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April 27, 2011

4 Steps You Can Take for More Profitable Trading

Trading Plan
You’ve just put your first live trade on in your broker account.

The market is moving against your position.

You aren’t comfortable as your position starts losing money.

You hope the market will come back in your favor but it keeps moving against you.

Fear starts to grip you and you begin to panic.

You don’t know what to do and the position keeps getting worse.

Finally you can’t stand it and close your position for a big loss.

Soon after you close your position, the market reverses direction.

You would have gained back all that you lost and ended up having a profit.

What went wrong?
You didn’t have a trading plan. You traded with your emotions. The key to being a successful trader is treating it like a business and controlling your losses. How do professional traders avoid trading with emotion? They define three objectives for each trade:

1. Set a profit target
2. Have a maximum loss
3. Define adjustment points and actions
4. Define how you will exit the trade

Let’s look at each one of these.

1. Set a profit target
It is important to get paid to trade. You need a clear idea in your mind when or where you will take profits in your trade. There are many ways to define your profit targets. It could be as a percentage of a spread credit received, or a percentage yield on your required margin. It could be based on movement of the underlying instrument. Whatever method you use, have a clear target. Don’t approximate it. Be specific and take profits earlier rather than later. If you take partial profits, take the lion’s share out quickly to lock in a profitable position.

2. Have a maximum loss
This is very difficult for most traders, yet it is probably the most critical to follow. You can’t have a profitable trading business if your losses exceed your profits. That’s simple mathematics. The biggest problem with large losses is it takes a larger percentage profit to get back to even. Professionals are fanatical about keeping losses small. You should be too.
Once you set a maximum loss, never exceed it. Take steps to reduce your risk as your position nears the maximum loss. You can do this normally by neutralizing part of your delta. A long put or call can help you stay in a position longer and give you a chance for the market to come back to your position. If you do hit maximum loss, exit the trade unless there is a very good reason not to.

One reason could be if volatility spiked against you and you are in a trade with all options in the same expiration month. If you were still in the middle of your expiration profit zone, and only at maximum loss due to volatility, I would typically stay in the trade. With this unusual exception, exit the trade if it hits your maximum loss. Survive to trade again the next month.

3. Define adjustment points and actions
The market will test your positions. Have clearly defined points where you will adjust your position and what you will do at that point. This helps you avoid freezing up with fast moving markets. If you know what to do ahead of time, you will be much less emotional about your trades. Have your adjustment rules and stick with them.

4. Define how you will exit the trade
If you reach your profit target or maximum loss, you will exit your trade. Your trading plan may include taking partial profits. Have this pre-defined of exactly how you will implement this. For example, at +10% profit, take 60% of the trade off and set a trailing stop of 5%.

Another type of exit is a time stop. Trades don’t always go in your favor right away. If it takes too long to start generating a profitable position, consider exiting based on poor price movement. This type of exit is based on how long you intend on staying in the trade. If you have a 30-day butterfly spread, you may set a rule if it is not profitable after 10 days, to exit the trade.

The market keeps changing too much to have a rigid plan
The markets do change, but your trading plans should change too. Keep track of your trades in a trading journal so you can see how you are doing over time. Successful traders keep good records.

Having a trading plan helps you trade without emotion
Setting a profit target, maximum loss and knowing how and when you will adjust a position and when you will exit are essential for all of your trades. If you don’t do these steps you’ll see profits slip away, losses grow too large and your trading account will shrink instead of grow. Treat your trading like a business.

Create your trading plan and start a trade journal
Set a profit target, maximum loss, adjustment where’s and how’s and how you will exit each trade. Document each trade and start tracking your trading performance. You’ll be glad you did.

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Tom Nunamaker

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Carlos Hank Rhon - September 25, 2012 Reply

Great article – Thanks for sharing. Enjoyed reading your views – Might just refer a couple of lady’s from the office to view the article.

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