Developing a Trading Plan

March 31, 2009 07:00 PM

Rick has been involved in various aspects of the futures and options markets, including positions as an economist and derivatives market analyst at the Bank of Canada and Finex. In 1996, he founded World Link Futures Inc. to serve the beginning futures trader.

Many who trade futures successfully rely on a trading plan. Just like how a business plan outlines the establishment and development of a proposed business in detail, a trading plan outlines, in detail, a structure for trading. There are two major components of a trading plan: A method of price prediction, which signals if and when to buy or sell a particular futures contract, and a risk management program, which dictates the amount of money to risk on a trade and specifies when to cut losses.

Trading plans are fluid in the sense that they are being tested constantly and amended to improve overall performance and profitability. Strict observance of the rules of the trading plan is the hallmark of a successful futures trader. Beginners should consider testing their trading plan in a paper trading account prior to risking actual money. (See "The Wisdom of Paper Trading.")

Price Prediction
Profit on a futures trade is earned if you buy low and sell high, or sell high and buy back low. While simple in concept, this requires you, the trader, to have some idea of where prices will be several weeks or months from now. That is, it requires a price prediction methodology. Most traders tend to rely on some variation of fundamental or technical analysis to predict prices. Many also spend considerable time and energy attempting to identify new measurements or signals that provide the edge in predicting prices. Stories abound of traders who claim to have discovered proof-positive techniques for predicting prices and then offer to sell the information to you for a price. Be careful and skeptical of such grand claims.

Traders tend to begin with a price prediction technique or model with which they are most comfortable. After use in actual trading decisions, resulting profits and losses provide valuable feedback on the effectiveness of the technique. This feedback, in turn, is used to refine and improve the model. It is important that after every adjustment to the prediction model you accumulate feedback to ascertain the desirability and effectiveness of the change. Only those changes that improve prediction performance of the model should be made permanent. With this process, you eventually may develop a trading model that generates reliable buy and sell signals. Of course, it also is possible that you may determine that the model is unsatisfactory and a new one should be developed. Finally, keep in mind that there is no guarantee that a model that has performed well in the past will continue to be an effective predictor in the future.

Risk Management
The other major component of a trading plan is risk management. This means establishing thresholds to limit loss on any individual futures position and establishing objectives at which profits on individual futures positions will be taken.

The relative size of losses and gains must be such that, over time, gains exceed losses, so that trading is profitable. This, in turn, depends upon the frequency of loss relative to the frequency of gain. For example, assume that a trader using a certain predicting model is right half of the time, and wrong half of the time. However, when wrong, loss is limited to $500 per trade and when right, profits are allowed to accumulate to $1,000 before the trade is offset or closed. Over time and after many trades, this trading program should be profitable, all else constant.

The example above illustrates a simple risk management rule that you will find in almost all futures trading textbooks: Cut losses and let profits run. In other words, if you close positions that begin to lose money and leave open those that are profitable, you will make money in the end. Successful traders confirm this basic truth. Many even admit that they are wrong more often than right in predicting prices, but when they are right, they make a considerable sum of money that exceeds all losses combined. The result: Trading is profitable overall.

Determining the exact amount of loss that should be tolerated before a position is closed depends upon several factors. The amount risked on any position depends upon the amount of margin in your account. Often, it is suggested that no more than 10% of total margin should be risked on any one position. The amount risked also depends upon the volatility of the product being traded: The greater the volatility, the more risk because you want to be able to carry the position through transitory price movements and to not have to exit a position prematurely. The size of your average trading gain also determines to what level you should limit loss. As mentioned earlier, you need to limit loss to a level such that, over time, losses do not exceed gains in the aggregate.

Just as with developing a prediction model, the parameters of a risk management system should be evaluated over time and amended when appropriate. Actual trading performance provides the trader with valuable feedback to perform such an analysis.

Trading plans are individualistic, based on such factors as personal experience, education, risk capital and tolerance toward risk. For this reason, trading plans may differ greatly from one trader to another. A trading plan may work better with some people than others. Consequently, you must develop a trading plan that works best for you. Among other things, this requires patience, rigid adherence to the rules that you establish, meticulous record keeping of trading performance (which provides valuable feedback) and an open mind to try new methods. There are no guarantees of profitability in the world of futures investing, but the discipline of a trading plan goes a long way toward making you a successful futures trader.

About the Author
Rick Thachuk is president of WLF Futures, Options & Forex Education Network. Contact him via