Stock Trading For Beginners

In part III of stock trading for beginners, we will be learning how to outline a successful trading plan. The trading plan is the life blood of a trader and will generally dictate when and how you will make a trade. Having a well thought and proven trading plan is the most important thing in your trading arsenal and should be your first priority before any capital is risked on any trade.

A trading plan outlines how a trader will find and execute trades, including under what conditions they will buy and sell securities, how large of a position they will take, how they will manage positions while in them, what securities can be traded, and other rules for when to trade and when not to.

No two trading plans will be the same so, your trading plan should be custom tailored to your preferences. Your plan can be as simple or as complex as you like. Just know that there are many ways to skin a cat so stick with what works. Your strategies may not work forever but your plan shouldn't go through too many revisions in a short amount of time.

In my opinion, the most successful traders have well researched tactical or active trading plans. The key word here being "researched." Knowledge is the key to being a successful trader! The tactical trader needs to come up with rules for exactly when they will enter a trade. This could be based on a chart pattern, the price reaching a certain level, a technical indicator signal, a statistical bias, or other factors. Likewise, you trading plan must also state how to exit positions. This includes exiting with a profit, or how and when to get out with a loss. Tactical traders will often utilize limit orders to take profits and stop orders to exit their losses.

Rules or topics to include in the trading plan may include:

Only Risk 1% of Capital Per Trade

That means that the distance between the entry point and stop-loss point, multiplied by the position size, can't be more than 1% of the account balance. This rule governs position size, because position size is the only unknown and needs to be calculated. The trader may opt to risk 2%, 5%, or 1.5%.

Assume a trader has a $50,000 account. That means they can risk $500 per trade (1% of $50,000). They get a trade signal that says to buy at $35 and place a stop loss at $34. The difference between the entry and stop loss is $1. Divide the total amount they can risk by this difference: $500 / $1 = 500 shares. If they buy 500 shares and lose $1, they lose $500 which is their maximum risk. Therefore, if they want to risk 1%, they buy 500 shares.

Leverage or No Leverage

The trading plan should outline whether leverage can be used or not, and how much if it is allowed. Leverage increases both returns and losses.

Correlated or Uncorrelated Assets

Part of the risk management process is determining whether correlated assets are allowed to be traded, and to what degree. For example, an investor must decide if they are allowed to take full positions in two stocks that move very similar. Doing so could result in double-risk if both hit the stop loss, but also double-profits if the targets are reached.

Trading Restrictions

A trading plan may include curbs that stop trading when things aren't going well. For example, a day trader may have a rule to stop trading if they lose three trades in a row, or lose a set amount of money. They stop trading for the day and can resume the next day. Other trading restrictions may include reducing position size by a set degree when things are not going well, and increasing position size by a set amount when things are going well.

The risk management section of the trading plan may include all these rules, customized by the trader. It may also include other rules that help the trader manage their risk according to their objectives and risk tolerance.