The starting point of a trading plan

Many trading plans focus on the entry signals.  I believe, the starting point of a trading plan is a risk management plan that stops you out of your position.  The stop should be at the place where your initial entry signal is invalidated.  Let me explain.

Many traders use technical analysis using chart patterns as part of their trading plan.  They might use breakout levels of, say, a “head & shoulder” pattern neckline to enter a trade.  The trade’s stop shouldn’t be the neckline, but at the very least a closing price for a time period that is back inside the pattern, proving that its breakout is invalid (maybe just a “trap”) for the given timeframe.

Another example.  A fundamental trader might look at a specific metric or a ratio to trade a security.   If the number is the entry signal, one should ask what has to happen to the price to prove that the signal is invalid.

Once the invalidating price level has been established, then work out the math backwards from the percentage of equity you are willing to risk and then see how many contracts (or shares) can be traded within that level.

A more practical example:

Take Gold futures, what I’m trading right now.

Long (bought).  Entry price at 1,336.90.   It broke a resistance level that would be invalidated, not only if it closed below 1,336.90, but also if it went below 1,330intraday.  I put my stop at 1,329.90.  My risk per contract is:

(1,336.90 – 1,329.90) x $100

where $100 is the multiplier for Gold futures.

The multiplier is a number that is unique to each future’s contract and has to be known by the trader.  It reflects the number of units in a contract. In the case of Gold, its contract is for 100 oz.  Since the price stated is per ounce, then the contract is worth 100 times the price.  The price difference between entry and exit of $7 equates to $700 of risk for the trader.    For corn, for example, the contract is worth 5,000 bushels.  The price stated is per bushel. Therefore, one penny change in price is equal to $50 change for the future’s contract value (5,000 x ($0.01) = $50).

Once I have established the risk per contract, then I decide how many contracts I want to trade.  Since this is a small account, $700 is plenty of risk.  One contract will do, thank you very much.  Let’s play.  If my account was over $100,000, I might trade 2 or 3 contracts, depending on what percentage of my equity I’m willing to risk losing.

In sum, the starting point of a winning trading plan is assuming that each trade will be a loser.  The exit should reflect the rationale of the entry and its timeframe.  The amount of contracts (or units, or shares) should be a function of the difference between entry and exit and the percentage of your account you are willing to lose (shouldn’t be more than 1-2% per trade).  

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