Most market professionals will recommend that traders be prepared with a well-rounded trading plan. A trading plan is one of the most important factors in a day trader’s success. A trading plan serves as “the guide” for the trade. This plan differentiates trading from gambling and allows day traders to make intentional, strategic moves. Once a trading plan is formulated, a trader can eliminate emotion and focus on the trade at hand.
Of course, this begs the question of what a well-rounded trading plan looks like.
As mentioned above, a trading plan should serve as the guide for the trade. Essentially, this allows you to trade in an almost robotic manner, which eliminates some of the emotional influence that can cause you to make poor decisions. The ultimate goal of your plan should be to create a situation where you are either clearly right or clearly wrong. If you are right, you take your profits and move on to the next opportunity. If you are wrong, you limit your losses and move on as well. This right/wrong approach allows you to take a “black & white” approach to day trading, which can help you avoid unhealthy rationalization.
You cannot control the market, but you can control your own actions. There are so many factors that influence the market, but a trade can only end two ways; you are either right or wrong. By accounting for both scenarios, you can limit surprises and come to the market more prepared. Of course, this approach relies heavily on clearly defining the points at which you would be right or wrong.
Components of a Well-Rounded Trading Plan
Everyone approaches trading differently; therefore, everyone will have a different approach to planning a trade. That being said, most successful trading plans share a few key characteristics.
Rationale – Rationale is arguably the most important part of any trading plan. Consider this the “why” behind the trade. Why are you interested in this particular stock? What setup did you see? Why is now the best time to make your move? Make sure you have solid rationale before placing any trade, as this can make or break the effectiveness of the rest of the components. For example, “I’m buying this stock because it’s breaking 52-week highs with above average volume” is a well-thought out rationale, whereas “I think this stock can go higher” has absolutely no merit.
Aligned with Trading Strategy – When focusing on the rationale behind your trade, make sure that the setup aligns with your strategy. If you stray from your strategy, you are entering unchartered territory, which may limit your probability for success. That’s not to say that you should never attempt to broaden your trading style, however it’s important that you focus on setups that make you the most money.
Risk Assessment – Almost every single trade has an associated risk; that’s simply the nature of the stock market. You cannot control the risk itself, however you can limit your exposure. Make sure you are fully aware of the risks involved in a trade so you can plan accordingly. Focus on the risk/reward ratio of the trade and make sure that there is actually a favorable setup. Ask yourself how much you stand to make on the trade and compare that to the potential losses.
Market Assessment – While it’s impossible to account for every factor that influences the market, you should understand general trends. Make sure you account for broader market conditions. For example, if you primarily go long and the market is down 3% on the day, you may want to be extra cautious. You will also want to account for other market trends that may affect the outcome of your trade. For example, if IPO’s have been hot for the past few months, you may want to think twice before shorting an IPO (regardless of how ridiculous the valuation is).
Entry Price and Position Sizes – Once you find a favorable setup and understand “why” you are entering the trade, it’s important to focus on the “how” and “when.” This is the part where you actually execute the trade. You need to decide a good price to buy/sell the stock and decide an appropriate position size. These numbers should not be arbitrary. For example, buying at a known support level is a strategic decision, whereas buying at a random price is not. Make sure you understand the risk involved with your entry price and position size. Your entry price and position size will dictate your potential gains or losses, so you need to make sure you fully understand the implications of your decision.
Exit Price (Profit) – Many traders struggle with deciding when to take profits. Greed can cause traders to hold a stock for too long, and fear can cause traders to close a position too early. If you don’t have a planned exit price, you may be forced to make decisions on the fly. These impulsive decisions are rarely as strategic as a well-thought out trading plan. You should know in advance when you want to take profits and why.
Exit Price (Loss) – If you go into a trade without accounting for failure, you are being foolish. Even some of the best traders only have a 50-70% win rate, which means that everyone faces a losing trade at one point or another. Taking a loss is not a problem; it’s simply a part of trading. Taking an unnecessarily large loss is the real problem.
You should have an exit price in mind before you enter the trade. This allows you to limit your risk exposure and get out of the trade at the right time. It also keeps you from rationalizing your position. Your exit price should not be arbitrary. It should be the point where your plan was proven wrong. For example, if you enter a trade because the stock has been holding support all day while inching towards highs, you may want to consider putting a stop loss right below the proven support level. If you continue to hold past that point, you are straying from your trading plan.
Execution – It’s easy to make sense of all of these components on paper, however, when you trade, you are faced with making decisions on the fly. It’s important that you stick to your trading plan and let it guide you in the markets. A good plan is only as effective as its execution. If you fail to follow your own plan, the plan itself is of no use.