Six Attributes of a Good Trading Plan

As a trader, you’ve probably found that having the right trading plan plays a significant role in your trading success. A basic trading plan should tell you what, when and how much to trade. It should also have specific instructions on when to close out your trades. As traders, we all need a well thought out trading plan to navigate our way through the turbulent waters of financial markets, with the added benefit of having something to hang on to when we’re in the middle of a trade.

Devising a trading plan needs detailed analysis and careful consideration. Unfortunately, we are not able to go through how to develop a complete trading plan in a short article such as this. However, we are going to discuss some fundamental points to assist anyone who already has a trading plan or is in the process of developing one, helping to make sure it includes these minimum standards.

1. A trading plan that suits your character

In any trading plan lies a trading philosophy that determines the overarching framework. The trading philosophy represents your beliefs about the markets. For example, it shows whether you believe in short-term technical trades, or if you think success can be achieved by making long-term fundamental trades. It shows if you are a trend trader looking to move with the flow of the market, or if you are contrarian in nature and are looking for opportunities to go against the others.

Regardless of the trading philosophy you choose, our suggestion is to make sure that it A) is proven and valid, and B) suits your personality. If the trading philosophy does not suit your character and the way you look at the markets, you will inevitably deviate from your plan and potentially put yourself in a difficult situation, both financially and psychologically.

Once you are confident that your trading philosophy is appropriately reflected in your trading plan, your plan should be capable of delivering and managing desired trading opportunities in the context of your trading philosophy. To achieve this, you need to make sure all the below requirements are met as a bare minimum.

2. Your trading plan should be bias-free

Biases occur because we have pre-set ideas in our minds that stop us from making objective decisions. This problem lies within human nature and is the result of our emotional and cognitive limitations. Within the long list of biases that exist, there are two which are the most harmful to many traders: confirmation bias and hindsight bias.

Confirmation bias is when we systematically look for what confirms our prior beliefs and ignore most evidence that challenges our set preconceptions. An excellent example of this bias is when we are trying to ascertain a simple breakout strategy by looking at a chart, a strategy used by many traders to trade the news. If the market keeps going in the direction of the breakout, we gladly count it as a success (after the fact), but if it fails — that is, it reverses its course after the breakout — we call it a Bull/Bear Trap and forget about the failure which has just happened. By renaming the model, we have shifted our attention from a failed breakout strategy to a now successful Bull/Bear Trap!

Under the influence of the confirmation bias, we are likely to pursue trading patterns which otherwise would have had little to no merit. This bias makes us derive conclusions that we’d like to see, instead of seeing what’s actually happened in reality.

The second most crucial bias traders face is the hindsight bias. Hindsight bias is when we look at a chart and find ourselves counting easy trades that would have worked well in the past. It is the moment that you go “it was an obvious head and shoulder” after seeing what had happened afterwards.

This bias comes from our tendency to distort our judgment towards the successful event. If you are given a set of questions about uncertain events (i.e. is the market going to consolidate, trend, reverse etc…) and the correct answer at the same time, it is very likely that you would distort your analysis to conclude in line with the correct answer, as if it really was obvious.

Hindsight bias makes trading look easy, and can trick you into believing in trading rules and your ability to forecast – either of which may not be accurate. If your trading plan has seemingly worked well on historical data but is failing to deliver desired results in real time, then it may be suffering from the above biases. Biases must be removed from your trading plan in order for it to be objective and testable.

3. Your trading plan should be objective

An objective trading plan can enable traders of different market views to arrive at the same trading decision. It has enough details and instructions that it takes any confusion out of trades and leaves no room for personal judgment.

For example, a good trading plan does not allow traders to draw any trend lines they see fit, but instead, it dictates the trend line which is appropriate to be drawn.  It has as many detailed guidelines as possible to stop traders from improvising.

4. Your trading plan should be testable

The best way to make sure your trading plan is objective and bias-free is to convert it into a set of clear trading rules and let a computer test the trading plan for you. This is called backtesting. By using a computer to do the testing, you are essentially removing human emotions and biases from the equation. Often during the backtest, you will get a much better understanding of the strengths and weaknesses of your trading plan.

The downside to backtesting is that it is not easy (it requires coding), and validating a backtested result requires some maths and statistical skills to avoid being trapped by the backtest itself. However, this is still one of the better and cleaner ways to ascertain the validity of your trading system.

5. Information about the market you are trading

The trading plan must hold enough historical information about the performance of the patterns and behaviours of markets you are looking to trade. Whilst the type of the information required depends on the trading strategy, below are a few suggestions that we think should be present in any trading plan that is based on intraday charts:

• Average size and duration of price swings per trading session
• Average range per trading session
• Times of major turning points per trading session
• Correlations between various trading sessions
• Historical reactions of the currency to news announcements
• Important pivots and trends
• Technical indicators that have worked best over recent history
• Historical reaction to the session opening and closing times
• Volatilities per trading session (this can be used to set dynamic stop losses)
• Intraday correlation with other markets

The above should be modified based on your trading strategy. Note that the more you can do to add to the list above, the more confidence you can have in your trading plan.

6. A solid risk management plan

Many of us believe that “stop losses” are the same as risk management. The truth is, stop losses are an essential part of a risk management plan, but are only an element of appropriate risk management. A good risk management plan should have three parts:

•  Tradable instruments: Sometimes you may need to leave a specific currencies/indices out of your tradeable universe just because they can’t justify the risks you will have to take to trade them. On the other hand, you may at times need to add a few instruments to your universe in order to reduce your risk and maximise your return. You should be able to refer to your risk management plan for these types of questions.
• Trading size: Your risk management plan should be able to tell how much to trade each time. It must have a mechanism in place to make sure one or two bad trades do not impact the integrity of your account.
• Stop losses: Your risk management plan should make sure that your stop losses suit the trading strategy you’re pursuing. For example, a trend trading system may require having close stop losses, whereas this might not be the case for a mean-reverting strategy. Stop losses should be adaptable to market changes and should be backtested and validated during the testing process.

Conclusion:

Trading plans are vital for trading success. They have many parts which should be carefully designed and tested. We appreciate that contemplating all the above points can be challenging and time consuming, however you will become more confident in your trading as  you will have in place a structured and improved trading plan.