Here on Babypips, we have an endless parade of new traders asking for trading plans to help them become profitable. And that’s alright; it’s what you’d expect on a forum with a name like ‘Babypips’.
But it seems to me that, as good as the Babypips School of Pipsology is, most of these new traders come out the other side (assuming they have completed it at all, which is all too rarely the case) without a clear idea of what a trading plan is, or better put, what it consists of. What makes a trading plan a trading plan? And knowing that, how do you build and refine one of your own?
This post, hopefully, will set out the key elements of a trading plan and how you go about refining one to suit your trading style. Of course, this is all very much ‘IMO’, and I’m not going to deal much with risk management, which the School of Pipsology does a very good job of covering.
What this post will not do is recommend any particular strategy as a starting point; only you can decide what strategies suit you, and it's largely a matter of combining self awareness with trial and error.
The anatomy of a trading plan
Ultimately, a trading plan consists of four well defined elements: your trading signal, your entry signal, your exit signal and your stop loss. Let's look at each in turn.
The trading signal
Every trading plan starts with a trading signal. This is the set of conditions that tells you that a profitable trading opportunity exists, and all of your other signals will almost certainly relate back to this signal in some way. This is also the element of a trading plan that (nearly) everyone instinctively understands is necessary.
Trading signals should be clearly defined; you should never be in any doubt about what does, and what does not, constitute a trading signal. Just as importantly, you should be able to articulate why the signal is being used.
That’s actually more important than it sounds. One of the big reason that otherwise diligent traders fail to make consistent profits is that they deviate from their trading plan. That is much more likely to happen when you can’t even explain why you need to wait for a particular signal in the first place!
Take the legendary 3 Ducks system as an example. Here a trading signal is generated when price is above (or conversely, below) the SMA(60) on the H4, H1, and M5 simultaneously. Why? Because just as the highest tides occur when the Sun, Earth, and Moon are all in alignment, some of the most consistent price moves are likely to occur when the long, medium, and short term time-frames are all showing the same bias.
And being able to articulate that, you are far more likely to actually keep out of the markets when your trading signal is not present.
The entry signal
If new traders all instinctively understand the need for a trading signal, very few of them seem to understand the need for an entry signal. In fact, most of them couldn't tell you the difference. However, the distinction is important, and will often make the difference between a profitable trade and a loss. To use a sports analogy, if a trading signal is the start of a cricket game, the entry signal tells you when it is your turn to go to bat.
Imagine a trend trader using an SMA crossover system. His trading signal occurs when one SMA crosses over the other, with both SMAs showing a clear upward (or downward) trajectory; a new trend has (potentially) been born!
Does he just hit ‘buy’, though? That would actually be pretty dumb, a lot of the time. One of the known weaknesses of crossover systems is the vulnerability to whip-saws. If we’ve had an explosive impulse move that has triggered the crossover, we can’t know if the trend will sustain; buy now and we may be buying at the top of a price spike!
Even if the trend does have legs, after a strong movement there is likely to be a retracement, and so buying now will mean a large stop loss (and a smaller position) to guard against that, suffering through a period of negative balance, and lower eventual profits in the event of a successful trade.
So although we have a trading signal, we may not want to enter the market until a bit later. Our trend trader might therefore require a retracement to one of his SMA lines as his entry signal. Yes, he risks price running away without him, but he can also use a shorter stop, is less likely to get whip-sawed, and a successful trade will be that much more profitable.
Without an entry signal, your entry point is largely random; it's whatever the price happened to be doing at the moment you looked at the chart and saw your trading signal. And you can't get consistent profits from random entries. That's not what 'random' means.
With a little work, knowing how to get into a trade is not much of an issue. After all, every trade, win or lose, requires an entry. Generally, however, only winning trades require an exit signal, so we have far less practice at knowing when to get out!
Although it should go without saying, you should never get into a trade without a very clear idea of when you are leaving it. Like your trading signal or your entry signal, your exit signal needs to be clearly defined. It could be as simple as a set number of pips from your entry point, or it could be determined by price action or your indicators. And it's perfectly reasonable to have more than one exit signal - I always use a fixed profit target, but if there is a scheduled news event later in the day I may well have time as a secondary exit signal to make sure I don't get caught up in news generated volatility.
The point is that you need to know what your exit signal is ahead of time; otherwise, you're just guessing.
Technically another exit signal, the stop loss is particularly important. As with your other signals, you need to pre-define it, and also understand it. This is your major risk management tool, and poor stop loss placement is a big reason that otherwise good systems don’t turn a profit.
As a general rule of thumb, stop losses should be placed at the point on the chart where it becomes clear that the expected price movement is unlikely to materialize. Part of the difficulty in setting stop losses stems from the fact that the markets don’t move in straight lines, and even successful trades will often go through a period of negative equity. The question is, how far is too far?
Trading a small stable of currencies that you know well helps you answer this question, but for new traders volatility indicators, such as the Average True Range, can be very helpful. It gives you a sense of how much a currency moves even when going sideways, and using a fraction or multiple of the ATR is a common starting point for setting stop levels.
Refining your trading plan
So, that’s a trading plan in a nutshell – a trading signal, entry signal, exit signal, and stop loss. The four elements every trading plan needs. You work hard, putting it all together, writing down clear, unambiguous definitions for each stage of the trade. All set, right?
Well, not really. The truth is, your trading plan is almost certain to suck right now. I don’t care how much you back tested it, it’s just not as good as you think it is.
But it can be.
The reason that I’ve been banging on and on about defining everything is because once you have defined it, you can then redefine it. And you should. Repeatedly.
Every month or so – or whatever time period feels right to you - you should review your recent trades and see how redefining different elements of your trading plan would have affected your performance. For example:
1) Can you tighten your trading signal to make it exclude more of your losing trades?
2) Can you relax your trading signal to make it include more winning trades?
3) Can you adjust your entry signal to get into your trades at a better price?
4) Would extending your profit target have resulted in an overall increase in profitability?
5) Would tightening your stop losses have resulted in an overall increase in profitability?
It is asking these sorts of questions, repeatedly and over time, and making incremental changes to your trading plan that helps you build a profitable system that works for you, on the currencies that you trade.
It’s also how you stay in tune with the ever changing markets, why the old trading plans you find on the internet don’t seem to work, and why profitable traders simply can’t hand you a flow chart to follow. A trading plan is a constantly changing, growing, almost organic set of rules that is closely matched to a particular psychology, set of circumstances and menu of instruments. They are about as transferrable as fingerprints, and while you are more than welcome to take inspiration from other traders, at the end of the day you are ultimately going to have to grow your own.
I hope that helps. And good hunting.