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  • The Importance of a Trading Plan Introduction

    It doesn’t matter whether you’re spread betting or trading CFDs; whether you concentrate on FX, individual equities, commodities, stock indices or trade a bit of everything. When you trade on margin and employ leverage then it’s vitally important to spend time and effort incorporating money and risk management into your trading plan.

    Everyone will have their own attitude and tolerance towards risk. But the bottom line is that leveraged trading exposes you to the possibility of losing more than your original deposit. This can be offset to a great extent by careful money and risk management, which includes using stops to protect you against unexpected market movements. Before opening a new position it is vital to create a trading plan. Without one, it is impossible to take the emotion out of trading or maintain the discipline necessary to achieve consistency which is a vital component in trading successfully. By identifying the price levels for opening a trade as well as where to place your stop-loss and where to take profits, it’s more likely that you will be able to think clearly when real money is at risk. But first it’s vital to establish your ‘risk capital’.

    Risk capital is essentially money you can afford to lose. Obviously no one likes losing money and we speculate to make a profit. But this can’t be guaranteed and there will be times when trades go wrong, no matter how good one’s planning and analysis has been. So, assuming a worst case scenario, your risk capital is money that, if lost, won’t affect you materially.

    How to create a trading plan:

    Money management is about dividing your risk capital up into smaller tranches. In essence it’s a way of ensuring that you don’t put all your funds at risk on a small number of trades.

    Conservative money management means never risking more than 1% of your risk capital on one trade. This would give you the capacity to make 100 consecutive losing trades before you have exhausted all your risk capital – something which would be highly unfortunate.

    However, unless you have an extremely large pot of risk capital, this 1% rule wouldn’t give you much scope for prices moving against you and possibly hitting your stop loss.

    For this reason many traders will choose to allocate as much as 5% of their risk capital on a single trade. This should give the trade more room to ‘breathe’ given the same risk capital. However, the 5% rule only gives you the capacity for 20 consecutive losing trades.

    Importance of risk management:

    It’s impossible to take the risk out of trading as that’s what it’s all about. So the most important thing for anyone to do is to reduce this risk to an acceptable level. This will vary from trader to trader. But do everything you can to make sure you’re comfortable with the risk you’re running on a particular trade BEFORE you open a position. This will help you to preserve your risk capital and assist in maintaining a healthy psychological outlook when you trade.

    How to manage risk:

    The final element of a trading plan is risk management. This involves carrying out technical analysis to identify where to enter and exit a trade. This process links up with money management. The amount of money you are prepared to risk on any one trade is the difference between the opening level and the stop loss multiplied by the trade size. This should be no more than the size of an individual tranche established when you divided up your risk capital into equal portions. Technical analysis helps you to identify whether a market is trending or ranging while highlighting areas of support and resistance. In this way it is possible to choose the optimum opening level for a trade together with a profit target and the all-important stop loss. If this is done carefully then it will increase the probability of the trade being profitable.

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