Before starting your trading plan template, it's 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 or they know a Fed report is coming up.
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 the trading activity, including identifying trades, placing orders and managing exits.
While discretionary traders may mix some degree of intuition into their trading plans, system traders use an entirely objective trading plan that takes the guesswork out of trading and (ideally) provides consistency over time. In this section, we'll discuss how to develop a trading plan; the next section, Testing Your Trading Plan, introduces the various methods used for testing the viability of a trading plan.
Your trading plan is a written set of rules that defines how and when you will place trades. It includes the following components:
Market(s) That Will Be Traded
Traders aren't limited to stocks. You have a wide selection of instruments to choose from, including bonds, commodities, exchange traded funds (ETFs), forex (FX), futures, option and the popular e-mini futures contracts (such as the e-mini S&P 500 futures contract). Any instrument you choose for trading must trade under good liquidity and volatility so you'll have opportunities to profit.
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 fill orders quickly. Liquidity is important to traders because it helps ensure that orders will be:
- 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 or falling – creates an opportunity to profit. Keep in mind, it's impossible to make a profit if price stays the same.
It's 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. You may need a separate trading plan for each instrument or type of instrument that you trade (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 their trading skills - and trading trading account - increase.
The Primary Chart Interval You'll Use to Make Trading Decisions
Chart intervals are often associated with a particular trading style. They 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's 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 simply provide different views of the markets. While you may choose to incorporate multiple charting intervals in your trading, your primary charting interval will be the one you use to define specific trade entry and exit rules.
Indicators and Settings You'll Apply 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 don't 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 trade, and can also be used to define the number of shares or contracts that you'll trade. It's very common, for example, for new traders to start with one e-mini contract. After time, and if the system proves successful, you might trade more than one contract at a time, thereby increasing your potential profits, but also maximizing potential losses. Some trading plans may call for additional contracts to be added only if a certain profit is achieved. Regardless of your position sizing strategy, the rules should be clearly stated in your trading plan.
Many 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
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:
- 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. Review the Order Types section of this tutorial, or see Introduction to Order Types for more in-depth coverage.
It's said that you can enter a trade at any price level and make a profit by exiting at the right time. While this seems overly simplistic, it's pretty accurate. 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: If you set this up as an bracket order (OCO order), once one order gets filled (either the profit target or the stop loss), the other order will automatically be canceled. If you place the orders manually, remember to cancel the remaining one to avoid an unwanted position.
Getting Ready for Testing
When developing your trading plan, remember to include all of the important elements:
- Trading instrument(s)
- Time frames
- Position sizing
- Entry conditions (including filters and triggers)
- Exit rules (including profit target, stop loss and money management)
Keep in mind, writing down your trading plan is only the first step in a lengthy process. At this stage, it's still just an idea - or a template for the final product. You'll have to thoroughly test your plan before putting it in the market. In the next section, we'll show you how.
How To Start Trading: Testing Your Trading Plan
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