Important elements needed to shape a successful trading plan
Overall market risk:
The staple behind any trading plan places strong emphasis on risk and money management principles.
Overall market risk is the pre-determined maximum permissible capital at risk at any one time.
An example is an account with overall market risk set to not exceed 4% of the total account equity. Two open trades with a risk of 2% hits the risk ceiling. Four open trades risking 1% also reaches the threshold.
What about if a trade’s risk is at breakeven? Technically speaking, risk is never reduced until the position is liquidated. However, unless a major event causes the market to gap, breakeven stops are generally honoured, therefore. opening another trade is mostly acceptable, though is trader dependent.
Protective stop-loss placement:
While the practice of employing protective stop-loss orders is sometimes questioned, many support the use of a stop and should, therefore, be included in your trading plan. It helps contain risk.
Although the stop value must adhere to your maximum overall permissible risk (see above), it should also be positioned as and where your strategy dictates.
For instance, a long (buy) trade at the top edge of a demand area, an approach based on price action, traditionally states that protective stop-loss orders are best suited a few points south of the zone.
Risk/reward:
The risk/reward ratio measures how much your potential reward is, for every dollar you risk. A risk/reward ratio of 1:3 means you’re risking $1 to potentially make $3. A risk/reward ratio of 1:5 means you’re risking $1 to possibly make $5. This is an incredibly important aspect of a trading plan’s risk profile.
Determining the risk/reward ratio of your trading strategy, however, means little without understanding the win/loss ratio – the win/loss or success ratio is a trader’s number of winning trades relative to the number of losing trades.
Suppose a strategy’s average risk/reward is 1:5, meaning a risk of 20 points gains 100 points. In isolation, you’d be hard pressed to find a trader on the planet pass on these stats. Yet, what if this strategy managed to achieve these gains only 15-20% of the time? Although a marginally profitable strategy, it doesn’t boast the appeal it once did. Without the win/loss ratio taken into account, it’s impossible to understand a strategy’s potential, in terms of risk/reward.
The bottom line is to ensure your method has a positive expectancy, the amount we expect to make for every $ of risk we take. It is the return we can expect over the long run.
Knowing when enough is enough:
Having the discipline to know when to stop trading is good risk management, and a skill often overlooked. It helps avoid revenge trading, an emotional response to recover losses, and helps curb greed. For that reason, it might be an idea to incorporate the following rules in your trading plan:
- Profitable trading day – target achieved. Sign off and shut down the computer.
- Maximum permissible daily loss of 2% reached. Sign off and shut down the computer.
- If no setups are present, trying to create one is seldom a good idea. In this case it’s best to sign off and do something else.
Hardware risk:
Should your computer malfunction whilst in a trade or your internet suddenly trips out, do you have a plan in place to deal with this?
An easy way to overcome this is have an additional (back-up) internet connection and invest in a mini portable generator. Further to this, always have the telephone contact details of your broker nearby.
Money management:
Trading capital should always be money you can afford to lose, period. If you drain the account, it should make little difference to your current standard of living.
In the event of a large drawdown, what plan do you have to help manage this? A trading plan should include a cut-off point. For example, if your overall account equity drops below 25%, all trading should seize until you recognise the cause(s) behind the drawdown. This helps eliminate the risk of a margin call.
Position size:
Having set your overall market exposure, the size of your position should never surpass this value. Being disciplined and sticking to your noted risk parameters is crucial. It doesn’t matter how much conviction you have in a particular setup, it can still fail. Position sizing, therefore, is a vital component that deserves the utmost respect.