5 Simple steps to develop a profitable trading plan
By Dale Gillham
No doubt you have been on the kind of road trip where someone inevitably says, “Are we there yet?” If you have never been somewhere before, it is unlikely you will ever get there without a roadmap.
When we don’t have a plan, we often live in hope that we won’t suffer bad consequences from our actions. When it comes to trading, not having a solid plan generally means the trader is most often wasting their time in a futile exercise to generate profit. When we know what we are aiming for, we have a much higher chance of success, a lot less stress and we generally get where we want quicker. This is because a plan provides you with the roadmap you need to achieve your financial goals, so that you hit the target every time.
In the stock market, your roadmap is your trading plan—a written plan that helps you identify why you are investing and what you want to accomplish. It also provides the basis for your decisions and dictates the actions you need to take when making a profit or loss.
Would it surprise you to know that typically only 35 percent of the traders have their trading plans written down? Of that 35 percent, 94 per cent of traders said they were more successful when they stuck to their trading plan. A goal without a plan is merely a wish. So here are my 6 simple strategies to develop a profitable trading plan.
1. Portfolio type: The portfolio type you select will determine the appropriate stocks to trade.
The portfolio you select will also determine the goal of your portfolio, whether it be growth, income or both. You need to be comfortable with the level of risk you take because one thing is certain: The market will always be there, but you may not if you trade outside your risk tolerance.
2. Investment timeframe: Your plan must have an appropriate time frame that suits your lifestyle.
Do you want to trade over the short, medium, or long term? If you lead a busy lifestyle, I recommend that you select medium to long term as your investment timeframe. To many who lead busy lives attempt to trade short term, which is very risky if you do not have the required time. You don’t have to trade frequently to be profitable. Trading is about figuring out what works best for you so that you can ensure that you are trading for a lifestyle not making it your lifestyle.
3. Trading rules: You need to clearly document your buy and sell rules in your trading plan.
When determining your trading rules, you need to phrase each rule as a yes/no answer, if you are buying for example, your entry signal may be: Has the stock formed two consecutive closes above a downtrend line. If the answer is yes you buy, if not wait for the next opportunity.
Ensuring you have a proper set of clearly defined trading rules and sticking to them will drastically increase your probability of success in the stock market.
4. Money management: This area of your trading plan is one of the most important aspects to consider when trading.
You should never invest more than twenty percent of your total capital in any one stock, therefore, the amount you invest is relative to the number of stocks you hold. For example, if you decide to hold between eight and twelve stocks, you would invest between twelve and eight per cent (respectively) of your total capital in any one stock.
5. Risk level: What is your risk tolerance?
How much are you willing to risk on each trade? You must set a stop loss or an exit price in case price falls after you enter the trade. Remember, for stocks, this is usually ten to fifteen per cent below your purchase price depending on the volatility of the stock.
There is an undeniable link between risk and knowledge. The more risk you take, the higher the level of knowledge required to manage the risk.
Understanding your tolerance to risk will help maximise your wealth creation potential. I always recommend that an individual’s comfort level in regards to risk should be determined by what I like to call the “sleep factor”. In other words, only invest in assets that allow you to sleep at night.
To sum up:
You need to use a trading plan every time you intend to trade, as it will assist you to formalise your thoughts while you analyse whether or not the stock fits with the overall goal of your portfolio.
The plan also helps manage your risk, as you are aware how much money you are willing to lose if the stock falls in value. Your trading plan will not only ensure that you stay on track but it will also dramatically increase your profitability in the market.
Good luck and good trading!
Dale Gillham, chief analyst at Wealth Within and author of Accelerate Your Wealth.
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