On many occasions, I've discussed the importance of having a trade plan. Once I posted a lengthy reply to a reader who asked how I use a trading plan.
Today I'm using a recent post by Doug Hirshhorn, CEO of Edge Consulting, a firm specializing in “Peak Performance Coaching.” It's titled: The Trader Journal.
His trade journal is for the day trader, but there are several very important points for us, option traders who hold positions for one week to several months. I've highlighted portions of the text because these are the points that I believe are most relevant to our trading methodology.
"While trading looks fun and is often fun to do—you have to remember the reason you trade is to make money, not entertain yourself. And the way to make money is by focusing on your trading process and executing it consistently.
I’ve created a daily trading journal that my private clients are required to complete every day. It’s not a choice, it’s a commitment.
The purpose of the journal is to keep them objective in their decisions and hold them accountable on a daily basis. Just like top athletes videotape themselves to review performance and search for areas to improve, traders can use a trading journal for the same purpose.
To get you off to the right start for 2011, here are nine questions you should include in your own daily journal:
What is my game plan today? Is today a day to make money, limit losses, or do nothing?
What is my market thesis and is my current portfolio in line with it?
If I had no positions on right now, would I re-create this exact portfolio?
Are my current positions correctly sized?
Did I follow my game plan today?
What’s working (making money) and what’s not working (not making money)?
What did I do well today? What did I do poorly?
What will I do different next time?
On a scale of 1 (low) to 10 (high), what was my level of focus today?
Remember, great traders aren’t born, they’re made. And the way they become great is by focusing on their process and being accountable. The daily journal is a tool you can use to do just that."
Questions 7 and 8 may not apply on days when no action is either contemplated or taken.
Question 9 emphasizes the importance of paying attention when you do not expect to be trading. There may be a cheap way to cut risk or an opportunity to open a new trade (assuming your portfolio is well under your size limit)
Questions 3 and 4 have appeared in this blog several times. They are crucial to any traders success. Doug has his traders take the time to verify that the answers are 'yes' on a daily basis. That's an excellent idea.
Question 6 is designed to prevent us from making the same trade time after time – with no thought. There's nothing wrong with entering into the same type of trade – when you reach the decision that it is appropriate. There's everything wrong when the trade is simply done from habit.
Updating the plan
Doug's list refers to keeping a journal in which thought s for the current day are recorded.
However, it's also advantageous to write a trade plan for every trade and to keep that plan updated.
- As time passes, the situation becomes more (or less risky). The greeks change, market conditions change, other positions in your portfolio change. Do not believe that a trade plan should be written in stone (although specific parts may be).
- Profits may have accumulated more rapidly than anticipated, and it may be prudent to exit early. The conservative trader may choose to exit and the aggressive trader may conclude that this is an opportunity to seek an even higher reward. If either is true, update the plan
- Updating requires an examination of the position and the decision (question 3) of whether it deserves a place in your portfolio must be made. Knowing what you own is mandatory. Lazily closing your eyes and hoping all works out well is foolish. We have good tools to reduce risk. Use them when needed
Instead of considering the trade plan to be untouchable (as some traders advise), a frequent re-evaluation allows a trader to refine these plans. This is not only a profitable task, but it's a true learning experience. The trader must decide if the position is worth owning. That's the same as making a new trade, and is the best kind of experience.
The more often a trader examines a trade plan, the better he/she understands the position. That results a clearer understanding of the strategy and what it is designed to accomplish. You may discover that you own the wrong position and make the switch. That may seem unlikely, but new traders canot be expected to find the best trade (for their situation) every time.
Please believe me when I state that it is not a smart thing to enter into a trade just because 'it feels right.' You must have a better reason for making the trade. If it's a directional play, are you bearish/bullish for a good reason? If it's a non-directional play (such as an iron condor) does the reward justify taking the risk?
There is no way to answer the previous question unless you have some profit target (reward) in mind AND a good idea of how much can be lost in the worst case scenario. The point is: Think about what you are doing. Trading is not to be done by rote.
Trade a 20-point iron condor and collect $4.00 credit.
Sure the maximum gain is $400 and the maximum loss is $1,600, but in the real world you would probably exit before the entire $400 is earned. That means your profit potential is less than $400. It's important to know the real profit target.
I trust that the maximum acceptable loss is less than the $1,600 maximum. If so, you must decide how large the loss can become before exiting the trade. By writing that number into your plan, you will always be aware of that dollar amount. This is the part of a trade plan that should NOT be flexible. Sure, you can hold out for another dime, but you should not decide that your original plan – to limit risk – must be discarded.
As the trade progresses, you may want to make minor changes, but the experienced plan writer understands that it's worthwhile to have a written reminder – just in case action is needed when the market is volatile and many things are occurring simultaneously.
One of my plans for Options for Rookies Premium is to follow specific trades and to write and update the trade plan for each.
The negative aspects must be given a mention:
- It takes time
- It requires thinking
- It's not as much fun as making trades that feel right at the time
- It takes discipline
- You may not want to adhere to the plan when it is time to do what the plan tells you to do
I understand completely. As a true beginner with no trading experience, making these plans is virtually impossible. How can you have any idea when the trade may become uncomfortable to own? How can you know how much profit to seek or where to limit losses?
The answer is: You cannot know, but you can guess. When you are at this stage of your trading career, one of the things you are learning to do is to write a trade plan. Thus, the plan may not prove to be very valuable, but just coming to that realization and updating the plan is a giant step forward.
It won't be long before those plans represent solid ideas that you will use to make trade decisions. Plans become more useful as you practice writing and modifying them.
One good method for learning about trade plans is to write one for each paper-trading account position. Think about it: It takes extra time, but the sole purpose of paper-trading is to learn something useful. If you not only gain trading experience, but also gather plan-making experience, it's a double win for you. There are no guarantees, but a successful plan writer has a better chance of succeeding when real money is at stake. And that's the bottom line, isn't it? Doing everything you can to recognize risk and avoid blowing up your account has to be a top priority. And that possibility is almost never given much thought by the overconfident rookie trader.
Keep the plan simple. Add details when ready. The initial plan can begin with a profit target plus the maximum loss you are willing to accept. The next time you can consider at what price the underlying must be, before risk makes you uncomfortable. You may not get it right, but it's good thinking practice.
Clarification: When speaking of risk in this context, I almost always refer to the risk of mounting losses. However, when a position has been working well and profits have been accumulating, there is always the risk of losing those profits. That's a true risk. So one of the factors to consider is reducing trade size, exiting the trade, or adjusting to lock in profits. 'Risk' refers to any position that doesn't feel right. If profits could easily vanish, that's just as much of a risk as the chance that losses can suddenly increase. In either situation, it is your money that's at risk, and a good trade plan insures that the chances of losing that money are minimized.
Trade plans are helpful.