Trader’s Guide 2.8- The Trade Plan
Trade plans are a crucial aspect of any investing or trading strategy. It involves identifying and assessing the potential risks involved in a trade or investment, and developing a plan to minimize those risks. Without a proper risk management plan in place, an investor or trader may be left vulnerable to significant losses.
One story that illustrates the importance of risk management in investing and trading is that of a wealthy businessman who thought he had it all figured out. Let's call him Mr. Smith. Mr. Smith had made a fortune through a combination of savvy investments and calculated risks. He had always believed that he had a sixth sense when it came to the stock market and was confident in his ability to pick winning investments.
However, Mr. Smith's luck eventually ran out. He became overconfident and started taking on more and more risky investments, convinced that he couldn't lose. But as the saying goes, pride comes before the fall. One of Mr. Smith's riskiest investments turned sour, and he lost a significant portion of his wealth as a result.
If Mr. Smith had implemented a proper risk management plan, he may have been able to mitigate the impact of this loss. By diversifying his portfolio and setting clear risk tolerance guidelines, he could have avoided putting all of his eggs in one basket and better protected himself against potential setbacks.
The importance of sticking to a risk management plan is emphasized by famous traders such as Paul Tudor Jones, who said, "Risk management is the most important thing in trading. It's the only free lunch you get in this business." Another famous trader, George Soros, also emphasized the importance of risk management, stating that "I am a risk taker. But that doesn't mean I am unprepared to deal with the consequences."
So, how can investors and traders develop a systematic trade plan that includes risk management? One useful approach is to create a trade plan for each individual trade. This trade plan should include a risk management component that helps to minimize the potential risks of the trade.
For example, let's say an investor is considering a trade in XYZ stock. Before entering the trade, the investor might create a trade plan that includes the following elements:
Setting a stop-loss order: The investor can set a stop-loss order based on a trend line break. If the stock price falls below a certain level, the stop-loss order will automatically sell the stock and limit the potential loss. This can help to protect against significant market dips and minimize potential losses.
Determining the appropriate position size: The investor should consider their risk tolerance and financial situation when determining the appropriate position size for the trade. If the investor is willing to take on more risk, they may choose to allocate a larger portion of their portfolio to the trade. On the other hand, if the investor has a lower risk tolerance, they may choose to allocate a smaller portion of their portfolio to the trade.
Researching the company and market conditions: The investor should thoroughly research the company and market conditions before entering the trade. This may include evaluating the company's financial statements, analyzing market trends, and keeping track of news and events that could impact the stock price. By staying informed, the investor can make more informed decisions about their trade.
Setting a profit target: The investor should set a profit target for the trade, which will help to guide their decision-making and allow them to capitalize on potential gains. The profit target should be based on the investor's risk tolerance and the potential return on investment.
By creating a trade plan that includes a risk management component, investors and traders can better manage their risks and make more informed decisions about their trades.
There are many examples of how sticking to a trade plan can help make a trade profitable or minimize a loss. One example of a trade that was made profitable due to holding on to it is the trade of Peter Lynch, a famous mutual fund manager, in the stock of Hanes Corporation. Lynch purchased the stock in the 1980s, and despite facing setbacks and market dips, he held on to the stock for several years. Eventually, the stock price rose significantly, resulting in a profitable trade for Lynch.
Another example of a trade that was minimized due to a stop-out is the trade of Jim Cramer, a financial commentator and former hedge fund manager. Cramer was once in a trade that was not performing as expected, and he had set a stop-loss order at a certain level to minimize potential losses. When the stock price fell to that level, the stop-loss order was triggered, and Cramer sold the stock, resulting in a smaller loss than he may have faced if he had held on to the stock.
It's important to note that even if a trade feels right at the time or even works out, not sticking to a trade plan can inevitably lead to losing in the long run. This is because without a proper risk management plan in place, an investor or trader may be taking on more risk than they can handle. By sticking to a trade plan and adhering to risk management guidelines, investors and traders can better protect themselves against potential setbacks and achieve consistent returns over time.
A metaphor that can be used to understand the importance of risk management in investing and trading is that of a high-wire act. Just as a tightrope walker needs to carefully balance and plan their steps to successfully navigate across the wire, investors and traders need to carefully balance their risks and rewards to achieve their financial goals. Without a risk management plan in place, they may be left vulnerable to missteps and setbacks.
Risk management is a crucial aspect of successful investing and trading. By developing a systematic trade plan that includes a risk management component, investors and traders can minimize the potential risks of each trade and achieve consistent returns over time. This may involve techniques such as setting a stop-loss order based on trend line breaks, determining the appropriate position size, researching the company and market conditions, and setting a profit target. By regularly reviewing and updating their trade plans, investors and traders can ensure that they are effectively managing their risks and positioning themselves for success. It's important to remember the importance of sticking to a trade plan, even if it feels right at the time or works out in the short term, as not doing so can inevitably lead to losses in the long run. By adhering to risk management guidelines and following a systematic approach, investors and traders can better protect themselves against potential setbacks and achieve consistent returns over time.
