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ABCs of Developing a Trading Plan by Kathy Lien

When it comes to trading currencies, there’s nothing more important than having a Trading Plan.  A Trading Plan is like a business plan that allows you to take calculated and well thought out risks. By having a trading plan, it reduces the impact influence of emotions and allows traders to refer back to tactics established when they are more rational and less emotional. Here’s my personal 5 step Trading Plan, one that I encourage new traders to follow:

Step 1:  The A-B-C of Developing a Trading Plan

The first step is to create a trading strategy and to define a trading plan.  The biggest mistake that new traders make is to trade on gut, a feeling or someone else’s trading tip.  Even if you make money on the trade, this is a trading sin because you can’t possibly replicate the profits again unless your friend gives you another tip.  A successful trader is not just a one hit wonder.  You need to develop a trading strategy that YOU understand inside and out.  Warren Buffet made his billions in equities by trading only what makes sense to him; foreign exchange should be approached in the same way.  

Whenever I give a presentation or lecture, I am always asked what is the best indicator or time frame to trade on.  My answer is that there isn’t one.  Both short term and long term traders can be profitable just as technical or fundamental traders can be as well. The key is to find a trading style that fits your personality and not to try to mold your personality to fit a specific trading style.  If you are reading this, there is a 99 percent chance that that you are an adult and as an adult we all have fully developed personalities that are difficult to change.  By now you should know whether you are someone who is impatient, needs instant gratification, sits glued to the trading screen and becomes agitated by every 10 pip fluctuation OR someone who wants to approach trading from a more relaxed, patient and longer term perspective. 

If you need instant gratification, trading on daily charts may not be suitable for you.   On the other hand, if you are a more relaxed and patient person, you may not be able to stomach the volatility of 5 or 15 minute charts.  Money can and has been made trading any time frame, just make sure you find one that is right for you. 

When developing a trading strategy, the first 3 questions that you need to ask yourself are the following:

Q1:  Is your strategy based upon fundamental analysis, technical analysis or both?
Q2:  Does your strategy rely on trading ranges or a trend?
Q3:  What time frame does your strategy trade?  Does it use 15 minute, hourly or daily charts?

By answering these questions, you will have developed an initial trading style.  This is the easy part.  After that, it is time to get further in touch with your trading strategy.  Certain strategies work better on specific currency pairs.  For example, EUR/GBP is a currency pair that typically trades in a range, therefore it is more suitable for a strategy that involves buying low and selling high instead of buying high and selling higher.   So much sure you answer these questions as well:

Q4:  What currency pairs will you trade?  Just the majors or just the crosses
Q5:  Will you hold positions after 5pm or over the weekend?
Q6:  Does interest rates matter to you?  Will you only go long currency pairs that pay you interest?

Step 2:  Money Management Rules

The next step is to consider risk management because knowing when to enter a trade is just as important as knowing when to exit it.  Trading is just like surgery where you want your doctor to get both the first incision and final stitching right – only this time, you are the doctor.  One popular tactic is averaging up and down but the difference between those who do it well and those who do it poorly is intent.  If your initial strategy calls for averaging in to get a better price, then that’s fine, but if you are averaging in to bail yourself out of a losing position, that’s probably the worse thing that you can do.  Know exactly what you plan on doing before you place the trade and how many times you are willing to average in.  On exits, think about trailing your stops.

The currency market is a very trending meaning that one way directional moves can last for thousands of pips with little retracement.  Because of the nature of the market most fund managers choose to be trend followers.  In order to capture as much of the trend as possible, while at the same time limiting risk it is very important to use a trailing stop.  I like to trade in multiples of two lots.  My first target is usually a conservative achievable level while my second is usually 3 times my amount risked.  When my first target is hit, I will move my stop to breakeven on the second half of my position and keep trailing my stop it upwards with the goal of never letting a winner turn into a loser.

Step 3:  TEST, TEST, TEST

Once you have created your trading strategy, it is time to TEST, TEST, TEST.   Everything needs to be back tested and forward tested.  The best way to backtest is to use a coding program like Easy Language.  However not everyone including yours truly knows how to do that, therefore a poor man’s way of backtesting would be to review your charts.  Depending on your time frame, look for at least 20 to 50 samples of your strategy or setup triggering.  Then look at a more granular time frame to make sure that execution was possible.  This sounds hard but it really isn’t.  For the most part, it takes no longer than an hour of work depending upon how complicated your trading strategy is.  You test a car before buying or leasing it.  There is no reason why you shouldn’t test your trading strategies before applying it.   Only after you have done your visual backtest should you trade your strategy on a demo account because what may be theoretically possible may not be physically feasible.  You will often find this the case if you try to trade breakouts or news.  If you can make money trading the strategy on a demo account, then you can move onto a live account, but if you can’t make money in a demo, you probably won’t make money trading live, which means that it is time to go back to the drawing board. 

Step 4:   Know your Strategy like Your Best Friend

On a mechanical level, there are two types of strategies.  One that has a high number of profitable trades but a low level of profit per trade.  With this type of strategy, the amount of money that you may lose or gain on any one trade is about the same, but because you are profitable much more often than not, the overall expectancy is still positive. The second type of strategy is one where you have a low number of profitable trades, but a very high profit factor, which means that for every one trade that is profitable, the profits far outweigh the losses, leaving the expectancy of the strategy still positive.  This is characteristic of many breakout or trend following strategies and knowing what type of strategy you have lets you understand when it makes money AND when it loses it. 

That way you can gage whether your losses are within your expectations or whether your strategy has gone completely haywire.  In that case, you don’t need a rocket scientist to tell you that its time to pull the plug on the strategy and go back to Step 1. 

Step 5:  Improvement

Finally, the last step is one that you will need to do over and over again, which is to look for improvements. Every week, my trading partner and I will hold a self-reflection session.  We will talk about each of the trades that we have taken over the past week.  We go over what went wrong, the mistakes that we have made, whether there is a pattern to the losing trades and what we could have done better. 

A great example of much needed self-reflection was a conversation I had with a trader at an expo in Malaysia.  He told me that he has a trading strategy that is very profitable but he has one problem which is that whenever news is released, his strategy fails – and believe it or not, he asked me what he should do.  I told him its simple, if you make money in normal trading conditions and lose money when news is released, then stop trading around new releases. Small adjustments like these can be the difference between success and failure and generally take a clear head to identify. 

Kathy Lien
Kathy Lien

KATHY LIEN is Managing Director and Founding Partner of BKForex Trading Signals and BK Asset Management. Having graduated New York University 4 years early, Kathy started working on Wall St at the age of 18.

Her career started at JPMorgan Chase where she worked on the interbank FX trading desk making markets in foreign exchange and later in the cross markets proprietary trading group where she traded FX spot, options, interest rate derivatives, bonds, equities, and futures. In 2003, Kathy joined FXCM and started DailyFX.com, a leading online foreign exchange research portal. As Chief Strategist, she managed a team of analysts dedicated to providing research and commentary on the foreign exchange market. In 2008, Kathy joined Global Futures & Forex Ltd as Director of Currency Research and in 2012, she decided to branch out on her own with Boris Schlossberg to start BK Asset Management.

As an expert on G20 currencies, Kathy is often quoted in financial newspapers worldwide and appears regularly on CNBC. Kathy is an internationally published author of Day Trading & Swing Trading the Currency Market, The Little Book of Currency Trading and Millionaire Traders: How Everyday People Beat Wall Street at its Own Game.