Trading Principles: Part I – The Trading Plan
February 12th, 1:15 pm by Guru Team
Written by pawelskrzypek
In my posts to the eToro blog, I would like to describe basic elements that are most important to trading (of course, in my opinion) and show why these elements are important and shouldn’t be forgotten during trading.
For me the most important elements in trading are:
1. Plan/Strategy/System – I mean ordered method of trading, tested and proven profitable, including rules for entry, exit and risk control.
2. Rules of trading – rules which should define our trading
3. Risk control – methods of controlling and limiting risk
4. Mindset – dependency between trading style and mindset
5. Probabilities – thinking of probabilities, not uncertainty
6. Discipline
In my first post I would like to write about trading plan, known also as a trading system or trading strategy.
We can think about trading plan as about something like business plan for other business. In business plan we plan our activities, calculate our costs and profits, calculate risks for our business and many more factors. Exactly the same should be done for trading plan. Trading is a business, of course, if we treat it seriously. People risk money in trading, sometimes even big amount of money, so it needs to be treated seriously. Many persons don’t treat trading in that way, they open positions on news or just listening to tips of others and don’t have a plan what to do with opened position, but everybody must know that opened position is a risk of loss of money, so should be opened according to the plan and analysis.
Each trading plan should have at least the four elements listed below:
1. Rules for entry – entries are less important for the trading plan, contrary to popular belief, but should be defined in each plan.
2. Rules for exit – exits are much more important than entries, because exit will define if we make money or not. There should be rules for exit with profit and for exit with loss (limiting loss). Exit also defines our risk management by limiting loss.
3. Money management and position sizing – rules for determining position size and maximum exposure to the market for particular trader and all our exposure.
4. Testing – back-testing and forward testing
Ad.1 Entries are most popular element of trading plan, there are many systems and strategies which defines how and when to open position, for example open buy position when RSI is oversold, open sell position when MA12 cross MA20 from up to down and many, many more. What is important is that we have to find something which works for us. For me, entry is really not very important; I open positions according to medium trend just looking at chart. The sizes of positions are determined by my money management.
Ad.2. Exits are much more important. We need to define when to exit with profit, when to exit with loss, exits could also be determined by market conditions. For example, exit could be defined with constant pips value like 20 pips for TP and SL, or exit when RSI change to overbought or MA crosses different way. I look at price action and overall price movement. If price is in consolidation I’m using 40 pips target to exit, if moves strongly I have open target till next consolidation area. I also have a special mode, defensive mode, when I try to exit at break even without loss of my whole position, just for limiting potential losses.
Ad.3. Money management and position sizing are as important as exits, for me. We should have defined rules how big a position to open and what is the hard stop for a position (unconditional close of position in loss to protect capital). It could be as simple as for example, risking 1% of capital in one trade or as complex as dynamic active exposure management (one example is described in my trading strategy). We should remember that if we use simple method we should determine our hard stop loss before opening a trade and never move it against us (making bigger loss).
Ad.4. Testing – your whole strategy (entry, exit and money management) should be back-tested on historical data and forward tested with small capital in real trading. Never trust back-tested results, because it is very easy to make good results during back-testing, so we have to always do forward test. As forward test I mean using your strategy with live account, real money, but small size, max 10% of your original account for at least 3 months. There is no need to rush in trading, tested and proven profitable strategy is very valuable and needs very hard work, please remember about it. Never trade an untested strategy in your full account; it’s the simplest way to blow it out!
We need to always remember about our trading plan, especially what to do when market goes against us. We need to have a plan when to take a loss, because losses are part of trading and sometimes need to be taken to protect your account. We should make every effort to avoid losses (that is purpose of my defensive mode for example), but sometime we have to take loss. Extending your stop loss is just extending your loss and it is the straight way to bankruptcy.
I hope that you find this post valuable and will always remember about your trading plan, not opening positions on tips or emotional factors. If you have any questions please do not hesitate to ask.
A more detailed description of my strategy can be found at here and you will find in it how I deal when market goes against me.
In my next post I will write about fundamental rules of trading, which should be used in each trading plan.
