The importance of a trade plan, and how to create one
Don’t like reading? Video below!
Let’s talk about the importance of keeping a trade plan. The general view on trading and what you will hear from professionals and myself alike, is that you need to have proper risk management and keep your losses under control. However, this is easier said than done, especially in the fast-paced realm of options trading. A trade plan is in irreplaceable tool that will assist you in the pursuit of risk management and controlling the inevitable losses. These are two of the primary reason day trader’s fail, and especially options traders. More of these reasons are discussed at length in our video and article about some of the top reasons of why day traders fail. However, in this article we will be focusing specifically on an actionable way to mitigate risk and approach the market with a clear head.
What is the purpose of a trade plan? The purpose of a trade plan is to allow you to follow a rules-based approach to your trading. This is important, because without a plan you are playing a guessing game and essentially gambling. This approach is risky, and when emotional attachment eventually sneaks its way into your psych for that particular trade, you’re going to end up losing money. Remember, trading is a game of psychology and mastering your own mind. Bringing a rules-based approach to the markets allows you to eliminate most of the thinking required with trading! The beauty of having a trade plan is that it allows you to keep control of your losses and eliminates any self-doubt or greed that may otherwise get into your psych.
By simply having (and following!) a trade plan, you are setting yourself up for success before even placing your trade. You eliminate all of the losing tendencies and habits that traders without a trade plan experience - This alone gives you an advantage when you approach the stock market.
Now, the question is, what should you include in your trade plan? I have included a template that you are welcome to download and utilize with your trading. It includes all of the relevant fields that should be utilized when setting up a trade plan, and is curtailed specifically to options traders.
The most important parts of a trade plan to consider, are your risk points. What does this mean? You must have a defined risk area identified within your trade plan. It is a great idea to place risk points in an area where you have identified your analysis was incorrect.
Meaning, if you expect XYZ stock to up, on a certain timeframe, at what price level would this analysis be incorrect? For example: if XYZ is trading at 10, and your analysis gives you the expectation that it will go up to 12 - Would you consider this analysis incorrect if price action went to 9.5 on XYZ? These are questions you need to ask yourself when establishing your trade plan and assessing where you could be wrong with your analysis.
The next most essential part of your trade plan is: where you will take profit? Will you take profit when you hit a certain percentage of gain? For example, will you take gains at 30%? Or, will you take profit when an expected price target is hit? Will you take partial profit at a certain level? These are things to consider and establish before you execute the trade. Doing so, will alleviate stress and complications you may be facing with your trades.
Hopefully this helped you establish setting up a proper trade plan. Be sure to download the template.