27/02/2010 05:03:56
Tom Leeson
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Posts: 662
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Developing a trading plan defines the most important role of the strategist. Putting
together a trading plan is a creative process wherein we apply our collective
research to establish a set of definitive trading rules. These research
176 Make Money Trading
concepts include risk management, intra-market relationships, technical
analysis, and trade order dynamics. In other words, our individual research
will provide the building blocks for establishing the rules of our trading
plan. This is the point where we must roll up our sleeves and define the
details of our business.
TRADE PLANS
EXCERPT FROM
Make Money Trading
How to Build a Winning Trading Business
Jean Folger & Lee Leibfarth
Trading plans must be somewhat dynamic. As traders gain more trading
experience and greater skill, their plans should evolve as well. Very few
experienced traders continue to use exactly the same trading plan as when
they began trading. One of the key decisions a strategist should make is
when and why to revise a trading plan. These criteria should be considered
part of the overall trading plan and should be put into place before actual
trading occurs.
It is important to mention that the greatest advantage to using a trading
plan is the consistency that it offers. Consistently following the rules
of an effective trading plan will allow a trading business to make money
over time. Remember, we cannot win every trade, and we should not focus
on the results of only our most recent trades, but instead in consistent
trading over time. A trading plan should not change after each trade. In
fact, changing a trading plan too often will create an overly flexible plan
that will equate to not having a plan at all. A trader must strike a balance
between deciding when to change the plan, and allowing enough trades for
a trading plan to have the chance to demonstrate profitability.
Building a successful trading plan is a process, as illustrated in Figure
7.1. This process allows traders to develop and test their trading plans
through a logical and systematic progression. The initial step is to define
the trading plan objectives and establish a set of trading rules. A trading
plan must be written, and should include the following components:
• Timeframe or conditions under which to reevaluate the trading plan
• Market(s) to which it will be applied
• Primary chart interval that will be used to make trading decisions
• Indicators and settings that will be applied to the chart
• Positions size that will be used, including when to increase/decrease
size
• Entry Rules
• Exit Rules
The process of developing a trading plan is similar to hiring a new
employee. In order to consider this trading plan for employment, it must
prove that it has the performance record, character, and skill to benefit
your trading business. The steps to evaluating a trading plan include historical
modeling (reviewing resumes), forward performance testing (checking
references), and live-market performance testing (the interview). It is
only after a trading plan has successfully gone through this process that
it has proven it is ready for employment in the market. Additionally,
criteria must be set to determine when a trading plan needs additional
development (training) or when it may need to be taken out of the market
completely (fired).
Once the rules of a trading plan are defined, it can be tested on historical
data. This process, referred to as historical modeling, or backtesting,
can help prove the validity of the plan. It is essential to use enough data
that the historical modeling becomes statistically significant. Analyzing just
a few trades does not offer the type of confirmation that we are looking
for. In general, the more trades that are involved in the historical model,
the better. It is also possible to revise the plan at this point, as this process
often leads to important research that can improve the performance of the
plan. Traders must be careful, though, not to reconstruct a plan that will
only work on historical data (this is known as over-optimizing).
Once the trading plan has shown positive, satisfactory results in historical
modeling, it is time to practice applying the plan to the real market.
This step is called forward performance testing, and is sometimes referred
to as paper trading. Since there is no real trading at this point, we are only
placing trades via an order entry simulator or on paper. At this point, the trading plan can no
longer benefit from hindsight, and must prove itself in the real market
environment. This testing will take some time in order to gain enough
trading experience to become significant. A minimum of ten trades is
recommended before making any initial judgments about the system. Forward
performance testing is a vital step in the trading plan development
process, and traders should look for good correlation between this and the
historical modeling. If it is determined that the trading plan is performing
as expected, it is time to begin live-market performance testing.
At this point, traders must put real money on the line to test the
system. Live-market performance testing should only be conducted with a
minimum position size. Remember, we have not yet completed the development
process and are still testing. Large losses at this point can cause a
significant setback to the overall business. While this step will feel exactly
like real market trading, it is intended as a bridge to get the trading plan
closer to being fully applied to the market. The focus of this phase is to
establish a correlation between the live-market trading results and the previous
development steps. Live-market testing will often provide feedback
that will lead to future revisions of a trading plan. In some cases, traders
may find that they do not yet have the market trading skill or mindset
to follow the trading plan. This may require tailoring the plan to make it
more tradable for the individual market trader.
Once a trading plan has gone through this rigorous process with positive
results, it is ready to be fully applied to the market (traded for real).
Traders should not rush through the testing process or try to take short
cuts. Any setbacks along the development process require traders to go
back to the initial phase, and continue through each step. These setbacks
should not be considered failures, for each time a trader goes through the
process of testing a trading plan, he or she becomes a more experienced
and savvy trader.
A key part of this process is having the tools to evaluate a trading
plan. This is accomplished by analyzing and comparing statistical results,
or performance reports, from each phase of testing.
edited by tom on 27/02/2010
edited by tom on 27/02/2010
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