Years ago during my university days, I was told of a study into Harvard business graduates. The study was designed to establish the common factors that lead graduates to ultimately succeed financially.
Interestingly, twenty or so years after their degrees, five per cent of the graduates were earning 95 per cent of the total money earned by all graduates.
It was the same five per cent that had written down their goals and dreams all those years ago. The maintenance of a written life plan somehow helped these graduates to attain their goals. Some even carried their personal mission statements in their wallets.
Do you want to be in the top five per cent of investors?
Quick – grab a pen and paper and get writing. It is absolutely essential! Take heart from the words of Warren Buffett: “To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What’s needed is a sound framework for making decisions and the ability to keep emotions from corroding that framework”. A trading plan can provide you with the framework that you need to succeed in the sharemarket.
Putting pen to paper
Wayne Goldsmith is a sports scientist and consultant. He says the first step towards achieving sporting success "is to define specific goals to accomplish within set time limits. Wanting to 'win' is not sufficient. The daily process of moving towards that goal must be mapped out to ensure success."
Treat the business of trading as seriously as if you were preparing to represent your country at the Olympics. Define your personal level of aggression, estimate the returns for different strategies and be realistic about your own capabilities. Consider every conceivable occurrence in advance.
Money is made as a by-product of following a sound trading plan, and adhering to the principles of money management.
If you end up losing a significant proportion of your trading capital due to greed and ignorance, you can no longer trade, and you are out of the game.
What to include
Your plan must cover some basic issues such as your trading goals and objectives, which accounting structure from which to trade, and how you will handle your positions when you go on holidays. A trading plan must also cover 3 essential areas:
- Position Sizing
Decide whether to use fundamental or technical analysis methods to trigger your entry into a position. There is no room for gut-feel in the markets when you are starting out.
Over time, you may develop an inkling that a trade will work out well, but this will take many years of successful trading. When experienced traders talk about a ‘gut-feel’, it often means that they have internalised many of the indicators that imply an enduring trend, after years of honing their skills.
Trading is about making money. It is not about feeling right. Stop trusting your gut feelings. Traders can only afford to trust their trading plans.
Develop a scientific process for analysing signals, and do not let your emotions dictate your trading habits. You need to define your signal in words so that another trader unfamiliar with your technique can duplicate your strategy. If it’s not "duplicatable", it’s not a system.
Before you place your order, you must decide on where you will exit. I advocate that you use a stop loss to capture your profits and avoid large losses. There are four main ways to set a stop loss:
• Pattern based stop loss traders will exit trades if the share breaks downwards through a trend-line or a significant line of support.
• Technical indicators can be used as a stop. A dead cross of two moving averages may trigger an exit.
• Percent drawdown or retracement methods suggest that if the instrument drops in value by a set percentage eg. seven per cent, then an exit should be made.
• Volatility based stops rely on significant changes in volatility past a pre-defined level in order to trigger an exit.
To exit a position in the sharemarket, you can choose to implement one of these types of stops or even a hybrid of any of these methods.
Derivatives can use all of these types of stops and more. If you are unfamiliar with any of these techniques, it is essential that you research them to find out the most appropriate stop for your own requirements.
The key to managing risk is to position size correctly. Buy fewer shares and allow the price action room to move if conditions have become lumpy. Seek risk by buying more shares when in profit, or if conditions are more stable.
There are many ways to correctly gauge your position size according to sound risk and money management principles. Whichever method you follow, make it explicit by writing it in your trading plan.
If you would like to download a trading plan template, there is one available for free from my website. It will help you work through all of the vital issues that need to be included in a sophisticated trading plan to can give you an edge in the sharemarket.
Louise Bedford has a free 5-part e-course waiting for you at http://tradinggame.com.au. She is also the author of The Secret of Writing Options, The Secret of Candlestick Charting, Charting Secrets and Trading Secrets.