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The Stock Trading Plan - Why You Must Have One To Trade Successfully

This is the continuing story of our two imaginary traders, Peter and Paul.

Peter is a professional trader, Paul is not. Peter has a tested, proven, written trading plan that he follows each time he enters a trade, Paul does not.

Peter and Paul have had vastly different Stock trading experiences - Peter has just made another substantial profit - this time from the Bear market, Paul has lost heavily.

A chance meeting with Peter's group of friends one day at lunch launches Paul on a learning curve that will see him become a good trader, but not without some hard lessons along the way.

Today Peter shares his trading plan and the importance of having a trading plan with Paul.

"Today we will work on your Trading Plan," Peter told Paul as they sat down for the start of their next weekly mentoring meeting.

Peter handed Paul a copy of Robert Miner's book, Dynamic Trading, and said, "Here, read this section of this wonderful trading book." Paul read to himself quietly as Peter poured them both a cup of coffee.

"The purpose of Technical Analysis is not to be able to accurately identify every market position, all of the time. While this may be the daydream of many analysts and most amateur traders, it is an impossibility.

"Every method of technical analysis has it's limitations and at times will provide contradictory information. Unless the analyst, trader or investor is willing to accept that his or her analysis will from time to time not provide a confident opinion of market position, he or she is doomed to failure.

"The objective of technical analysis is to identify those market conditions and the specific trading strategies that have a high probability of success.

"If there is a key concept associated with trading and investing, it must be probability. All consistently profitable traders and investors know that every trading and investing decision only has a probability of success, never a certainty.

"Losses are inevitable and are just as much a part of successful trading as profits. If a trader has a successful trading plan, he or she should have no more emotional response to a loss than to a win. Each will be inevitable.

"While it may be difficult to maintain a completely non-emotional relationship to trading and investing, an understanding that trading is a Business of probabilities will go a long way towards developing a stable attitude towards the Business.

"All successful traders have a defined, written trading plan. The trading plan can take many forms. At the very least, it will provide the minimum guidelines that must be satisfied before a trade will be considered. It may be as complex as a long set of very restrictive rules that must be satisfied before a trade can be considered.

"Each has it's strengths and weaknesses. Neither method, whether rules or guidelines, guarantees success, but the lack of either will ensure failure.

"Why have a trading plan and not follow it? Each guideline and rule must be included with reason and purpose. All successful traders and investors consistently follow their trading plan and they know that if they violate their trading plan it will always be costly in the long run.

"A trader who does not consistently abide by his or her trading plan is doomed to failure."

Paul looked at Peter after he finished reading, and understood the implications of what Robert Miner had written. He had never had any sort of trading plan. He had just taken the advice of other people and bought, held and hoped for the best.

Peter said, "You need a trading plan my friend if you are ever going to make money in this Business. Then you have to have the ability to follow it.

"The paragraphs you have just read are as important, and maybe more so, than learning any method of analysis or trading strategies or methods.

"Even a trading plan that included technical analysis and trading strategies that were 100% accurate, in other words, would indeed predict the future trend of a Stock or Index every time with perfect certainty, would not result in you making a profit if you do not know and act in accordance with the qualities discussed above."

"With this in mind, I will now share with you my trading philosophy, trading plan and rules.

"I have found having this set of guidelines gives me a high probability of making successful, profitable trades. As Robert Miner said in his book, some losses are inevitable no matter what rules or strategies are used. They are a cost of doing business.

"A Trading Plan and rules that you have tested and trust will help you remove the two biggest enemies traders face - Fear and Greed. These two factors have probably cost more traders more money than anything the market can throw at us.

"By writing down and consistently following a solid plan that you have back tested and proven to be profitable with you paper trading, you put yourself ahead of 90% of market participants who fail to do any research or testing before they risk their capital in the market, and are eventually wiped out or give up because "the market just isn't for me."

"You must remember however," Peter continued, "These are my guidelines. You might feel comfortable with them or you may not -you have to develop your own style.

"These rules also do not constitute trading advice...you must sit down and determine what your rules and guidelines are going to be. Use these...or not. You must however decide which of the parameters you are going to use for your trading, then -

Write them down into a plan of action - and follow the plan.

Peter's Trading Philosophy -

He went on, "My trading objective is to enter trades in the direction of the major trend using daily end of day data. There are three conditions under which I will enter a trade -

When pattern, price and my mechanical filters indicate a trend reversal has taken place.

On the first correction within the new trend, for example, the first higher low in a new uptrend.

On any trend continuation signal once the Stock or Index has signaled the new trend is underway.

"The initial trend reversal position will always be in lots of 2 Futures positions or $20,000 invested in a Stock. A trend continuation trade entry will be 2 or more futures positions and $10,000 invested in a Stock.

Stop loss orders will be placed 5-50 cents or points past the extreme of the most recent swing pivot at the time the trade is placed - the number of points or cents used depends of the Stock or Future being traded.

"These numbers will be different for every trader depending on risk tolerance and account size. Only take on as much as you can handle psychologically, or you set yourself up for failure.

"If your position size is too large, you will tend to jump out at the first sign of trouble, often at the worst possible time. Trade within you comfort zone and success is much easier.

"My initial capital exposure never exceeds 5% of my available account equity. Additional positions will not be taken unless the initial position is in profit and taking the additional position keeps the risk of the entire position below 5% of account equity. In other words, additional positions are only taken using the markets money.

Trading Rules and Trading Plan -

Peter continued as Paul took notes, "My Trading Plan and rules offer two types of trades - Trend Reversal entries and Trend Continuation entries.

"Trend Reversal entries are taken any time a Stock or Index completes a reaction and appears to be going into an Impulse Trend.

They are also taken when a clear 5 Wave sequence has completed, as we can expect at least a substantial correction, and possibly a change in trend at the end of a 5 Wave sequence.

The rules for Trend Reversal trades are -

The price must break a valid trendline.

The Moving Averages must cross, indicating a change in the short term trend.

For Long Trades, the Stock or Index MUST make a higher swing high, followed by a higher swing low on the daily chart. We enter the trade once the price rallies from the higher low.

For Short Trades, the Stock MUST make a lower swing low followed by a lower swing high on the daily chart. We enter the trade once the price falls from the lower high.

"Trend Continuation entries are taken within the Impulse legs of Trends. They are not taken when price is within a consolidation period or a reaction.

The rules for Trend Continuation trades are -

For Long Trades, the Stock price must be above a valid Trendline.

The price bars must be above the longer term (usually 18 days) Moving Average on the daily chart.

The Stock must be making higher swing highs and lows on the daily chart.

The reactions within the uptrend must be less than 4 days.

For Short Trades, the Stock price must be below a valid Trendline.

The price bars must be below the longer term (usually 18 days) Moving Average on the daily chart.

The Stock must be making lower swing lows and highs on the daily chart.

The reactions within the downtrend must be less than 4 days.

"Moving average periods are Stock or Index specific, in other words, try to find a combination that works on the markets you are interested in trading that don't give too many whipsaws. For example, 9 and 18 periods work well on many Stocks. Sometimes you can go as low as 6 and 13, or you may need as much as 15 and 30.

"Play with it and find the optimum Moving Average numbers for the Stocks you trade. Then you can add the Trendline and swing high and low rules and you are ready to look for some trades.

"A Valid Trendline must touch at least 2 and preferably 3 data point extremes - three significant highs or lows within a trend.

So, in summary, this is Peters Trading Plan...

To enter a trade on a Trend Reversal, he needs a Trendline break, a Moving Average crossover, and a swing higher or lower to get set in an uptrend, and a trendline break, a Moving Average crossover and a lower swing low and lower swing high to enter a downtrend.

To enter a Trend Continuation Trade, he needs a strongly trending market with reactions to the main trend of less than 4 days. He enters with the main trend as the reactions come to an end and places his stop loss orders just past the swing pivot extreme in case the trend fails to continue.

"Now we have looked at my rules for entering trades, lets put them to work on a Stock," he said to Paul.

Turning to his computer screen, Peter opened a chart of IGT and scrolled back to 2001 - about half way through the bear market. Charts available at StockTradingReview.com

"We know that at this point in time, the weekly and monthly trend in this Stock was down, so we are looking for a valid entry with the trend at the end of a larger degree reaction - a trend continuation trade.

"I have removed all but two moving averages for clarity - these are 7 and 13 periods.

"You can see that the Stock made a low on August 8th, then rallied for 14 trading days including the inside day after the day of the high.

"It then fell sharply, breaking a swing low. Two inside days then one day up followed, then another inside day, followed by a day that broke the low of the inside day but closed slightly higher.

"The moving averages were coming very close together, therefore the third filter I use to enter was nearly in place, as we had already had the trendline break and lower top.

"The Stock broke down the next day, and at the close, the moving averages had crossed - I sold $20,000 worth of IGT short at the close and it fell sharply for 5 days before recovering.

"It had a two day rally, then a day down, so I moved my stop loss order to above the swing high this day down formed and was taken out of the trade three days later after price rallied.

"My entry was at $13.18, my exit was at $10.70, giving me a net profit after Brokerage of $4,605 for a 13 day trade.

Paul could see the set-up quite easily now once it was shown to him in an example.

Peter continued, "Lets have a look at another example." Peter opened a chart of MER and scrolled back to one of his trades from May 2002. Charts available at StockTradingReview.com

"This trade was also when the bear market was well underway and MER was in a strong downtrend on the weekly and monthly chart.

Looking at the daily chart, Peter said, "This Stock made a low, then rallied for 10 days. It then made a lower swing low and then rallied 2 days - the lower swing low is Filter one.

"It touched my short term trendline 4 times as it rallied before breaking down - that is Filter two.

"It then fell two days, had a one day rally, then gave a sell signal as it took out the low of that day.

"This trade didn't result in the same quick profit as the one in IGT, but it was very satisfying all the same. My entry was at $40.55 and my exit was at $33.20 as it broke upwards through my stop loss order above a swing high.

"This Stock gave me several more good profits as the downtrend continued. The set-up is always the same.

"A short term Trendline break, a Moving average crossover, a lower low and lower top in a downtrend.

"Let's have a look at an uptrend so you get the idea of what it looks like in a rally." Peter opened a chart of MSFT from Mid 2003, when the weekly and monthly trend had turned upwards. Charts available at StockTradingReview.com

"You can see here that MSFT made a high in early July and then sold off for nearly over 5 weeks.

"Then the moving averages crossed and the short term downtrend line was broken convincingly by a large rally off multiple lows at around $25.50. This set up a 5 day rally, then the Stock fell one day before recovering at the close to be up on the day.

"The buy signal was generated at the close, as this met all of the conditions. The Stock rallied over 20% during the next 5 weeks - that was very pleasant to watch."

Paul could see the simplicity of Peter's trading methods and was keen to go out and apply them in the Stock market.

Peter cautioned him however, "Remember Paul, not all trades are this easy and turn out as well, but by trading these types of trends on the daily chart, when the weekly trend is also in the same direction, we have a high probability of a profitable outcome in a large percentage of cases.

"Trying to guess tops and bottoms is a dangerous practice. It is a high risk trading strategy that rarely produces consistent profits.

"It can be done using time, price and pattern to help us, as I did at the low in the S&P 500 the other day, but the easy trades are when we take a piece out of the middle of each with-the-trend range, and leave the tops and bottoms for others until our understanding improves.

"Before you trade the market with actual money, I want you to paper trade for 3 months, or until you are profitable 70% of the time.

"Once you are profitable with your paper trading, only then are you to risk your money in the market - is that understood?"

Yes Paul replied.

Peter continued, "Stay well within your comfort zone, preserve your capital and build your account over time. Your success should then be assured.

"The rules are there for you to learn and apply, but your greatest enemies are your own fear and greed.

"These two will rob your account if you don't gain control over them. You must take every trade your system gives you, follow your rules exactly, and cling to your trading plan like a shipwrecked sailor does to a life raft.

"Imagine that your life depends on you following your trading plan perfectly...because it does.

"At least the life you wish for yourself and your loved ones does."

Paul agreed to study hard and to try to overcome his emotions of fear and greed. He knew it wouldn't be easy, but he was going to do whatever it took to succeed as a trader.

With that, the lesson was over for that week.

Paul left Peter's office feeling like he had just been handed the keys to the Bank vault and knew his trading would never be the same again.

When he arrived home, he went straight to Incrediblecharts.com and studied his watchlist. He picked out some Stocks that looked promising and started to paper trade them.

He couldn't wait for his next meeting with Peter - he was again filled with hope and gratitude for the time Peter was spending with him, and he vowed that once he was a profitable trader, he would help others succeed in the market.

His new trading life was about to begin...

To Your Trading Success,

Tony Spann and the Team

Stock Trading Review is dedicated to helping you succeed as a trader by sharing with you simple and easy to follow tips and techniques.

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(c) 2005 Stock Trading Review - All Rights Reserved.

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