The Trading Methodology or System
For starters, a trading plan will include a system or trading methodology
you will use to trade with. A trading system is basically a set of rules and
conditions that will get you in and out of the market. You can have several
systems, if you like, that differ with different market conditions. Some
people hear the words “trading system” and think it must have computer
generated signals. That’s not true; systems do not have to be mechanical.
They can be totally discretionary as long as they follow the same rules all
the time. A signal in a system can simply be buy on Tuesday if Monday is an
up day. Or it could be a discretionary methodology you use to make trades.
You may look at several indicators and then make a decision based on them
in combination with a news story. It doesn’t matter as long as you’re consistent
and have rules you follow. But regardless of whether it’s computer
generated or not, make sure you back test the system over historical data.
The main drawback with nonmechanical systems is that it’s much harder
to back test discretionary systems. You can learn the hard way to see if your ideas work, which is by losing money in the market, or you can back
test. You want to make sure your ideas have a history of working, because
if they didn’t work in the past, they probably won’t work tomorrow.
By having a system or methodology, you will know how and what you
will trade; nothing should come as a surprise and you will reduce the number
of bad trades you make. Oh, I’m certain you will still make lots of bad
trades. But you’ll probably make fewer. Bad trades are different from losing
trades. Many good trades will not work out and you may lose on them,
however, bad trades are stupid mistakes that a system can prevent. With
a system, you’ll know that if a certain condition is met you will be in the
market, and win or lose this has proven to be a good trade in the past. However,
no matter how bored you are or how much extra margin you have, if
these conditions or criteria are not met you shouldn’t do anything.
Don’t Forget about Getting Out
One thing I need to stress is that
entering a trade is only half a trade. You need to get out of them as well.
Too many people come up with great buy signals but then forget they have
to exit a trade. Even more important than getting you into a trade, a system
must have rules for getting you out of the trade as well. Don’t ignore
this part of trading, the exit really is the difference between what makes a
winning or losing trader. Look back at the crude trade, an exit strategy is
what makes one a better trade than the other. A good system will have options
for getting you out of winning, losing, or break-even trades. I would
say that before you even enter a trade, you should know where or why you
would get out, both with a winning and a losing trade. I didn’t use the word
“stops,” but it is implied in this paragraph. Though a game plan will monitor
the stops, the trading plan sets the parameters for them. What’s good
about having predetermined exit rules is that once in a trade, a trader can
relax a bit and not have to look at the market tick by tick.
Money Management
Though a trading system is important, money
management and risk parameters are an even more important part of the
trading plan than the actual buy and sell signals. You need to know how
much to risk, how many contracts or shares to trade, when to increase position
size, and which stocks or markets you can afford to trade. A money
management plan will let you know how many total trades you can have
on at once and how much you should risk in each and/or in total. Knowing
how to use the proper position size is a large part of money management
and also of determining how well you do. Trading more than you can afford
to lose can easily get you into trouble, even if you are right on a trade.
If you trade above your means, you may not be able to hold the position
when there is a little blip against you. So even though you were correct in
the long run, you may end up exiting with a loser.
If you work on a good risk plan you will reduce the chances of blowing
out. I know that anytime I took a really big hit it wasn’t because I was
wrong in the market (yes I was wrong, but the reason I blew out was I
used poor money management and traded too large a position or allowed
myself to risk too much on a trade). Hell, I even blew out once being right
in the market direction. But I tried so large a position that I panicked when
it immediately went against me, and I reversed my position trying to make
up the loss.
Do yourself a favor and take the time before you trade to come up
with a good risk plan as it will make having and following a game plan so
much easier. If you have been trading for years, take an hour and evaluate
what you think is your risk strategy. Later in the book I’ll go over money
management plans in detail. I’m not sure which chapter it is yet. Just look
in the table of contents if you can’t wait to get to it.
Knowing Your Trading Mentality
When making a trading plan you should figure out which stocks, sectors,
or commodities you will trade. Markets move differently from each other,
some trend more often, while others are choppier, some are wilder than
others with wider ranges, and therefore you have to trade less size and use
wider stops. People have preferences for some markets over others and
this is all part of their trading mentality. Unless you are using a software
program that scans everything and tells you which stocks/markets meet
your criteria, your trading plan should be tailored to the stocks or commodities
you will be looking to trade.
For some people it’s fairly easy, they just trade the S&Ps, others may
only trade oil driller stocks, while others may include any stock over $20
with at least a million shares a day traded. It’s not important what you plan
on trading, just know it in advance so that during market hours you can
focus on trading and not have to worry about finding markets.
Another part of the trading mentality is determining your trading time
frames when you are making a system. Some people can hold stuff for
years while others get fidgety after 12 seconds. The shorter the term you
hold, the more you will trade and the smaller your stops and targets will
be. I’m definitely not a quick in and out guy, so I can’t follow a system that
my friend Bruce, who makes 200 trades a day, would use. I prefer holding
for a few days to a couple of weeks. So I have larger targets and therefore
bigger equity swings. When he holds stuff overnight he will call me
and everyone else he knows who trades 15 times to see what we think.
He then sleeps like a baby, waking up every hour or two crying. Again,
everyone is different and this difference should be incorporated into the
trading plan.
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