George has been stock trading as a hobby for about five years and recently started full time trading. Like many stock traders and investors, he lost about half of his portfolio in 2008. He trades stocks and options, and has read many books and taken many courses. The first question I asked George was if he had a trading plan. He did, but after more questions on this it seemed to me it was not strategically aligned with his needs. See How to Create a Stock Trading Plan and Sample Trading Plan Using VectorVest for details on trading plans.

The first step in writing a trading plan is understanding yourself and what your trading objectives are, how trading fits into your life. How much money are you trying to generate per year? How much time are you willing to put into trading? How well are you able to take the emotions of trading: fear and greed? How does this trading plan fit into your overall financial plan? We explored these in more detail.

George said he wanted to make a lot of money, maybe 100% per year. That led to a discussion of how reward relates to risk. How he resolves the conflict between greed (high returns) and fear (low draw down) is key to determining what kind of trading he is emotionally able to do. He mentioned that even though he had a trading plan, he often did not follow it once he was in a trade. This is typical for many traders. Getting into a trade is easy. Little emotions are involved. Once you have real money on the line, fear and greed often take over.

I described how I use asset allocation to determine the size of each portfolio, and how I use position sizing to manage risk. For example, I allocate no more than 25% of my net worth to stock-related assets, and each trade is sized so I can only lose a pre-determined amount of money. My maximum loss never exceeds more than 5% of net worth, and often is less. Most traders use 1-3% of net worth to size positions. George has not allocated his assets into different classes, but concentrates on stock and options.

He also focuses more on stop management than position sizing to manage risk. I explained how I sometimes raise stops in trend-following trades, but also use scaling out to manage risk. Scaling out is when you keep the amount you have at risk (including profits) below a preset level, reducing the position size as profits grow.

The books and courses he has been learning from are based on techniques of trading. I suggested he get the one book I recommend to every trader: Trade Your Way to Financial Freedomby Dr. Van Tharp. This covers many of the topics we discussed. If I could have only one trading book, this would be it.

George likes to win. We all do. But with trading, losing trades are inevitable. However getting a high winning percent of trades is not the only way to get profits. What is important is the amount of profit compared to the amount of losses. A system with 10% winners can be profitable as long as the profit from winning trades is higher than the losses of the losing trades. He hadn’t really thought about that before.

George is willing to put a lot of time into trading but when we explored this, he would rather spend less time trading and more time playing golf, etc. I mentioned how I generally use other people’s trading systems (autotrading them) instead of building trading systems. This allows me to spend more time on my other interests.

We also discussed different asset classes and why I am diversified amongst them. I hold working interests in oil and gas wells, raw land, rental property, foreign currency, precious metals and collectibles. This is key to why I have never had a year where my overall portfolio has decreased more than 10%. George saw the value in that and decided to explore other asset classes, reducing his exposure to stocks.

During our two hour lunch, George was able to better understand himself as a stock trader and investor, to decide how to better manage risk, and to investigate different trading systems that he can trade with less time and that fit his trading personality better. I hope some of this helps you too to improve as an investor and trader.

Please leave your questions and comments.

The simplest and most common position sizing method is to allocate equal amounts of the portfolio to each position. For example, a $100,000 portfolio would put $20,000 into each five stock positions. This is what the High Performing System does: equally sized positions with 100% invested.

Effective position sizing depends on the level of risk the trader wants to take and the reliability of the trading system. Dr. Van Tharp explains the many choices of position sizing and how to develop your own method in his excellent book called Definitive Guide to Position Sizing.

Here is one way you can use position sizing to change the risk of a trading system. For example, if a system has a 30% drawdown and you would prefer only half of the drawdown, you could put on half-sized positions. In the $100,000 example, you would put $10,000 into each position instead of $20,000. Of course, the returns would be reduced too.

Another position sizing method–one of my favorites–is scaling out of a trade. This means that as profits are made, some of the position is closed to realize those profits. I use this method to keep the amount I have at risk in each trade around my target, instead of letting the at-risk amount grow as profits grow. Dr. Tharp explains this in detail in his book. Scaling out smoothes the equity curve by
lowering drawdown. However, sometimes it does not make as much profit as would have been made if scaling out was not done.

Please leave your questions and comments on position sizing by leaving a comment.

I never hold a stock position without a good-till-canceled stop order. Otherwise all the money I have in the position is at risk: it could go to $0! There are many ways to determine where to put your stop.

The simplest stop is to place it a percent below (long position) or above (short position) your cost per share. Another is to use a trailing stop. This stop automatically adjusts to be a percent of the highest high (long) or lowest low (short). Beginner stock traders overuse this technique, often using tight trailing stops like 5%. Using stops that are too close to the opening price will not give enough room for the stock to move into profit. Many stocks are volatile and need room to move without getting stopped out. Generally I only use trailing stops if I decide to close a position but think it might keep making profit. In that case I will use a tight (2-3%) trailing stop.

Chart readers often set stops near support (long) or resistance (short). Determining support and resistance is more an art than a science. Several trading systems I used were based on support and resistance. I prefer to put these kind of stops just beyond support or resistance, since I assume many other stock traders are using support/resistance. This keeps me from getting stopped out when the market makers “run the stops.”

You can also use mental stops. These are stops you do not place orders with your broker. Instead you check the stock price yourself and compare it to your stop. I often use mental stops with closing prices, while also having wider stops placed with my broker.

An advanced technique which I also use is adaptive stops. Instead of keeping the stop price fixed during the entire trade, it is adjusted during the trade based on how the stock price moves and how long the trade has been on.  This tends to prevent winners from turning into losers, replaces positions that have gone nowhere, locks in profits and reduces the amount at risk. See When to Close a Stock Trade for more information on this.

I also avoid placing stops that end in 0. For example, I avoid stops at 2.00, 1.50, 10.10. Why? Because many people round their stops and I don’t want my stop to be where many others have theirs.

The recommended stops given in the High Performing System I use have been optimized to reduce risk without significantly lowering returns. However, broker-placed stop losses are not used in the hypothetical back test results. All trading decisions in the simulation are based only on closing prices.

Please ask your questions or share your experiences with stops by leaving a comment.

I have spent tens of thousands of dollars on stock trading courses, books and other educational material. Yet, I learned much more from my losing stock trades than from all those. Losing trades are the real tuition of a stock trader. So here is my confession and what I learned from it. Hopefully you can learn from it too.

By mid-February 2009 my stock portfolio was up almost 20%. I was feeling good, probably over confident. As part of my market neutral trading plan, I put on a large March Iron condor index option spread. Iron condors are profitable when the index stays within a range (between the short strikes). Soon after I put on the position, the index started rapidly dropping.

Recently I have been developing a way to hedge against such moves to offset the potential Iron condor losses (I put on Iron condors every month). In October 2008, hedging turned a 25% losing Iron condor into a 25% winner. So I felt like I knew what I was doing. I developed my hedging approach through training and experimentation. I had the rules in my head: a mental trading plan.

Following my mental trading plan, I started hedging my March Iron condor in early March. Soon after I hedged the market turned upward. I sold the hedge at a loss. Within a week the market had moved high enough to put the Iron condor at risk again, so I hedged again. The market reversed for two days and my hedge lost money again. By the time I closed the March Iron condor it had a 30% profit, even though it was threatening to be a big loser twice during the month! My hedge losses erased all the Iron condor gains and all my year-to-date profits.

Painful as this was, I objectively evaluated what went wrong (after a few days to get over the shock). I made several mistakes:

1. I did not have a written trading plan. It was all in my head. This caused my emotions to affect my trading. I always follow my written trading plans. But with a mental one, it was easy to second guess myself.
2. I started to hedge too soon. My rule is to hedge only if the Iron condor is threatened within two weeks of options expiration. Almost all of my Iron condors expire on the third Friday of the month. This one used quarterly options, which expire at the end of the quarter, much later than regular monthly options. I forgot about this in the heat of the moment and hedged this position as if it expired on the third Friday. This resulted in me hedging too soon. I would not have hedged the first time if I remembered this was a quarterly option. Not having my trading rules written down was a major factor in this mistake.
3. My rules to manage my hedge are vague, based somewhat on gut instincts. My instincts failed me that month. This is a trading system failure. I need to clearly determine how I will manage the hedge and write that in the trading plan.

Bottom line: I need to update my market neutral trading plan to include hedging with precise rules on how to manage the hedge. This was a very costly error that I still have not financially recovered from.

What is a Trading Plan?

Unfortunately for a lot of people who start trading, many will find success difficult to achieve. One wonders what the minority are doing right that give them the advantage over the vast majority who leave the market with less money than what they had when they started trading. Sadly, a lot of those who fail walk away with very little of what they had originally. So what is it that separates the successful from those who fail? If you ask anybody who has studied trading for any period of time, they will answer ‘psychology’. They will add that ‘your psychology’ is what will make or break you as a trader.

Essentially, your mental ability to manage losses and profits, the good times and the bad, your capacity for risk management, and the self-discipline necessary to avoid becoming too greedy are all subsumed beneath the heading of ‘trading psychology’, along with many other similar skills and abilities. If we are naturally inclined to break all of the time-tested trading rules, how can we overcome those natural tendencies and therefore control our mindset?

One of the biggest reasons that our mindset is such a determinant of our trading success is that our emotions influence our actions. Irrational emotions have little place in our trading; however, removing our emotions from our decision making is easier said than done. It is our emotions that cause us to break the trading rules that have been proven to work over hundreds of years.

Must Suit You

First and foremost for a good trading plan is having a plan that perfectly suits you and is right for you. The best traders have discovered an approach that they are very comfortable with and confident in … however most importantly it suited them. None of them have found any magical solution nor have they found that perfect trading approach that gets it right every time.

Then of course, how can you possibly develop an approach that is right for you if you really don’t know yourself? I believe that the first part of assembling your trading plan should be to conduct a self-assessment.

A good trading plan suits who you are, and many other factors including even the seemingly unimportant things like how much time you have to commit to your trading, your level of computer proficiency, your environment and your tolerance to risk.

The last one is important. Most people have a different tolerance to risk and managing risk is a vital part of trading well consistently. So if we all have a different tolerance to risk, clearly we won’t all have the same level of comfort and confidence in the same trading plan. Therefore, we all have to discover that approach that suits us as an individual person.

Important Factors

Some of the more important factors include your personality traits like patience, confidence, decisiveness, emotional stability, mental agility, and probably most importantly, your attitude.

Another key ingredient to the trading plan is the ease in which you can execute it … over the years, I have had the pleasure of speaking to thousands of traders from many countries and during this time, I have learnt many things. Based on these conversations and my own observations, I am convinced that generally people fail at trading for two main reasons.

First, the majority of actions required for success are counter intuitive and if people are not aware of this, they often consistently make poor trading decisions.

Second, and backing up my point here about ease of execution, when people realize that trading is not as easy as they thought it would be, they tend to over-complicate their trading plans which often causes further problems. Software now available with a myriad of technical indicators probably doesn’t help this situation.

Keep It Simple

Whenever I speak to people, I mention that a trading plan needs to be simple as it makes it easier for us to follow it. Furthermore, simple approaches have proven over time to work. When you think about it, the time tested trading rules like cutting your losses, letting your profits run, follow the trend and keep trade sizes small (just to name a few) are based on very simple concepts.

For example, after you enter a trade, if the price moves down to your pre-defined initial stop loss point, then close the trade and cut the loss. It sounds simple because it is. The others are just as simple. Don’t over-complicate your trading plan – it doesn’t need to be.

Finally, some advice for putting one together … obviously having a trading plan facilitates your decision making by helping reduce the influence of your emotions from the equation and, therefore, will hopefully make you trade more efficiently.

The best way to ensure you get the most from your trading plan is to write everything down. I believe your trading plan should take into account three broad areas (nothing new here), as follows:

• your trading mindset (or psychology)
• your money management (position size, pyramid strategies, and so on)
• your trading method (requirements for trade initiation, filtering processes, daily routine, and so on)

One thing I have experienced over the years is many people who accept that a trading plan is an essential requirement to trading well, yet they don’t know where to start to put one together. I accept that it can be overwhelming at first to tackle this issue.

Three Key Decisions

So let me simplify this for you. There are three key decisions you need to make when trading and if we think in these terms and your trading plan answers each question, then you may have the makings of a simple yet robust trading plan. Despite what I listed previously as the three broad areas in your plan, your trading boils down to the following:

• Under what circumstances will you enter a trade?
• How much money will you commit to the trade?
• Under what circumstances will you close the trade?

Never picture your trading plan as a detailed document containing pages and pages of information because then it will overwhelm you and may deter you from compiling one in the first place. Think in the simple terms above and once you have answered the above questions, then you can add some detail to it as time goes by. A trading plan is simple, easy to execute, and most importantly suits you and your personality.

How Can Stuart Help You?

If you would like to learn more about developing a trading plan that will work for you, register below for your free trading plan template and over 4 hours of audio interviews with Stuart McPhee answering his clients most important trading questions.

I decided that my trading style was going to be longer term, more specifically, swing trading. I looked at many different timers and liked the VectorVest (VV) confirmed calls timeframe. In addition to the timeframe, I liked the VV timer in that it had been extensively tested by many traders and consistently made profit. In effect, I used the VV timer as my baseline. While looking at the VV confirmed calls, I noticed that I could make a lot more money if I could get the signal sooner, even 1 day early would make a big difference.  Then I looked at the many indicators and tried to come up with a simple and repeatable way to get a signal sooner or the same day as VV without a lot of additional whipsaw. Take a look at the correlation between my Long Term (LT) timer and VV confirmed calls.

If you notice, I have not mentioned strategies yet. At this point, I am strictly trying to get more profit out of the market as a whole. Again, I was trying to keep it as simple as possible.

Once I had a LT timer, I looked for other ways to make more profit. I then started developing my bottom feeder timer, to cut the losses when a LT down was ending and a LT Up was starting. Again, I looked at many indicators to come up with a simple and repeatable way to get a signal to take more profit out of the “market”.

At this point I still have not looked at any strategies for individual stocks. I am only looking at how much market share I am getting. I define “market” as the S&P. I buy and sell the SPY on my signal dates to see if I am making a profit.

This is how I developed my two timers. About this time I joined a yahoo group and noticed that Lionel had developed a similar “2 timer” methodology.  It gave me confidence I was on the right track, that two people could work independently and come up with the same basic concept.

At this point, it was a simple (but laborious) process to find stock picking strategies that work best with my timers/signals. I looked for strategies that worked consistently over a large timeframe (9 years) and over shorter timeframes. I am not looking for the flash in the pan that makes big money in just one timeframe. I am trying to put the odds in my favor.

One of the biggest mistakes commonly made by stock traders is closing positions at the wrong time or in the wrong way. This presentation describes exits in general, as well as details of more advanced stop techniques used by professional stock traders. Closing positions properly is much more important to success in stock trading than opening positions. In future posts I will go into more details on how I close directional positions. For now, I recommend taking a look at Jim’s presentation.

Please leave comments, questions and criticisms as comments here. Jim and I will respond. Jim also hopes your input will help to improve his exit approach.

If any of you are part of a trading community and might want to use a private message board, let me know and perhaps I can host it for you. I would want someone in your group to moderate it.