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Have you completed lesson 3’s action steps?
If not, complete those steps before reading on.
What is a Trading Plan?
Contrary to popular belief, you do not need to know where market
tops and bottoms are to make money in the markets. In fact,
that is where most people go wrong. The best traders in the
world realize that neither they nor anyone else knows what is
going to happen. Sure, everyone can point out tops and bottoms
after the fact, but no matter what anyone tells you or tries
to sell you, NO ONE can pick tops and bottoms consistently.
So how do you make money without picking tops and bottoms?
I am glad you asked.
Successful trading is not dissimilar to a successful business.
You see, every successful business has a business plan and so
do successful traders. The astute reader may have already realized
this from the previous chapter, where I mentioned that “successful
traders have a systematic way they approach the market.”
A trader’s business plan is known as a trading system; it defines
your approach to trading. A properly constructed trading system
will leave no room for human judgment, because it will define
your actions, given any circumstances that may arise. It is
a distinct set of rules which will instruct the trader what
should be done and when to do it.
The importance of a trading plan cannot be understated. Without
a consistent set of guiding principles to govern your trading
decisions, you will most likely hop from one trade to the next,
impelled by emotion or hysteria. I believe by not having a
plan, you are planning to fail.
Trading systems themselves will come in many varieties, and
they all take the guesswork out of trading. A trading system
will determine for you when to buy or sell. “System trading”
has proven itself consistently to be the most effective long-term
trading technique.
In fact, you may have even heard the story about one of the
most famous system traders of all time, Richard Dennis. It
just so happened (in mid 1983) that Dennis was having an ongoing
dispute with his long time friend Bill Eckhardt about whether
great traders were born or made. Dennis believed that trading
could be broken down into a set of rules that could be passed
on to others. On the other hand, Eckhardt believed trading
had more to do with innate instincts, and that this skill comes
naturally.
In order to settle the matter, Richard suggested that they recruit
and train some traders and give them actual accounts to trade
to see which one of them was correct. He named his protégés
after visiting turtle farms in Singapore; he decided to grow
traders like the farmers grew turtles, hence the name: Turtles.
To cut a long story short, Dennis taught his trading methodology
to these groups of students who later became some of the most
successful traders of all time; proving once and for all, that
system trading could indeed be taught.
Just like the turtles, I too have studied under a mentor who
tutored me in the “science” of trading. And now I am passing
these secrets on to you.
A trading system is simply a set of rules that address every
aspect of a trade such as entry and exit conditions and money
management. Regardless of how complex it may be, a good test
for your trading plan is to hand it to someone else to read
thoroughly and then see if they have any questions about it.
If they can easily understand all the rules and the requirements
of your strategy with little to no questions, then you have
compiled a sound investment plan.
All successful traders that I have come in contact with can
do this. What’s more, they have their exact trading methodology
written down.
Since most traders lose money and do not have their trading
methodology written down, does not it make sense to do what
everyone else is not doing? If you are trading now and have
not taken the time to clearly write out methodology, then stop
trading and get it done!
Why is it so important to write a plan? When you take time
to sit down and spell out how you perceive the markets, you
are accepting the fact that you might be wrong. You are beginning
to accept responsibility. Once you write down how you perceive
the markets, the only conclusion you can arrive at, if the market
does not behave according to what you wrote, is that your perception
is wrong. When you write down how you are going to enter a
trade only if certain events transpire, you are eliminating
any possibility of misplacing the blame on the market. You
are forcing yourself to have discipline.
When you take the time to write down your trading rules, you
are also transforming your mental reality to a physical reality.
You will no longer be able to fudge the numbers, or avoid taking
responsibility.
By writing down your methodology, you are forcing yourself to
create a series of decisions based on how you see the markets.
The Format of Your Trading Plan:
Again - to draw on the business plan analogy - just as a there
is a standard format for designing any business plan, there
is also a format for designing a trading plan. In fact, there
are three major components within any trading plan: entry, exits
and money management rules. In the chapters that follow, we
will go into these in more detail and you will work through
a process to design each component. Here is a quick summary:
1. Tested Entry Rules
Entry rules are a precise set of rules that a tradable instrument
must pass before you enter a trade. Entry rules should be simple,
direct, and leave no room for human judgment.
2. Strict Money Management Rules
Perhaps the most important and least addressed aspect of trading
is the ability to manage risk. A profitable trader is one who
has the ability to manage the risks associated with trading.
This is achieved with strict money management rules.
3. Tested Exits Rules
Entering a stock is all to no avail if you do not know when
to exit your position. Having a set of rules that define your
exit is equally important as a set that defines your entry.
Although simple in their explanation, these three components
can together and will have an enormous effect your trading.
The advantages of utilising a trading system are numerous; most
market participants agree that their greatest benefit is the
tempering of destructive emotions, considered the enemy of all
successful traders, and removing it from the decision making
process.
While it is true that there are no holy grail trading systems
however, what you’ll learn in the following chapter is about
as close as you can get.
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