How To Start Trading: Trading Plan Development

How To Start Trading: Trading Plan Development

Before learning about trading plan development, it is important to note the difference between discretionary and system traders. Traders typically fall into one of two broad categories: discretionary traders (or decision-based traders) who watch the markets and place manual trades in response to information that is available at that time, and system traders (or rules-based traders) who often use some level of trade automation to implement an objective set of trading rules.

Because it is often viewed as easier to jump into trading as a discretionary trader, that’s where most traders start, relying on a combination of knowledge and intuition to find high-probability trading opportunities. Even if a discretionary trader uses a specific trading plan, he or she still decides whether or not to actually place each trade. For example, a discretionary trader’s chart may show that all criteria have been met for a long trade, but they may skip the trade if the markets have been too choppy that trading session.

Systems traders, on the other hand, follow the trading system’s logic exactly. Because system trading is based on an absolute set of rules, this type of trading is well-suited to partial or full-trade automation. For example, a system can be coded using your trading platform’s proprietary language, and once the strategy is “turned on” the computer handles all trading activity (including identifying trades, order entries, management and exits).

While discretionary traders do not always operate under a specific set of trading rules, system traders require a comprehensive trading plan that takes the guesswork out of trading and provides consistency over time. In this section, we will discuss how to develop a trading plan; the next section, “Backtesting and Forward Performance Testing” introduces the various methods used for testing the viability of a trading plan.

Developing a Trading Plan
A trading plan is a written set of rules that defines how and when you will place trades and includes the following components:

Market(s) That Will Be Traded
Today’s traders are not limited to stocks; you have a wide selection of instruments from which to choose, including bonds, commodities, currencies, exchange traded funds, futures, option and the e-minis (such as the e-mini S&P 500 futures contract). In order for trading to be successful, however, any chosen instrument must trade under good liquidity and volatility.

Liquidity describes the ability to execute orders of any size quickly and efficiently without causing a significant change in price. In simple terms, liquidity refers to the ease with which shares (or contracts) can be bought and sold. Liquidity can be measured in terms of:
• Width – How tight is the bid/ask spread?
• Depth – How deep is the market (how many orders are resting beyond the best bid and best offer)?
• Immediacy – How quickly can a large market order be executed?
• Resiliency – How long does it take the market to bounce back after a large order is filled?
Markets with good liquidity tend to trade with tight bid/ask spreads and with enough market depth to quickly fill orders. Liquidity is important to traders because it helps ensure that orders will be:
• Filled
• Filled with minimal slippage
• Filled without substantially affecting price
Volatility, on the other hand, measures the amount and speed at which price moves up and down in a particular market. When a trading instrument experiences volatility, it provides opportunities for traders to profit from the change in price. Any change in price – whether rising prices in an uptrend, or falling prices during a downtrend – creates an opportunity to profit; it is difficult to make a profit if price stays the same.

It is important to note that a trading plan developed and tested for the e-minis, for example, will not necessarily perform well when applied to stocks. Separate trading plans may be needed for each instrument or type of instrument (one trading plan, for example, may perform well on a variety of the e-minis). Many traders find it helpful to focus initially on one trading instrument and then add other instruments as trading skills increase.

Primary Chart Interval that Will Be Used to Make Trading Decisions
Chart intervals are often associated with a particular trading style. Chart intervals can be based on time, volume or activity, and the one you choose ultimately comes down to personal preference and what makes the most sense to you. That said, it is common for longer-term traders to look at longer-period charts; conversely, short-term traders typically use intervals with smaller periods. For example, a swing trader may use a 60-minute chart while a scalper may prefer a 144-tick chart.

Keep in mind that price activity is the same no matter what chart you choose, and the various charting intervals provide a different view of the markets. While you may choose to incorporate multiple charting intervals in your trading, your primary charting interval will be used to define the specific trade entry and exit rules.

Indicators and Settings that Will Be Applied to the Chart
Your trading plan must also define any indicators that will be applied to your chart(s). Technical indicators are mathematical calculations based on a trading instrument’s past and current price and/or volume activity. It should be noted that indicators alone do not provide buy and sell signals; you must interpret the signals to find trade entry and exit points that conform to your trading style. Various types of indicators can be used, including those that interpret trend, momentum, volatility and volume.

In addition to specifying technical indicators, your trading plan should also define the settings that will be used. If you plan on using a moving average, for example, your trading plan should specify a “20-day simple moving average” or a “50-day exponential moving average.”

Rules for Position Sizing
Position sizing refers to the dollar value of your trad, and can also be used to define the number of shares or contracts that you will trade. It is very common, for example, for new traders to start with one e-mini contract. After time and if the system proves successful, the trader may trade more than one contract at a time, thereby increasing potential profits (but also maximizing losses). Certain trading plans may call for additional contracts to be added if a certain profit is achieved. Regardless of your position sizing strategy, the rules should be clearly stated in your trading plan.

Entry Rules
Frequently, traders are either conservative or aggressive by nature and this often becomes evident in their trade entry rules. Conservative traders may wait for too much confirmation before entering a trade, thereby missing out on valid trading opportunities. Overly aggressive traders, on the other hand, may be too quick to get in the market without much confirmation at all. Trade entry rules can be used by traders who are conservative, aggressive or somewhere in between to provide a consistent and decisive means of getting into the market.

Trade filters and triggers work together to create trade entry rules. Trade filters identify the setup conditions that must be met in order for a trade entry to occur. They can be thought of as the “safety” for the trade trigger; once conditions for the trade filter have been met, the safety is off and the trigger becomes active. A trade trigger is the line in the sand that defines when a trade will be entered. Trade triggers can be based on a number of conditions, from indicator values to the crossing of a price threshold. Here’s an example:
Trade filters:
• Time is between 9:30 AM and 3:00 PM EST
• A price bar on a 5-minute chart has closed above the 20-day simple moving average
• The 20-day simple moving average is above the 50-day simple moving average
Once these conditions have been met, we can look for the trade trigger:
• Enter a long position with a stop limit order set for one tick above the previous bar’s high
Note how the trigger specifies the order type that will be used to execute the trade. Because the order type determines how the trade is executed (and therefore filled), it is important to understand the proper use of each order type; the order type should be part of your trading plan. Please review the “Order Types” section of this tutorial for more information or the Introduction to Order Types guide for more in-depth coverage.

Exit Rules
It is often said that you could enter a trade at any price level and make it profitable by exiting at the appropriate time. While this seems overly simplistic, it is quite true. Trade exits are a critical aspect of a trading plan since they ultimately define the success of a trade. As such, your exit rules require the same amount of research and testing as your entry rules.

Exit rules define a variety of trade outcomes and can include:
• Profit targets
• Stop loss levels
• Trailing stop levels
• Stop and reverse strategies
• Time exits (such as EOD – end of day)
As with trade entry rules, the type of exit orders that you use should be clearly stated in your trading plan. For example:
• Profit target: Exit with a limit order set 20 ticks above the entry fill price
• Stop loss: Exit with a stop order set 10 ticks below the entry fill price
• Note: The remaining order will have to be canceled to avoid entering an unintended position
Figure 2 shows a template used for developing a trading plan that includes all of the important elements:
• Trading instruments
• Time frames
• Position sizing
• Entry conditions (including filters and triggers)
• Exit rules (including profit target, stop loss and money management)