Following Your Trading Plan
11/05/2009 12:01 am EST
Let's say you have made a detailed trading plan. You know the exact criteria, or "rules," that you will use to place a trade. You have a checklist to make sure you follow each of these rules. You have a money management strategy so you know how much you will risk on each trade, and you know what your risk/reward ratio must be. You know what time of day you will trade, what time frames you want to look at, and what currency pairs you want to look at. You have a spreadsheet ready to track each trade for further analysis.
The reality is that this is the easy part. To give an analogy, there are many people who could learn an NFL offense. They could watch film, go to meetings, and learn which route each receiver will be running on each play. However, there are only a handful of people in the world who can execute these plays with a blitzing linebacker bearing down on them in a game situation. In other words, very few quarterbacks have the ability to execute.
Of course, the gap between learning plays and playing quarterback in the NFL is much larger than the gap between making a trading plan and following it. But the point remains that if we can't execute the plan, then it doesn't matter how great the plan is. It may seem easy to follow a trading plan, specifically if it incorporates all of the points I listed in the first paragraph. For those of you who have traded with real money, you know that this is not the case.
There are many obstacles that prevent most traders who have an excellent trading plan from following it properly. Almost all of these factors are psychological. The other factors are problems such as the Internet going out right before a trade. Events like that are rare, and should be accounted for in the trading plan anyway. These psychological roadblocks can take a serious toll on trading performance. For those of you who have experience trading, I am sure you have had many moments where you wondered why you are not making as much money as you should be based on your trading plan. The answer, of course, is that you are human, and humans have emotions.
There are three primary mistakes that derail even the best trading plan. The first is taking a trade that is not part of the plan. The second is not taking a trade that is part of the plan. The third mistake is changing the rules of the trading plan based on a statistically insignificant event.
Taking a trade that is not part of the plan is extremely tempting. There are any number of reasons why a trader would take a trade that is not part of the plan. You could be having a losing streak and be desperate for a win. You could be having a winning streak and think you are invincible. You could receive a tip that a large bank is buying yen (keep in mind this tip could be from a bank trying to sell yen and looking for suckers to buy their yen). You could see something that was part of an old strategy you heard about. You could even straight up gamble just to get in the market. All of these scenarios are dangerous. If you lose, you feel miserable because you know you violated your rules and it cost you. That can lead to even more psychological damage. If you win the trade, that only encourages you to continue a behavior that will not be profitable in the long run.
Passing on a trade that is part of the plan is the second most common error. This happens for a variety of reasons also. Maybe you have lost two in a row and are scared of taking another trade, only to see the trade you passed on become the big winner. Or you have won three in a row and think the streak can't last forever. Regardless of the cause, this is also very dangerous. It is not uncommon for an emotional trader to pass on a trade that fit their rules, but that ends up winning, only to place a trade that doesn't conform to their rules and ends up losing. These errors are why most traders do not maximize the results of their trading plan.
Changing your rules bases on a small sample size of trades might be the worst thing you can do. Let's say you have placed 300 trades with your current rules. Although you have had your ups and downs, this has been a profitable strategy. Then let's say you lose five trades in a row, which can happen. All of the sudden you change your time-tested rules that have withstood hundreds of trades based on this sample size. Overreacting to a small sample of trades can lead you go down a dangerous path. If you change your rules to accommodate those five losers, you may wind up losing far more than if you stayed on course. Naturally, it is wise to reevaluate your rules from time to time. But do not make major changes based off of five trades.
Hopefully, these examples will help you stay the course and follow your trading plan. If you have ever asked yourself why you are not as profitable as your plan indicated you should be, check to see if one of these stories applies. Better yet, learn from these examples and stay disciplined right from the start.
By Bradley W. Gareiss of GFTForex.com