Trading Strategies: Profitable traders always have a trading plan? The alternative is just not an option. Trading is a speculative business but it is a business. A plan is the foundation upon which you will build your trading future. In fact you must write your plan down on paper. If anyone was to ask you how exactly you trade, you should be able to tell them off the top of your head. It isn’t necessary that it’s complicated. In fact simplicity is usually more beneficial. Just know that you will not succeed in trading without a plan and the discipline to follow it.
Trading strategies achieve a number of important objectives.
Many traders enter a market based on a hunch, on emotion or a tip. While some new traders have difficulty making the decision to enter a trade, most are trigger happy and are all too eager to get in there. Remember, the only reason you can enter the market is because the person on the other side of the trade has a different opinion. Why is your opinion the correct one? When do you get out if it starts to show a profit? More importantly, when do you get out if it shows a loss? Trading strategies identify those entry and exit points and trades are executed using appropriate trading order types.
Most traders want to be in the market all the time. It’s a psychological need. After all, if I don’t have an open position how can I make any money? Some miss the excitement of the trade and enter out of boredom. Often is better to stand aside, however, because the conditions aren’t right. In these circumstances it is better to sit on the side-lines and let the market develop until it gives you a signal. Patience is a valuable trait and a good trading plan will prevent unnecessary trades that diminish your financial and psychological capital. Psychological capital is valuable as well. It includes the confidence in your ability to achieve a positive outcome and resilience in the face of adversity.
Surprisingly, it can be more difficult to manage a profit than a loss. It is relatively easy to identify when you are wrong. When the market goes in your favour a different problem arises. At what stage do you take your profit? For example, when a trader takes a long position and the market does rise, it will rarely do so in an uninterrupted manner. Regardless of the time frame within which you trade, the market will experience dips. These downturns often flush traders out of their position only for the market to turn and make further highs. It’s a frustrating experience to be right in the direction of the market but to be taken out of it by whipsaw movements. The same phenomenon occurs in a falling market when the trader is short. The market may make a surprisingly strong rally forcing short traders to exit at a loss. A good trading plan will provide effective management of profitable trades allowing the market the “breathing room” necessary to cope with its inherent volatility.
No one enters a trade unless they have a reasonable expectation of a profit. However, losing trades are inherent in the business. It is not possible to trade without experiencing losses. In fact, some successful traders have a higher percentage of losing trades than winning ones. The profit they make on the winning trades far outweighs the losses from the losing trades. It’s not that anyone should welcome losses only that it is unreasonable to expect to trade without them. The extent of an “acceptable” loss should be calculated before the trade is even initiated. While your plan may signal that you need to exit at a loss, accepting it and taking the decision to realise the loss is more difficult. Accepting small losses, however, is essential to capital preservation.
The importance of effective risk management cannot be over emphasised. Money management is as important as the trading strategy but traders often neglect to give it the focus it deserves. The best trading plan in the world can be destroyed by bad money management. There are as many trading techniques as there are traders in the world. The successful ones know how to manage risk.
A library could be filled with books on trading psychology. It’s an aspect of trading that is difficult to master because everyone reacts to market movements in their unique way. People have different appetites for risk. The dynamics and volatile nature of markets make trading one of the most challenging activities to undertake. The longer you trade the more you will understand your psychological strengths and weaknesses. Traders cannot control the markets but they can control how they react to the market. A trading plan puts investors in control of themselves and allows the market do whatever it has to do. There is such a thing as psychological capital as well as financial capital. Without a trading plan it is likely that your psychological capital will run out just as easy as your financial capital. Avoid emotional exhaustion by sticking to the rules of the trading plan. It will give you the level of confidence and peace of mind not experienced by amateurs or gamblers.
As in any business performance evaluation is vital. What is my percentage winning to losing trades? What is my average profit? What is my average loss? What is my risk/reward ratio? These are important questions to answer. An effective trading plan allow for monitoring and evaluation of results. Keeping records of your trades allows further analysis. Often a slight change in the parameters of your trading plan can make a huge difference. This is a continual process that will lead to consistency and better results.
Development of a trading plan demands back-testing on previous market data. If it has performed in the past it is reasonable that it can perform in the future. Trading will test your nerves like few other professions and success is impossible unless you have faith in your plan. If you have tested your methods then you won’t be surprised by the market. Even if you are surprised you’ll know how to deal with it.
Another word for back-testing is paper trading. Paper trading involves applying your methods to a real market using historical data. However, the results attained from paper trading can give a false impression. The reason for this is that the vital element of human emotion is missing. Markets are made up of people risking their hard earned money with all the hope, fear and greed that this entails. These emotions are absent in paper trading strategies because the profits and losses are not real. People react differently to risk and a system that produces profits during paper trading may not do so when real money is at risk. Suddenly a loss means something and emotional reactions to the volatile nature of the market may result in interference with the system and inferior results.
Traders and investors may use Fundamental Analysis, Technical Analysis Indicators and/or Chart Patterns to develop their trading strategies. Investors tend to buy and hold an asset and hope it grows in value over time. The time frame tends to be longer than a trade and the profit target may be unknown when the investment is made. The number of decisions to be made is less frequent. It is often said that stock markets outperform over the long term but this is not guaranteed. Ask investors who invested in the S&P500 in early 2000. In 2012 the S&P was still below these levels. So even if you are a long term investor it’s important to get the timing right.
Trading could be said to be a more active approach to financial markets. They tend to keep a closer eye on market movements and actively manage their positions. Traders take advantage of shorter term moves in the markets. They will as easily go short as go long. Trading strategies are more exact in terms of timing entry and exit into the markets. Targets for profits and limits for losses are well defined (or should be anyway!). Frequently they use technical analysis indicators and chart patterns to aid decision making. Technical indicators help to analyse price behaviour including trend, momentum and volatility. Chart patterns are also effective in developing trading strategies and entry or exit levels.
Developing trading strategies takes a little bit of work but is ultimately very rewarding. Acting on a whim or gut feeling is not consistent with a successful long term plan. It’s just not going to work. As stated previously, simplicity is often the best approach. Many technical analysis traders only use a handful of indicators. For example, a trader who likes to trade with the trend may use Fibonacci retracements combined with a momentum indicator and moving average at turning points. Start with a small amount of money and a basic approach. As your knowledge and experience increases develop the plan to further improve your trading strategies.