Trade The Journey

Trade The Journey

Formulating a Trading Plan

A trader’s plan is their roadmap, their GPS for navigating the market’s randomness and unpredictability. Without a map, how will you know where you are going? Or when to make the correct exit if you make it to your destination or worse yet miss your destination?

For a long time, I traded without a plan thinking that the knowledge I acquired over the years would assist me in entering and exiting the trades. I knew how much I planned to risk, and I knew what a good trade looked like. The problem with this plan, which essentially isn’t a plan, is that there are no rules or parameters for judging what is a good trade and what isn’t.

By entering the trade haphazardly, you are setting yourself up for a very bumpy ride and potentially large drawdowns. A drawdown is a trader’s biggest threat because it removes the possibility of remaining in the market long enough to experience profitable trades. It’s not just an exercise to complete but also good business.

And make no mistake about it, as a trader, you are in business. You have expenses, which are discovering the trade didn’t work, you have overhead and if you’re lucky, you have profits. Any successful business has a business plan and you should have one too.

With this being said, I’d like to provide an overview of my trading plan and what I use to identify trades and the strategies I implement based on the chart.

The first part of your trading plan should start with selecting the security or financial instrument you plan to trade. I selected options because of the leverage, the predefined risks, and the opportunity to make probability-based trades. Options isn’t the only financial instrument available, there’s also outright trading of stocks, futures, bonds, forex, and other assets that may better match your personality.

Next, I defined the signals and chart patterns that could develop into a potential trade. In the past, I didn’t use indicators because I thought that the patterns formed on the chart showed me everything I needed to know about the sentiment of the stock or index I was interested in. However, I find the ADX and the RSI to be particularly helpful.

The ADX helps me identify if the stock is trending and how strong the trend currently is. The RSI which stands for relative strength index is a momentum indicator and helps me identify if the stock or index is overbought or oversold. The reason I added these indicators is to assist me in developing a story about the position I am about to undertake.

For some time, I’d enter the trade with an outright call or put option position, hoping that the stock would make a considerable move in a short amount of time. Unfortunately, stocks tend to trend sideways most of the time with breakouts occurring some of the time but not as often as I anticipated. A better option would be finding stocks with a likelihood of breaking through their resistance or support levels if it’s in a sideways trend. Using these indicators reinforces my conviction about the direction or lack of direction the stock may exhibit.

For the ADX above 25, the stock is exhibiting a strengthening trend and for the RSI, 20 and below indicates a stock that is oversold, and above 80 indicates a stock that is overbought. These indicators are the only two that I currently have on my chart in addition to the moving averages, 20 SMA, 50 SMA, 100 SMA, and 200 SMA. The moving averages assist me in identifying short-term, medium-term, and long-term trends.

What I don’t have is an indicator that shows the amount of randomness or uncertainty in the market.  Some would say that implied volatility could be used to give you an idea of the amount of uncertainty forecasted by the market. Implied Volatility is more of a tool for options traders, however volatility can be used by all market participants to help identify periods of particularly extreme movements.

Next, I develop a list of stocks that meet the criteria of either a trending or non-trending stock and then select the appropriate strategy. One of the main reasons I developed a trading plan is because I was selecting the wrong strategies and not giving the stock the appropriate time to make its movement.

The next part of the plan for me is selecting the duration of the trade, how long am I willing to remain in the trade amid volatility or uncertainty?

To recap, I have identified a few underlying stocks that currently have options and based on the chart patterns, and indicators, I have a few strategies to select from.

The final part of the trading plan is setting my entry and exits, based on the strategy selected. Any losses I experience should be expected based on the amount of risk I am prepared to take. Just like the traditional business plan process, you may need to pivot a few times as you gain experience and find out what really works and what doesn’t.

Below is an expanded version of my trading plan:

Step 1: Identify overall market sentiment and the technical story of the indices.

Step 2: Based on market sentiment and technical story, identify sectors for potential trades. This past week I selected a stock in the consumer staples sector based on the chart pattern and the market’s retreat from its January highs. Some sectors do well when market participants are jubilant and other sectors do well when market participants are seeking to avoid risks.

Typically, I don’t have a preference for bearish, neutral, or bearish strategies. However, I do prefer seeing a clear picture of the technical pattern potentially developing. If the stock is too volatile or I can’t see what’s going on, I’ll move to another stock. There’s no reason to open a trade when you aren’t sure of the direction or technical pattern.

Step 3: Once I find the stock I’m interested in, I identify targets for the stock both above and below where the current stock price currently is. I also look at the put/call ratio, to get an idea of the sentiment on the stock I’m about to trade. I’ve had a few bad experiences trading against the put/call ratio which indicates the amount of bearishness in the option strike I have chosen. Even if you’re trading stocks, the put/call ratio can give you a good idea of whether you should be long or short.

Step 4:  Identify whether market-moving economic reports may occur within the timeframe you have set up your trade. Surprise news events is one aspect of trading you can’t plan for, but economic data reports are released weekly. There’s really no reason you should be caught off guard by these reports but it happens.

Step 5: Next I select the appropriate strategy based on the technical pattern I currently see developing. A bullish outlook could inspire me to create a bullish put credit spread, call debit spread or purchase an outright call if I feel the underlying stock could make a large move quickly. A neutral outlook would influence me to place a butterfly or iron condor option position. With a negative outlook, I could purchase a bearish call credit spread, a put debit spread, or purchase an outright put option.

Step 6: Set my entry and exit target. If your chart has some moving averages, some well-known indicators and an observable chart pattern, you can be sure that your competition is seeing what you’re seeing. On the one hand, this can be discouraging because everyone has a relatively equal advantage excluding the firms that have access to up-to-date information, computer power and models.

On the other hand, with everyone having the same access and information available on the charts, you can anticipate how others might react to the developing chart patterns and indicators. Setting entry and exit targets involves skill in recognizing the various reference levels noticeable to everyone and levels only seen by the trained eye.

Your entry and exit levels should also be based on risk/reward opportunities. Some like a 2:1 risk reward, others prefer a 3:1 ratio.

Step 7: With your entry and exit set, prepare the trade with a limit order that details the price you’re willing to pay to open the position. A limit order sets the maximum price you are willing to open or close a position at. A market order gets you in the market at the next available price.

This is my process for reviewing a potential trade. Your process may be entirely different and that’s okay because there are many ways to trade the market. The only part of the trading process that every trader should have in common is having a trading plan.

The next part of the plan involves managing the trade, which I will cover in the next article.

                                                                   “Every battle is won before its fought” – Sun Tzu

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