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Chapter Two: Planning

Shortcut to penury

If you don’t have a plan, you’ll soon have nothing. Trading without a plan is plain stupid. The inexperienced crash out quickly and those who by some fluke survive long enough to gain a bit of experience can still be wiped out in an instant. That’s no way to live.

A trading plan brings order out of chaos, structure out of confusion. It enables me to manage my reaction to change, following predefined and well-thought-out paths.

The greatest benefit of all is that it enables me to manage risk. (For the record, there is nothing more important than managing risk when handling leveraged financial instruments, which are akin to financial hand grenades.)

Taking time to carefully define a trading plan is an essential prerequisite for successful trading. Even an intuitive trader needs a plan indicating when those intuitive decisions need to be made and what needs to be decided.

Undocumented plans are worthless. Incomplete plans are worthless. Ambiguous plans are worthless. The properly documented plan must have no loopholes requiring ad hoc decision making in real time. Every contingency must be foreseen and allowed for. I want to plan my trade and trade my plan.

Having no plan, or a sloppily prepared plan, is the quickest way to the poor house!

What’s in a plan?

My trading plan provides points of reference as market action unfolds quickly in real time. It enables me to know what to do next, and how to do it. It thus answers four questions:

1 When should a trade by opened? I need a trigger that tells me when to enter the market. If and when I see this trigger, I act.

2 How large should the trade be? I need to know how many contracts to trade. This is the key risk and money management decision. If my position is too big, I am overexposed to risk. If it is too small, I am not taking full advantage of the opportunity.

3 Where should the initial stop be placed? I never trade without a physical stop loss order in the market. Period. Stops are not perfect, but they are my best protection against disaster. The plan must tell me exactly where the stop is to be placed.

4 How will I close the trade? Before getting in I must know where I will get out. It’s easy if my initial stop takes me out of the trade and it ends as a loser, but, oddly enough, it’s harder with a winner. Will I set a target, trail stops, or both? Traders beat themselves up over winners all the time. Why didn’t I hang on? Why didn’t I get out while I could? How could I have let that win turn into a loss? Don’t beat yourself up, don’t agonise; have a plan and trade that plan.

Guiding principles

I always keep the following principles in mind as I develop and make use of a trading plan:

 Don’t overtrade. Seek high quality trades, and keep out of the market if the entry trigger doesn’t appear during a session. My personal rule is to take at most one trade each day (in any particular market). Leverage on futures trading is such that just one or two trades can yield an excellent monthly return, so why look for more? I need to be honest with myself – am I looking for profits, or am I looking for action? If I am addicted to action, I am not a serious day trader.

 Keep it simple. I know I have truly understood a complex idea if I can express it in a simple, clear, concise form. I work hard to eliminate unnecessary complexity from my plans.

 Stick to the plan. I may as well not have a plan if I don’t adhere to it. It is much easier to stick to a simple plan than a complex one, which is one reason why simplicity must be an overriding goal.

 Eliminate errors. Just one implementation error can totally destroy a trading month. Errors are hard to eliminate because trading is stressful and fast moving. This is one of the great advantages of automation. A computer doesn’t get tired, impatient or flustered, regardless of market conditions. When trading manually, a simple system is much less error prone than a complex one; another reason to strive for simplicity.

 Understand the rationale. Plans should be based on a sound trading idea. In my case, I look for entries based on intraday support and resistance levels and how I believe the market reacts to them. Other traders may use different stimuli. The point is your trade should be based logically on the assumptions you make about market action in certain situations; I never enter a trade if it is not in accordance with one of my theories of market action. For example, I might look at the market over the last three years and notice that a particular strategy would have been successful if I used it every Tuesday. (These kind of things do happen, and people publish books about them.) Now, if I can come up with a rational reason why that is happening, I might trade that strategy, but, if not, I will keep well away from it. All sorts of coincidences can occur when you look back over history…

 Have patience. Things sometimes seem to happen slowly – even for a day trader. I may not get a trade for a few days. I may have a string of three or four losing trades and be in a drawdown for a while. When I was addicted to trading action, these periods were excruciating. Now I trade automatically and remain detached from the process. I resist temptation to change my plan because nothing is happening. A no-trade day is a good day because I maintained discipline. Opportunities will come – the market will be waiting for me tomorrow.

Automate for perfection

As a manual day trader I had a plan. Of course I did!

 Was it complete? I think so, but I could always sort out a tricky decision at the time if there was an ambiguity… right?

 Did I stick to it? Of course I did! Well, most of the time, unless it was telling me to do something obviously wrong.

 Did I trade it accurately? I did my best, but I’m only human. Everybody makes the odd mistake. That’s not the end of the world, is it?

 Did I have fun? You bet! Nothing matches the buzz you get from trading, especially on those winning days.

If any of this sounds like you, let me tell you how I made a quantum leap forward in my trading performance, and improved my lifestyle at the same time.

I wrote computer software (TradeOnAUTO) that let me record a trading plan and then request my computer to automatically trade the plan while I was doing something else. (As I live in Australia and trade in Chicago, the something else was usually sleeping.)

Let’s ask those questions again, this time from the point of view of an automated trader:

 Is my plan complete? Yes, indeed. The computer won’t trade it until it is fully specified.

 Do I stick to it? Absolutely. I am, after all, not even there. My computer does exactly what it has been told to do, while I do something else.

 Do I trade it accurately? Yes, 100% correct. The computer doesn’t make mistakes. And, as an added bonus, it does it all so much faster than me.

 Do I have fun? Of course, but it’s not gambling fun now. I’ve got time, and the peace of mind, to enjoy doing so many other things.

Planning template

Figure 1 shows the interactive form I use to fully specify my day trading plans. Each plan (describing a unique strategy) is named and stored in a library. When I trade, I activate the plan (or plans) I intend to use in the coming trading session.

Figure 1: Plan entry form

In Chapter 4, I describe what the various entries on the form mean. For now it is sufficient to note that there are four main sections to be completed. These are:

1 Chart Period and Entry Searching

2 MoneyManagement and Position Sizing

3 Pullback Characteristics

4 Trade Management.

By the time all sections of the form are filled in, the information entered constitutes a fully specified plan, capable of being traded automatically by my computer.

Simulation

To be an effective day trader, it is a good idea to think of your business activity as two distinct processes. There is the planning process, and there is the trading process.

For me, the trading process is a mechanical activity during which I attempt to implement my trading plan flawlessly. As already mentioned, my ability to do this has been greatly enhanced by the development of the TradeOnAUTO software, which enables me to leave the computer to automatically implement strategies based on my preferred trading style.

But how do we answer the questions thrown up during the analysis of strategies? That is to say, how can we determine how well our proposed strategies have performed in the past, before we convert them into a trading plans and actually trade them?

For too long, I didn’t have adequate tools to help me answer these questions. However, I recently built simulation software, which has revolutionised my planning sessions.

What the simulator does is allow me to set up a specific strategy, based on my general trading style, and then apply that strategy across several years’ history. It answers the question: “What would have been the outcome of running this strategy over the last two or three years?”

Before I had a simulator, answering the question would have taken literally days of work. The only way I could do it was by manually analysing hundreds of charts, a time-consuming and error-prone task. With the simulator, it takes just a few seconds to cycle through the database. Each simulation produces a detailed list of trades taken during the trial period, together with a concise set of statistics that can be used to compare the effectiveness of different strategies.

A simulator is not a simple thing for an amateur trader to develop. It is a complex programming task and requires large volumes of detailed intraday session data.

The TradeOnAUTO simulator is the ideal tool for evaluating strategies based on the trading style discussed in this book. It is available from the TradeOnAUTO website (www.tradeonauto.com).