What is a Trading Plan?

Contrary to popular belief, you do not need to know where market tops and bottoms are to make money in the markets. In fact, that is where most people go wrong. The best traders in the world realize that neither they nor anyone else knows what is going to happen. Sure, everyone can point out tops and bottoms after the fact, but no matter what anyone tells you or tries to sell you, NO ONE can pick tops and bottoms consistently. So how do you make money without picking tops and bottoms?

I am glad you asked.

Successful trading is not dissimilar to a successful business. You see, every successful business has a business plan and so do successful traders. The astute reader may have already realized this from the previous chapter, where I mentioned that “successful traders have a systematic way they approach the market.”

A trader’s business plan is known as a trading system; it defines your approach to trading. A properly constructed trading system will leave no room for human judgment, because it will define your actions, given any circumstances that may arise. It is a distinct set of rules which will instruct the trader what should be done and when to do it.

The importance of a trading plan cannot be understated. Without a consistent set of guiding principles to govern your trading decisions, you will most likely hop from one trade to the next, impelled by emotion or hysteria. I believe by not having a plan, you are planning to fail.

Trading systems themselves will come in many varieties, and they all take the guesswork out of trading. A trading system will determine for you when to buy or sell. “System trading” has proven itself consistently to be the most effective long-term trading technique.

In fact, you may have even heard the story about one of the most famous system traders of all time, Richard Dennis. It just so happened (in mid 1983) that Dennis was having an ongoing dispute with his long time friend Bill Eckhardt about whether great traders were born or made. Dennis believed that trading could be broken down into a set of rules that could be passed on to others. On the other hand, Eckhardt believed trading had more to do with innate instincts, and that this skill comes naturally.

In order to settle the matter, Richard suggested that they recruit and train some traders and give them actual accounts to trade to see which one of them was correct. He named his protégés after visiting turtle farms in Singapore; he decided to grow traders like the farmers grew turtles, hence the name: Turtles.

To cut a long story short, Dennis taught his trading methodology to these groups of students who later became some of the most successful traders of all time; proving once and for all, that system trading could indeed be taught.

Just like the turtles, I too have studied under a mentor who tutored me in the “science” of trading. And now I am passing these secrets on to you.

A trading system is simply a set of rules that address every aspect of a trade such as entry and exit conditions and money management. Regardless of how complex it may be, a good test for your trading plan is to hand it to someone else to read thoroughly and then see if they have any questions about it. If they can easily understand all the rules and the requirements of your strategy with little to no questions, then you have compiled a sound investment plan.

All successful traders that I have come in contact with can do this. What’s more, they have their exact trading methodology written down.

Since most traders lose money and do not have their trading methodology written down, does not it make sense to do what everyone else is not doing? If you are trading now and have not taken the time to clearly write out methodology, then stop trading and get it done!

Why is it so important to write a plan? When you take time to sit down and spell out how you perceive the markets, you are accepting the fact that you might be wrong. You are beginning to accept responsibility. Once you write down how you perceive the markets, the only conclusion you can arrive at, if the market does not behave according to what you wrote, is that your perception is wrong. When you write down how you are going to enter a trade only if certain events transpire, you are eliminating any possibility of misplacing the blame on the market. You are forcing yourself to have discipline.

When you take the time to write down your trading rules, you are also transforming your mental reality to a physical reality. You will no longer be able to fudge the numbers, or avoid taking responsibility.

By writing down your methodology, you are forcing yourself to create a series of decisions based on how you see the markets.

The Format of Your Trading Plan:

Again - to draw on the business plan analogy - just as a there is a standard format for designing any business plan, there is also a format for designing a trading plan. In fact, there are three major components within any trading plan: entry, exits and money management rules. In the chapters that follow, we will go into these in more detail and you will work through a process to design each component. Here is a quick summary:

1. Tested Entry Rules

Entry rules are a precise set of rules that a tradable instrument must pass before you enter a trade. Entry rules should be simple, direct, and leave no room for human judgment.

2. Strict Money Management Rules

Perhaps the most important and least addressed aspect of trading is the ability to manage risk. A profitable trader is one who has the ability to manage the risks associated with trading. This is achieved with strict money management rules.

3. Tested Exits Rules

Entering a stock is all to no avail if you do not know when to exit your position. Having a set of rules that define your exit is equally important as a set that defines your entry.

Although simple in their explanation, these three components can together and will have an enormous effect your trading. The advantages of utilising a trading system are numerous; most market participants agree that their greatest benefit is the tempering of destructive emotions, considered the enemy of all successful traders, and removing it from the decision making process.

While it is true that there are no holy grail trading systems however, what you’ll learn in the following chapter is about as close as you can get.

MUST DO ACTION STEPS: The good news is there are no action steps for this chapter. Just continue to affirm “I will find a system that fits me and I will become THE world’s best trader at this ONE style of trading”.