Low-Risk Trading in Financially Strong Stocks (Part 5)

10/09/2009 12:01 am EST

Focus: STRATEGIES

Formulating a Plan

This five-part series is a simplified guide to investing in stocks that return 20% or more per year with minimal risk. The previous parts discussed the advantages of investing in financially strong companies, how to identify them, how to maximize returns and minimize risks, and the psychology of trading. 

In Part 5, we offer tips on formulating a trading business plan so you can trade like a professional.

In Jack D. Schwager’s book, Market Wizards, he says, “Trying to win in the markets without a trading plan is like trying to build a house without blueprints—costly (and avoidable) mistakes are virtually inevitable. A trading plan simply requires combining a personal trading method with specific money management and trade entry and exit rules.”

Start-up companies fail for two reasons: 1) They don’t have enough start-up capital; and 2) They are not run like a business. A business plan is needed to set down future goals to keep the business on track during the journey. If you are serious about becoming a successful trader, you need to approach it with the same rigor as if you were running a company.

A crucial part of your business plan is knowing your expectations. You’ll need to determine your trading risk/reward ratio and the percent of profitable trades you hope to achieve. Gather this information, from backtesting and/or actual trade records. If your records show a positive return, this plan may be used to confirm the validity of your trading. 

See Figure 7 below for expected return calculations:

chart
Click to Enlarge

In the process, it will give you give you the confidence you need to weather those inevitable losing streaks. 

Answer the following questions:

  • What is your goal in percentage return per year?
  • What is your trading account size?
  • What percentage of your trading capital are you comfortable risking per trade?
  • From backtesting or current trading records, what is your trading risk-to-return ratio?
  • What is the maximum drawdown you are willing to accept before re-evaluating your system?
  • How many trades does your methodology generate per year?
  • What is the percent of profitable trades?
  • What are the expected returns per trade based on the equation in Figure 7?

For illustrative purposes, a professional trader’s business plan is below:

Business Plan

Goal:  $250,000 per year
Trading Account Size: $500,000
Risk per trade: $12,500
Executed trades per year: Approx. 50
Expected returns per trade
 [(.46*1.7) – (.54*1)] * $12,500
 (.78 - .54) * $12,500
 .24 * $12,500 = $3,000

 Expected return per year
 $3,000 * 100 = $300,000 

My volatility trading system generates about 50 (2 sides each) excellent trading opportunities per year. Through rigorous backtesting of this method for five years on 15 different equities, it has a 1.7 to 1 reward-to-risk ratio. This, along with 46% profitable trades yields excellent returns as may be seen above of 50% return per year on trading capital risking only 2.5% of capital per trade. 

If my account ever drops to 40% of my initial capital, I will re-evaluate this as a valid trading system.

This five-part series distilled the advantages of investing in financially strong stocks, how to identify them, how to maximize returns and minimize risks, the psychology of trading, and how to formulate a trading business plan—so you can trade like a professional.

By Dale Brethauer, trading mentor, Pacific Trading Academy

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