Almost every successful businessman will tell you that record keeping is critical to running an efficient business. Whether designing sophisticated aeronautics or simply selling scented soap, all businesses record and analyze their transactions to refine and optimize execution. When it comes to trading FX, however, very few traders diligently record and review their trades. FX trading, with its instantly dealable rates and self-organizing accounting software, makes it easy to forsake the discipline of keeping a trading diary. Yet a diary can improve a trader's performance far more than any piece of advanced technical analysis software or even a $2,000-per-day trading seminar. This article will outline what to record in your journal and will provide an example from the writer's own trading diary.

Why is keeping a trading diary so valuable? First, as human beings with faulty memories, we simply forget many of the circumstances surrounding our best and worst trades and, as a result, we learn little from them if they are not recorded. Second, the gap between what we think we do and what we actually do during trading can be embarrassingly large - a problem that can easily be identified with proper note taking. Finally, the mere act of keeping a diary introduces a methodical element to trading that prevents us from trading randomly and impulsively - the culprit behind most trading disasters. (For further reading, see Ten Steps To Building A Winning Trading Plan.)

Keeping a diary need not be cumbersome or complicated. Here is a list of three key issues that should be covered in every trade:

1. What did you trade and why?
The reason for a trade can be either fundamental or technical (preferably both), but there must be a reason. Too many retail traders put on a trade because they think that prices have either risen or fallen "enough", without any technical or fundamental justification for their opinions. Worse, many traders get into positions out of sheer boredom, forcing a trade and then spending the rest of the time trying to justify it. Even if boredom is the primary driver for the trade, having a diary will make the trader record that fact and he or she will be able to see the consequences of such behavior.

2. Where is your stop and limit and why?
It is astonishing how many traders get into a trade without any clear idea of where to take a profit or when to get out if the trade moves against them. However, by writing down specific stop and limit orders, the trader consciously plans ahead for any contingency that may occur. Even if a trader disregards the initial stop in the heat of the battle, the act of recording all of that activity will be invaluable in doing post-trade analysis and enforcing better discipline on the next trade. (For more information, read A Look At Exit Strategies.)

3. Did the trade work out as planned?
There is often an enormous gap between how the trade setup looks on charts or through the prism of backtesting software and the emotional reality of having money at risk. Comparing the difference between the two can help traders understand their strengths and weaknesses and improve long-term performance. (For more insight, see Backtesting: Interpreting The Past.)

Because trading is such a visual craft, attaching a chart with annotations will complete the diary process by providing a pictorial reference point for further study.

Let's take a look at a recent trade I made in USD/JPY and the various comments I made regarding its outcome.

Figure 1

1. What did I trade and why?
I went short USD/JPY at 1pm EST on June 8, 2006, at 114.27. The pair had already rallied significantly after the dollar was boosted by the death of a major al-Qaida terrorist and the relatively dovish comments of European Central Bank President Jean Paul Trichet. Against expectations by some market participants of a 50 basis point hike, Trichet raised rates by only 25 basis points. Dollar/yen had risen in an almost uninterrupted fashion to nearly 115.00, but at 8am EST it made an exhaustion spike higher and left a shooting star pattern on the charts, suggesting that buyers could not sustain the highs. I felt that 115.00 would be a tremendous barrier for dollar bulls to overcome, as many option-related traders were willing to defend that level very aggressively. When price dipped below 114.15, it suggested that further downside may be on the way and I shorted the pair on a small rebound at 114.27.

2. Where did I set my stops and limits and why?
I set my stop at 114.58. Although that price level was below the swing high of 114.75, I felt that any break above 114.50 by anything more than a few points completely negated my bearish thesis and that I should get out because the market would likely make a second run at the important 115.00 figure.

I always trade with two targets because I believe that while the near-term direction of the currency pair may be somewhat predictable, the amplitude of the move is not. That's why I set the first target at a reasonable distance from entry and the second target farther away in case the move gained momentum. Therefore, I set my first target at 114.01, just ahead of the 114.00 figure, and my second target was set at 113.80.

Did the trade work out as planned?
Partially. Just as I had expected, the pair traded lower and by 6pm EST, it reached my first target of 114.01, allowing me to bank 26 points. I instantly moved my stop to break-even, but then had to step away from the screen for several hours. When I returned, I saw that price had missed my second target by just a few pips and was now trading back near the 114.00 level. As price once again began moving my way, I sold one more quarter of the position at 113.95, locking in another 32 points on that part of the trade. Just a few seconds later, prices collapsed and hit my second target of 113.80. Did I execute to plan? Not quite. I rushed my second exit, fearing the loss of immediate profit more than the lure of additional gain and gave up 15 points of potential profit.

The act of maintaining a diary crystallized my dominant behavioral patterns, clearly showing that I am not capable of holding most of my positions long enough to achieve a 2:1 risk/reward pattern. In my case, it is even more critical to choose only the highest probability setups that have an expectancy rate of better than 60% in order for my trading to succeed.

For other (more patient) traders, the diary process may reveal that they should expand their risk parameters in order to allow for the possibility of capturing larger gains. Regardless of the conclusion, the process of diary writing reveals the true human nature of trading that those clean, crisp charts and the coldly efficient results of backtesting systems simply cannot convey. It also demonstrates why computerized systems have such a difficult time trading markets. In fact, I have witnessed the results of hundreds of systems trade in real time and not one of them was profitable in the long term. Trading requires all of our emotional and analytical capabilities in order to produce success. The act of keeping a trading diary helps us better understand the demons that drive us and, in turn, makes us better traders.

(Follow and discuss traders' journals at TradersLaboratory)

Want to learn how to invest?

Get a free 10 week email series that will teach you how to start investing.

Delivered twice a week, straight to your inbox.