Revising the Trading Plan

Chapter progress:

The main purpose in revising your trading plan is to address problems or drawbacks you did not see at first. This may include changing the currency you are trading, changing the timeframe on your charts, changing indicators, changing the time of day you are actively trading, or even changing your broker.

The leading cause of needing changes is losses bigger or more frequent than expected, resulting in a really low gain/loss profile or even a negative one, where losses exceed gains. But you should revise your plan even if the gain/loss ratio is acceptable. After all, a better gain/loss ratio is always to be desired.

Re-Evaluate Your Trading Strategy

The first step in evaluating your plan is to do an honest and thorough look-back of your existing trades. Every trading advisor recommends keeping a trading journal but realistically, perhaps 1% of all traders actually keep a trading journal. You do have, however, your brokerage statement showing entries and exits. You should divide up the winning trades from the losing trades and put a dot or other marker on the chart to show where each one took place.

Now try to remember why you took each trade — what indicator was foremost in your mind when you pulled the trigger? For example, a currency may be vastly overbought and now you see the stochastic oscillator hooking down, along with relative strength. The bar is unimpressive and may be a doji or other pattern indicating the upmove is over. This is a signal to exit a long position but is it also a signal to enter short? You want to be sure that you are not getting short on impulse, but on hard indicator evidence that it will generate a gain.

How many trades should you include in your analysis? Statisticians say that you need 30 instances of anything to draw a valid deduction, so we will say 30, but in practice, you may discover errors by looking at just ten or it may take as many as 50.

Re-Evaluate Your Analytical Process

You always have a choice between a plain stop-out to get square, or stopping out a long and going short at the same time. If stopping and reversing results in a high proportion of losing trades on the reversal leg, stop doing it. You may wish to continue stopping if those trades are winners, but the lookback is telling you that you are missing a persistent uptrend that will keep going and make the short trade a loser. You are being nailed on temporary pullbacks. That is the second lesson of the past trade examination — you are failing to see the big-picture trend. You should add a wider timeframe chart to judge better whether the reversal is wise.

In addition to looking at multiple timeframes to get perspective, the next process that may need re-evaluation is your indicators themselves. Do they really work for you? This is the hardest test to go through. You may be devoted to the idea of your indicator, such as Fibonacci retracements. Nevertheless, try as you might, the retracements you see do not line up with the proper Fibonacci numbers, so you take trades on the assumption that you are simply not seeing the chart correctly. This is a very bad idea. You should feel in sync with the market, and the way to feel in sync is to understand why your indicators are showing you the signals they do. Every indicator on the planet is wrong sometimes. Stepping back and asking “what is market psychology” will help you detect when an indicator is going to give a false signal. Some indicators are prone to false signals, like the stochastic oscillator in a long-lasting trend. It is the nature of some indicators that use a fixed lookback period to be wrong when a move exceeds the lookback period. You do not have to remember the exact formula of an indicator to acknowledge that it has this inherent limitation. You need to look at other indicators. This idea can be hard to accept.

Re-Evaluate Your Tactics

Entries and exits are clearly the crux of the matter. It would take only the smallest of changes in one or the other to flip a losing win-loss ratio to a winning one. The main components of trading tactics pertain to entries and also to stops and targets. You can have a so-so entry, even a very late one well into a move, but still make gains and avoid losses if you get out at the right time. Market lore has it that entries are the main thing, but unless you can afford to sit out pullbacks like a long-term trader, you absolutely need to exit at the right time and place, whether it is a stop rule or a take-profit rule.  Remember, you are not taking any risk when you are out of the market and you do not have to take every trade.

Tactical Rule #1 is to take only trades that have an expectancy of a positive (winning) return. 

In the stop-and-reverse case above, it is not enough to get rid of the reversal part of the stop-and-reverse trading strategy. Getting rid of the reversal does not tell you where and why you should reverse (eventually) or re-enter. It puts you back at square one looking at the chart as though the next trade is your first trade, even though you have already analyzed the chart conditions.

This is where a change in tactics is called for. You may want to add conditional trades. In the case of the stochastic signaling a sell, instead of running right out and actually selling, you can place conditional orders that will get you short if the price falls below some benchmark level. In other words, you are qualifying the short sale — it has to “prove it” that it is a worthy trade. At the same time, you want a second conditional trade that gets you long again if the price rises past some benchmark level or by some specific number of points. Conditional trades can be tricky to place properly but can rescue you from indecision, impulsive trades, or overly rigid tactics (like always using stop-and-reverse).

Diversify

If your losses are too high relative to gains, you are taking too much risk of loss. This seems too obvious to mention, but you did not give enough weight to the risk of loss on those losing trades — as your track record demonstrates. A ridiculously simple way to reduce losses is to reduce risk, and diversification is the easiest way to reduce risk. By adding another currency that is not strongly correlated with your primary currency, you have another shot at making a gain. If you add NZD/USD to a one-currency portfolio that consists of AUD/USD, you are not getting diversification. The same thing holds for EUR/USD and USD/CHF — they move more or less in lockstep. To the AUD you might want to add GBP, and to EUR you might want to add JPY.

Quiz:

1. You should revise your trading plan

2. The key to better trading tactics is

3. A surefire way to reduce risk is to:

Done