determine your position size based on your entry, stop loss, risk level, and capital.

7. Keep Things Simple

When it comes to trading, rules are good. However, if you have too much to think about or way too many rules or an overly complicated system, it can work against you. It can make it more difficult to make trading decisions. This can be a problem given that trading may require you to make fast decisions. Complication and speed don’t match up well. While complicated trading strategies certainly can work, those are best off for more seasoned traders who already have mastered the basics and who know their strategies very well to where they can execute without much thought. It’s best to keep things simple, at least at first. You’ll be more likely to quickly recognize good setups, and your brain will be less cluttered with “noise” during trading hours. You’ll also be less likely to overtrade.

8. Backtest, Backtest, Backtest

Once you’ve developed a plan, back-test the plan. Go back and look at historical intraday charts of stocks that fit your plan. Look at the intraday price action. Where does your plan say you would’ve entered? Where does your plan say you would’ve exited? How many winning trades are produced? How many losers are produced? What is the size of the winners versus the size of the losers? Is the system profitable overall?

I’ve back-tested my strategies the old fashioned way. I developed spreadsheets that had the dates, trades, tickers, and profit/loss for each trade. I would then look at the total profits along with the money made per trade (the expectancy) to determine whether the strategy was worthwhile.

Some trading strategies can be back-tested automatically. Some trading platforms, like Ninjatrader, have back-testing capabilities. This can save you a lot of time compared to manually backtesting. Unfortunately my trading strategies can’t be manually back-tested, since they involve trading individual ticker symbols on specific days. It’s not like trading an instrument like the S&P E-mini which can be back-tested easily with automation. Thus, you can imagine the hundreds of hours I’ve spent back-testing my strategies. It’s paid off, but it was hard work. This is one of the reasons why I tell people that trading is the “hardest easiest way to make money.” Anyone who tries to tell you that trading is easy by marketing you “one simple pattern” or something like that is full of shit. Trading is hard, and I don’t know of a single successful trader who became successful without a ton of hard work.

Make sure when you backtest to have a large enough sample of days and trades to where you can be reasonably sure your system works. A sample of 10 trades isn’t going to cut it. If you have a small sample of trades and your system seems to “work”, it may just be working by chance. Remember that market conditions vary from day to day and you need a large enough sample to test your strategy under different market conditions. I’ve had strategies that looked promising on a small sample but ended up being unprofitable when tested over a large sample of trades. I can’t tell you what an appropriate minimum sample would be, as it would vary by strategy and how often the strategy produces trade opportunities. Most of my back-testing has involved back-tests of at least 25-30 trades or more. The bigger the sample you can get, the better. Also, you’ll want to see how your system worked in different market conditions. That means not limiting your sample to recent weeks or months. Try getting samples from at least a year or two ago. Thinkorswim, the platform I use for all my charting, has an OnDemand feature where you can look at the historical intraday action of just about any stock. You can go all the way back to 2009. I’ve gone back and studied some of my trades from 2014.

…if your strategy doesn’t work very well when you back-test it, you can be sure it’s not going to work in real time.

Back-testing is important because if your strategy doesn’t work very well when you back-test it, you can be sure it’s not going to work in real time.

9. Backtesting is Good, But Nothing Beats Real-Time Testing

Certainly, backtesting is important. However, backtesting has its limits. The biggest thing is you are automatically biased when you back-test a strategy. It’s easy to say, “Yeah, I would’ve done this in that situation”, but you already know what happened. Your mind is biased because of that knowledge. When you’re trading in real-time, you don’t know what’s going to happen, and you don’t know if you’ll do the same thing. All trading systems look better when you back-test them versus when you trade them in real-time, for that very reason. Also, back-testing may not be able to account for things like slippage, lack of fills, or borrow costs/availability if you like to short. So, keep all that in mind. While back-testing can tell you whether a plan will probably work, real-time testing will tell you if a strategy will work.

10. Testing Only Works When You Follow Your Rules

Remember you won’t know if a system is going to work if you don’t follow your rules. The other important thing about this is that, if you follow your rules well, you will know what changes you might need to make to make your system better.

How can you know if your system works if you don’t follow it?

For example, if your system has a method for taking profits at point X, and you take your profits at point Y, you aren’t testing your system. How can you know if your system works if you don’t follow it?

Prepare, Perform, Profit

Trading is about preparation and performing what you’ve prepared for. If you do those things, the profits will follow. I hope these tips help you become a more profitable trader.

May the profits be with you!

Disclosure: I am an Edgewonk affiliate and receive a commission for people who sign up for it through my site link. It is a product I use myself and has helped me a lot with my trading.

Leave a Reply

Your email address will not be published.