3.
Chapter 3
Develop a plan that works! All beginners know that they need a plan, however, Master Traders won’t develop just any plan but, instead, ones that are customized to fit their personalities.
3.1 The function of a business and trading plan
As soon as you’re aware of what you want and you know what your goals are, you have to develop a plan of how you can achieve these goals. Every journey begins somewhere and, so, every plan has a starting point. The starting point is the status quo, the point where you are now. What resources are available to you and what do you need in order to achieve your goal?
In order to find the appropriate measures for achieving your goal, it’s crucial that you understand what your status quo is like. In fact, depending on the starting point, you’ll have to take different measures to achieve your goal.
The more detailed your plan, the more it will help you in your trading. The really exciting thing when developing a plan is identifying issues that you’ve never thought about. This is because, in the course of developing a plan, the many pitfalls on the road to success become apparent to traders and can, thus, be removed.
So, for example, a friend of mine, who trades stocks and derivatives - although he was trading successfully - discovered that he was running the risk of actually losing money, or even going bankrupt on account of the tax regulations. This trader was trading stocks and futures, namely, and in Germany, they’re treated differently for tax purposes. Capital gains from stocks are taxable at only half the appropriate tax rate, while capital gains from futures are taxable at the full rate.
As long as he continues to make profits with stocks and futures he doesn’t have a problem. However, as soon as he makes profits in the futures area and losses in the stocks area, he runs the risk of driving his account to ruin because of these tax regulations. For example, if he earns money when trading futures (let’s say Euros 1,000,000) and he makes losses when trading stocks (for example, Euros 800,000), at the end the year, he would have a pre-tax profit of Euros 200,000. However, as he can only deduct 50 percent of the capital losses from stock trading (i.e. Euros 400,000) from his entire capital gain from futures, he has to pay tax at a rate of 50 percent on Euros 600,000. Thus, his tax liability is Euros 300,000. However, as his net gain was only Euros 200,000, after tax he even has a loss of Euros 100,000. (Translator’s note: The above example makes reference to the tax treatment of capital gains prior to 2009 when, in Germany, the tax rules changed.)
You can be certain that there are not only tax pitfalls but also emotional, social, financial as well as many other ones. The aim of a plan is to explain and examine as many aspects as possible that will both help you and hinder you.
When developing a plan, inevitably, gaps will appear that have to be filled and issues will emerge that you hadn’t thought about before but that still have to be clarified.
For instance, many traders lack an answer to the question of what they should do if they’ve been stopped out and then the market moves in “their” direction after all. What are your re-entry rules? Or, what would you do if you suddenly came under a great deal of emotional pressure, for example, if you were told that you have a disease, if your parents were to have an accident, or if your wife wanted to divorce you?
I had a client who, as a trader, lost his entire capital in six hours because, one morning, after his positions had been opened he found out that his brother had been in a car accident. Naturally, he drove straight to the hospital but he forgot about his positions and his open limits. The market moved against him the whole day and, of course, the trader didn’t waste any time at all on the market - nor could you blame him for that. However, as he didn’t have any rules for such an emergency, he lost all of his capital.
When you start trading you’re sure and certain that you’ll make gains. But what happens if you don’t? At which point should you stop trading: at a loss of 20 percent or of 50 percent, of 80 percent, or never? When will you make changes to your strategy? I know many traders who have been unsuccessful for years because they keep on changing their strategy at irregular intervals. Brimming with optimism, they start with a new trading system and during the first drawdown phase they begin to make changes to the system.
These traders have never been aware of the extent of a typical drawdown of this system and the normal duration of its loss-making phases. When you develop a trading plan you should think about all these issues. You have to know what sort of drawdown your trading system usually leads to and what you would do if the normal limits were to be exceeded. Imagine that you’re making a living from your trading, but you know that loss periods of three to four months are quite normal for your trading style. How will you ensure that, during this time, you’ll have enough cash available for your living expenses? How will you be able to deal emotionally with such lean times?
From these questions you see that, above all, a plan will help you to consider many aspects before you start trading. This will be of valuable help.
The plan that you develop can be compared with a business plan for a company. Every successful company has a business plan that describes in detail which goals are supposed to be achieved and with what funds and resources.
With a plan you pursue several goals.
For a start, a plan serves as an operational support. It shows you what steps have to be undertaken, at any given time, and in what sequence in order for your business to develop successfully. It sounds so simplistic that you might think that developing a plan is a sheer waste of time. After all, you know what has to be done. So what’s the point of writing down the things that we perform day in, day out?
In particular, the plan should help you to keep track of things. Trading is a job that demands all the resources within us. Frequently, because of our trading activity we’re so close to the market that we lose sight of the big picture. In day-to-day business, small losses, which have been taken into account in the plan, vex us and they cause emotional stress that is greater than necessary. We can get carried away and possibly do something stupid. Yet, even in difficult situations, here, it’s absolutely essential to keep track of things and to make the right decisions for your own business.
Excellent traders have the ability to take a step back, to see things from the right perspective, to know, at all times, where they are in their plan and what the next step is now going to be. This is the only way that they can achieve an optimal emotional state and they are then in the right mood for tackling the task at hand. There’ll be more on this in Chapter 5.
Consider carefully the following: When you draft a plan make sure that you have enough time as well as peace and quiet and ensure that you are in an optimal emotional state in order to be able to weigh up alternatives and to define the best steps for achieving your goal. A plan helps you to identify optimal decision alternatives for every situation.
In the hurly-burly of day-to-day business you don’t have the necessary peace and quiet and you can quickly lose sight of what’s important. Then, if you don’t have a plan that provides suggestions of how you should proceed, you run the risk of being pulled in a particular direction into the maelstrom of events and that leads you away from your goal instead of bringing you closer to it.
In your plan, for example, you’ll set daily limits for losses, as well as measures that have to be taken once these limits have been reached. I’ve come across traders who lost their entire account in one day because they’d never decided on what action they should take in the event of a loss of 5 percent, 10 percent or 50 percent. However, for example, I only trade with one contract if I’ve lost a particular amount in one day and if I hit another limit I completely reorganize my trading.
Moreover, with a plan you’ll be able to make faster decisions.
Imagine that you’re in a building, which is totally unfamiliar to you and a fire breaks out. What do you do? What’s the fastest way for you to exit the building? The way that you got into the building is already blocked. If you’d been able to memorize the layout of the building beforehand, you’d know where the appropriate escape route was because everything that your brain has already figured out, in advance, it can retrieve in a matter of seconds.
Therefore, people with plans can make faster decisions. Every second can mean thousands of Euros for you. Traders who were long on September 11th had to act quickly. Every second that they hesitated cost them dozens of DAX points and, thus money. Traders who had a plan knew what had to be done. Working with only a stop-loss was not sufficient in this case. Without disaster plan you would have been completely disorientated on September 11th. Traders who were long in S&P were not necessarily stopped out but, instead, still had another five minutes to close their positions before the market closed for four days and then opened 100 points down.
A simple plan that provides that, in the case of extraordinary events, all risky positions have to be exited immediately would have spared many traders from enormous...
