Chris Conway on how to build a trading plan: money management, exit & entry strategies

You wouldn’t start a business without a business plan, so why would you start (or continue) trading or investing without an investment plan? In this three-part series, Chris provides a blueprint for building your plan and whilst the focus is on trading, the questions are relevant to anyone engaged in financial markets. 

STEP 7 – Money Management

Risk management is about defence and having a strategy in place to cut your losses efficiently, whereas Money Management is about attack and ensuring your get the most out of your trades by letting your profits run.

Unless you are a professional trader, your trading funds should be an amount of money that you are prepared to lose and which won’t make a difference to your standard of living should it disappear. Whilst the intention, of course, is not to lose it, the reality is that you might and no trader – regardless of experience of prior profits – should ever forget that fact.

Question 1 – How will I handle a large drawdown – or profit?

Best to make sure this is well thought out and answered in your plan, because it will almost certainly happen at some point. A string of losers in a row, the market diving sharply, or heaven-forbid you risk too much on one position and blow a big hole in your account (this shouldn’t happen, unless you are breaking the rules!).  Either way, everyone endures drawdowns at some point. On the other end, what happens if you make a whole lot of money? Best to have a plan for that to, otherwise you won’t know what to do with it when it comes.

• In the event of a large drawdown, I will pause my trading strategy and only commit new funds once I have identified the problem and forward tested the changes
• When I have built up equity in my trading account (beyond that which I need to trade my strategy) I will withdraw excess funds and/or scale up my position size to reflect the bigger trading pool

Question 2 – How will you manage profitable positions?

Often an afterthought for many traders, especially newbies, is what to do if the position goes the right way. We are so often concerned with the entry decision and the potential for loss, that everything going right and making money is often a secondary consideration. This could lead to panic and poor decision-making should the stock really take off. There are ways to manage positions, particularly if you don’t have the time or want to watch your positions actively, and that is via a trailing stop loss. As the stock moves higher, you periodically increase your stop level by a defined amount, i.e., if the stock goes up 5% in a day, that is your trigger to raise your stop loss 5% from its initial position at the end of the day. The goal is to get your stop loss to breakeven initially, and then into profitable territory. Using a trailing stop loss will allow you capture most of the move higher and avoid still being in the trade if it collapses back to your entry price or worse, your original stop level.

• I will use a trailing stop loss that I adjust every hour/day/week/month
• When the stock I am trading goes up X%, I will raise my stop loss by X%

STEP 8 - Exit Strategies

Why put exit strategies ahead of entry strategies? Simple. They are more important. When you first start trading, you think your success will be determined by what you buy and when you buy it. You put so much energy into your entries, that you tend to neglect your exits. Usually, about 6-12 months into your trading journey – if you keep at it and you are doing it right – you realise that exit strategies are far more important than entry strategies. Any mug punter can buy something. How you manage your position, to minimise damage if you get it wrong and maximise reward if you get it right… well, that takes some critical thinking and disciplined execution.

An exit strategy helps you to control your risk – which is the only thing YOU CAN CONTROL in the market. You can’t control what a company CEO does, or how the market will react to news, or how the market will behave at a macro level. All those things are beyond your control. At best you might be able to anticipate how they will affect your positions. But control them? Not a chance. And, if you think otherwise, you’re wrong. YOUR RISK. That is it. Make sure you have it figured out before taking that next trade.

Question 1 – Will my exit strategy be rigid or dynamic?

A rigid exit strategy would be one that applies a stop loss say 10% below entry, with a target 20% above. The values don’t matter, it’s the fixed nature of the stop and target. Once set, they don't move. Rigid strategies can be useful for those considering longer-term trading/investing timeframes. They are very easy to execute and they don’t require a lot of work or adjustment once in place.

A dynamic strategy can have any number of elements. The starting point might be the same 10% stop and 20% target, but the stop might be trailed in increments of 5% - i.e., if the stock price moves up 5% from the initial entry, the stop loss will also be moved 5% higher. A dynamic strategy might also consider nearby technical levels – support/resistance, moving averages, previous swing points, etc. Stops can also be tied to volume, i.e., if volumes start to drop off, stops are moved higher more aggressively. There is no end to how dynamic you can make a stop loss but make sure it is manageable.

Question 2 – Will you scale out or scale up?

If a trade is going your way, do you take profits along the way – perhaps at predetermined levels, i.e. half when the price action is halfway to your target, 25% at three-quarters of the way, and the final tranche at the full whack. It’s a common strategy that a lot of traders employ but it will depend on your risk profile. There are also some traders that like to add to their winning position as it goes higher, rather than take risk off the table. Think about your risk profile and whether you look at a winning trade as an opportunity to swing for the fences, or as a fleeting gift that could evaporate as quickly as it arrived.

STEP 9 - Entry Strategies

Entry strategies or ‘setups’ are all about whittling down the 2200-odd stocks on the ASX to a handful of high-quality, liquid, tradable opportunities, from which you might select one on any given day. 

Why have an entry strategy at all? Well, if you have a good one you can increase the probability of a trade’s success and, if you have a bad one but at least apply it consistently, you can adjust it until it starts to work.

Be mindful that there is no magic here. There is no secret entry strategy that will unlock massive profits and guarantee success every time. And whatever strategy you adopt, it needn’t be complicated. 

Question 1 – What type of strategy will you employ?

This question goes back to what type of trader you want to be. If you are a trend trader, you will likely be looking for breakouts or retracements, whereas if you are a swing trader you are probably looking for mean-reversion/reversals. Don’t try and do too much. Pick one strategy as your dominant one and understand that most of your trades will be generated by that strategy, and you might take a setup here and there of the other variety. I am a trend trader and breakouts are my favourite setups. Every now and then I will look for some oversold, mean-reversion opportunities. 

• My primary strategy is trend following, looking to ride momentum until the market tells me the trend is no longer valid
• My secondary strategy is to look at overbought/oversold opportunities which may have been driven by news, as prices often revert after extreme periods of price action.

Question 2 – What are your setups?

 A ‘setup’ is a set of characteristics that define your entry. It’s difficult to talk about these things without providing some examples. I like to see exponential moving averages in a certain configuration), I like to see important support/resistance and swing points in play, and I like three-bar candlestick reversal patterns off key levels. Sometimes I will also consider volume and what role it is playing in the strength/weakness of the trend. Those are the elements I like to look for and they fit the pattern of seeing a TREND, seeing a key LEVEL, and seeing SIGNAL. If you don’t know what these things are, that’s OK, but you do have some work to do. For those of you who follow, it doesn’t need to be any more complicated than that. You want to be able to identify the elements of your strategy in real time and efficiently so that you can make quick decisions if necessary.

• I will keep my setups clean and simple, focusing on just a handful of elements.
• My entry strategy will have the following elements at a minimum…
• I may also consider X and Y in my decision making.

Question 3 – How will you find your setups?

As noted above, there are more than 2000 stocks on the ASX. Are you going to look at 2000+ charts every day? Of course not. Maybe you limit your universe to the top 100. You could very easily set up a chart template and scroll through 100 charts looking for the visual cues of your ideal setup. Not hugely practical or efficient, but possible. Alternatively, you could invest in some trading software and data and scan the 2000+ stocks on the market for charts that have the characteristics you are looking for. If the elements of your setup are clearly defined and tight, you might find yourself looking through 5-30 charts each morning at most – all with the characteristics you want to see. That’s pretty powerful stuff. 

• I will use software/data to scan the market for the opportunities I am looking for
• I will limit my universe to the top 20/50/100 to make sure my process of setup identification is manageable.

FINAL QUESTION – Can you write it down?

The purpose of this entire series was to get you to think about how you engage with the market and write down answers to the questions posed. In doing so, you need to be precise. Be clear, be unequivocal, be explicit. This is the only way to remove your emotions from the process. Anyone should be able to pick up your trading plan, understand it, and execute it. It’s a lofty goal but, if you can achieve it, then your work is done – and you will elevate yourself above 85% of others in the market who have no plan. 

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Analysis as at 01 July 2022. This information has been provided by Marcus Today (AFSL is 473383), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.