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efore we go too much further, you need to begin developing a plan.A good plan has a beginning, a middle, and an end. The first part is the most important, yet the most neglected, by the majority of traders. It entails developing your trading philosophy. The middle section requires you to write an action plan. This is the backbone of your day-to-day trading plan. The last part has to do with how you enforce parts one and two.
Obviously from the title of this chapter, you know I expect you to put your plan in writing. Here’s where all too many traders balk. The common response heard is often, “I know what I’m going to do—trade and make money. Preparing a written plan is a waste of time. Time I could be trading. End of story!” In other words, it is not unusual to see the majority of new traders start off half-cocked. Then they wonder why most lose their riskcapital in less than 3 months!
Dear Bunkie Buddy, there are literally thousands of reasons to write down your thoughts of how you plan to trade. Those thousands of reasons all have dollar signs on them. Over the decades I have been intimately
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involved with traders of all stripes, and the most common reason so many of these traders have left the market broke is that they lost track of their primary objective and trading strategy. They never spent any time seri- ously thinking about what they were getting into and how well they must be prepared to accomplish their goals. Clearly defining exactly how, when, where, what, and why you plan to trade goes a long way toward building a trading philosophy that will sustain you during the first 3 months of trading. Additionally you must clarify your thinking behind your decisions.
If you thinkyou can just workall this out in your mind over a week- end or while you are trading, stop reading right now. Give up the idea of being a professional or semiprofessional trader. Go backto dabbling on an online brokerage site or whatever you were doing. Save yourself the stress and financial loss awaiting you. Or take the time to think this whole idea out and put it on paper, which is one of the keys to being prepared for the unexpected.
The reason I insist that you put your thoughts on paper is that there is no better way of totally exploring and fully understanding the chal- lenges ahead of you. This process is not just for trading or investing in high-riskventures. It works for every major, life-altering event. I wish more people would adopt this concept when considering marriage. It would cut the divorce rate in half, in my opinion.
The development of a written trading plan will substantially improve your chances of surviving the first 3 months of trading and guide you through your entire career as a trader because it prepares you for the obstacles you will encounter. A well-thought-out plan is to the trader what the ocean charts are to the sea captain. It gives you insights into what you will probably encounter as you enter this new phase of your life and how you will have to adjust. By answering the questions asked in this bookand providing the information requested, you solve problems that could otherwise stall or destroy your chances of success—problems you may not consider without going through these exercises.
You cannot hold in your head all the information you need to trade successfully. You must have some written document to refer to when you encounter one of the many obstacles you will face. The most debilitating of them will be your own personality. The most valuable function of the exercises in this bookmay well be to do some serious soul-searching to determine if you are psychologically prepared and suitable to be an active trader. Your emotions will try to tell you the market is not always right.
This will often result in a drawdown of your riskcapital. It is at these
times that you will need a written document to refer to and to help you get backon track.
Trading is a business. You buy and sell valuables with the objective of making a profit. It is no different from buying and selling boats, cars, homes, or any other tangible objects. Traders often overlookthis simple fact because they never take possession of the stock certificates, physical commodities, or option contracts. All are held in street name by your brokerage or clearing firm. If you had to provide for the safekeeping of these entities or, as in the case of trading precious metals, obtain assaying reports before you could transfer the entities to another buyer, you might thinkdifferently. Then it would seem more like a business. Don’t let these conveniences get you off track. Active trading is a business, and every business needs a plan.
Another very important reason for writing a plan is that writing evokes thought. Once you begin putting your ideas on paper, your mind kicks into a higher gear. Thought number 1 spawns thoughts 2 through 10. Your mind races, and you are thinking about things you never con- sidered previously. The more you write, the more clearly defined your ideas become. Writing is like planting acorns. It helps your ideas grow to mighty oaks, strong enough to weather the tempests you will endure as a trader.
“I SEE,” SAID THE BLIND MAN WHEN HE NEVER SAW AT ALL Writing helps you see what the blind man sees. It provides a much deeper insight into what you plan to do by eliminating the distracting activities that surround you. If you are thinking, for example, of getting into trading because there is a raging bull market going on and all your friends are trading their collective brains out, your decision-making process is faulty.
This happened at the tail end of the 1990s. Day trading was all the rage.
Millionaires populated the trading floors as we moved to the 2000s. Then the market tookbackwhat it had given and a goodly number of those invincible traders left the trading floors bleeding and naked.
A wild bull market forgives arrogance and ignorance. Some traders have been known to mistake one for their own skill and expertise. During these major bull moves, they picked the wrong stock and made a hand- some profit based on the momentum of the entire market. These traders got rich by being lucky. They began to trade at the best of times. They also made money because they could get by being nearly right, rather
than being absolutely right. And they gave all or much of it backbecause they never really understood, when the market turned against them, why they were so successful in the first place. Another big reason so many gave so much backwas that they had not thought out what they were doing. They did not develop a plan. No thought was given to mapping out avenues of escape, protecting profits, or knowing when to step aside.
Nor did they do any soul-searching. They just charged blindly into the market.
I know many of those traders now, and they are having big problems adjusting. Not long ago, they considered themselves wealthy and brilliant.
They were totally independent, working solely for themselves as profes- sional traders. This allowed them to set their own hours, workwhenever they felt like it, and vacation at will. The dream lifestyle was theirs while they were still in their twenties. Then the market turned on them. It was right. They were not invincible. The easy money of the 1900s became the blood bath of the 2000s. The easy-rider lifestyle vanished. It reminds one of how it must be for a star athlete who gets permanently injured in his rookie year in the NFL and then is never heard from again.
If these traders had prepared themselves better with a written business plan and some serious soul-searching, more could have survived. That’s what writing a business plan for trading is all about. That’s what realizing what the market is and accepting it for what it is, is all about. That’s what surviving and being paranoid is all about. That’s what this bookis all about.
Writing is also about commitment. When you put your thoughts in writing it somehow makes them more real. You are more responsible for them and must live up to them. To really put the pressure on yourself, give your plan to your mentor to read. Or you can share it with a fellow trader or a trading instructor you may have met. Better yet, give it to your spouse. This act alone demonstrates your commitment and your con- fidence that you have developed a good plan. If for some reason you are reluctant to share your plan, perhaps because you thinkit is too personal or you are ashamed of it for some reason, that is a sure sign you are not ready to trade.
Askthese mentors to second-guess you. Let them pickyour plan apart. It’s like presenting your master’s thesis to the review committee of your professors. You need their blessing before you launch into your new profession. If you have been dishonest with yourself, they should tell you.
If you have held backkey information, especially about yourself and your
weaknesses that may impede your success, they should tell you. If you have overlooked some key area, they will send you back to the drawing board.
Find your weakness before the market does. If the market discovers you cannot control your greed, it will wipe you out. If it learns you cannot control your temper, it will aggravate you until you are out of control. If it sees any weakness in you, it will exploit it. Before I go too far, please understand that I do not thinkthe market is a conscious being of any sort.
But all the individuals who pour their emotions into it are out only for themselves. Therefore when you trade, you respond to the emotions of others, and this brings out the best or the worst in you. Facing the market is not any different from facing any other challenge that can have a pro- found impact on your life—you either rise to the challenge or succumb.
A written plan defines what you do once you take the plunge. For example, what will be the time frame of your trades? Will you be a day trader? A swing trader? Or will you be holding positions for longer than a few days or a week? What style of trading will you specialize in?
Momentum? Trend following? Do you expect to adapt any special strat- egy? Trading stocksplits? Specializing in playing earnings reports? IPOs?
If you trade commodities, will you be a day or position trader? A scale or contrarian trader? What about options? Do you plan to be a buyer or seller? Or do you plan to combine more than one trading vehicle? Or to use trade combinations, like spreads and strangles, or use one entity to hedge the riskof the other? My point is simply that stating you will be a trader is not enough.
Preparing a written plan is also the first step of visualization. This is a technique borrowed from sports psychology but used by many profes- sional traders. Just as athletes picture in their minds the perfect golf swing or pole vault before attempting one, traders run through their minds how a trade will play out. On a broader scale, your plan should describe ex- actly how you want your new profession to roll out. Granted, the odds of being right on the money with your predictions are probably slim to none, but the visualization of what you thinkcan or may happen becomes your benchmark. When you review your progress on a daily, weekly, monthly, quarterly, and annual basis, you will know where you stand. By knowing that, you can adjust your trading and your plan.
Further analysis provides insights about what areas of your trading need extra help, where you can get that help, and in what areas you are excelling. In a later chapter you will see how you can precisely measure
your progress. Naturally, you want to eliminate the negative and accen- tuate the positive. This will come into greater focus when we discuss making individual trades and evaluating your performance.
A big part of developing any plan is setting goals. Far too many traders never take this step, or they shortcut it by stating a dollar amount they want to generate daily, weekly, or whatever. Being profitable cer- tainly is important, but it is premature to set it as your first and only goal.
I tell the traders I mentor to begin by thinking about just making good trades. For the first weekof trading, set a goal of making four good trades, for example.
WHAT IS A GOOD TRADE?
A good trade is simply one you are satisfied with, meaning one in which you maintain total control. You begin by doing your research, selecting a stockto trade, and visualizing the trade. For example, you do your homeworkand become proficient enough in technical analysis to spot a stockthat is in an uptrend. It has moved up a few points and encounters some resistance. Then it trades sideways and drifts back. Checking vol- ume tells you that buying has dried up. The price has stabilized, and you believe it is again heading higher. The only area of resistance above it is
$3.50 away. It is currently sitting on its previous resistance, which is now support. The 10- and 20-day moving averages are heading higher on the 60-minute chart. You enter a limit order after the first 20 minutes of trading a few pennies higher than the offer. You are immediately filled.
Once in the trade, you watch it like a sniper stalking prey. Your price objective is 1 stick(dollar) of profit. Your stop-loss order is placed a quarter lower, which is just below the first level of downside support. If the stockplods higher on weakor mediocre volume, you will exit promptly with whatever profit you can get or exit on any sign of weak- ness. If the price moves higher on medium-to-strong volume, you will hold your position and move your stop up appropriately. Your stop-loss order becomes a trailing spot and will follow prices higher. It will be kept below the upward-moving price around areas that will become sup- port if the price falls. Areas of resistance or support tend to have more trading activity and thus give you a better chance of getting your stop- loss orders filled. Your trailing stop follows the price higher as your position gains in value. As the position approaches the next area of re- sistance, you close the position at a profit.
That’s a good trade. Not necessarily because you made a profit, but because you maintained control. If the trade had drifted aimlessly side- ways, you would have exited with a small loss or would have broken even, particularly if volume waned. If the price moved south, your stop- loss order would have taken you out of the trade.
Goal one for new traders is to only make good trades. Too much emphasis on making money, especially from day one, is unrealistic. No one starts out at the top of his or her profession. It is usually a slow, steep climb to the top. A newbie day trader might set the goal of not being down more than 20 percent over the first quarter of trading.
Also remember, you must pay commissions on each transaction (a buy or a sell, two commissions per round turn, or a complete trade).
Commissions draw down your equity the same as losses. Nevertheless, you must learn to accept them just as you would any other overhead in a business. No one wants to pay salaries or office rent or insurance, or buy expensive equipment, or hold inventory, etc. But one must if one is going to run a business. Trading is a business, and it has its overhead.
I’ll go into the expenses shortly in more detail because every business also needs budgets. You must know how to calculate your breakeven to plan how you transition to become a full-or part-time trader.
An initial goal of just making good trades is more realistic than setting a gross dollar amount. Keep in mind you must set goals that harness your psyche and emotional energies. Do this first and then go backto the monetary side later. The reason I say this is that your emotional side often colors how you set all other goals. For example, I like to exceed my financial goals. It means more to me to double my set goals, rather than get halfway to what is an unreachable goal. The end result can be the same, but it is what you are comfortable with and helps your trading that counts.
Let’s say we had two traders expecting to make $200,000 a year in net trading profits. One performs better being under constant pressure;
the other doesn’t. Trader one sets a profit goal of $400,000. The other prefers to set modest goals and exceed them. So trader two sets a goal of $100,000. Both make $200,000 and are satisfied. When trader two reaches the goal of $100,000, he or she becomes more relaxed and trades better. Trader one, on the other hand, knows that not being under pressure will lead him or her to become careless and inattentive.
It is just a matter of creating the goals and routines that address your personality, especially your emotional makeup. A key issue is always discipline. I know one trader who does substantially better when he is
being observed. He knows the rules of trading and will follow them if someone is there to police him. If he trades alone, he tries to bully the market by overpowering it with volume. For example, he’ll try to create a mini bear market by showing large sell orders, so the other traders key off his orders and short with him. This can sometimes drive the market lower, and if he is trading large volume, he can take a small profit, a few pennies, and get out with a few hundred dollars’ profit. But if he attempts this when the market is not just right, he takes large losses. Believe me, risking $5000 to make $500 is not the way to get rich in this business.
When this trader is wrong, he gives backall he has won and more.
Therefore, this trader should make it part of his plan never to trade alone.
Let me tell you another little tale of woe. I worked with another trader, let’s call him Jackie, who traded great in the morning. Most days the markets open with a shot of volatility as overnight and early morning orders are fed into the systems. Volume continues to stay strong until just before noon in New York(EST). Then there is a slowdown until the traders set up for the close. Now Jackie did very well from the open until the morning lull, which begins anywhere from 10:30 to 11:00 a.m. He would be regularly up anywhere from a thousand to several thousand dollars. Then he gave it all back—up big by 10:00 but then break even or worse by 2:00 p.m.
I would tell Jackie, “Go home before noon. Find something to do.
Lift weights (he was a body builder). Play golf. Pickyour kids up from school. Study trading. Anything but trade!” Now those are strange words to hear from someone who works for your brokerage firm since it makes its money on trading volume. Nevertheless, I wanted him to succeed and trade for years, rather than months. Jackie wouldn’t listen. Eventually, he got tired of hearing me harp on leaving early and began trading from home. Within a few months, he had lost all his riskcapital and was back to his day job. If he had only written a rule prohibiting trading after noon in his plan and followed it, I believe he would be still trading and would be much wealthier than he is today.
That is only my opinion, and I have not followed his career since he closed his account. But my point is that we all have certain shortcomings that we must plan to control if we are going to succeed at trading. I, for example, have a propensity to hold on to trades too long. Then I find myself fighting to get out of a trade. If I would only sacrifice a few cents profit when a trade is heading into resistance, I’d be better off. To deal with this personality quirk, I force myself to always trade with a stop- loss order in place. Another trader I know does great analysis but does