Over the last few weeks I've been writing about elements I believe a trader needs to consider and, perhaps, include in a trading business plan. Those elements of obtaining knowledge, exercising discipline, being patient, managing money, having an exit strategy before entering a trade, and identifying reward to risk potential are, to my mind, extremely important in attempting to create a successful trading business. They are much more important to my way of thinking than almost anything else I do as a trader yet some or all of them are overlooked by a large number of people who try to trade.
I wrote relatively extensively in my first book, "Trade Your Way to Wealth," about the creation and content of a plan. In my estimation, the first requisite is to have one; a plan, that is. A large proportion of coaching students who have visited with me came with no plan and that, I believe, is one of the critical reasons their trading had not gone well before our sessions. If we agree that discipline is a critical element of successful trading, we necessarily must have some plan otherwise there is nothing for us to discipline ourselves to do. Just buying or selling a stock requires no plan in and of itself, but buying a stock exposes us to risk, sometimes very high risk, and it seems we should at least incorporate a plan of exit strategy in case the play goes against us. In other terms that might be called a plan to cut losses. So, too, it seems basic that we should also have a plan of what we are going to do if the play moves favorably. How will we go about letting profits run or will we voluntarily cut them at some point?
After last weekend's article, a subscriber asked on the blog how one goes about calculating reward to risk ratios. I have suggested that traders incorporate that element of reward to risk potential in their trades since it can help achieve profits and keep us in the game more easily even if we suffer some string of losses (as almost all traders ultimately experience). In general I would contend that reward to risk should at least be considered as an element in any trading plan. What specific ratio might be chosen is up to the individual. 1:1, as I wrote last weekend might not be the best since if we are successful on only half our trades we will ultimately go broke because of commissions. In that case, we would lose a dollar, win a dollar, etc., but while our actual trades might break even, each would result in a commission so ultimately the account would be drawn to nothing. On the other hand, a reward to risk of 2.5:1 might assure that we could lose 7 trades out of 10 yet still make a profit. A reward to risk of 20:1 would be wonderful, but might be very difficult to find. The idea, then, is for a trader to incorporate a reward to risk that fits his particular trading personality and needs.
Using reward to risk analysis before making a trade provides no guarantee. It only helps the trader reach a decision of what the potential reward to risk might be. To make the calculation, I simply measure the distance from my entry to my initial exit strategy that might be the break of a price support or trend support for example and then compare that distance to the distance from my entry to the next area of apparent resistance (in a bullish trade). As an example, if I were to buy XYZ at $20 with a price support at $19 and the next apparent overhead resistance at $23, the potential reward might be $3 and the risk $1 for a 3:1 ratio. Of course, it is important to realize that these are just tools and because we see a support at $19 doesn't mean that we couldn't suffer a larger loss, for example, if some bad news came out and the stock gapped down to $15. Similarly, just because there is some resistance at $23 doesn't necessarily mean it's time to get out when the stock hits that level because it might keep on going. The calculation is simply a helpful element in attempting to gain some small edge in trading and while it is not going to work all the time, it can help make better trades.
Finally, when writing about the necessity of having a plan, I want to emphasize that each plan is likely to be different. That is why I never reveal the specific contents of my own plan though I have always been happy to discuss the elements I include. The specifics of the plan are for each individual to decide and are unique to him. Trying to copy my plan, for example, simply is unlikely to work since my risk tolerance, account size, knowledge, time devoted to trading and trading practice, patience, discipline, emotional reactions, goals, etc. are necessarily going to be different from those of every other trader as he creates his own plan. In fact, that is the paramount reason I have been writing this recent series of articles about what I consider to be important trading elements. They are offered as food for your thought with the hope that you critique the ideas for your own possible use. I'm guessing that it will be your own thoughtfulness or lack thereof that will ultimately help decide how well your trading goes. By that, I do not mean to encourage indecision because as we will see in a future article, indecision can also be a trader's enemy.
by Bill Kraft, Editor
Copyright 2010, Makin' Hay, Inc.
All Rights Reserved
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I still don't understand what a plan is. Can't Bill at least give sample plans?
Thanks for writing, Anonymous. Actually I have given sample plans in previous articles. My book, "Trade Your Way to Wealth" also reviews the creation and elements of a plan.
I am new to trading. I want to start trading full time. I understand that I will need $25,000 to day trade in a margin account. But how much will I actually need to start will to trade. I know this depends on what you want to make for an income, but please give me some thought on what I will have to start with. My plan right now was to try and make $2000 a month with trading after commisions. I was going to try and do that with $5000 in a margin account. Is that crazy? Any insights would be appricated. Thanks again.
Thanks for writing, Anonymous. Since I am without information concerning your training, knowledge, experience, capital, amount of risk money, etc., there is no way I can answer your questions except in the most general terms and the answers must not be construed to be investment advice since they are not offered as that. In general, I have found that most people who are entering the trading business are under-funded just as are most people opening any new business. Another issue that frequently arises is that expectancies are unrealistic. In your case, you suggest making $2,000 a month on $5,000 in a margin account. In other words, you believe you can regularly make 20% per month with no losing months or at least no reduction in principal at any time. While there may be months when some traders may make 20% or more, my experience suggests that it is extremely rare that a novice trader could do that with any consistency or regularity. Risk must be taken into account and no matter how good a trader may be he will sometimes suffer losses. Since you asked the questions about how realistic your "plan" may be, it seems that you have not done any practice. Paper trading, virtual trading, or practice trading are essentially the same thing and can help a trader see just how well he actually does without risking real money. Even when one does well paper trading, one must understand that trading real money is much different from practice trading because emotions become significantly more involved and can lead to less success or worse losses than were experienced with the paper trades. One serious issue that often arises with people who are excited as they begin trading is that they put the cart before the horse. They trade first and then educate themselves. That can be a costly approach because we pay for our education one way or the other and piling up losses can be a faster more expensive route than paying for books, DVDs or hands on training. May I suggest you first work on gaining trading knowledge, then create a plan, then paper trade the plan to see how you do and only after you have proven to yourself that you can be and are being successful with your paper trading might you begin making trades utilizing a money management element in your plan together with strategies to cut losses and to let profits run. In my estimation a good plan contains a number of additional elements as I have often written and as discussed in my first book, "Trade Your Way to Wealth," but should certainly incorporate those critically important elements as well. I'm guessing this is not the answer you wanted, but my advice is to prepare well first, and that includes study and practice, before putting the first dime at risk. You wouldn't risk your life with a surgeon who had no training so why risk your money without first getting the knowledge? I know it takes patience not to jump right in, but as I have also frequently written, patience is a critical element in successful trading.
I really appricate your comments. You have given me a lot to think about. I have considered all the factors and risks with trading. I have traded small amounts of money for the past year now. I find it very hard to paper trade because there is no emotion. It's kind of like playing poker with no money at risk. You have a tendency of going all in all the time because you have nothing at stake. My biggest problem is creating a plan. I really want to gain more knowledge before I quit my job and do this full time, but sometimes reading all this info can be overwhelming. My target day to start trading is January 1, 2011. That gives me a goal. It scares me to death that I am making a bad decision to trade. I have a wife thats pregnant with our first child. Your last email post bothered me about indecision and vacillation. It might be no matter how much education I get I might not have the traits to be a good day trader. I have losts and gains with real money with tradeing this past year. I have my good days and bad days. I just don't know when I should take it as a sign that trading is not for me, even though I feel deep down that I could be a great trader. Thanks for letting me ramble on. I appricate your honesty. Thanks again.
Thank you for writing, Anonymous.
Clearly you seem to be facing a very serious decision. I'm not sure, though that you only have two alternatives. Instead of quitting your day job on January 1, 2011 and becoming a full time trader, why not consider continuing to work as you enter trades where you are actually putting money at risk? While you are absolutely correct that paper trading does not incorporate the emotions involved when actual cash is on the line, it can be very helpful in understanding the intricacies of various strategies. Let me say, it sounds as though you may not quite be utilizing the paper trading exercise properly. Instead of going "all in" with the paper trades, I would suggest you use a money management system just as you would if real money were on the line. Going all in with the paper trades is much different that real money trading where you would be very unlikely, perhaps even foolhardy, to go all in. The idea of paper trading is to replicate as much as possible what you will be doing when you trade real money. That means, among other things, that you have an entry strategy, an exit strategy, a potential reward to risk requirement, and a money management plan. If you are not incorporating these things in your paper trading, you are missing important pieces of the puzzle.
Your comment about playing poker is troubling. Most good traders don't look at trading as gambling and those who do try to make themselves the house rather than the gambler. As one great instructor once told me, successful traders trade on the edge of boredom so if it is excitement you are looking for, you might consider something else to release that need.
I gather you must still be relatively young with a baby on the way. Remember there is no rush. You have plenty of time. I didn't start full time trading until well into my 50's. I urge you to exercise patience in increasing your knowledge.
Finally, while almost anyone could learn to trade, you are right that trading is not for everyone. Good traders are patient, knowledgeable, risk aware, and often risk averse. While they feel the emotions, they do not let the emotion control the trade; rather, they trade with discipline. If you believe you could be a great trader, I suggest you analyze the elements in you that lead you to that belief. Is the belief based on known abilities to be self-disciplined, patient, questing for knowledge, or is it some ephemeral feeling. I suggest some deep introspection to make sure you are willing and able to do the work and undertake the discipline before you quit the day job. Trading is seductive because we can see the great potential, but in so doing we also need to be sure that we understand it is work and it can involve great risk. Clearly, you are approaching this issue seriously and I commend you for that. Ultimately only you and your family can decide whether (and when) it is for you to do full time, part time, or not at all.
Again. I really appreciate you taking the time to write. I will be buying your book. As with any endeavour in life there is risk. There are some days when I make a good trade that I feel like I can make this my full time profession. On the flip side I have bad days and don't have any confidence. The last thing I want is to be a satistic of how many day traders fail. I know that the failure rate is high. Thanks again.
Michael, you're welcome. Good days and bad days are to be expected, and we want to make sure that we avoid having our emotions on either day control our trading. The emotions are normal and all we need to do is be aware of them and know they are normal and in the meantime stick to the discipline of our plan. Here's to good trading!
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