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Essentials of a Trading Plan - Part 1: Why Do I Need a Trading Plan?

Education / 6 Min Read
Milan Cutkovic / 15 Jan 2021

As someone new to trading, it can be quite confusing on how to begin. For starters, it will be very helpful to check out the Forex 101 article, especially if you are a beginner trader. If you already have, the next step then is to come up with a trading plan! This will be the first article in a 4 part series that will help a new trader understand why it is important to have a trading plan and what are the different aspects to consider.

The common question often asked is why would one need a trading plan? To exemplify its importance, here is an example. 

Imagine opening a business - say, a cafe. Instead of selecting a location randomly, the standard approach will probably be to draft up a plan with the following considerations:

  1. An in-depth research of the market environment 
  2. What the competition is doing 
  3. What is the unique selling point and how to get an advantage in the market
  4. The cost-benefit analysis of running the cafe 
  5. Various financing options to get started  

There definitely is much more to it but to sum it up, there is plenty to do before the first cup of coffee is sold.

When it comes to starting up a business, developing a plan to serve as a framework is seen as essential. However, in trading, there are unfortunately plenty of traders who think that it is not necessary to have a trading plan despite its numerous benefits!

Identifying expected outcomes and setting realistic goals

First, a trading plan will present a trader with the question of why they are trading in the first place. It is critical to know the answer as it will help a trader to determine their expected outcome from this endeavour. For example, there will be some who want to make a living from trading only, while others will take it as a hobby to get some extra income. Whichever view you adopt, there is no right or wrong answer! More importantly, the trading plan is there to help the trader realise what it is exactly that they want out of the market, so realistic goals can be set.

Thus, a trading plan should be treated as a personal roadmap, which outlines all the goals that one wants to achieve. While the hobbyists might be satisfied with a couple of hundred dollars per month, there will be others who might expect much more. The hobbyist’s roadmap will probably be centered around getting some extra income, while working toward steadily increasing it. For others, they might aspire to become professionals, and thus will have bigger goals, which makes it crucial to have a detailed plan and a clear vision to achieve it.

Therefore, every trader will benefit from having a trading plan regardless of skill or interest level as it makes it easier to identify what type of trader one is, which then determines what risk profile and strategy suits them best.

Avoiding emotional pitfalls

The second benefit of a trading plan is that it can bring order and structure into your trading. Trading may be stressful and emotional at times. It happens to all traders all the time and results in them overreacting and taking a trade purely based on emotions, instead of facts and figures. Although having a trading plan will not negate this entirely, being organised will give the trader a clearer picture of what they are looking for in the market. As a result, this reduces the probability of ending up with losses due to impulsive and emotional trading.  

Moreover, a trading plan makes it much easier to analyse the trader’s results! Imagine operating without a clear strategy and relying on intuition of what is the best move. The strategy involved will wildly fluctuate, constantly shifting from trading technical patterns on the hourly chart, to scalping the Aussie Dollar on a five-minute-chart or trading the news. While a statistical analysis of the performance can be performed, the results will not provide any valuable insight because of how often the trader skips from one system to the next in such a short time.

On the other hand, by developing a concise strategy and plan and sticking to it for a while, only then will a trader be able to effectively analyse their performance and gather valuable information. 

What kind of trader are you?

Last, a trading plan will help the trader identify what their trading preferences are. Are they more comfortable trading short-term or do they prefer medium-term to long-term trading? By understanding what style is best suited for each individual, it allows for them to learn more about their risk appetite. One does not need to know the answer immediately, and preferences can change with time. Therefore, this is a situation where a demo account can be very helpful, as a trader can practice without real money.

Understanding one’s own risk profile is fundamental to trading as everyone has different approaches. Some are natural risk takers, and when they hear the word “risk”, they start associating it with “opportunity”. However, there are others who are more risk averse, and prefer to limit risks to the lowest possible level. Knowing and understanding one’s own risk profile will allow each trader to adjust their risk management techniques accordingly.

Furthermore, this helps in identifying other personal traits that can make an individual a successful trader; in other words knowing their edge as each trading style is defined by each individual’s own strengths and weaknesses.

How does a trading plan help with trade performance?

Simply put, a trading plan basically helps a trader to identify what are their expected outcomes, set realistic goals, understand their own risk profile, which in turn determines their trading strategy and style. This helps to eliminate emotional pitfalls that might be present when one is trading. 

However, formulating a trading plan is just the initial step. What comes next is evaluation. It is important to note that a trader must constantly analyse each and every individual trade undertaken and its following results closely. Was the plan followed, and if not, why? The frequency of evaluation differs from trader to trader. Intraday traders should do a daily review of their trades, while for long-term traders, it might be sufficient to do a weekly review.

Having a trading plan also allows an individual to track whether there have been improvements made. After each analysis of the trader’s performance, where things went right or wrong can be easily deduced. No one can be a perfect trader as losses are part of the game. However, by constantly analysing performances, errors and weaknesses can either be eliminated or reduced, whereas, winning streaks can be further built upon.

Conclusion

This brings us to the conclusion of the first article, which tackles the why and how a trading plan is beneficial. Please stay tuned for Part 2 as it will cover how to set your goals and which risk management techniques to adopt!   

Essentials of a Trading Plan - Part 2: Goals and Risk Management

The information provided here has been produced by third parties and does not reflect the opinion of Axi. Axi has reproduced the information without alteration or verification and does not represent that this material is accurate, current, or complete and it should not be relied upon as such. The Information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.

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