Trading | October 19, 2021

5 Elements of a Smart Trade Plan

When you buy a stock, it’s likely because you sense an opportunity. But how often do you establish the parameters for making profits? How will you know when to get in or out of a trade?

These are questions you should ask yourself before entering a trade. Creating a step-by-step trade plan—a blueprint for how to build positions and reshape them as conditions warrant—can help you develop a disciplined approach to your trading.

Before beginning any trade plan, perform a quick self-evaluation:

  • Are you buying a stock based on fundamental (company performance) or technical (market trends and averages) reasons?
  • Which investing style do you prefer (e.g., growth or value, trend, or countertrend)?
  • Determine your view of market sentiment: Is momentum generally tilted up or down?

Once you have your bearings, and you’ve identified a list of stocks or exchange-traded funds (ETFs) based on your research analysis method—fundamental, technical, or both—you’re ready to embark on the actual planning. Here are the five key elements to include in a smart trade plan: 

Element 1: Your time horizon

How long do you plan to hold a stock? What purpose will it serve in your portfolio?

Your time frame depends on your trading strategy. Generally, traders fit into one of three categories:

  • Single-session traders are very active and look to gain from small price variations over very short time periods (minutes or hours) throughout the trading day.
  • Swing traders target trades that can be completed in a few days to a few weeks.
  • Position traders seek larger gains and recognize that it often takes longer than a few weeks to achieve them.
     

Element 2: Your entry strategy

Once you have a list of stocks and ETFs you’re considering, look for entry signals—for instance, divergences from trend lines and support levels—to help you place your trades. The signals you employ and the orders you use to make good on them hinge on your trading style and preferences.

Let’s look at an example of a potential breakout stock, one that is moving outside a support or resistance level with increasing volume.

Is this stock poised for a breakout?

XYZ has just broken through a resistance level, but that doesn’t mean it’ll keep rising. A trader might consider buying XYZ at $123 and placing a stop order at $120.

A screenshot from StreetSmart Edge® shows entry into the market at the resistance level of $123 with a stop order price of $120 and a support level just under $115 for stock XYZ.

Source: StreetSmart Edge®

In the chart above, XYZ has just broken through a resistance level—the price where selling might be strong enough to prevent further price increases. Typically with breakouts, consider limiting trades to stocks that have broken through resistance areas and where trading volume is above average, not just for the trading day but for the specific time of day. 

In this example, a trader might consider buying XYZ at $123 (the “entry”) and placing a stop order at $120. If the stock drops below $120, the stop order would become a market order to sell the stock. However, there’s no guarantee that execution of a stop order will be at or near the stop price, so risk is not entirely eliminated.

Another potential scenario is a stock that is experiencing a pullback. In the second chart, the stock has fallen from a recent peak. In the event of a pullback, look for some area of support—a price level at which demand might be strong enough to prevent further declines—such as pulling back to a moving average or an old low. Some traders even wait until the stock moves above the high of the previous day—a sign that the pullback might be over. In this example, XYZ is still trading above the support level of $30.50.

Has this stock pulled back?

A screenshot from StreetSmart Edge® shows entry into the market at $31 with a resistance level of $$31.50 and a stop order price just under a support level of $30.50 for stock XYZ.

Source: StreetSmart Edge®

Examples are hypothetical and for illustrative purposes only.
 

Element 3: Your exit plan

When it comes to an exit strategy, plan for two types of trades: those that go in your favor and those that don’t. You might be tempted to let favorable trades run, but don’t ignore opportunities to take some profits. For example, when a trade is going your way, you could consider selling part of your position at your initial target price to make gains, while letting a portion run. 

To prepare for when a trade moves against you, you can set stop orders underneath a stock’s support area so you can choose to sell if it breaks below that range.

Element 4: Your position size

Trading is risky. A good trade plan establishes ground rules for how much you’re willing to risk on any single trade. Say, for example, you don’t want to risk losing more than 2%–3% of your account on a single trade. You could consider exercising portion control, or sizing positions, to fit your budget. 

Here’s a scenario: A trader with $150,000 in total capital is interested in a stock trading at $67 a share. This trader’s maximum budget per trade is $15,000, or 10% of the account. That means the maximum number of shares the trader can buy is 223 ($15,000 ÷ $67). 

Let’s say the trader’s risk per trade is 2%, meaning the trader wants to lose no more than $3,000 of their $150,000 capital. Dividing the maximum risk amount by 223 shares reveals the stock can drop $13.45 per share ($3,000 ÷ 223), establishing a stop price of $53.55 ($67 – $13.45) to limit losses. The trader may never have to use this stop order, but at least it’s in place if the trade moves the wrong way.

Element 5: Your trade performance

Are you making or losing money with your trades? And importantly, do you understand why?

First, examine your trading history by calculating your theoretical “trade expectancy”—your average gain (or loss) per trade. To do this, figure out the percentage of your trades that have been profitable versus unprofitable. This is known as your win/loss ratio. Next, compute your average gain for profitable trades and average loss for unprofitable trades. Then, subtract your average loss from your average gain to determine your trade expectancy.

How profitable are your trades?  

40% of your trades are profitable with an average gain of $500—an average of $200 per trade. Your 60% of unprofitable trades averages a loss of $250—an average of $150 per trade. Subtracting $150 from $200 gives you a trade expectancy of $50 per trade.

A positive trade expectancy indicates that, overall, your trading was profitable. If your trade expectancy is negative, it’s probably time to review your exit criteria for trades.

The final step is to look at your individual trades and try to identify trends. Technical traders can review moving averages, for example, and see whether some were more profitable than others when used for setting stop orders (e.g., 20-day versus 50-day).

Sticking to it

Even with a solid trade plan, emotions can knock you off course. This is particularly true when a trade goes your way. Being on the winning side of a single trade is easy, but what matters is cultivating a continuum of winning trades to build your confidence as a trader. Understanding what goes into a smart trade plan is the first step to  prepare you for your next trade.

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