By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical
Larry Hite (1956 -)
Of all the chapters in this book, this one is perhaps the most important, and also one of the most difficult to write. It is difficult to write for several reasons, not least because I have never met you, and may never do so, although I hope you will ‘e-meet’ me metaphorically in one of my trading rooms, or indeed at a seminar.
And the reason it is hard to write, is that as you will see from the title, this chapter is entitled ‘Your Trading Plan’. It’s not mine, or anyone else’s but yours, and yours alone. It will be personal to you, your circumstances, your view of money, and your goals and objectives in entering the trading world. Over the years, your plan will alter, just as in other aspects of your life. As your knowledge grows, so your plan will change.
My purpose here therefore, is to try to provide you with ‘food for thought’, the basic ideas, principles and concepts, which you can then develop into your own unique and personal trading plan. After all, it would be very easy for me to give you a blueprint of a trading plan and leave it at that. However, this is not what this book is about. In everything I write, I am trying to help, educate and teach based on my years of trading experience. And just as with every other aspect of trading, there is a great deal of nonsense written about trading plans, generally from people who have never traded in their lives, and it shows. These are then my own thoughts, observations and ideas, which I hope will help you to understand why we need to have a plan, but where that plan stops and what I call ‘discretionary trading’ steps in, and in order to start the ball rolling, let me begin with a simple, extreme example to explain this statement.
You may already have come across the term ‘black box system’ which generally means a piece of software that mechanically produces the buy and sell orders. Your entry and exit signals if you like. In other words, you do nothing, other than follow what the software is telling you to do. In addition, the system may also implement the money management rules that we looked at in
the previous chapter. And that’s about it. Now, ask yourself a question. If anyone, anywhere, was ever able to develop a ‘black box’ system that worked, and worked consistently, then such a system would rule the world for its inventor. No one else would survive against it.
That’s the first point. In other words, no one has, and no one ever will develop a ‘black box’ system that works consistently to produce profits in all markets, and in all market conditions.
The next point is this - it may be very easy to produce a black box to signal an entry, but what about the exit, which is much harder? Can a black box system see the market, react to the fundamental news, react to relational markets, or consider the technical picture in multiple time frames. No. In closing a position in the market, most black box systems will simply reverse the initial entry rule which is why none of them work. No, let me correct what I said here - they can work for a time, but then fail, and this is no great surprise, since it is impossible for anyone to design a mechanical system which has the flexibility to adapt to different market conditions. Some of the systems may work if the market is trending, but then fail in sideways moving markets. Others may work when price congestion is dominating market behaviour, and then break down when the trend begins.
Many people have tried and failed, from ‘learned institutions’ to ‘trading gurus’. All these systems have one thing in common, they all fail, and some in spectacular fashion.
So what can we learn from all this? And more importantly, what is the relevance to us as humble retail traders when considering the ‘trading plan’? One thing I hope is clear from the above. A trading plan is many things, but one thing it is most certainly not is a set of mechanical rules, which you then follow on each and every trade. If it were, then we could call it a ‘black box’ trading plan, since this in essence is exactly what it is. A set of rules, that you follow blindly, irrespective of market conditions, and this is the problem. Most people who write about a trading plan will suggest that you write your rules, and then apply them to the market. Blindly. Sorry, this is complete rubbish, and in the rest of this chapter I’ll explain why, and more importantly how to develop your trading plan so that it is meaningful, but protects your capital at all times.
Let’s start with why we have a trading plan.
love to use analogies to try to explain concepts in a simple and clear way, (that’s the theory anyway!). The analogy that I believe works well here, is to think of a journey by car from A to B.
First we decide that we actually want to travel from A to B. Then we get in our car and start driving. Do we drive at the same speed all the way? No - we are constantly having to adjust our speed for a variety of reasons. The road conditions may vary, the weather may vary, the amount of traffic may vary. These are all variables which influence both our driving style, and speed. If the roads are dry, and empty, then we can drive fast, but if it is raining heavily and there is a great deal of traffic, then we are more cautious and drive slowly, and only speed up once conditions allow. We are driving in a discretionary way, because the prevailing conditions dictate that this is the most sensible way to drive.
When you think about it, what we are actually doing is assessing risk - no more, no less. If the roads are wet, and visibility is poor, then we drive more cautiously, in order to lower the risk of an accident. As road and weather conditions improve, then we feel comfortable in increasing our speed as we now judge that there is less risk in driving faster.
To extend this analogy further, for those of us lucky enough to have cruise control on our car, would we consider driving with this on all the time? The short answer is no, since at some point the weather or traffic conditions or both, would force us to go back to our discretionary driving, or if not, accept the fact that sooner or later we would crash.
It goes without saying that there are some ‘rules of the road’ which we never break, and these are always in force, such as which side of the road to drive on. We all drive on the right, or the left, depending on where we are in the world, and this, by and large, avoids chaos. Everything else we do on our journey is based on our assessment of conditions (other than stopping at traffic lights!)
To summarise.
We plan our journey from A to B. Our journey has two primary rules: Drive on the correct side of the road
Virtually every other decision is discretionary. I accept the above is not a perfect analogy, but to me it best describes the core principles of what I believe should be the foundations to a sensible and workable trading plan. If you have a trading plan which is a ‘black box’ set of rules, then you are on ‘cruise control’ and sooner or later you will crash, but as I hope I have explained, a methodology based on such an approach will ultimately fail.
There is no doubt that you do need to have a trading plan, but one that is realistic and workable. This is what we are going to cover next.
Let’s start with the easy part - the two rules of driving (trading!)
Rule one - Every position will have a stop loss
Rule two - The maximum loss on any position to be x%
These are the only rules which apply to every trade. Every other decision you make as a trader should be discretionary, and based on market conditions. The remainder of your trading plan will be developed around you, your personality, time available to trade, experience, trading capital, and many other factors. Nothing else is written as a ‘rule’ which has to be obeyed come what may. The
only two rules which apply are those written in red above. It is no
coincidence that both of these apply to protecting your trading capital. As I tried to explain in the previous chapter, this overrides everything else. Your trading capital is like the ‘crown jewels’ and should be treated as such. These two rules are the foundations on which your own personal trading plan is then built. Let’s get started on building your plan!