How to Build a Winning Trading Plan
12/07/2015 9:15 am EST
Knowing why—instead of just how—is the key to avoiding common trading mistakes, so Adam Lemon, of DailyForex.com, outlines the questions a trader should ask and the key elements every winning trading plan—in writing—must contain, not just for the benefit of forex traders, but for every style of trading.
You have probably heard it before: every trader should have a winning trading plan and they should follow it. I am saying it here, again, but I am going to explain how to go about actually making the plan and how exactly to follow it. Many traders make the mistake of just trying to get something down on paper as a guide. This is an admirable intention, but the true reason why a winning trading plan (which is always a written trading plan) is useful is because it is the very act of making a personalized plan that burns into a trader's mind the why and not just the how. Knowing why you are doing what you are doing, instead of just knowing how, is the key to avoiding common trading mistakes.
Some people think that it is only daytraders that need written trading plans. In fact every style of trader needs it.
It is really important to emphasize that many traders get to a point where their analysis is pretty good: good enough to know what they should be trading and in what direction. The problem is that although you would expect this to be enough, it is not enough to make money—at least not for most people—because they fall down on execution. It is in overcoming that final hurdle of executing trade entries and exits that a written trading plan is really most helpful.
Initial Questions to Answer
- What is your edge that you are going to try to use to make money? Do you believe that the direction of the forex market can be predicted? If so, how? Will you use trend following, mean reversion, or some combination of the two? Will you use fundamental and sentiment analysis or just pure numbers?
- How much money can you both want and afford to risk trading forex in your trading plan?
- Which is the best forex broker for your account size, country of residence/citizenship, and trading style?
- What is your risk management strategy going to be? What will your stop loss be based upon?
- Make some kind of back test covering many years and calculate best case, worst case, and average case scenarios for your trading account. Can you handle the worst case?
Size Your Risk Per Trade Based Upon a Worse Than Worst Case from These Results
- Which currency pairs are you going to trade? How many trades will you have open at any one time maximum?
- How much discretion are you going to allow yourself in picking currency pairs, opening trades, and exiting trades? This is very important. How much will be based upon hard and fast rules?
- Will you manage open trades? If so, how?
- How much of your time will you devote to trading? Will you be a daytrader, swing trader, position trader, or some combination of these?
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Once you have thought about and answered these questions—and you should give them considerable thought and work—you should be in a position to begin writing your winning trading plan, which must be completely comprehensive and have a good, well reasoned answer to every possible question.
Writing Your Trading Plan
Your trading plan must cover everything and be in writing. A winning trading plan must contain the following:
- How you will decide which pairs to trade.
- The maximum positions at risk you can have at open at any time.
- Any daily, weekly, or monthly loss limits you have decided to apply (e.g. once 0.50% of account equity is lost in a trading day, stop trading for the rest of that day).
- Trade entry strategy, including position size and stop loss.
- Whether you will manage open trades actively or not.
- Trade exit strategy.
- Where you are going to use your own discretion, which prices are going to make you do what; i.e. if price trades above 1.1000 for an hour, you will consider exiting from half of the position size, but if it does not, you will keep the trade open as normal.
- How often you will review your trading and review your trading plan (this is very important). No plan should be static.
Reviewing Your Trading Plan
At the end of every trading session if you are a daytrader or otherwise at the end of every week, you should take notes, focusing on how well you were able to stick to the plan and whether the winning trading plan covered everything that happened. Were there moments where you were not sure what to do, as in really confused and not just indecisive? If so, then your trading plan needs to be changed to allow for these eventualities. Also, you may find that parts of your plan sounded okay in theory, but were just too difficult or emotionally painful to implement in real time with real money. Think hard about whether there is an easier way to do things. Losses are inevitable in forex trading, but they can be managed to some extent.
Secondly, you should keep an eye on your profits or losses. Are they much worse or better than your back testing suggested? If so, why do you think that is? Work on fixing the problem. A winning trading plan is one that wins over the long-term, after all.
It is vital that traders constantly work on reviewing and improving their trading. It is a crucial habit of all consistently successful forex traders.
By Adam Lemon, Contributor, DailyForex.com