Introduction

As discussed previously in goal setting, we must always have a plan before we place a trade, this plan is known as a Trading Plan. A trading plan is a written set of rules that defines how and when you execute a trade. A basic trading plan shall include the following components:

• Exit Rules

• Entry Rules

• Position Sizing

It is important to keep a written trading plan for reference rather than by memory because the time frame of the trade maybe longer than you expected and hence it is more effective to have the trading plan documented. Another rationale to have a written trading plan is that we do not change our plan easily when emotions come into play during a trade.

Exit Rules

Many inexperienced and newbies traders often place too much emphasis in looking for potential trades but very little attention on when and how to exit a trade. When an exit rule is not clear from the start and if the trade goes against you, many traders end up in a situation whereby they cannot sell to cut loss because the losses are already too big to be bearable and/or “emotions & hope” will get the better of their logical decision. Hence the trading capital is “stuck” and the trader also loses out on opportunity cost when a better trade comes along later.

Even if the trade does turn up with profit, when the exit rules are not clear, the trader may still be uncertain on when to exit the trade as there is no fix profit goals to guide the exit. As we have seen frequently, the trade will turn in the opposite direction and hence a profitable trade might become just breakeven or worst, turn into losses. Again, our emotions will again play with our mind and generate signals of hope that the share price will rebound anytime soon.

We have observed regularly that even mass market traders with many years of trading experience would tends to focus only on profit target but enter the trade without considering or defining the stop loss price. Generally, this is because our mind will generate so much positive signals and hope that the share price will go up right after we bought but ignore the fact that there is always a risk that the share price can always pull back. This is the common mistake that many newbies traders made.

Best practice used by professional traders/investors is that in every trade, there must be at least two exit rules. First, what is the stop loss price if the trade goes against you. Second, the trade should have a profit target. With these two exit rules clearly set and followed with discipline, there are good odds that you are able to make a profitable trade and at the same time protect your trading capital if the trade goes against you. An example of a simple exit rules is illustrated below:

You plan to buy Stock XYZ at $1.02 and the exit rules are:

• Stop loss at $0.97 around the support level

• Exit at ~$1.13 with target profit of 10%

The above are just example of very basic exit rules, it is important to develop your trading system or strategy which best suits you and define your own set of exit rules over time. Develop the best practice mindset to ensure that your trading plan is written down and followed with discipline.

Entry Rules

To the professional traders/investors, entry rules comes after the introduction of exit rules because exits are always far more important than entries. Entry rules are always closely related to the basis of why you pick that particular trade.

For example, when a stock is observed to be in an accumulation phase (refer to previous “iVSA Article 6 - How to Detect Smart Money Movement” http://klse.i3investor.com/blogs/ivsatradingtipsandplans/96519.jsp about accumulation phase and markup phase), the entry rule will most likely be a condition whereby the accumulation phase changes to markup phase. This is just one example of entry rules and there are many other entry rules once a trader/investor is trained on chart reading of market structure and Volume Spread Analysis.

It is important to keep your entry rules simple and as objective as possible. If the entry rules are too complex with too many conditions to be met and many are subjective, it will be difficult to make the entry decisions when opportunities present itself. For example, some technical indicator may indicate a buy opportunity while others technical indicators may point to the opposite signal of being overbought. This is called analysis paralysis and causes lot of confusion to the traders to the extent that some may not be able to pull the trigger on a trade.

Position Sizing

Position sizing refers to the method that a trader/investor uses to determine the scale of its particular trade. The purpose of position sizing is to cap the risk of a particular trade by limiting the maximum possible loss amount that a trade can incur.

There are various methods of position sizing with example below illustrates the fundamental method based on risk tolerance percentage. For simplicity, the trading cost or commissions are not included in the example below for ease of understanding.

• Assuming Stop Loss Price at $0.97 and Entry price at $1.02

• Difference between Entry and Stop Loss Price is $0.05

• Assuming you have a trading capital of $50,000 and your risk tolerance is 2%. Hence, 2% of your capital equals to $1,000, which is the maximum amount that you are prepared to lose in this particular trade

• Hence, your position sizing for this trade shall be $1,000/$0.05 = 20,000 shares.

• In other words, in the event that the trade goes against you and you exited at $0.97, you only lost $1,000 because of the prudent approach of risk management via position sizing as you only purchased 20,000 shares although you are able to purchase ~49,000 shares with your trading capital

• In actual scenario, the trading cost and commissions should be added to the difference between Entry and Stop Loss Price, based on per share basis.

This risk management approach is the best practice adopted by professional traders/investors worldwide to protect the trading capital as professionals know very well that that every trade is based probability of winning and there is no such thing as holy grail system that is sure win (but many mass market retailers are still chasing for such sure win system). Hence, it is important to have risk management to protect your capital. How professional traders can profit consistently in the long run is based on the time proven wisdom of “Let your Profits Run & Cut Your Losses Fast” and don’t pay so much attention to losses for each & a few trades but focus on the returns and drawdown of your OVERALL portfolio.

Conclusion

In life, failing to plan is planning to fail, trading is no different either. A trading plan not only can ensure your trades are able to win consistently, it also reduces our biggest enemy of emotion interference when deciding an action to the trade. By having a written trading plan for every trade is a good start point of your learning and journey to be a good trader/investor so that you can repeat your successful trades again and again with ease to make consistent money.

Successful and professional traders/investors treat trading seriously and as a business versus a gambling mentality that many mass market newbies traders have. Centuries of wisdom and facts have demonstrated that a successful business is always being run with a proven system, proper tools, correct mindset and efforts to generate above market returns consistently.

Last but not least, remember that trading/investing is a MARATHON, not a SPRINT. In other words, trading/investing in share markets is to generate income in the short term and build wealth for your financial freedom, but not a get rich quick scheme (with gambling, herd mentality & hope for the best mindset) and requires efforts to acquire the proper knowledge and skill sets.

Watch out for next article in this series of education articles brought to you by iVSAChart, “Article 9 - Back-testing Your Trading Plan” under Series B: Preparation Before Trading or Investing (what professionals worldwide are practicing).

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This article only serves as reference information and does not constitute a buy or sell call. Conduct your own research and assessment before deciding to buy or sell any stock. If you decide to buy or sell any stock, you are responsible for your own decision and associated risks.