How to build a trading plan?

By | February 15, 2014

How do you go about building a trading plan?  What do you need to consider, and what type of trader should you be? The last question is a logical place to start – deciding the type of trader you want to be, and understanding why.

Type of Trader

When creating a trading plan, a trader must decide the style of trading they will adopt. There are typically four types of traders in the market:

– Scalper (very short term)

tend to stay within boundaries of 1 minutes to 15 minutes time frame

–    Intraday Trader (short term)

tend to range from 5 minutes to 1 hour time frame

–    Swing Trader  (medium term)

will consider analysis done from 1 hour and above

–    Position Trader (long term)

will consider analysis done from 1 hour and above

As you can see, the time frame when analysing the market helps determine the type of trader you are, and as such the type of plan you need. It is generally accepted that the shorter the timeframe, the lower the risk/gain per trade. With more market noise, a higher level of discipline is needed.  

Trader type will dictate risk tolerance, as shorter-term traders tend to prefer lower risk as part of their plan to compensate for the frequency of trades initiated during the day. Swing and position traders normally have a position with wider stops and targets to compensate for the lack of entries they get from their analysis.

It is tempting to try and make a value judgment about different trader types – but the truth of the matter is that there really isn’t a better or a worse type of trader.  Each has its own strengths and weaknesses, and matches different individuals. 

There is a misconception that one can choose to be a particular type of trader – but this is a myth. A trader naturally develops a preference due to personal circumstances (e.g. only able to trade morning/ night for a few hours), their purpose for trading (e.g. hedging, extra income stream) and their preference for trading over a certain time frame and how the market reacts to it.

Type of Analysis

The other key element when building your trading plan is understanding, and then choosing, the way in which the analysis is done. As we talked about last week, there are two types ofanalysis – fundamental and technical. Each of these in turn has its own sub-classes. The two sub-classes under technical analysisare price-based analysis and indicator-based analysis.

Price-Based Analysis

Price analysis mainly relies on predicting the correct support and resistance that is likely seen and considered to be important by other traders worldwide. The logic behind technical analysis as a self fulfilling prophecy probably comes from price analysis.  Traders who use analysis that is based on price tend to believe that the market has priced both sentiments and fundamental information into price. There is no lag involved but, at the same time, market noises are not filtered out.

The following studies fall under the category of price analysis:

–    Chart Patterns

–    Candlestick Patterns

–    Fibonacci Levels

–    Gann Analysis

–    Elliot Wave Theory

–    Ichimoku Kinko Hyo

–    Harmonic Patterns

–    Pivots

Price-Based Analysis – Pros

Price analysis is simplistic, which is a good thing in technical analysis. It is also easier to determine where price is in relation to the underlying trend. One of the main advantages in price analysis is the precise levels to work with; for example, Fibonacci Ratios provide future price levels where the market is likely to find support/ resistance; trendlines can provide a range for the market to help place an entry or exit order.  Price based analysis is normally suited to swing traders and position traders; it’s set and forget type of trading.

Price-Based Analysis – Cons

The downside to price analysis is the lack of entry into the market. Often, at times when the market starts trending, traders will have to wait for a correction to happen before obtaining an entry. Depending on the type of strategy used, price analysis entries are mostly not optimal with a higher risk compared to indicator based analysis.

While the concept is simple, it’s actually harder and takes longer to become proficient in understanding price movements. Every tradable instrument has its own set of characteristics, meaning it’s not as simple as applying the strategy systematically across the range of instruments.

Indicator-Based Analysis

Beginner traders are commonly introduced to indicator-based analysis first.  There’s a great deal of reference material online and in publications about trading indicators.

Here is the list of some commonly used indicators in technical analysis:

–    Moving Average

–    Bollinger Bands

–    MACD

–    RSI

–    CCI

–    STOCHASTICS

–    Williams %R

These indicators serve as a way to measure momentum and volatility in the market and some, such as moving averages, are used to provide entry/exit signals as well as support and resistance in the market.

Indicator-Based Analysis – Pros

Advantages to using indicator-based analysis include the ability to filter out market noise, earlier entries compared to price analysis, and a lot of opportunities on a more constricted time frame.  For these reasons, indicator-based analysis is often suited to intraday traders.

Indicator-Based Analysis – Cons

On the other hand, the ability to pinpoint an exit level is compromised – because such exact judgment requires constant monitoring for changes in the indicator. 

The lagging nature of these indicators has the advantage of filtering out market noise but at the same time it could mean you end up experiencing a delay in detecting market changes; this, in turn, may delay your ability to act and react to market changes.

Understanding You

The final piece of the puzzle, and one that is often neglected purely because it seems a “soft skill” so to speak, is analysing your own trading style and knowing yourself.  Analysing your own trading style and preferences is crucial in building a successful trading plan.  You should never force yourself to adapt to a strategy that makes you feel uncomfortable – and if you are uncomfortable with a strategy, it’s probably not suited to yourtrading style and your personality.

Many people may think that they know their trading style; however, if you want to make sure that you truly understand your style, try experimenting with different trading types.  If you get the opportunity, try both forms of analysis before deciding on specialising in one. Most successful traders look at both price based and indicator based analysis as a whole, becoming a hybrid in terms of analysing the market. Not an easy task but it’s possible.

Beginner traders are better off sticking to one type of analysis until they are proficient and have enough experience before experimenting with others. I will be providing a Trading Journal Check list in the coming weeks.

One thought on “How to build a trading plan?

Leave a Reply