How to create a trading plan in 7 steps

What is trading plan?

A trading plan is essentially a framework that guides traders through the entire trading process. It sets the conditions under which a trader enters trades, identifies markets, exits trades and manages risks along the way. The trading plan ensures accountability and keeps traders focused on their personal strategy.

How to create a trading plan

Choose your analytical approach

The analytical approach answers the question, “how do you identify trade set-ups?”. It could be a combination of price support and resistance, trend lines, chart patterns, Fibonacci levels, moving averages, Ichimoku Clouds, Elliott Wave Theory, sentiment or the use of fundamentals etc.

This initial step of the trading plan helps traders to narrow their focus on a handful of scenarios that the trader is comfortable with. Thereafter, traders can look for opportunities to trade based on preferred trade set ups.

 Select your favourite trade setups

The trade set up is at the core of the trading process. But first, think of the analytical approach as the event that triggers the trade set up. An example of this would be viewing a consolidation pattern (listed in the analytical approach as a chart pattern) which then gives rise to subsequent action from the trader, i.e. the trader will decide to trade the breakout or wait for a pullback or combine breakouts with pullbacks only after the chart pattern has successfully played out.

Set ups are based on a number of factors that collectively lead to higher probability trades. If you are new to forex trading, this process may take some time to figure out but it is essential for traders to find a trade set up that works best for them.

 Limit the markets to focus on

When starting out, it is important for traders to limit the number of markets in focus. No market is the same and limiting the scope of markets can assist traders to understand the nuances of the market in question. Traders can even focus on specific time frames on a single market to familiar themselves with its characteristics and movements.

Think about your holding period

Time frames will depend on the type of trader. Traders that focus on short term trades (trades opened and closed on the same day) include scalpers and day traders. Medium term traders usually hold trades for a few hours up to a few days and are referred to as swing traders. Long term trading involves time frames ranging from a number of days, weeks, months and in some cases, years.

Know your risk tolerance

Each step in the trading plan is important, however, if risk management is missing, the whole plan will fall apart. In this step traders will need to discover their personal risk tolerance which corresponds with how far a trader is willing to set stop losses when limiting downside risk.

Recently the team at DailyFX researched over 30 million live trades to discover that traders with a minimum risk to reward ratio of 1:1 were three times more likely to turn a profit than traders without any defined risk to reward.

Plan how you will handle adversity (and success)

All traders will eventually experience the dreaded drawdown, so it’s important for traders to set a few rules to follow once this happens in order to manage emotions. An effective way to do this is to quantify an amount, or percentage loss, that would force the trader to take a step back and evaluate what went wrong/is going wrong. Do not fall into the trap of setting this figure along the way, rather quantify this upfront.

Now the good news – what to do when trades are successful. Confidence is good, but overconfidence can quickly turn winning trades into losing trades. If the market moves favourably, it’s not unusual to increase risk/exposure however, this should be kept to a minimum.

Have a routine for staying on track

Traders should set aside time to reflect on the week’s events and analyse individual trades. It’s a good idea to regularly review the trading plan and make tweaks if necessary. Periodical trade review and journaling are excellent ways to ensure you are following the process outlined in the trading plan. Make a note or save charts relating to successful/unsuccessful trade set-ups that can be reviewed later.

Trading plans should be rigid to begin with but should become a little more malleable as the trader becomes more familiar with the market in focus. The purpose of a trading plan is to give you a strong foundation and boundaries to operate within.