That’s because having a good trading plan in place will ensure that you view the market (and market opportunities) with as little emotion as possible and will keep you focused during times of fear and greed.
Why is this important?
Because both fear and greed can cause you to make mistakes. And mistakes, both big and small, cost money.
Mistakes — what are mistakes?
Before we move into the essential elements of your trading plan, let’s take a moment to discuss exactly what types of mistakes we’re trying to avoid by having a trading plan in place.
Overtrading can mean a couple different things, and all of them are bad.
For instance, your trading plan could call for trades to be held for a period of days to weeks. Without a plan you might flip flop in and out of positions for reasons that have nothing to do with a well thought out trading plan. Namely, boredom, excitement, or regret over missed moves happening in another sector.
What happens when you engage in this type of trading? You rack up commissions. If you don’t think commissions can seriously diminish your trading results I invite you to backtest . Another form of overtrading occurs when you load up on any single position. With a trading plan in place you might have a rule that limits your exposure to a maximum of 25% of total equity.
Without a trading plan you might drop all of your capital into a single stock…that’s struck by bad news overnight…and gaps down -60%.
Trading Based on Fear or Greed
When you have a good trading plan in place, your entry and exit signals are concrete and worked out well before hand. If a market moves against you but doesn’t take out a stop, you know the position is still open. Without a plan you might rush to close a perfectly good position due to any minor retracement or shakeout.
Trading Via News
When you’re trading with a plan your set ups are known beforehand and you search through the 7,000 available stocks with these technical and/or fundamental set ups in mind. This is like to going to the grocery store with a list of items you intend to buy.
When you don’t have a trading plan in place you can be tempted to buy any and all news stories, runaway charts, or guru tips. For instance, let’s say you wake up one morning to learn that AAPL has just had amazing earnings, in fact the news story is everywhere. Because you have no plan you rush to buy, not noticing that the chart is over extended.
This is like going to the grocery store on an empty stomach…after you haven’t eaten for 3 days. Within seconds you’ll be buying everything in sight.
Those are just a few of the things that can go wrong without a well thought out trading plan. Now let’s look at how you might go about putting together a trading plan of your own.
Your Trading Plan
When it comes to designing your own trading plan it’s important to note that your trading plan is not going to be the same as my trading plan. That’s because your needs and your risk profile are inherently your own. That’s why it’s important that you create your own plan.
Luckily, there are a few criteria that will be the same for every trading plan — and it’s those criteria that I’m going to talk about today.
What needs to happen in the past for your trade to happen today? Does your stock need to be up 100% in a year for you to even look at it? Do you need a moving average cross over to bring a stock onto your radar? Do you take fundamentals such as earnings per share, book value, debt levels into consideration? Do you use a combination of all? Also, what types of stocks will you be looking at? Will you be trading slow moving Mega-Cap stocks, or wild, volatile Micro-Caps? Or a combination of both?
Consider all of these items are when you are planning your set-up criteria.
A lot of beginning traders often mistake entry for set up. But it’s good to think of them as two different criteria. Your set up is what happened in the past to get you interested in the stock. Your entry is what happens in the present to get you into the stock. Does it need to trade over yesterday’s highs? Does the stock need to gap down or up? Do you set trigger prices? Indicator rules? Do you enter at the open? At the close?
What has to happen today/right now to get you into this trade?
Once you are in your trade, what has to happen to get you out of it? Do you use a trailing stop, or a fixed stop that you raise yourself? Do you use a moving average stop? Do you trade with a price target? Do you scale out of your position or do you get out all at once? Does it have to drop 7-8% like it does for O’Neil? Does it have to trade out of a consolidation box like it did for Darvas?
Without a doubt you should know this information before you place your trade. That way you can manage your risk and plan hour trade accordingly.
This criteria determines how much of your capital that you place on any given trade. Do you split it up evenly? Do you decide by volatility? Do you put all of your capital into 1 or 2 positions, or do you split it up between 30 positions. Don’t just gloss over this criteria. Many professional money managers believe it’s the most important one!
As you can see, there about as many different ways to put together your trading plan as there are traders. Which means you should really get to know yourself first and be honest with yourself about what type of trader you are and how you feel about risk.
That way you’ll be able to create the perfect trading plan of you!