YOUR TRADING PLAN
And the reason it is hard to write is that as you will see from the title, this is entitled `Your Trading Plan’. It’s not mine, or anyone else’s but yours, and yours alone. It will be personal to you, your circumstances, your view of money, and your goals and objectives in entering the trading world. Over the years, your plan will alter, just as in other aspects of your life. As your knowledge grows, so your plan will change.
My purpose here, therefore, is to try to provide you with ‘food for thought’, the basic ideas, principles, and concepts, which you can then develop into your own unique and personal trading plan. After all, it would be very easy for me to give you a blueprint of a trading plan and leave it at that. In everything I write, I am trying to help, educate and teach based on my years of trading experience. And just as with every other aspect of trading, there is a great deal of nonsense written about trading plans, generally from people who have never traded in their lives, and it shows. These are than my own thoughts, observations, and ideas, which I hope will help you to understand why we need to have a plan, but where that plan stops and what I call ‘discretionary trading’ steps in, and in order to start the ball rolling, let me begin with a simple, extreme example to explain this statement.
You may already have come across the term `black box system’ which generally means a piece of software that mechanically produces the buy and sell orders. Your entry and exit signals if you like. In other words, you do nothing, other than follow what the software is telling you to do. In addition, the system may also implement the money management rules. And that’s about it. Now, ask yourself a question. If anyone, anywhere, was ever able to develop a ‘black box’ system that worked and worked consistently, then such a system would rule the world for its inventor. No one else would survive it.
That’s the first point. In other words, no one has, and no one ever will develop a ‘black box’ system that works consistently to produce profits in all markets, and in all market conditions.
The next point is this – it may be very easy to produce a black box to signal an entry, but what about the exit, which is much harder? Can a black box system see the market, react to the fundamental news, react to relational markets, or consider the technical picture in multiple time frames. No. In closing a position in the market, most black box systems will simply reverse the initial entry rule which is why none of them work. No, let me correct what I said here – they can work for a time but then fail, and this is no great surprise since it is impossible for anyone to design a mechanical system which has the flexibility to adapt to different market conditions. Some of the systems may work if the market is trending but then fail in sideways moving markets. Others may work when price congestion is dominating market behavior, and then break down when the trend begins.
Many people have tried and failed, from `learned institutions’ to ‘trading gurus’. All these systems have one thing in common, they all fail, and some in spectacular fashion.
So what can we learn from all this? And more importantly, what is the relevance to us as humble retail traders when considering the `trading plan’? One thing I hope is clear from the above. A trading plan is many things, but one thing it is most certainly not is a set of mechanical rules, which you then follow on each and every trade. If it were, then we could call it a ‘black box’ trading plan, since this, in essence, is exactly what it is. A set of rules, that you follow blindly, irrespective of market conditions, and this is the problem. Most people who write about a trading plan will suggest that you write your rules, and then apply them to the market. Blindly. Sorry, this is complete rubbish. I’ll explain why, and more importantly how to develop your trading plan so that it is meaningful, but protects your capital at all times.
Let’s start with why we have a trading plan.
If you have read any of my other books on trading, then you will know that I love to use analogies to try to explain concepts in a simple and clear way, (that’s the theory anyway!). The analogy that I believe works well here, is to think of a journey by car from A to B.
First, we decide that we actually want to travel from A to B. Then we get in our car and start driving. Do we drive at the same speed all the way? No – we are constantly having to adjust our speed for a variety of reasons. The road conditions may vary, the weather may vary, and the amount of traffic may vary. These are all variables which influence both our driving style, and speed. If the roads are dry and empty, then we can drive fast, but if it is raining heavily and there is a great deal of traffic, then we are more cautious and drive slowly, and only speed up once conditions allow. We are driving in a discretionary way because the prevailing conditions dictate that this is the most sensible way to drive.
When you think about it, what we are actually doing is assessing risk – no more, no less. If the roads are wet, and visibility is poor, then we drive more cautiously, in order to lower the risk of an accident. As road and weather conditions improve, then we feel comfortable in increasing our speed as we now judge that there is less risk in driving faster.
To extend this analogy further, for those of us lucky enough to have cruise control on our car, would we consider driving with this on all the time? The short answer is no, since at some point the weather or traffic conditions or both, would force us to go back to our discretionary driving, or if not, accept the fact that sooner or later we would crash.
It goes without saying that there are some `rules of the road’ which we never break, and these are always in force, such as which side of the road to drive on. We all drive on the right, or the left, depending on where we are in the world, and this, by and large, avoids chaos. Everything else we do on our journey is based on our assessment of conditions (other than stopping at traffic lights!)
We plan our journey from A to B. Our journey has two primary rules:
- Drive on the correct side of the road
- Stop at red traffic lights
Virtually every other decision is discretionary.
I accept the above is not a perfect analogy, but to me, it best describes the core principles of what I believe should be the foundations to a sensible and workable trading plan. If you have a trading plan which is a ‘black box’ set of rules, then you are on ‘cruise control’ and sooner or later you will crash, but as I hope I have explained, a methodology based on such an approach will ultimately fail.
There is no doubt that you do need to have a trading plan, but one that is realistic and workable. This is what we are going to cover next.
Let’s start with the easy part – the two rules of driving (trading!)
- Rule one – Every position will have a stop loss
- Rule two – The maximum loss on any position to be x%
These are the only rules which apply to every trade. Every other decision you make as a trader should be discretionary and based on market conditions. The remainder of your trading plan will be developed around you, your personality, time available to trade, experience, trading capital, and many other factors. Nothing else is written as a ‘rule’ which has to be obeyed come what may. The only two rules which apply are those written in red above. It is no coincidence that both of these apply to protecting your trading capital. This overrides everything else. Your trading capital is like the `crown jewels’ and should be treated as such.
These two rules are the foundations on which your own personal trading plan is then built. Let’s get started on building your plan!
Your Trading Plan: Technical or Fundamental?
Having decided on the broad approach you are proposing to take, the next questions you might ask yourself in developing your plan, are as follows:
- Am I going to be a technical trader?
- Am I going to be a fundamental trader?
- Am I going to adopt both approaches and bolt in relational in due course?
Once again, there is no right or wrong answer. As we saw when I introduced these approaches earlier in the book, they have very different underlying philosophies. The central tenet for a technical trader is that the price chart is everything. Within each price, the candle is the views of every investor, trader, and speculator around the world. The price chart is the fulcrum of risk and market sentiment which is displayed second by second before moving on to the next phase of price action, whether on a tick chart or a monthly chart. The price also contains all the news which is absorbed and then reflected on the chart. In other words, the price chart contains and displays all the information about the currency pair in a simple and visual way. Any trading decision is then based on the chart using a variety of technical tools and techniques.
The fundamental approach is entirely different in concept and approach. Here, trading decisions are based on the ‘pure economics’ of the market. The underlying philosophy of the fundamental trader is that currency strength and weakness is determined by the ‘big picture’ data which reflects imports and exports, interest rate differentials, inflation and deflation, economic cycles, employment, housing, retail sales, manufacturing, and a whole host of other numbers, which determine whether a currency is in demand or not. For a fundamental trader, the technical picture is irrelevant, and they will only consider the chart when ready to trade, and as the mechanism by which they open a position. They do not believe in support and resistance, candlesticks, candle patterns, volume, or indeed any other technical indicator. Their analysis of the market is purely based on the economic picture, both at the macro and micro level.
Technical and fundamental traders never agree. Both maintain that theirs is the right approach, and the other is wrong, and here is where I step in.
By all means, investigate both as you will need to understand both, and my advice is simple. If both approaches have value, why to restrict yourself to one or the other – use both! And in my case, I use a third which is the relational element that I introduced earlier in the book.
My own trading has been based on a technical approach, ever since I first started all those years ago. However, I am the first to admit that I pay great attention to the fundamental aspects of broader economics, for many reasons, but for one in particular. Even if you decide ultimately that you are only going to trade using a technical approach, the fundamental news is always there. It dominates this market, and you only have to look at the economic calendar to appreciate why. Every day is full of economic releases, statements, and news announcements from around the world, which will impact the price on release. Therefore, in a sense, you cannot avoid fundamental releases anyway, as one of the decisions you will have to factor into your trading plan is this. Do I trade ahead of the news, through the news, or wait until after the news has been released and the market has reacted accordingly?
In other words, the news is there whether we like it or not, and to simply ignore it would be foolish in the extreme. If this is the case, then even if you ultimately decide that your approach is purely technical, the fundamental will always have an impact, whether in the timing of your decision in opening any new position or simply how it affects the price on the chart. You may decide, as many forex traders do, to ignore fundamental news completely, and simply consider the timing aspect. In other words, check the economic calendar on a daily basis, and note the times when the major releases are due. You can then simply avoid these completely, or manage positions closely during any release.
There are many free sites with good economic calendars which list all these for you and generally for weeks and months ahead. The site I use myself as you know is HTTP:// www.forexfactory.com, but there are others. The common theme with all these sites is that the news is ranked in terms of impact on the market. A red flag indicates an important item which will have a major impact, whilst orange and yellow releases have less significance. In addition, you will also find a wealth of other information, including historical charts for the release, an explanation of the data, a forecast of the expected number, and links to any associated sites or statements.
If you do decide to pay closer attention to the economic news, then this is a big subject in itself, but worth the effort required to understand, what is, in every sense, the ‘big picture’.
In a short book, such as this, it is impossible to give you a detailed view of the fundamental approach, but let me try to build on some of the concepts I introduced in an earlier chapter, which I hope will at least lay the foundations for you. The approach that many novice forex traders take, which I believe is a common sense approach, is to start by learning the technical approach first, and then to build on this knowledge adding in the fundamentals. Economics, after all, is a subject in its own right, and we are not studying to become an economist, just that we have sufficient knowledge to understand why the market has reacted in the way it has, or perhaps how it is likely to react in the future.
Therefore, let me try to give you some broad concepts here, which I hope will help, and the first point is as follows.
No single item of economic news, no matter how important, is likely to reverse a longer-term trend on its own. It will have an impact short term, and the market may reverse sharply on an intraday basis, but looking at the longer term trend, this is unlikely to change, unless the number is reinforcing a longer-term change in the data itself. Let me explain.
Most forex traders will be aware of the monthly release in the US, the Non-Farm Pay-roll. This is a number which always moves the markets, whether the number comes in above, below or at the market’s expectation.
Most forex traders will also simply look at the headline numbers in much the same way as the media since this is a quick and easy way to absorb the information. However, as I mentioned earlier, when you start to look at an economic calendar, such as the one on the Forex Factory site, you will find a historical chart which details all the previous releases going back over the last 12 or 18 months.
If the chart shows a pattern, let’s say of rising unemployment, and the number is positive, with a fall, this alone will not trigger a major change in the longer term trend. It may be the first signal, but on its own, it will not be enough to see any longer-term trend reverse. My point is this – always check how an economic number fits into the trend of the longer term. If the number confirms the trend, then it will continue. If it is ‘against’ the trend, then the market may pause and reverse in the short term, but the longer term trend will remain in place, if and until this data is confirmed, either in subsequent months or by other associated news.
The second broad principle is this.
Economic data from one country will impact all currencies, particularly for major economic powers such as the USA, Japan, and China. China is a classic example and every economic calendar now carries releases, since the economy of China is now so dominant, that any changes here are likely to have an immediate impact on global markets. Chinese data moves every market from equities to currencies, commodities and bonds, and perhaps even more so at present. With the markets generally very nervous following the financial collapse in 2007, any changes in Chinese data are seen as extremely significant and are the ‘hair trigger’ on which markets focus at present. This will change over time but is likely to remain a feature in the short term.
Third and last, and as I mentioned earlier in the book, economic data is cyclical in nature.
In other words, at present, given the ultra-low interest rate environment that exists in the world, these economic releases are far less significant, since this is a feature which is likely to remain in place for the next few years. This will change, but not just yet. As a result, the markets tend to focus on those releases likely to signal expansion and growth for an economy.
This, in turn, will lead to changes in interest rates in due course, which in turn will then become significant once again. It is rather like the leaderboard in a game of golf, or the teams in a football league. Throughout the tournament or the year, teams or players will move up and down the rankings, sometimes they are at the top, and sometimes they move lower – it is the same with the ‘groups’ of economic data. The market focus will change, depending on where the global economy is in terms of expansion or contraction, and the associated inflationary pressures which will then be reflected in related markets.
Now you may be reading this and thinking this all sounds very complicated. After all, we are here to trade and not to be economists or market analysts, which is certainly true and is a very common feeling. There is a great deal to think about when you first start, and my advice here, is always the KISS principle – Keep It, Super Simple.
With simplicity in mind, let me highlight what I believe are the first steps to take when thinking about developing your own approach to a trading plan. The plan is there to provide the foundations of your trading and not the detail. I could even go one stage further and say that it is really there to define the money management aspects of your trading approach, and from which all else flows. After all, if this is not in place, then it is almost impossible to be precise in the other aspects of your plan.
The Psychology of Trading
It is even perhaps the most important because it is the psychology behind trading which will ultimately determine whether you succeed or fail as a trader. Whilst being able to read a chart using price and volume is important, without an understanding of why trading really is ‘all in the mind’ you are doomed to fail, or locked into a cycle of behavior, which will destroy your wealth, and sometimes even your health.
Trading, when distilled down, is really a question of how well you can manage your mind.
These may seem harsh words but they are a fact of life, and in this chapter, I am going to try to explain to you why, as a trader, you need to treat the mental aspect of trading with as much respect as any technical or fundamental analysis of the market. I am also going to explain why you need to understand just as much about what is going on in your head when you trade, as you do about the market.
As traders, we are constantly told that having the right `mindset’ is paramount to success. We are also told that a successful trader needs to be `disciplined’ and needs to remove all emotion from their trading decisions, which I can assure you, is easier said than done. Trading psychology books and manuals will also stress the importance of having a trading plan, as well as the significance of our personal beliefs about money and risk. Most books will also explain how such deeply held beliefs about money and risk can cause traders many problems, and because often these beliefs are unconscious, they only manifest themselves during the trading process.
In other words, because trading is about loss and risk it can, and does, make us face up to our innermost beliefs about ourselves, our view of the world and can even trigger deep fear and emotional responses more commonly associated with stress and trauma. In many ways, trading is the mirror which reflects an internal world which we rarely consider or examine. Trading forces us to face up to these inner thoughts and feelings. It is the mirror which we rarely view.
During my live webinars and seminars, I always explain that trading is so stressful it can trigger our flight or fight response. This is the response that kept us safe during our early evolutionary history when most decisions were likely to be whether to face the ‘tiger’ (or another wild animal) and fight and face possible death or run for safety and lives to fight another day.
In my rooms, I also highlight what I call the `unholy trinity’ of trader fears. The first is the fear of a loss. The second is the fear of missing a trade, and the third, and perhaps the one which causes traders so many problems, is the fear of losing a profit. It is this fear which makes traders cut short their profits, and is the single reason brokers have given me as to why so many traders fail. However, before I move on to explain how to combat and overcome these fears I want to clarify how and why our `trading brain’ is so easily hijacked by these fears, and what happens when one of these fears is triggered.
But first a very short lesson in evolutionary biology.
Our brain is a truly wondrous organ, capable of great feats of imagination and creativity. Our brains also have an almost infinite ability to learn. We are the only creatures on this earth blessed with the ability to think highly complex and abstract thoughts. Our brains are designed to seek out novelty and rewards social interaction with the release of the chemical oxytocin, which makes us feel good. We are biologically stimulated to love or hate what is most familiar to us, and we are built to form attachments and to value what we own.
We are also the only creatures able to delay gratification. Studies in the relatively new field of neuroeconomics have shown that forgoing a present reward for a larger reward later, re-quires intense activity in the mature part of the brain, namely the prefrontal cortex, located at the back of our frontal lobe, and is part of the neocortex. As the name suggests, the frontal lobe sits at the front part of our brain.
It is the prefrontal cortex which is also responsible for higher level thinking, as well as our ability to concentrate, plan and organize our responses to complex problems. It also searches memory for ‘relevant experiences’ or previous patterns, and it is capable of adapting strategies to accommodate fresh data whilst also housing working memory.
From the above description, it is abundantly clear that this is the part of the brain which should be engaged when we trade. It is the part of the brain which allows us to make cool, logical and common sense trading decisions based on a clear analysis of our charts. Sadly, it just does not happen, and the reason for this lies in our evolutionary history.
Moreover, this area of the brain is the most recently evolved as our brain is the result of a long process of evolution, with a timeline counted in millennia. In very simple terms, the easiest way to understand our brain evolution is to use the ‘triune brain theory’, first developed by Paul McLean. In this theory, evolution has delivered three distinct brains and stages of development which now co-exist inside our skull. These three do not operate independently but are linked via a highly developed and complex web of neural pathways.
The first (and oldest) is the reptilian which controls our vital functions, such as breathing, heart rate, and temperature. The second to emerge is known as the limbic and is made up of a group of structures which serve to evaluate sensory data quickly and trigger a motor response. In other words, assess a situation and prepare the body for either fight or flight. And finally, the third, the neocortex, which is the brain which sets humans apart. It is the neocortex that has allowed us to develop new levels of advanced behavior – particularly social behavior as well as allowing us to develop language and higher level consciousness.
As you will appreciate, the above explanation is an oversimplification of the structure and function of our brains. However, it is a necessary first step in establishing the significance of understanding what is happening inside our head as we trade, and why it is just as important as understanding what is going on in the market.
For traders, the area of the brain which can cause so many problems lies in the limbic system and is known as the amygdala. This area is also often referred to as the brain’s fear center and is responsible for producing the fight or flight reaction. As the ‘fear center’ for the brain, the amygdala ensures we recognize and recall danger. It triggers our emotional fear responses by performing a ‘quick and dirty’ assessment of what is happening, and we respond even before we know it.
For example, if we are walking alone at night and we see a dark shadow, and perhaps hear an unexpected noise, our heart will start to race as fear begins to take hold and our body prepares to either run or stand and fight. At an earlier stage in our evolution, at a time when the local cats were more likely to be saber tooth tigers, it was those humans who reacted the fastest, and without thinking to such signals, who survived the longest.
So fear is there for a good reason. It is there to keep us safe and protect us and has ensured our survival. This automatic response is so powerful it is triggered even when there is no direct danger. Charles Darwin proved this in his study of human emotions. In one experiment he placed his face behind the thick glass of a puff adder’s enclosure and steeled himself to ignore the inevitable strike. However, when the adder did strike he jumped back, much to his own annoyance.
But, what does walking along a dark alley at night and Charles Darwin’s reaction to a caged puff adder has to do with trading? And the answer is, in both these scenarios it is the amygdala taking control and responding to a threat or perceived threat. For traders, the trigger could be the fear of a loss or even a sudden movement on a chart. Either can trigger the fight or flight response, and the amygdala sim-ply reacts in the way it has done for millennia, in an endeavor to keep us safe.
As traders, we should know that trading is primarily about managing risk in a universe that is perpetually uncertain, sometimes random and very often totally irrational. However, our brain simply does not like it and therefore re-acts accordingly, in an effort to keep us safe.
Do you have any Questions / Comments?!