5 Steps to Developing a Profitable Trading Plan
By Dale Gillham | Last Updated 08 November 2018
I am often asked by traders “how do I increase my probability of success in the share market or to be more precise, how can I trade better?” In this article, we discuss the 5 steps to developing a profitable trading plan that will ensure you are better prepared before you enter a trade.
Unfortunately, when it comes to trading, most individuals do things backwards and then wonder why they don’t get the trading outcomes they are seeking.
That’s because trading well is about being disciplined, which means gaining the knowledge, skill, and experience to ensure you are successful. But most who venture down this path simply set up a trading account so they can dabble in trading and, consequently, end up missing out on what’s really important.
And it’s not just new traders who are challenged with being profitable because we are often approached by traders with many years’ of experience who come to us for help as they continue to experience inconsistent results. Unfortunately, these traders are what I refer to as sheep given that they follow what everyone else does blissfully unaware that the majority of traders end up being lambs to the slaughter.
In the end, they experience the same roadblocks to success because they haven’t gained the right knowledge, skill or experience. And gaps in any one of these areas will cause inconsistency and a lack of success.
Increasing your probability of success
Finding the best or latest trading rule is not the answer because the market just doesn’t work like that. What you may perceive as the best rule today may not work in the market next week or next month. And your trading rules are only one part of the bigger equation.
The single most important thing you can do to increase your probability of success is create a proper trading plan with rules you have tested. Sounds simple doesn’t it? However, you may be surprised to learn that nine out of ten traders do not have a trading plan, or at least a solid one, and if they do, most don’t know how to test it properly.
A trading plan is essential
No doubt you have been on the kind of road trip where someone inevitably says: “Are we there yet?” If you have never been somewhere before, it is unlikely you will ever get there without a roadmap.
In the stock market, your roadmap is your trading plan - a written plan that helps you identify why you are investing and what you want to accomplish. It also provides the basis for your decisions and dictates the actions you need to take when making a profit or loss.
When we don’t have a plan, we often live in hope that we won’t suffer the consequences of our actions. Unfortunately, if you don’t have a solid plan to trade the stock market, it generally means you are wasting your time in a futile exercise to generate profits.
When we know what we are aiming for, however, we have a much higher chance of success, a lot less stress and we generally get where we want much quicker. This is because a trading plan provides you with the roadmap you need to achieve your financial goals, so that you hit the target every time.
But before you develop a written trading plan, there are three important steps you need to take:
- Gain a basic understanding of fundamental and technical analysis.
- Develop a written process that you can follow to assist you in making decisions. You need to decide how and why you will enter a stock, how to take a profit and what risks you are willing to take.
- Decide how to keep track of your investment decisions. Your documentation will include your trading plan, how you will record your trades and dividends, and your trade confirmations when you buy and sell.
Creating and using a trading plan has the power to put you in the top 10 percent of people who consistently take profits from the stock market. Once you have completed the above steps you are ready to build your own trading plan.
Sadly, not having a trading plan is one of the main reasons why so many traders fail when trading the stock market. Would it surprise you to know that typically only 35 percent of traders have their trading plans written down? Of that 35 percent, an overwhelming 94 percent of traders said they were more successful when they stick to their trading plan. Remember, a goal without a plan is merely a wish.
Developing a trading plan
Remember, when we invest, we want to do so with the highest probability of success. With this in mind, and knowing that, as humans, we can become very emotional, we need to develop a set of rules that are measurable, logical and, most importantly, repeatable. I am sorry to say that “gut feel” is not one of those repeatable rules. The rules have to be consistent in their application rather than subjective. The more subjectivity there is, the more our emotions play with our decisions and, consequently, affect the outcome. A well-written trading plan will help overcome this subjectivity and protect your capital.
So here are my 5 simple steps to developing a profitable trading plan.
1. Portfolio type
The type of portfolio you decide to trade will determine the most appropriate stocks to select based on your tolerance to risk.
In the Table below, I have provided four different types of portfolios. By no means are these the only portfolios you could construct, but they do provide an indication of the volatility associated with each investment. The portfolio you select will also determine the goal of your portfolio, whether it is growth or income or a combination of both.
Portfolio Selection and Risk Click to see the image in full size
You also need to ensure you are comfortable with the level of risk you take because one thing is certain, the market will always be there, but you may not if you trade outside your risk tolerance.
2. Investment time frame
Your plan must have an appropriate time frame that suits your lifestyle.
Do you want to trade over the short, medium, or long term? If you lead a busy lifestyle, I recommend that you select medium to long term as your investment time frame. To many who lead busy lives attempt to trade short term, which is very risky if you do not have the required time. You don’t have to trade frequently to be profitable. Trading is about figuring out what works best for you so that you can ensure that you are trading for a lifestyle not making it your lifestyle.
3. Trading rules
You need to clearly document your buy and sell rules in your trading plan.
When determining your trading rules, you need to phrase each rule as a yes/no answer. If you are buying a stock that is trending up, for example, your entry signal would read like this: has the stock formed two consecutive closes above a downtrend line. If the answer is yes, you buy, if not wait for the next opportunity.
When setting your exit rules, you need to include an initial stop loss in the event the trade turns sour after you enter, as well as an exit rule for when the stock is in profit.
Ensuring you have a proper set of clearly defined trading rules and sticking to them will dramatically increase your probability of success in the stock market.
4. Money management
This area of your trading plan is one of the most important aspects to consider when trading.
You must know how much you intend investing in any one trade. And once your entry rules are triggered, you need to work out your money management rules before placing a trade to ensure you do not take on too much risk. When calculating a stop loss, you need to use the most recent price available to determine your “buy price”, which will be the closing price for the previous day or week.
Let’s say your total capital is $100,000 and you decide you would prefer to hold eight stocks in your portfolio. The maximum you can invest in any one stock is, therefore, twelve per cent, or $12,000, of your total capital. Understanding my golden rules to investing, will ensure you don't over diversify your portfolio.
5. Risk level
What is your risk tolerance?
There is an undeniable link between risk and knowledge. The more risk you take, the higher the level of knowledge required to manage the risk, which is why it is important to always manage your investment risk. Risk tolerance is the degree of risk you are willing to take with your investments. Usually, the higher the risk, the higher the expected return. In some cases, the risk is almost zero and, in other cases, the risk is very high. For example, investing in a term deposit is virtually risk free and requires almost no knowledge.
Investing in the stock market, however, involves a higher degree of risk, which, therefore, requires a much higher level of knowledge and skill. Understanding your tolerance to risk will help maximize your wealth creation potential. I always recommend that an individual’s comfort level in regards to risk should be determined by what I like to call the “sleep factor”. In other words, you should only ever consider investing in assets that allow you to sleep at night.
Believe me, it is far better to sleep than worry about how your investments are performing. Therefore, you need to decide how much are you willing to risk on each trade? And you must set a stop loss or an exit price in case price falls after you enter the trade. For stocks, this is usually 10 to 15 per cent below your purchase price depending on the volatility of the stock.
Ensure you use a trading plan every time you trade
You need to use a trading plan every time you intend to trade, as it will assist you to formalize your thoughts while you analyse whether the stock fits with the overall goal of your portfolio.
The plan also helps manage your risk, as you are aware how much money you are willing to lose if the stock falls in value. Your trading plan will not only ensure that you stay on track but it will also dramatically increase your profitability of success in the stock market.
Others who read this article also enjoyed reading:
- Timing the Stock Market - Debunking the Myths
- How to Become a Full-Time Stock Trader
- 10 Top Share Tips
- Protect Your Portfolio From a Stock Market Correction
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