5 Elements of a Smart Trade Plan

Professional traders live by maxims, and one of the big ones is "Plan your trade and trade your plan." The market can be volatile, so creating a trade plan can give you a tool for keeping a cool head as you build and reshape positions when markets are on the move. 

A trade boils down to a series of decisions about what to trade, how much to trade, when to enter, and when to exit. Thinking through those decisions before placing a trade by compiling them into a trade plan can help ensure you enter your orders correctly, can potentially help you manage risk, and can help you establish routines that fit with your trading objectives.

We're going to focus on stock trades, but the principles of having a plan apply regardless of the product or market you're trading in.

The decision to place a trade usually comes down to a hunch that you can turn a profit. Turning that hunch into a concrete objective can be a north star, guiding all other decisions you make along the way. A few questions to ask yourself:  

• What exactly do I expect to happen in the market? 
• How will I profit?
• What tools or forms of technical analysis or fundamental analysis will I use?
• How long do I expect this trade to last?
• What could go wrong?

Here are some examples:

• To profit from a short-term bullish swing within a stock's intermediate-term upward trend by buying at support and selling at resistance.
• To profit from buying an undervalued stock and selling when the stock rises to my expected intrinsic value in the next two months.

Once you know what you're trying to accomplish, you can map out the details of your trade.

A watchlist is a list of securities you're interested in trading because they meet certain criteria. Watchlist criteria can be as broad as picking stocks in a certain industry or sector, but for a trade plan, you'll typically want to try to develop more specific criteria that correlate with your objective. Watchlist criteria are often fundamental (based on a company's financial results) or technical (based on a stock's historical price movement) factors. 

For example, criteria for a bullish stock trade could include:  

• Stocks in an uptrend on a daily stock chart.
• Stocks with a debt-to-equity (D/E) ratio below 0.50.

You can use research tools like the stock screener on schwab.com, which allows you to search for stocks that meet criteria you define.

After creating your watchlist, you need to determine when to buy. These are known as entry rules—guidelines that dictate when you'll purchase a security on your watchlist. Determining your entry rules before you buy reduces the guesswork when deciding when to enter a trade. 

Entry rules may be different depending on the investor's goals. For example, to some longer-term investors, a watchlist candidate with sufficient fundamental criteria might be the only entry criteria. For shorter-term trades, they might consider buying a watchlist candidate after it shows certain entry signals, such as:

• A bounce off support or a breakout from resistance.
• A breakout of a basing pattern on a daily chart.
• A price that closes above a 200-day simple moving average. 

The entry signals tell you it's time to trade the stock you have on your watchlist. Once you have that decided, it's important to consider other factors, like the amount you'll trade and how to manage risk.

Trading is risky. A good trade plan establishes ground rules for how much you're willing to risk on a single trade. For a general rule, some traders may risk up to 1%–2% of their account on a single trade and allocate up to 5%–10% of their portfolio in any single position. Buying more shares means putting more at risk, so you could consider exercising portion control, or sizing positions, to fit your budget. 

Questions to consider include:

• How much of your portfolio are you allocating to this trade? 
• How much are you willing to lose on a given trade?

For example, a trader with $150,000 in total capital might choose to allocate up to 5% of the portfolio in a single position, $150,000 x 5.0% = $7,500, and they might be willing to lose up to 1%, or $1,500, on a given trade.

Diversification is a simple and effective way to reduce portfolio risk, and it starts on the front end by committing only part of your capital to any one position.

Before placing a trade, you also want to specify when and how you'll close it out. For a technical trader, this might be as simple as when the price goes up or the chart changes. For a long-term buy-and-hold investor, it may be when a company's profit drivers change, and that might be years into the future. 

Among the questions to consider are:

• What's the target price, or the price you hope the stock will reach?
• Are you using a stop order? What is it?
• What is the risk-to-reward ratio? That means how many dollars do you expect to gain for each dollar you commit to the position?
• What are fundamental or technical changes that would cause you to close the position? 

Let's look at an example of buying a $67 stock with a stop order or exit price of $57. This is where "how much to buy" and "when to sell" can intersect to manage risk. A more active trader may decide they only want to risk 0.5% of their portfolio, or $750 per trade, so let's go through the calculations of how to determine the number of shares that could be purchased. 

Start with the difference between the entry price, $67, and the exit price, $57, or $10, then divide the amount the trader is willing to lose, $750, by that difference to determine the number of shares: $750 / $10 = 75 shares. 

If they purchase 75 shares, for a total purchase price of $5,025, they'd be allocating about 3.4% of their total account value.

Even if you're buying a stock for the long run, make sure to have a plan to evaluate it regularly to make sure the prospects remain favorable. Sometimes, people fall in love with an idea and hold on too long. Listing the things that would cause you to change your mind at the time you place the trade can help you keep a clear head about the company's results.

For example, exit criteria on a stock trade could include:  

• The price falls 3% below a recent significant support level. 
• The stock price reaches your estimate of its intrinsic value.
• New information suggests your estimate of intrinsic value was overly optimistic.
• The D/E ratio on the stock rises from current levels.

Closing out the trade isn't the final step; instead, you need to evaluate your results. Here are a few things to consider:

• How did your trade perform relative to your trade plan, portfolio size, and a market benchmark like the S&P 500® index (SPX)?
• What worked with this trade, and what didn't? Why?
• What should you try next time?

For example, maybe you were expecting the stock to break its resistance level, and it didn't. Did your stop orders kick in, or did you face a larger loss than you were hoping for? Do you need to adjust your stop criteria?

Or maybe you were looking for a stock price pop after the company reported earnings, and that's what happened. That's good.

Paying attention to your performance and tracking it over time can show you what you're doing that works and help you get better results over time. You can build daily, weekly, and monthly routines that can help you monitor your watchlist and potentially sharpen your performance.

Daily:

• Monitor open positions: Look for new support levels and opportunities to adjust your stops. 
• Monitor watchlist: Look for entry signals and consider buying if opportunities arise.

Weekly:

• Plan for the week ahead: Identify potential news events relevant to your portfolio like earnings announcements, dividends, or major economic news. 
• Search for value stocks: Look for and add new candidates to your watchlist.
• Maintain your watchlist: Remove value stocks from your watchlist that no longer meet your watchlist criteria.

Monthly or quarterly:

• Monitor earnings releases.
• Record your trades in a trading journal. Review your activities at the end of the month or quarter, and ask yourself the following questions:
  • Were my entries, stops, and exits performed effectively?
  • Are my growth rate and discount rate assumptions accurate for the current market conditions?
  • Are my larger portfolio allocations appropriate for my goals?

Trading is like any other endeavor. You may be able to improve over time if you pay attention to what you're doing and look for opportunities to hone your edge. 

Also, track your trading history to calculate your theoretical trade expectancy, meaning your average gain (or loss) per trade. You can calculate a win/loss ratio by determining the percentage of your trades that have been profitable versus those that haven't.

Some traders keep track of their trade plans in an old notebook. Some use spreadsheets that let them track, sort, and analyze. 

If you're new to trade planning, check out the Schwab Trade Plan Worksheet. This sheet is useful for investors and traders alike to evaluate their trades before and after. It sets out the steps you should follow to analyze your trade before you make it and after you close it out. You can start by filling out the sheet for each trade you make. Over time, you may want to refine it for your own needs.

The market is volatile, and your emotions can easily knock you off course. While it's no guarantee for success, a solid trade plan can help limit some of the inherent risk. Understanding what goes into a smart trade plan is the first step to prepare you for your next trade.