Plan
Your Trading and Trade as per your Planning
I believe trading
is a business and hence I strongly recommend a prospective trader
to treat his trading as if he is starting a new business. For any
new business, a business plan is very valuable. The same is true for
a trader. A business and trading both have considerable similarities.
In a conventional business, we sell things at prices higher than what
we have paid for them. The same objective is there in trading- buy
low and sell high. Trading and business both require capital and are
carried out with one objective- to earn profit. Success in both greatly
depends on our ability to buy and sell smartly- buy as cheap as possible
and sell as expensive as possible. However it is not difficult to
see many businesses lose money or fail over time. Similarly, some
traders lose money in trading and are forced to quit trading.
Every business
has considerable risk and hence a business plan is helpful in
planning for the future. Every business plan has some stated
objectives and it contains strategy about how to reach there.
A business plan acts as a guide for its owner and keeps him
focused on achieving his goals. The same can be said about a
trading plan. It can help a trader formulate his goals and develop
a strategy to reach there. Once in place, it acts as a guide
to keep efforts focused and as a control to keep one's behavior
in check. As there is no one-plan-works-for-all business plan,
there is no one-size-fits-all trading plan. What is good for
one person may not work well for others! As no two people have
exact similar circumstances, constraints or preferences, there
is no ready-to-use trading plan that I can offer to you all
in this book. Every trader will need to create his trading plan
by himself, and to provide some guideline, I will write about
what I think should be included in a typical trading plan.
How do most
people get into trading world? As most people usually don't bother
to create a trading plan, let us think for a moment what brings them
into stock trading. As I know, most people start trading without putting
any serious thought into it. Quite often, an individual hears a friend
or a stranger talking about some impressive profit in some trade.
This acts as a temptation for him to trade stocks for seemingly easy
money. First, he starts by watching a few stocks, say around 6-8,
but as time passes, his list gets narrower as stocks that are not
doing well get dropped from his watch list. So after some time, he
forgets about the stocks that were on his watch list but did not do
well, and he keeps focusing only on those 2-3 stocks that are doing
well. This fills him up with false confidence that he has exceptional
stock-picking skills. At this point, he genuinely believes that he
has skill-set necessary for success in trading and now he doesn't
want to waste any time. He makes his first trade. It may be just a
coincidence or there may be a lot of research behind it, but his first
trade is more likely to be in profit than in a loss! Maybe that is
a hidden law of Capitalism to bring more and more people into trading
so as to keep the cycle of wealth rotation running smoothly! After
the first trade, there is no looking back! Before one even realizes
it, he is hooked up. He is addicted to stock trading! As there is
no formal trading plan, in the end, most traders fall in known trading
traps: small profit-big loss, taking positions against the trend and
ignoring use of stop-loss. Hence I recommend that every trader create
a trading plan before he enters trading.
As mentioned earlier,
people enter trading without any plan or any idea about how they want
to approach trading. To me, trading is like a business and like in
any business one needs to do some thinking and planning before he
gets in. One has to decide how much money he wants to start with,
what his strategy is and what the goal is. I strongly believe one
should write down these things on paper before he makes any trade.
This is like having a business plan.
Let
me give you some ideas about what should be part of a good trading
plan.
How
much money do you need to start trading with?
There
is no standard number. It all depends on one's financial situation,
circumstances, experience, investment objectives and risk tolerance.
For a novice trader, I think he should start with an amount from 5
to 20 thousand dollars. This starting amount has to be the amount
that if one loses it all, it will not create financial hardship for
him or for his dependents. If it were all lost, it wouldn't create
a stress on one's bank account, retirement plans or on lifestyle.
This is like a risk capital. Let me highlight the importance of this
starting amount. There is a big difference between trading and any
other business. In any other business, it is not difficult to determine
when to call the quit. However in trading, I have seen people continue
trading for a long time despite the fact that they know that they
are not making any money! May be it is hard for one to accept the
fact that trading is not for him or maybe it is the hope of winning
in the end that is not letting people quit the game. Nevertheless
it is very important for a person to accept his limits and understand
that there are a lot of things for which one does not have necessary
skills, emotions and/or aptitudes. Every one of us can't be a successful
auto mechanic, plumber or a heart surgeon! In the same way, the stock
trading may not be appropriate for every one of us! This is why it
is important for a person to start with a pre-defined risk capital
to test himself for trading, and then if successful, he can keep doing
it. If he loses his risk capital, he will need to stay away from trading
for a considerable time if not forever.
Write
down here: My risk capital is: ___________________
What
is our objective with regard to trading?
When
a person starts a business, he has some goals, objectives or expectations
about how much business he wants to do or money he will make/lose
over a specific period. As I keep saying, trading is also a business
but you would be surprised to know that there are a lot of people
who have no goals or objectives when they are trading. (I am not talking
about dreams of making millions! They are there in every trader!!)
Unless a person knows where he wants to go, how can he plan? Unless
he plans, how can he reach there? If a person has a goal, he can create
a road map or a plan to reach there. To have some profit objectives
is absolutely required if one wants to be a successful trader.
If you are starting with 20,000 dollars, an objective could be to
make 500/1,000/1,500/2,000 dollars every month. Or it could be like
10, 25, 50 or even 100% return per annum. Start with a number that
makes sense to you and then later in the Chapter you will see if this
goal is achievable or not. If not, you will need to fine-tune it.
Write
down here: My goal is profit of _______ per month or ____% return
per annum.
What
is your plan to achieve your goal?
This
is a tough question and there is no straight answer that fits all
traders. However here are some guidelines and ideas. See if they make
sense. If they don't, try to find your own version of it.
For
one to reach his monthly profit target or annual return objective,
he needs to look at following factors:
- Trading Odds
(ODDS).
- Desired Profit
in a successful trade (PPT).
- Planned Maximum
Loss in an unsuccessful trade (LPT).
- Trades per
month (TPM).
Let us take an
example of a trader who wants to make 1,000$ per month. If his stock
selection is average, his trading odds will be 50%. Half of the trades
result in profits and half result in losses. Now if he takes say 300$
of profit in a profitable trade and 300 dollars of loss in a losing
trade, you can see that with 50% success rate, he will not reach any
where. He will in fact lose money because of the commission on both
sides of each trade. So to reach to his goals, we will need either
boost his Trading Odds (ODDS) and/or increase Profit Per Trade (PPT)
in comparison to Loss Per Trade (LPT). Based on these three variables
and your monthly profit target, you will get an idea about how many
trades you will need to make per month.
- Increase
the odds. What is the success rate or odds for a trade to
be in profit? It can be any number between 0 to 100%. However
for an average trader, it can be expected to be around 50%. If
a trader makes ten trades, on average five may turn profit for
him and five may result in losses. So to come out as a winner
in this game of trading, one will benefit by increasing his trading
odds. Question is: is it possible to increase odds of success?
If so, how far one can expect to go? This is the area most addressed
in investment and trading books. One will find several books on
the topic and this one- Profit From Prices- also deals with it.
Based on my experience, it is possible to push the ratio to around
70% with the signals discussed in this book. However at this stage
when we are developing our trading plan, I will advise one to
be cautious than being too optimistic. I think you should take
50% ratio in your planning calculations with a goal to push it
higher to around 70% as you gain more experience in trading.
Write down:
I want to achieve a success rate of ___.
- Have
more profit in a winning trade than a loss in a losing trade.
This is crucial to keep in mind if one wants to succeed in trading:
Small Losses Big Profits. This is easy for anyone to say or advise
but it is very hard to practice in real life. Most of the individuals
have their emotions and psychology trained in quite an opposite
fashion, and most of the time it acts against them. When a trader
is in profit, he doesn't want to take any risk on that profit
so at the first justification or sign of risk, a profitable position
is likely to get closed. On the other hand, when a trade is in
a losing position, he will neglect all negative developments and
signals. Instead of acknowledging that he might have made a mistake,
he will hold on to the position hoping/praying for one powerful
positive news/development in the stock. A losing position is often
time held too long in the hope that some day the stock price will
reverse its course and there will be profit (or no loss)!!! So
in short, normally an individual is practicing in the trading
world what most of the religions have been teaching for thousands
of years: Pass on the joy (profitable positions, I mean) to others
and keep the bad part, bad incidences/happenings and bad luck
to oneself (losing positions). Pass on nice smelling flowers or
perfume to others but keep holding onto rotten bad smelling corpses
for yourself! Believe it or not, the truth for most investors
is: Small Profits and Big Losses!
So how much money should one risk per trade? How much profit should
one go for in a trade? There are no straight answers but one can
risk anywhere from 1% to 10% of his risk capital per trade depending
on his situation, circumstances and objectives. For most novice
traders, I would say they should not risk more than 5% of their
risk capital on an individual trade. Profit target should be around
2 to 3 times the amount risked on that trade. I have made this
a guideline for myself: Before I enter into any position, I like
to see if the position offers me two to three times more gain
opportunity than the risk or loss exposure it has.
My Goal is
to make ____$ profit per successful trade and want to stop my
loss at _____$ at most in every unsuccessful trade.
- 3. How
many trades will be required per month? Let us do little math
here. Let us take ODDS as a ratio. For 50% odds, it is .50 and
for 70% success ODDS, it is .70
Expected Profit per Trade= ODDS * PPT
Expected Loss per Trade = (1-ODDS) * LPT
Expected Net Profit/Loss per Trade = Expected Loss per Trade -
Expected Profit per Trade.
Hence, # of Expected Trades per Month =
(Expected Monthly Profit)/Expected Net Profit or Loss per Trade.
As an example, with an expected ODDS of 60% (.60), PPT of 500$,
LPT of 250$ and Monthly Profit Target of 1000$
Expected Profit per Trade = .60 * 500 = 300$.
Expected Loss per Trade = (1 - .60)*250 =100$
Expected Net Profit or Loss per Trade = 300$ - 100$ = 200$.
Hence, # of Trades required per month= 1000$/ 200$ = 5 Trades.
Now, put your numbers in the formulae above and find out how many
trades you will need to make per month to reach to your target
profit per month.
My Target Trades per Month are =_________ trades.
What
is my trading (entry and exit) strategy?
This is the
major component that will determine any one's success or failure
and it forms the central part of any trading system. How to select
which stock to buy or short? Does it have the required PPT potential
at the risk of LPT? When to take this position? What is going to
be an exit strategy? It is not easy to answer these questions.
Some trading
strategies look at fundamentals of the stock or market to answer
above questions. Some others use the news, announcements or earnings.
Some strategies even look at interest rate movements, money supply,
Inflation, consumer sentiment or other economic/psychological indicators.
However majority of trading systems base their trading decisions
on technical indicators like MACD, ROC, Volatility, Bollinger Bands,
or on contrary indicators. Or one can invent and use his own ratios.
In short, a trader has thousand of choices. However, when you are
choosing a strategy, you need to make sure it is capable of taking
you where you want to go. Try to find answers to following questions:
Has it the success
rate you are looking for?
Has it
the potential to give you your target Profit Per Trade at the cost
of target Loss Per Trade?
Will it give you enough trading opportunities that you need to reach
to your monthly profit trades target?
Once you select
a trading strategy (trades selection method), before you go ahead
and make trades, test it out- first on paper and then in real life.
Find what works for you and then stick to it.
This
book is also primarily about trading strategies. In
the subsequent chapters I am going to show you how to read
daily stock prices and find trading signals to answer two
most basic questions: What to buy/short and when. I will also
show you when to book profit or close a position, and how
to protect yourself in case of a loss with use of a
stop-loss.
How
are we going to monitor or manage our business of trading?
Now
thanks to the Internet, a trader should create a transaction portfolio
on websites like Yahoo! Finance, or should use personal finance software
like Quicken or Microsoft Money. Every trading day, he should look
first at the aggregate portfolio value before looking at the prices/profit/loss
of individual positions. Value of the trading portfolio should be
viewed in context with our trading plan. One of the biggest traps
for most investors is human psychology or emotions. An average individual
hates to look at bad things or admit a mistake. Traders and investors
alike keep looking at or talking about their winning positions more
often than they look at or talk about their losers. This makes them
feel happy and proud; but the neglected losers keep eating up their
portfolio value more rapidly than what their winners are doing to
make them wealthier. As mentioned earlier, winners stay for a short
time but losers end up with a long relationship with most investors/traders.
Being happy, feeling good is definitely a good thing but this has
to be a secondary trading objective. The primary objective in trading
needs to be to be rich and make more money. For just happiness and
feeling good, Las Vegas could be a much better alternative!
Also,
before one enters into a trade, he should write down at least the
following things. Our mind and way of thinking keep changing so often
…that they work as our enemies in trading. Didn't you know that each
of our friends and relatives sort of knew that we were in a big tech
bubble during 1999-2000? I don't remember if anyone told me in those
days that AMZN or Yahoo were about to crash from their 200 dollar
levels; but if I ask most my friends today they sound like they were
the people who knew exactly that there was a bubble going on! This
does not help anyone! For success in trading, one needs to be honest
with oneself and one way to achieve this is to keep a diary and enter
the following information for every position he takes.
Stock
Trade Date
Trade Price
Number of stocks (100, 200, …1000…)
Justifications for this position
What are the risks
Trading with trend or against trend
Intended holding period in days/weeks
Profit Target in terms of stock price and in terms of overall amount
of profit
Stop-loss in terms of
stock price and in terms of overall likely amount of loss
Read
the Profit from Prices eBook online chapter by chapter.