The Anatomy of a Trading Plan

 

Preparation is key if you want to have an ounce of success in the securities markets. More often than not people are drawn by the possible riches of the market, then they neglect the most important aspect of trading. A trading plan.

In this Blog I want us to discuss "A Trading Plan". A trading plan consist of three components; the "strategy" and risk management. The third component of a trading plan is the Traders mindset. All these components contributes to the Trader's success, you can't leave one at the door.

The Strategy

There are various ways to trade the markets. Without going into more details; the two common ways are derived from fundamental analysis, where a large of pool of people uses Value Investing, or technical analysis.

Fundamental analysis, for the sake of simplicity we'll take as if value investing is the only way to do fundamental analysis, is the art of diving into company financial statements to diagnose the state of the company. In this approach, the focus is on the company and its ability to continue to do business whilst rewarding the shareholder. Billionaire investor, a legend, Warren Buffett is the poster boy of value investing, an approach that was pioneered by Benjamin Graham, his mentor and author of The Intelligent Investor. I haven't met an Investor who hasn't come across this book.

Technical analysis is the art of reading the chart, price and volume analysis of the security's price or simply, price action. The Chartist try to identify repeatable patterns to exploit. There are various technical analysis approaches; from naked chart analysis, to using technical indicators, or a combination of these. 

The two approaches can be combined; Nicolas Darvas considered himself a techno-fundamentalist, as described in his book How I made $2 000 000 in the Stock Market. Thus, there's no need to fight which method is better than the other. If you want more information about the company, choose value investing, and if you want to take advantage of the stock's price action then choose technical analysis.

Risk Management

Risk is inherent in the stock market, at any time you must estimate and manage risk. There's confusion between risk and volatility and we have cleared that confusion. Once you understand that trading involves risk, then you have to accept risk. People think that knowing, understanding and accepting risks are the same thing. You can know and understand the presence of risk, but you must accept it in order to have a piece of mind when trading your hard earned money. Before you place a trade you must accept the trade outcome, profitable or losing trade; if you can do that then you won't be emotional about the outcome.

It's recommended that you risk less than 2% of your capital to avoid the risk of ruin. Below is a borrowed table from Rayner Teo

With 2% risk you can afford to have 5 open positions, if all trades become losses, you'll be down 10% and only need 11.11% to break even. 20% loss seems small, but returning 25% just to break-even is emotionally draining, trust me I know. It's important to consider total portfolio risk at any period, that is how many 2% risks are open, more than 5 positions is a lot.

You must set a stop level every time you place a trade, you must know where you'll exit if the market invalidates your analysis. If your platform doesn't have a stop loss function, you have to monitor the market all the time relative to your time frame. 

If you can't take a loss then you'll have a problem in the market, period.

A combination of strategy and risk management should give you an edge in the market, that is, the approach must have a positive expectation to give you consistent profitability in the long run.

Psychology

Once you're armed with the first two component you're almost ready to begin your trading journey. However, if your mindset isn't there yet you'll have difficulties accepting your losses, patiently waiting for the market to reach your entry/exit signals, and worst case you'll hop from one approach to another hoping to find the Holy Grail. There isn't much to say here except that you need mental strength  and a probabilistic mindset to survive in the market.

Mark Douglas wrote a book covering trading psychology, below is the summary of the book.

1. Anything can happen. 
2. You don't need to know what is going to happen next to make money.
3. There is a random distribution between wins and losses for any given set of variables that define an edge.
4. An edge is nothing more than an indication of a higher probability of one thing happening over another.
5. Every moment in the market is unique.

The central point of these three components is your Holy Grail.

That's all you need in order to be among the profitable traders in the market.

We couldn't help but make this Blog a video. Enjoy.

Did I miss something? Leave comments below, let's discuss.