How to build a Trading Plan

2nd February 2016, 10:50 PM

Fail to plan and you plan to fail. If you are serious about being successful in any business and trading is
not an exception, you should follow those words blindly as if they were carved in stone.

If you are one of the few traders who have written a trading plan, you are in luck! While writing a trading
plan is no guarantee of success, you have started the process to eliminate one major roadblock, the
emotional mind, so create a trading plan and start trading like a robot instead. If your plan uses flawed
techniques or lacks preparation your success won't come immediately, but at least you will be in a position
to detect those flaws through the execution of your plan and modify it in the process. By documenting
the whole process, you will learn what works, what doesn't work and how to avoid repeating old and
costly mistakes.

Trading is a business, so you have to treat it as such if you want to succeed. Reading some trading books,
studying multiple strategies, buying the best trading software, opening a brokerage account or starting to
trade is NOT part of a plan - it is a recipe for disaster. If you don't follow a well written trading plan, you
are doomed to fail every single time you try to trade any market.

A plan should be carved in stone before you start trading, but it should always be subject to re-
evaluation. A trading plan is subject to change as the trader's skill level and understanding of the market
improves. Each trader should write their own plan, taking into account personal trading styles and
goals. Using someone else's plan does not guarantee you will be able to execute it the same way that
person does.

Traders who win consistently treat trading as a business. While it's not a guarantee that you will make
money, having a plan is crucial if you want to become consistently successful and survive in the trading
game.

WHAT COMPONENTS MAKE A GOOD TRADING PLAN?

Your skills as a trader and your edge

Are you really ready to trade this strategy? Have you tested this supply and demand strategy by paper
trading it? Do you have confidence that it works? Can you follow your own trading decisions without any
kind of hesitation?

Professionals trade based on probabilities and an edge. They don't gamble. As supply and demand traders,
your edge is supply and demand, trading with the footprints of the big fishes, the dinosaurs.

A professional trader is ready every single day to execute his trading plan, he will take profits from the
rest of the "herd" who, lacking a plan, give their money away by always making the same mistakes over
and over, for instance, taking low odds counter-trend trades, buying into bigger timeframe
supply/demand in control or after a very strong rally in price are just a few of the mistakes the herd
continually makes.
Don't get overly hooked up on whether you are drawing a level right or wrong/ properly, because on quite
a few levels there is no right or wrong, and no 'proper' way to draw them - they are nuanced, and on
different days I might draw them differently, and my analysis and therefore conclusions would therefore
be slightly different because you mind has gained more experience and knows that you should 'tweak'
them a bit. Some levels of course are very clear and there's only one way to draw them, bullish or bearish
engulfs for example. Pretty much all of your decisions in trading should boil down to not worrying too
much, and just accepting that about 40/50% of the time you'll be right, and 40/50% of the time you'll
be wrong.

Managing your emotions

Are you emotionally and psychologically ready to battle in the markets? Emotions will take control every
time you analyse the markets, you need to have a sound plan to combat anger, fear, pain and greed.
Because if you don't, your emotions will kill your trading plan. You need to have a proper control of your
emotions in order to execute your trading plan, let your emotions take over and you will blow up your
trading account over and over.

This is the most difficult aspect of trading. You can read dozens of books, be good at spotting trading
setups and pulling the trigger but if you let your emotions control your trades and your goals, you will not
become successful.

Daily routine and trade preparation

Executing a daily routine is key to your trading success. You are already executing a bunch of habits and
routines every single day of your life. You wake up at 7 a.m, have breakfast, read your favourite
newspaper, drive to work, lunch at 1 pm etc.

Your trading space (area) should not offer any distractions. Remember, this is a business and distractions
can be costly. You must create new habits and a daily routines for your trading. Read more about it in the
Daily Routine lesson

Set a maximum number of hours to trade a day

Time variable is key to trading, it can lead to over-analysis. In order to prevent that from happening, you
must set a maximum number of time you'll spend in front of the charts. 1 hour a day, 2 hours a day. Set
that limit and stop analyzing the markets once the that deadline been hit.

Select your Trading Sequence and Entry Timeframe

You know there are different timeframes you can trade, you can hold a trade for hours, days, even weeks
and months. First of all, you should decide which type of trader you are, select your entry timeframe and
that will be law! You won't be allowed be break that rule unless there is an exception described in full
detail in your trading plan.
You have a few choices: longer term, swing and intraday/scalping.

Select the trading sequence that best fits your personality and your job. If you are not a full time trader
already, you will probably have a full time job or a half time job. You will not have time to spend in front
of the charts for hours every day, you must choose a bigger timeframe sequence because they are slower
and will let you do your analysis without feeling you're missing all the moves.

If on the contrary you are more aggressive and love fast charts, you will probably go for a smaller
timeframe trading sequence with an entry timeframe like M15 or M5. You must choose the sequence that
fits your personality, one you feel comfortable with. Remember, what works for me or someone else will
probably not work for you.

Choose your Entry rules and IF THEN scenarios

Before you start writing your own plan you need to have a strategy and an edge, a set of rules you've
consistently tested for months and most importantly a series of rules you feel comfortable with and
believe in. You need to see your trading patterns playing out for months. When I say months, I mean
months and months of intense testing. Do not trade live unless you've been testing your strategy
profitably for at least 6-9 months consecutive months, else you'll be blowing up your account very quickly.

You should list all IF THEN scenarios that are high odds according to the set of rules you are trading and
only take those you've listed on your trading plan. Ignore and negate any other scenario that has not been
included in your trading plan. If in doubt, stay away from the markets and wait for a clear setup and
scenario.

A couple of examples of IF THEN scenarios that could be used:

• Daily demand zone nested within weekly demand zone, with weekly and monthly charts in an
uptrend

• Daily demand zone nested within monthly demand zone, with weekly downtrend and monthly
chart still in an uptrend

Set Risk Level and Risk Tolerance

Having a good understanding of risk tolerance is crucial to your success. It is also a key component of any
good investment policy. You must be a methodical investor and follow a disciplined, mechanical trading
strategy. As a methodical investor you will make decisions based on hard facts.

How much of your portfolio should you risk on any one trade? It can range anywhere from around 0.5%
to as much as 3% of your portfolio on any given trade.

Establish the maximum risk you will take on any one trade and don't change it during the first year of
execution of your trading plan. Set a small risk, one you feel comfortable with, where losses won't affect
you psychologically. It may be 0.5% or 1%. The bigger the risk the faster you might blow up your account,
so trade with a small risk for months, you will stay longer in the market with your initial equity and you
will learn that trading live is a different monster.

Don't choose a high risk level, you won't be ready to accept the big drawdown your account will probably
suffer. You will blame the markets for your losses, you will blame the strategy, you will blame everything
and everybody except yourself, however the only one to blame will be yourself because you were the one
who chose to set a high risk level you were not ready for yet.
Set Exit Rules and your Risk Reward per trade
Most traders make the mistake of concentrating most of their efforts in looking for trade signals, but pay
very little attention to when and where to exit. Many traders won't close their losing trades because they
don't want to take a loss. You must get over it or you will not make it as a trader. If your stop gets hit, it
means you were wrong, that's all, go for the very next valid trade! Don't take it personally, remember,
trade like a robot. Professional traders usually lose more trades than they win but by managing money
and limiting losses they still end up making profits.

What is the minimum risk/reward you will accept? Many traders will not take a trade unless the potential
profit is at least three times greater than the risk. For example, if your stop loss is a dollar loss per share
or pip, your goal should be a $3 profit. Set weekly, monthly and annual profit goals in dollars or as a
percentage of your portfolio and re-assess them regularly.

Before you enter a trade, set realistic profit targets and risk/reward ratios. You must set an exit rule.
Choose a fix exit ratio like 3:1 (three times your risk), this means that you are willing to risk $100 trying to
make $300. It's very important that you are happy with your earnings and exits, don't think every trade
you take will give you a 10% benefit, that's probably not possible, it's not sustainable as a trading plan. Be
realistic and set a fix exit ratio for at least 1 year and re-evaluate your trading plan and exit rules after
that.

By setting a fixed risk/reward for every trade, you will be removing most of the emotions and
psychological issues in your trading. Where to exit your trade? Is there more than 3:1 for my entry? Am
I trading with the trend? Yes to both, pull the trigger and expect the edge is on your side this time, else
next one.

The smaller the risk reward for your trades, the easier you will hit your take profit and targets. Expecting
5, 7 or 10 to 1 per trade is not realistic and you will end up blowing up your account. Don't be greedy. Any
hedge fund or serious investor will probably be happy with 3-5% a month, or even 5% a year.

Set Realistic Monthly Goals and stop trading when reached

Many aspiring traders have unrealistic goals. They start with a $5,000 account and expect to make $5,000
in their first month of trading. No wonder many traders fail.

Trading is a function of risk and reward. The more you risk, the higher the profit potential. Or the larger
the stop loss, the higher you can set your profit target.

What is the monthly account growth you are expecting? Are you happy with 5%, 10%, 40%? Of course it
will be much better to have a monthly account growth of 40%, that means more money for you, I don't
think anybody would deny that.

Are you looking for a pay check or trading as a longer term investment? This is very important because
it will dictate the type of trades you are looking to trade. You want to trade as a long term investment
with money you don't really need for your everyday life? Or you need a monthly pay check because trading
is your only source of income and you don't have much money to invest?

If you're trading a $50.000 account, are you happy with a 10% monthly income? That means $5.000 a
month. Is that enough for you? Be realistic, expecting a monthly goal of %30, %40 or more is not
sustainable, you will probably blow up your account very easily. Big investors are happy with 5-10% profit
a year but it's common to see small investors aiming for a 30%, 50% or higher per month. Put your feet
on the floor and be realistic!

You reached your monthly goal the 5th of current month? Stop trading. You reached it the 20th? You stop
trading. Stop trading and enjoy the money you've earned. FULL STOP.

A 5-10% monthly goal can be reached and it's sustainable. The problem is that most small investors don't
have the money needed to earn their living with that small account growth percentage. If you have $5000,
you can expect an average of $400-$500 a month. What can you do with that money if you live in Europe?
Not much really. No wonder why many traders aim for a very high monthly account growth.

Money will come to you if you do things right over a large period of months, believe me, money will knock
on your door. Follow your trading plan, take a small risk, be happy with a small 5-10% monthly account
growth and let the universe do what it has in store for me. It just works like that.

Have realistic expectations and understand the risks of trading. Stop reading web site's articles selling you
to become a millionaire overnight, that doesn't happen. Set small achievable goals. Don't shoot for the
stars. Try to make $100 per week on a trading account of $5,000. That would be $400 per month or 8%
based on your capital. Per month!

You might not achieve your weekly goal every week. There might be some weeks when you make less. Or
you might even lose some money. But in the long run you should be ahead and see your account grow.
And with proper risk and money management you should be able to control your risk while growing your
account.

So the key is to have a trading strategy with a winning percentage of 50% while achieving a reward-to-risk
ratio of 3 to 1. This formula is mathematically guaranteed to be consistently profitable.
For example:

• If you have a $10.000 account with 1% at risk per trade = $100

• 3:1 R:R = $100 per loser and $300 per winner

• 10% monthly return is $1.000

• 20% Monthly return is $2.000

• 30% monthly return is $3.000

Are you happy with $1.000 a month? $3.000? You need more money to reach the end of the month and
pay your monthly expenses? Should you set a higher monthly goal then? 40%? 50%? Remember the higher
the monthly goal the more difficult, unsustainable and unrealistic it will be. You'd better increase your
equity rather than risking a bigger percentage per trade.

Think like a professional, a professional trader will not put at stake all of his capital or a big amount of it,
he will just risk a small percentage. He will put a limit on both sides of the equation by setting a credible,
feasible and realistic monthly goal but most importantly he will also limit his losses and maximum
drawdowns.

Your Win/Loss Ratio is key

Now let's say you are right every other trade, i.e. your trading system has a winning percentage of 50%.
This means that in the long run you can expect as many winning trades as losing trades.

For our example, let's say you place 10 trades risking $100 on each and a 3:1 exit for $300 - five of them
are winning trades and five of them are losing trades. So you would make $1.500 on your winning trades
(5 * 3 * $100) and lose $500 on your losing trades (5* $100). Your gross profit after 10 trades would be
$1.000. You now need to deduct your commissions, which would vary depending on your broker and the
markets you trade.

Therefore your net profit after 10 trades would be around $1.000.

If trading Forex you can use platforms like MyFxBook to track your results in a very detailed way. There
are other platforms and tools that will allow you to analyze your results in a lot of detail.

Set Maximum Monthly Drawdown

Risk management will make money for us in the long run, but there is always another side of things. What
would happen if you didn't use strict risk management rules?

Consider this example: Let’s say you have a $10,000 and you lose $5,000. What percentage of your
account have you lost? The answer is 50%. Simple enough.

That's what we call drawdown. A drawdown is the reduction of one’s capital after a series of losing trades
during a specific period of time. This is normally calculated by getting the difference between a relative
peak in capital minus a relative trough. We normally note this down as a percentage of their trading
account.

We need to have an edge on our trading, that is the whole reason why traders develop and/or follow
trading strategies. Supply and demand is our edge. A trading strategy that is 60% profitable sounds like a
very good edge to have. But just because your trading strategy is 60% profitable does that mean for every
100 trades you make, you will win 6 out of every 10 trades? Not necessarily!

How do you know which 60 out of those 100 trades will be winners?
The answer is that you don’t. You could lose the first 40 trades in a row and win the remaining 60. That
would still give you a 70% profitable system but you have to ask yourself this question: Would you still be
in the game if you lost 30 trades in a row. I think you wouldn't
This is why risk management and drawdown is so important.

Drawdowns are part of trading whether we like it or not. The key to being a successful trader is coming
up with a trading plan that enables you to withstand these periods of losses. And part of your trading plan
is having risk management rules in place, drawdowns included.

The same way we set a monthly goal, we must also set a maximum monthly drawdown that will prevent
us from taking more losses. It might be 5% or 10% but you need to set a maximum drawdown. Once this
drawdown % has been hit you will stop trading that month. It can happen on the 5th of the current month
or the 20th, it just doesn't matter, you will stop trading, you'll then analyze your losses and take the steps
necessary to prevent them from potentially happening again in the future.

A 5-6% monthly drawdown is a decent drawdown. Remember that you will have to recover that
drawdown the next month before reaching your target. If your target is 10% a month, you will need to
make at least 15% to recover from a losing month.

Remember you can also experience a consecutive streak of losing months, so the drawdown will
accumulate over a period of time. If your maximum drawdown is high, you might end up with an
accumulated drawdown of 30% or more in 2-3 months. It's very difficult to recover from such a big
drawdown, the psychological impact on your trading will be so big that you will end up taking more risk
to recover the losses and eventually blow up your account by breaking every single rule in your trading
plan.

Maximum number of trades open at one time

Setting the maximum number of trades open at any one time is directly related to your monthly
drawdown. You must have a way to limit the number of trades you can be triggered on at any given
moment, else you might end up with a number of losses that will exceed your maximum drawdown.

Consider this scenario. You have established a 5% maximum drawdown, you risk 1% on each trade and
you are allowed to have 5 trades open at the same time. If more than 5 trades at 1% risk are open your
drawdown might end up being 6% or more. If you are risking 0.5% on each trade you are allowed to have
10 trades open at the same time.

You must trade like a professional, a professional trader will establish a maximum monthly drawdown and
respect it. His career and success depends on it.

Filter out the instruments that are not clearly trending

Try to locate the best looking charts and trends on your trading portfolio. Do this analysis the first day of
your trading week and arrange a bad and a good lists. Focus only on the instruments that are clearly
trending and providing you with the setups established in your trading plan.

• Go through all the instruments you trade and filter out the ones that are clearing trending from
those that are not
 • Ignore the ones that are ignored until next week. Set alerts for an specified event to happen
before you look at it

• Do the same process every week and filter out instruments. You will be switching them from the
bad list to the good list and vice versa every week

• On Metatrader platform you can minimize the charts so you can only see the instrument and
timeframe. Arrange the instruments you trade in such a way so you can have 2 lists (a good one
and a bad one). On the left side if you want to trade them this one, or on the right side of the
window if you are not interested in to trade them this week

CORRELATION
Correlation is something very common in Forex, it's also common in stocks and its indexes. We're not
going to deal with correlation in much detail, but we should be aware that it exists and it can be a handicap
if you have a few positions opened in correlated instruments, no matter if they are currency pairs, stocks
or commodities.

Many Forex currency pairs are highly correlated, that is, they move in the same direction at the same time
with very similar price action patterns. Correlation is not a science, they can work for an extended period
of time and then stop working completely for some time.

As a rule of thumb, avoid trading highly correlated instruments at the same time. Why? A change of
market dynamics or big news event could cause an unexpected movement in price and cause you several
losses at the same time.

For instance, if trading Australian dollar currency cross pairs, taking a short on AUD/USD, AUD/CAD,
AUD/JPY, AUD/SGD and a long on EUR/AUD would not be a good idea. At 1% risk, you'd be positioned
short with 5% of your account. If all the trades fail to work, you would not be allowed to trade any more
than month if your maximum drawdown was 5%.

In order to account for correlation, it'd be safer to set a maximum number of correlated instruments you
can trade at any one time. Two or three would be a good number to start with.

How many trades do you need to reach your target?

The number of trades you will need to reach a specific target depends on a bunch of variables you need
to set before you start trading.

These variables are:

• Entry timeframe. The timeframe chosen will directly affect the number of trades you'll see. The
bigger the timeframe, the least trades

• Number of traded instruments. The more instruments you track, the more trades you will have.
This is directly related to the entry timeframe
 • Your monthly goal. If you monthly goal is low, your target can be easily reached with a large
timeframe and a small number of instruments

• Win/Loss ratio. This ratio is crucial, it will influence what you expect from your trades and how
losses can affect you

• Risk/Reward. The higher the risk reward, the more difficult to reach it will be. Be flexible. 3:1 is
good to start with. Five/six to 1 is good when WK and MN zones are in control and trending

Keep records of each trade

You must log each trade you take so it can be analyzed after the fact and learn from it. This will also help
you to adjust your trading plan in the future.
If you win a trade, you want to know exactly why and how the trade was won. More importantly, you
want to know the same when you lose, so you don't repeat unnecessary mistakes. Write down details
such as targets, the entry and exit of each trade, the time, the trend for each timeframe in your sequence,
and record comments about why you made the trade and lessons learned.

Also, you should save your trading records so that you can go back and analyze the profit or loss for a
particular system, draw-downs (which are amounts lost per trade using a trading system), average time
per trade (which is necessary to calculate trade efficiency) and other important factors, and also compare
them to a buy-and-hold strategy. Remember, this is a business and you are the accountant.

Conclusions after the trading week is over

Set a date and time at the end of every week and go through all the trades you've taken and/or planned
during the week. Did they work? Was the trade missed? If so, why? Why did the losses happen? An error,
trading plan broken? Learn from each trade you took or planned every week, see if you missed something,
confirm that you've been following your plan and kicked your emotions out of the equation.

Do this every single week and only once at the end of the month. This will help you to be on the right
track, if you see you are consistently stepping off your track, stop trading and go back to testing mode.

A money management strategy to start with would be something like this:

• Risk per trade: 1%

• Risk/Reward for each trade: 3 to 1, that is $300 per $100 invested

• Monthly goal: 5-10%. Once reached, you stop trading

• Monthly drawdown: 5%. Once reached, you stop trading

• Max of 5 open trades at any one time (5% risk). If more than 5 are taken, you would be breaking
the maximum drawdown % specified in the plan 5%)

Revise your plan every 3 months

Having a trading plan does not mean you can't change it. You should establish a fix period after which the
whole plan should be revised. This will help you to learn about the errors you have made. Each loss is a
lesson.
After three months executing your trading plan, you will have accumulated a bunch of losses you will need
to review and get some feedback from. This feedback will allow you to confirm that what you have being
doing has followed the plan, or on the contrary it will tell you that you've broken a few of the rules.

Establish a minimum of three months before you revise your trading plan. After three months, study all
the trades you have taken and adjust the plan if you need to. Stop trading if your results are not as
expected and go back to the testing stage on Forex Tester before you decide to trade live again.

The next post will show a real example of a supply and demand trading plan to trade with a trending
market.