As Benjamin Franklin wisely said in the 1700s, “By failing to prepare, you are preparing to fail."
Fast-forward to 2016 and apply this to your trading or investing approach. How much have you prepared?
Any small business owner knows a business plan is essential. No bank would ever give you a loan without a business plan. The goal of investing, of course, is to grow your wealth and let your money work for you, similar to a small business investment. So, if you haven't taken the time to write out a business plan, carve out some time this weekend. By the way, this is something you can share with your partner.
(Hint: Good communication with your significant other about investing plans can help keep everyone on board with the approach, the desired goals, and the time investment needed for successful trading and investing.)
5 Essential Components of a Trading Plan
1. Buy criteria: This could take weeks or months to refine and could evolve over time as market environments change. Spend time studying, learning, and developing an approach. Do you buy stocks based on fundamental or technical analysis, or a little of both? Are you a fundamental stock picker, but like to use charts to fine-tune entry points?
- Write down a specific fundamental criteria to look for in a stock. This could include: P/E ratio, annual earnings increases, or rising dividends.
- What indicators do you utilize and what signals do you need for confirmation? Develop a plan, paper trade it, and once you are comfortable, write it down and adhere to it.
2. Sell criteria: One of the cardinal rules of successful trading is knowing where to exit before getting into a trade. How do you determine a trade objective? If you’re a technical trader, you could utilize resistance points from long-term charts (think weekly or monthly) or chart pattern targets. Make a plan for exiting profitable and losing trades, write it down, and automate an exit point.
- Trailing stop orders are a type of stop-loss that dynamically follows market prices and can be used to protect open positions, both long and short. For a long position, a trailing stop can be set at any value below the market price, and for short positions, a buy-to-close order can be placed above the market. For example, you might buy a stock at $25 per share and would like to protect it with a trailing stop. You could choose an offset of $2, which means the stop order will rise as the stock price rises, but if the stock price falls $2, the stop becomes a market order to close the position. Stop market orders do not guarantee an execution at or near the activation price. Once activated, they compete with other incoming market orders.
3. Time frame: Determine your trading time frame. Are you a short-term swing trader, looking for two- to three-day opportunities, or do you want to hold positions for multi-month moves? Write it down.
4. Risk management: It can’t be overstated how important risk management is to successful trading and investing. Set specific risk parameters that you’re comfortable with and follow them. For instance, some traders look for a risk/reward ratio of about 1:3, which means they are willing to risk $1 to potentially earn $3.
- Some traders follow the so-called 2% rule, which means they’ll never risk more than 2% of an entire portfolio in one trade.
5. Specific financial goals: Write down your specific goals, but try to dig deeper than simply "saving for retirement." Determine a dollar amount within a specific time frame. For example: “Grow my investment portfolio to $1.2 million by age 65.”
How to Measure Trading Success
It’s been said: “I'm a great believer in luck, and I find the harder I work the more I have of it.”
When it comes to trading, hard work can pay off. What is work when it comes to trading? Keeping a trading journal and reviewing trades on a weekly or monthly basis. What went right? What went wrong? Are you following a trading plan, or did emotional trading take over? A review process can help keep you accountable and allow for adjustments as needed to help you reach your goals and approach trading like a business.