Would you ever go on an all-day hiking trip without a map, plan, or some essential surviving tools? I bet you wouldn’t.
Why then take a trade without a plan?
The number of traders without a well-defined trading plan is simply astonishing. Most of them end up losing their entire trading account along the way.
In this article, we’ll show you how to build a trading plan in 16 simple steps and trade the markets like a pro.
Plus, we’ve made a handy trading journal template for you to easily track all of your trades and evaluate their results!
#1 Assess Your Risk Tolerance
Assessing your risk tolerance is an important step in building a trading plan because it will impact your trading strategy, risk management, and other aspects of your trading.
In general, traders can be grouped into two categories depending on how they tolerate risk: (1) risk averse and (2) risk tolerant.
Risk averse traders don’t like taking large risks in trading. They aim to make small profits and keep their losses under control. Bear in mind that the higher the risk you’re willing to take, the higher the potential payoff. Risk averse traders want to grow their accounts slowly and steadily.
Risk tolerant traders are the complete opposite – they’re not afraid of risk, which means that their trading strategy is more aggressive and their potential profits are significantly higher than the profits of risk averse traders. However, this means that their losses are higher as well.
Assessing your risk level is not always an easy task, especially if you’re just starting out with trading. There are many online quizzes that you can take and assess your risk tolerance.
#2 Keep a Trading Journal
Trading journals are written records of all trades that you take and include their position size, traded instrument, direction (long or short), entry and exit points, their result, and any other field you find useful.
Regularly keeping a trading journal should be an important part of your trading plan, since trading journals can be very useful in improving your trading performance and spotting regular mistakes that lead to losing trades.
#3 Perform Regular Journal Retrospectives
To get the most out of your trading journal, you need to perform regular journal retrospectives. Go through all the trades you recently took and check how they have performed. Traders do this usually on weekends or once per month.
The goal of journal retrospectives is to make an objective evaluation of your trading performance. Filter all trades that hit your stop-loss or were closed in a loss and try to identify mistakes that led to taking those trades.
Naturally, every trading strategy will have a few losing trades here and there, but if you find a recurring pattern in your losing trades you can take action and fine-tune your strategy.
- Do specific chart patterns often lead to losses?
- Are your stop-losses too tight?
- Or did you take trades that aren’t in the direction of the underlying trend?
Regular journal retrospectives will help you find answers to those questions.
#4 Know Your Trading Strategy
Another important step in building a well-round trading plan is to know the strengths and weaknesses of your trading strategy. No trading strategy is completely bullet-proof – some strategies work better when the market is trending, while some are designed to take advantage of ranging markets.
In fact, many professional traders use more than one trading strategy when trading the markets, depending on whether the market is trending or moving sideways.
#5 Identify the Market Environment
As already pointed out in the previous point, markets can trade in different environments, such as in uptrends, downtrends, or as sideways-moving markets. In addition, market environments can also be grouped depending on the current risk sentiment in risk-on markets and risk-off markets.
Each of the mentioned market environments has certain characteristics that traders need to know about before placing a trade. For example, overbought and oversold levels in technical indicators could work great in a ranging market but produce a large number of fake signals when markets are trending.
Similarly, high-yielding assets often outperform low-yielding ones when markets are in a risk-on mode.
Successful traders make their trading decisions depending on the current market environment and follow rules built into their trading plans.
#6 Apply Strict Risk Management Rules
A trading plan without well-defined risk management rules is not really a trading plan but a gambling plan. Risk management is arguably one of the most important aspects of trading and traders should always keep a close eye on their risk levels, potential losses, free margin, etc.
Without risk management, even the best trading setups could be a disaster for your trading account. Imagine a great trade that initially went in your favour only to reverse and hit your stop-loss because your take-profit was too wide or you didn’t have a take-profit at all.
Or, to take another example, let’s say you took an extremely large position size and lost 50% of your trading account on a single trade. It takes a profit of 100% only to return to break-even!
That’s why there isn’t any serious trader out there who can consistently profitable without having strict risk management rules in his or her trading plan.
#7 Define Your Entry and Exit Levels
A well-defined trading plan needs to have rules for defining entry and exit levels of a trade. After you spot a promising trade setup that aligns with your trading strategy, use your entry and exit rules to identify possible levels at which to enter into that trade, take profits, and cut losses.
While a trading strategy tells you whether to go long or short depending on the trade setup, your entry and exit rules (combined with your risk management rules) define levels at which to enter into that trade and set your SL and TP levels.
#8 Define Your Trading Style
Your trading style plays an important role in defining other aspects of your trading plan. Depending on your trading style, you’ll have to adjust your risk management, your preferred trading timeframes, and your trading strategy.
There are four main trading styles out there: scalping, day trading, swing trading, and position trading.
- Scalping is a fast-paced trading style that is based on very short-term timeframes with tight stop-loss and take-profit levels. Scalpers usually hold their trades for a few minutes to lock in small profits, which means they need to take a large number of trades in order to grow their accounts.
- Day traders open their trades early in the morning or during the day and close them by the end of the trading day. The usual holding period of day traders is a few hours.
- Swing traders stick to their trades for days or even weeks. This means that they need to have relatively wider stop-loss and take-profit levels to account for market fluctuations.
- Position traders base their trading decisions mostly on fundamental analysis and hold their trades for months or even years. These traders usually have large trading accounts and very wide SL and TP levels.
#9 Don’t Neglect Market Fundamentals
While technical levels are important, never underestimate the power of market fundamentals. Changes in fundamentals create trends, reverse them, and break important support and resistance levels. This is especially true on longer-term timeframes and trading styles, such as swing and position trading. However, short-term traders can benefit from fundamental analysis as well.
Broadly speaking, market fundamentals are what give a trading instrument its fair or intrinsic value. In the case of stocks, traders should pay attention to number like price-to-earnings ratios, earnings per share (EPS), and the potential of a company’s management.
Forex traders follow reports such as GDP, inflation rates, unemployment rates, trade balances, and government deficits, and use models that are based on interest rates, the balance of payments, and monetary and fiscal policies. In the short-term, market reports that miss or beat expectations to a large extent can have a significant impact on exchange rates.
If you’re a longer-term trader or want to take advantage of short-term price fluctuations as the result of news, fundamental analysis should be an integral part of your trading plan and strategy.
#10 Set a Precise Reward-to-Risk Ratio for Potential Trades
Each trade with defined exit points (SL and TP levels) has a reward-to-risk ratio. This ratio, also called R/R, is simply the ratio between a trade’s potential profits and losses. Let’s say you buy a stock and set both your profit target and stop-loss level $10 away from the current price. In this case, the R/R ratio would be 1, i.e. you’re risking $1 to make $1.
The best trades usually have reward-to-risk ratios higher than 1. If you set your profit target $30 away from the current price and your SL level $10 away, the R/R ratio would equal 3:1, i.e. you’re risking $1 to make $3.
The same principle applies to other markets as well, such as the currency market for example. Placing a take-profit and stop-loss level 60 pips and 30 pips away from the entry price, respectively, would return an R/R ratio of 2:1.
The minimum R/R threshold for your trades should be defined in your trading plan under the risk management rules. Never take a trade that has a lower R/R ratio than the one set in your plan.
#11 Define Your Maximum Risk-per-Trade
Another important risk management rule is that the potential loss on each trade never should exceed a pre-set amount set in your trading plan. This is also known as the risk-per-trade.Your risk-per-trade defines the maximum amount of risk (as a percentage of your trading account) you take on every single trade. The larger your trading account, the lower should be your risk-per-trade.
As a rule of thumb, start with a 2% risk and decrease it as you grow your account.
#12 Think About Your Maximum Drawdown
Another important when thinking about risk management is your maximum account drawdown. A drawdown is defined as the largest distance between a peak and a trough in your trading account balance.
For example, if your trading account size is $10,000 and you lose $2,000, but manage to recover some losses afterward, your account drawdown would be 20%. As a rule of thumb, the more risk you’re taking, the larger will be your maximum drawdown. By keeping your trading risks under control, you’ll be able to maintain a relatively small drawdown and grow your account.
#13 Add Rules for Confirming a Setup
Having a trading strategy that tells you when to go long or short in the market and knowing where to place your stop-loss and take-profit levels is only one side of the coin. To increase your success rate and avoid fake signals, you should always look for additional clues from the markets to confirm a trade.
To build a bullet-proof trading plan means to only take trades that are confirmed. Traders usually use technical tools to confirm a trade, such as candlestick patterns.
A strong engulfing pattern (a candlestick that engulfs multiple previous candlesticks) signals strong buying/selling pressure and shows that the market is respecting the levels you want to trade. /su_box]
Similarly, a close above yesterday’s high or below yesterday’s low can also be used as a signal to enter into a long or short setup, respectively.
#14 Use Pending Orders Where Necessary
Pending orders are a great way to enter into a trade without having to stick to your computer screen all day long. Unlike market orders that open a trade at the current spot price, pending orders wait for the price to reach and cross a pre-specified level after which they become regular market orders.
Pending orders are especially popular among day traders who want to catch price breakouts above or below important technical levels. Pending orders that you could incorporate into your trading plan include buy stops, sell stops, buy limits, and sell limits, for example.
#15 Protect Your Profits with Trailing Stops
As their name suggests, trailing stops trail the price of an instrument and move your stop-loss level automatically with each price-tick that goes in your favour. However, if the price starts to reverse, a trailing stop will stay at its current level and protect your profits or lower your losses.
Trailing stops can be used in combination with a wide range of trend-following strategies in order to stay inside a trend as long as possible. Alternatively, some traders prefer to manually move their stop-loss levels of profitable trades.
#16 Pay Attention to Market Correlation
Today’s financial markets are all interconnected – when one market moves up, another market will usually either follow or move in the opposite direction. There is almost no market that is completely independent of other markets.
This is why you need to pay attention to the correlation factor of trades inside your portfolio. For example, being simultaneously long the US dollar and short Gold could increase your trading risk as those instruments move in the opposite directions most of the time, i.e. they are negatively correlated.
The process of building a portfolio of trades should be an important part of your trading plan.