Hey folks, my name is Jon Wirrick and I’m here to talk about one of the most overlooked, yet critical aspects when it comes to success in trading—having a solid business plan in place.
You’ve surely heard the maxim “treat it like a business” when it comes to trading. What does that mean? Do you have to get a business license, hire employees and incur a slew of overhead expenses? Thank goodness no! That’s actually one of the key benefits of trading for yourself.
What you do need is a business plan. You should have an overall plan detailing how you trade, as well as an individual plan for each trade that you place. Your plan should detail critical elements, such as what to buy, when to do so, how much you’ll buy, and when you’ll take profits and losses. A good plan will enable you to answer these questions quickly and decisively. If you fail to create such a plan, you’re just gambling my friend; much like driving without breaks. As the maxim goes, if you fail to plan, plan to fail.
A Plan that Fits
When it comes to trading, there is no one-sizefits- all plan. The right plan for you is one that best accommodates your personality type, lifestyle and risk tolerance. Plans can range from being entailed and technical to those that are simple and brief. I’m a fan of= the simple variety because I’ve found that the simpler you keep your rules, the easier they are to follow and more likely you are to abide by them.
If you have limited dollars, tend to be very risk averse and can’t watch the market much during the day, then day-trading is probably not for you. Alternatively, if you have a large account, a high tolerance for risk and prefer to be active in the markets, then buying LEAPS may be like watching paint dry for you. It’s important to select a trading approach best suited for your personality. Selecting the wrong style for your personality will surely result in a lack of enjoyment and decrease the likelihood you’ll ever get good at it.
Are there universal principles that everyone should incorporate in their plans? Yes, I think so. A good example is the fact we harp on the tenet of trading with the market and not against it during our training classes — long-term studies have shown that most stocks follow the market.
How do you trade with the market? Preferring the simple approach and being a fan of William J. O’Neil, I use Investor’s Business Daily. They have a proprietary formula for determining institutional accumulation and distribution in the market. I find this important given that institutions are responsible for the vast majority of the market volume that drives markets up or down.
The IBD data helps me determine what the institutions are doing, enabling me to jump on board and ride their coattails. In the “What’s The Market Trend” section (usually found between B2 – B6), IBD ranks the NASDAQ and S&P 500 according to the accumulation/distribution of these markets by the institutions. A and B represent accumulation, C is neutral and D and E represent distribution. This is what Preston refers to as the market cycle. I like to combine this information with a simple chart of the S&P 500 to determine what the trend is and where we stand in that trend. Doing so gives me a directional bias in the market and provides me with an edge—a critical element in trading and something I won’t enter a trade without.
What to Trade
When it comes to trading there are myriad types of stocks to select from. The strategies you trade and your risk tolerance are the guiding factors in selecting the type of stocks to trade. I like to focus primarily on stocks that offer generous option premiums and that have weekly options available. This narrows my watch list to a select group of stocks, saving me time and keeping me better focused. The strategies I trade are predicated on the current market cycle. You have to adjust your level of bullishness or bearishness, as well as length of trades and overall aggressiveness according to what the market is giving you at the time (market cycle).
When to Trade
Determining when to trade is a major factor for successful traders. You have to know your signals and adhere to them when it comes to entering new positions. Different trades may have different signals. For instance, in a “money press” trade, we look for a stock with a compelling event in the not-too-distant future (usually several weeks out). This could be earnings, a product showing or any other compelling factor that would lead us to believe the stock is likely to hold strong and offer some good premiums. I often like to enter shorter-term trades on a compelling technical pattern like a gap or breakout to a new high or new low.
Position Sizing and Risk
It’s important to know in advance how much capital you can put into any one trade. I’m often asked “how many shares or contracts should I trade,” which is the wrong approach in my opinion. It’s better to think in terms of how much of your account size should prudently be put at risk. For some traders this is one percent of their account size (or less) for any single position, while others may risk upwards of 10 percent. Most option traders fall somewhere in the one to five percent range, based on individual risk tolerance.
Keep in mind that risk is the difference between where you enter the trade and where you will exit the trade at a loss. If I buy a call for $4 and I am going to use a 50 percent stop, my risk is $2 per share or $200 per contract. If I have a $50,000 account and I decide to use the two percent rule, I can allow myself to risk up to $1,000 per trade. In this case I would be able to buy up to five contracts of that $4 call option.
Proper trade sizing and risk management are critical elements in trading, especially when it comes to avoiding account drawdown, which is the amount your capital declines over time. If you start with $100,000 and you end up with $90,000, you’ve incurred a 10 percent drawdown. The deeper the hole that you fall into, the more difficult it is to dig yourself out. A 50 percent drawdown would require that you double your trading account just to get back to break even. Without doubt, protecting the capital in your portfolio is “the” most important rule in trading.
While not comprehensive, I hope these points will help get you on the right track in terms of creating a solid trading plan. There are plenty of books and resources that should prove helpful as well. I suggest you start out simple, then as you gain more experience and become more advanced your plan can change and adapt accordingly. The key is to get a good plan in place before you start placing trades and to always adhere to it once you get going. In short, plan your trade and then trade your plan.
Jon is an active trader and private coach to Traders Edge Network investors needing help learning to apply a consistent trading method. Through his mentoring, he has helped hundreds of people change their financial situation through trading in the financial markets.