Having a Trading Plan: Treat Your Trading Like It’s a Business

As Benjamin Franklin wisely said in the 1700s, “By failing to prepare, you are preparing to fail.”

Fast-forward to 2021 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 is likely to give you a loan without a business plan. The goal of trading is to potentially grow your wealth, similar to that of a small business investment. So, if you haven’t taken the time to write a trading 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 trading plans can help keep everyone on board with the approach, desired goals, and time investment needed for successful trading.)

Five Essential Components of a Trading Plan

Set specific financial goals. Write down your specific objectives, but try to dig deeper than simply “saving for retirement.” This could be a dollar amount within a specific time frame. For example maybe you want to make a profit of $1,000 a month from your trading. Or it could be a specific percentage gain you want to see in your portfolio within a specific time period. The financial decisions you make should align with your objectives.

Determine your 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 that works for you. 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. It’s a good idea to know earnings and dividend dates ahead of time.
• What indicators do you use and what signals do you need for confirmation? Do you want to follow trends, or do you want to invest in specific asset classes? Develop a plan and paper trade it. Once you’re comfortable, write it down and adhere to it. This is an important step because you’re looking to get the necessary information that can help you make your investing decisions.

Know when to sell. One of the cardinal rules of successful trading is knowing where to exit before getting in to a trade. If the market starts moving against you, you should be prepared to take your losses and exit your position. So, it’s important to plan your exits. If you’re a technical trader, you could use potential resistance levels from long-term charts (think weekly or monthly) or chart pattern targets such as a break in a head and shoulders neckline. Make a plan for exiting profitable and losing trades, write it down, and automate an exit point. You could include the following:

• Stop orders. Sometimes markets can move against you by quite a bit. Placing a stop order at the time you place your entry can help protect your positions. Where you place the stop is related to how much you’re willing to lose on a trade. It could be a percentage or dollar amount. It’s a personal choice and could involve analyzing past price moves to find what works best for your comfort level.
• Trailing stop orders. These are a type of stop order that dynamically follows market prices and can be used to protect long and short open positions. For a long position, a trailing stop can be set at any value below market price, and for short positions, a buy-to-close order can be placed above market price. For example, say you want to buy a stock at $25 per share and would like to protect it with a trailing stop. You could place a trailing stop order of $2, which means the stop order will rise as the stock price rises, but if the stock price falls $2, the stop order 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.

Identify your trading or investing 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? Maybe you do both, i.e., have some longer-term investments and some that are shorter term. Write it down.

Develop a risk management plan. Trading is about taking risks, so it goes without saying that risk management is very important to successful trading and investing. Consider setting specific risk parameters that you’re comfortable with, such as when to protect your capital, when to take profits, and the size of your positions. Remember: You’re operating in an uncertain environment, which means you’re likely to have losses. The key is to minimize those losses, and that means you should be ready to take action when necessary. There are different ways to manage risk. Here are a few examples.

• Some traders look for a risk/reward ratio of about 1:3, which means they’re 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.
• Some traders allocate specific percentages of their portfolio to different assets for better diversification.

How to Measure Trading Success

When it comes to trading, hard work can pay off. What’s work when it comes to trading? Keeping a trading journal and reviewing trades on a weekly or monthly basis can be helpful. Write down the five essential components of a trading plan and compare your trades against them. What went right? What went wrong? Did you risk too much? Are you following your 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 pursue your goals and approach trading like a business.