How to build your trading plan
Why having a trading plan is important? And what is a trading plan? Let’s discuss these two important questions.
First, a trading plan can be seen as the set of rules that will tell you exactly what to do in any situation. It is like having a recipe for a cake. You will just have to follow the instructions to bake a nice cake, and if you forget how much sugar to add it will be written there. Hence, it is something that you should consult often, especially when you do not feel sure about the best way to proceed.
So why is having a trading plan important? Because sometimes you will not know what to do, and emotions like greed and fear can let you deviate from your plan. And you know that this is a dangerous situation (see for example this article and the following ones).
Now, you may be wondering how to build a trading plan. There are many ways to do it, and I want to share here the four main element that you trading plan should include.
- What to buy. Are you looking at stocks, futures, options, forex, cryptocurrencies, REITs? What is the market or the markets you are interested in? Moreover, are there additional criteria to check? For example, if you are a long-term investor you may want to consider only stocks that are fundamentally strong. All this must be stated precisely.
- When to buy. This is often where technical analysis can help. However, how to do that depends on your strategy. Where a long-term investor may want to buy at a low price, ideally at some support level, a short-term trader could look at other indicators like moving averages, MACD, force index, and so on.
- How much to buy. This is usually done by means of position sizing, that will determine the number of shares, or contracts, or lots (depending on what you are buying – or short selling) according to your risk appetite. A video explaining position sizing can be found here.
- When to sell. Last, but probably first in order of importance. As well as the hardest to perform. If you are a trader, you should have your stop-loss, and maybe a take-profit order. You could also have additional rules, e.g., if earnings are approaching you may want to close your position. For options, you could have rules telling you what to do near expiration. A long-term investor could instead look at P/E ratio and other fundamentals to decide when to exit.
The take-away message here is that you need to define clearly all the details before you even think about buying someting. When you do it, your performance will improve. And to make them even better, a great way is to have a trading journal. But this is another story.
Risk comes from not knowing what you are doing (Warren Buffett)
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