A trading plan defines your financial goals and how you are going to trade to achieve them. It is all too easy to say “I am going to transform $10,000 into $250,000 in one year trading Forex” without having specific details about how what currencies to trade, how often, over what timeframe, and with what risk of loss. Without the details, it is just a fancy fiction, and unlikely to come true. A real trading plan includes those details about key components.
In practice, a trading plan is always a work-in-progress because we learn from experience and from reading about new techniques and mind-sets.
Choosing a Currency Pair
The first point in your trading plan is what currencies to trade, whether benchmark currency pairs like EUR/USD or GBP/USD, or currencies with less liquidity like the USD/CAD and AUD or NZD/USD. Perhaps you like cross rates because typically they are less volatile, such as EUR/JPY. You may consider exotics like emerging market currencies (Turkish lira, South African rand) or even exotic cross rates (lira/rand).
Volatility is just one criterion for choosing a currency to trade. You can research volatility by eyeballing charts, by looking at volatility tables online, or by devising your own spreadsheet and applying the standard deviation function. If you choose volatility as the primary criterion, be sure to look at the data in the timeframe you plan to trade. A currency may have low day-to-day volatility that masks high hourly volatility, and that does you no good if you are trading the one-hour timeframe.
Another criterion for selecting a currency to trade is trendedness. Measuring trendedness is a complicated statistical process that most traders have no interest in or the qualification to perform — and it changes over time – but you can eyeball charts of the various currencies to detect those that spend the least amount of time range-trading and the most amount of time with a directional slope, either hand-drawn or with the linear regression. Again, be sure to look at the same timeframe you will be trading.
A third criterion is whether you have knowledge and insight into the fundamentals of the country issuing the currency. A good example is the explicit plan by the government of Australia to reduce dependence on mining and to diversify the economic base, influencing interest rate management in recent years, plus a willingness on the part of top officials to jawbone the currency lower to promote non-mining exports, among other goals.
Choosing a Timeframe
Trading requires focus and concentration, no matter how well you set up your trades in advance. Your choice of timeframe is heavily dependent on other activities in your life, including a day job. If you have a day job without constant access to your screen during the time you want to trade, you have chosen a wrong timeframe to trade. Say you are in the New York time zone and want to trade the hourly chart from 8:30 to 11:00 EST, the most active and liquid time to trade Forex in that time zone. If you have a day job, chances are good that your boss would not approve of you frittering away most of the morning on your personal trading account. Yet if you wait until you get home at night at 19:00 EST, you will be stuck with the less active and illiquid New Zealand and Australian Forex sessions. If that is the only time you have available to devote to trading, you need to trade the NZD, AUD, JPY or another Asian currency.
To stick with the EUR/USD, the only solution is to change timeframes from one-hour to daily. It is not unheard of for a trader to relocate his home base from an inauspicious trading location to a better one — we know one trader who moved from California to Switzerland to be on top of the European session.
A second consideration in choosing a timeframe is what you can see on the chart with your own eyes. Forex traders like to emphasize that Forex prices are fractal, meaning that you cannot tell without a label whether a chart is of one-hour bars or daily or weekly bars. This is true, up to a point. But logically, an obvious reversal followed by series of big-bar higher highs with higher lows on a daily chart has more meaning than the same set of characteristics on an hourly chart. This is because on the hourly chart, the move can easily fizzle and fade away, whereas on the daily chart, it is more likely to have staying power. If you are looking at an hourly chart and cannot detect trends and patterns, widen the timeframe to a longer one.
A third consideration in choosing a timeframe is your capital stake. If you have a large capital stake – $25,000-50,000 — you are free to trade in any timeframe, including the daily. If you have a small capital stake, like $2,000-5,000, prudence dictates you should trade in a shorter timeframe, like 4-hour or 60-minute. You are not risking your capital when you are out of the market.
Choosing Technical Tools
Some technical tools will be more easily understood and applied than others. Some traders take to patterns like a duck to water, and some cannot get the hang of it, or find the reliability quotient of patterns too low. There is no single correct technical indicator or set of indicators for any specific currency or any specific timeframe. Everything works, and what is important is what works for you. The old joke has it that if you put ten traders in a room with one chart and one indicator, you will get ten different outcomes. This does not mean the trader with the highest gain is “right” and the other nine are wrong. The trader with the highest gain may have had a bigger starting capital stake or a higher propensity to take risk (or both). The trader with the smallest gain may be the best trader if his trading style results in staying in the game for a longer period of time.
The standard way to select technical tools is to backtest them on your currency and your timeframe. For example, you may like the MACD. You would test the hypothesis “What gains and losses would result from applying the MACD (and only the MACD) on my currency over the past X periods?” In the early days of technical analysis, traders spent countless hours performing backtests. Backtests have two problems:
- Conditions, especially volatility and trendedness, change over time (so you need a very long backtest period to cover them all).
- It is tempting to tweak the parameters of the indicator to “fit” the data in your period.
Backtesting has fallen out of favor because of these problems, and also because traders lack the data, software, or patience to invest hundreds of hours on a procedure that is inherently inadequate. The effort-to-reward ratio is low. But the fact remains that backtesting is the only way to estimate whether a technique that appeals to you will actually work on your currency pair in your timeframe. At the least, you should apply your technical indicator to a chart and count up how many times it signaled the correct trading decision versus the number of times it would have delivered a loss. It is important to note that no indicator is correct 100% of the time and every indicator fails sometimes. This is a fact of trading life you must accept, but you do not have to accept an indicator, however appealing, that fails more often than it succeeds.
Choosing the Rate of Return
Your rate of return is a function of risk-reward analysis, a complicated topic covered further in our course. Let’s go back to the opening paragraph here and examine your goal of converting $10,000 into $250,000 in a year of Forex trading. In order to achieve that goal, you need information on exactly what trades you need to take to earn that much. For example, if you make a net $10 per trade (after factoring in losses), you would need to make 25,000 trades, or 104 trades per day, assuming 240 trading days per year. This is obviously silly. What if you make $100 per trade? That would take 2,500 trades or 10.4 trades per day. To make $250,000 in year doing only one trade per day would mean you would need to make $1,041.62 per day.
Okay, which currencies move 100+ points every day, and do it in a manner that you can identify with your technical tools and take advantage of? Right away, we see that it is not reasonable to expect to make $250,000 from a starting capital stake of $10,000. Besides, you will experience long streaks of losses in Forex trading. Everyone does, without exception. In order to evaluate how much ending rate of return you can reasonably expect, you need to know your gain/loss ratio. If you are just starting out in trading, clearly you do not have a historical record of your gains and losses, so you are stuck with eyeballing your chosen indicators on charts to guess what they might be.
Some traders claim to have a 5:1 gain/loss ratio, meaning they make $5 for every $1 they lose. This may be true sometimes but it unlikely to be true over long periods of time. If someone has a technique for making a 5:1 win/loss ratio and they promote that technique, pretty soon a lot of traders would apply it and make it less effective (by front-running it, for example). This is why the 18-day moving average is sometimes used — to front-run the 20-day. In practice, you should be very happy with a 3:1 ratio, or a 2:1 ratio. Even a 1.5:1 ratio will keep you in business with a decent rate of return — higher than what is available in the “risk-free” sovereign bond market.
The need to develop an actual, real-time gain/loss track record is the primary reason a trading plan is always a work in progress. You may find that you wanted to trade, say, the benchmark EUR/USD, but given the time you have and time of day you have available to trade, and given technical tools that work for you, you get a better gain/loss ratio from trading AUD/JPY. Long run, staying in the trading business is more important than making a quick buck and giving it all back.
Choosing a Broker or Platform
It may seem as though choosing a broker/platform comes first, but that would be to allow the broker to dictate or at least influence your other choices. Choosing a broker comes last, after you know what currency behavior you can identify and indicators you like. For example, not every broker/platform offers the capability to draw linear regression channels. If you find linreg channels useful, find another broker.