Planning Your Trading: Part 1
We start this coaching blog with the topic of trade planning. We often hear that it is important to plan one’s trading: “Failing to plan is planning to fail”. But what is planning in the trading world and why is it important?
Let’s step back and begin at a wider level of abstraction. Why do we make plans at all? At various times we plan for our retirement, plan a vacation, make plans to meet friends, etc. In each of these instances, we have a goal—a desired outcome—in mind. Our plans are road maps that ensure we reach those goals. If we left retirement to our whim of the moment decisions to save some money, there would be no guarantee that we would have enough for a comfortable old age. Similarly, we can’t just count on friends being available to get together: setting a time and place in advance puts everyone on the same page. Plans are our ways of looking into the future and ensuring that we take steps now to achieve our desired ends.
When you begin trading, you are starting a business. Planning your trading is business planning. Just as an entrepreneur entering the restaurant business would research location, menu composition, pricing, and consumer behavior as part of developing a business plan, you need to research and plan your trading business. Planning your trading provides you with the road map that will help guide your decision-making.
Plans also have a psychological value: they turn intentions into commitments. It’s one thing to say to a friend, “Let’s get together some time.” It’s quite another thing to make a plan to get together for dinner at 7 PM tonight. Plans are ways of securing our priorities: committing to what is most important to us. A business plan not only maps out what the entrepreneur should do; it eliminates many less promising courses of action. Your trading plan will commit you to those markets and trading approaches that represent opportunity, filtering out extraneous opportunity.
In the heat of market activity, it is easy to become caught up in risk and reward and make decisions hastily and reactively. The presence of a plan—for individual trades as well as your overall trading business—grounds you. It is what makes market involvement more business-like than casino-like.
Think of your trading business as a manufacturing plant. Instead of manufacturing cars or cans of soda, however, you are manufacturing trades. Like any manufacturer, you have certain raw materials that you acquire, a process that transforms the raw materials into a product, and a method for turning the product into profits. Breaking down manufacturing into these three components helps us identify three crucial areas of business planning:
1. The acquisition of raw materials: Your raw materials as a trader consist of information and the ways in which you organize that information. You need to acquire information in a cost-effective manner (where costs are measured in time as well as money) and you need to acquire the right, high-quality information. The raw materials that you acquire will be ones that, properly organized, provide you with some objective advantage in the marketplace. Very often, that means acquiring information that others either don’t have or are not focusing upon. Such information could be fundamental information about a particular company; macroeconomic information about a region of the world; or supply/demand data derived from an analysis of price and volume patterns in financial markets. What opportunities do you see in markets that others are missing? That provides you with your trading “edge” in markets and dictates the raw materials you need to acquire for your business.
2. Transforming raw materials into a product: The heart of manufacturing is a quality-controlled process that turns raw materials, such as steel and glass, into an actual product, such as an automobile. A tight engineering and oversight of the manufacturing process ensures that each product will be of similar, high quality. When Honda or Toyota manufacture a car, for instance, each step of the process is automated so that fit and finish will be as close to perfect as possible. Similarly, traders refer to their “process” as a series of routines that they undertake to translate information into trades that possess a positive expected return. There may be opportunity in a sudden central bank decision to lower interest rates, but which markets will demonstrate the greatest opportunity? Which ways of trading those markets will bring the most favorable ratio of reward to risk? Turning information into high quality trade ideas and trades is the essence of your manufacturing process.
3. Transforming products into profits: Just because you have a good product doesn’t mean you can make money from it. The best automobile will sit unpurchased on the lot if it is not marketed properly and serviced well. Similarly, trades don’t just make money on their own: they have to be assembled into portfolios and managed. How do you size each of your positions? How do you make sure that your trade ideas are not so correlated that you’re really putting all your eggs in one basket rather than diversifying? How do you decide when your trade ideas are wrong and need to be taken off? All of these activities are essential to your business, influencing how well you actually make money from your ideas and trades.
If you are like most beginning traders, you don’t have a clear vision and plan for each of these three elements of manufacturing. Perhaps you have an idea of how to make money, but not a process that will ensure the consistency of your efforts and profits. The process of planning your trading will help you turn your trading intentions into actual, actionable commitments. Planning turns your ideas into a business.
Our next post in this series will start us on the journey of manufacturing profits.