Even experienced traders rely on written trade plans in order to manage fear, uncertainty, and changing market conditions, writes Mark Wolfinger, and new option traders should develop this habit as well.
I’ve posted about trade plans on MoneyShow.com in the past. However, it’s an important topic, so this time, let’s discuss it from the perspective of a rookie trader.
It’s advantageous to write a trade plan for every trade and to keep that plan updated. As time passes, or when the position changes (because of an adjustment), it’s time for another update.
Why? The primary purpose is to be certain that a trader understands why the trade was made. More importantly, the plan makes the trader think about situations when it’s no longer viable to hold the trade as it stands.
The experienced trader will recognize the need for taking steps to reduce risk. The inexperienced trader may become frozen with fear or uncertainty. Having a trade plan that applies to the current situation offers reasonable trading solution. The plan may be the decision to exit, reduce size, or make a specific trade to reduce risk.
Having a solid trade idea in times of stress makes a huge difference to the confidence level required to pull the trigger on the trade suggested in the written plan.
See related: Overcoming Fear and Indecision in Trading
Please recognize that it is not a winning strategy to enter into a trade just because it “feels right” when you have no real reason (other than your gut) for making the trade. [NOTE: If your gut has a good track record, then it's right to pay attention to it.]
If you are making a directional play, ask yourself whether you are truly bearish or bullish for a good reason. If it’s a non-directional play (such as an iron condor), does the reward justify taking the risk? If you have any reason to believe that a volatile market is approaching, then it is an inappropriate time for iron condors, writing covered calls, or other premium-selling strategies.
See also: The Iron Condor Has a Soft Spot
To decide if the risk vs. reward numbers for the trade are attractive, a trader must have both a profit target and a maximum loss target (your own worst-case scenario). Reminder: Just because a trade strategy comes with a built-in maximum loss, there is no reason to become lazy and allow the position to slowly reach that maximum. The plan must be realistic and based on having the discipline to take that lossâ€¦when the time comes.
In trading a 20-point iron condor by collecting a $4.00 credit, the maximum gain is $400 and the maximum loss is $1,600. In reality, you would probably exit before $400 is earned. Thus, the profit potential is less than $400. It’s important to know (fairly closely) the real target.
I hope the maximum loss is less than $1,600. If it is, you must decide how long to carry this trade before exiting. By writing that number into your plan, you become aware of that number. For more experienced traders, the number may be flexible but only if there is a good reason you can allow a slightly larger loss.
However, the trap that must be avoided is deciding that the loss has become so large that you may as well gamble with the position. Long-term success comes to traders who avoid the big losses.
As the trade progresses, you may want to make minor changes, but the experienced plan writer understands that it’s worthwhile to have a written plan just in case action is needed when the market is volatile and you, as an inexperienced trader, don’t know what to do.
The answer is to do exactly as the plan describes. It may not be the best possible solution, but it is a well-thought-out plan and is going to be a reasonable choice.
The negative side of plan writing must be mentioned: