12. Developing a Trading Game Plan

“Plan your trade and trade your plan.”

—Trading adage

“It was the change in my own attitude toward the game that was of supreme importance to me. It taught me, little by little, the essential difference between betting on fluctuations and anticipating inevitable advances and declines, between gambling and speculating.”

—Jesse Livermore

In the popular imagination, trade identification is more important than risk control. Yet, most successful traders argue the opposite. Before you start to trade you should first identify your trading edge, because knowing where your comparative advantage is helps determine the types of trades you enter. You should also decide how you will make your trading decisions. Are you a discretionary trader or a systems trader? Are you a fundamental trader or a technical trader? Knowing and controlling yourself is of paramount importance, as you cannot control the market.

Trading Edge and Trader Type

Ideally, how much money do you want to put into a trade? Zero. Ideally, how much risk do you want to take on a trade? Zero. How profitable would you like your trades to be? Ideally, you would like them to be extremely profitable. How long do you want to hold onto your positions? Ideally, you would like to hold your positions for only an instant. Arbitrage is a zero risk, zero investment profit opportunity. It is the ideal type of trade. Unfortunately, true arbitrage opportunities are rare. You don’t get to trade in an idealized world. Instead, you are confronted by a myriad of potential trading opportunities invariably mixed with various degrees of risk. Narrowing the list of potential trades to a smaller set of possible trades depend, in part, on your trading edge and trader type.

Trading Edge

Before you put on a trade, you need to ask yourself, where is your trading edge? What advantage, if any, do you have over other traders? Potential sources of a trading edge are faster reaction time, better technology, information asymmetry (you have information others do not have), lower transaction costs, and better analysis. Most traders have (or think they have) an edge in better analysis; that is, being able to see the market differently from other traders. Your edge may come in better knowledge of certain areas. For instance, you may have a better understanding of how certain politicians, policymakers, or regulators are likely to act in given situations or how the courts are likely to decide a given case. This knowledge is extremely valuable for some trades and useless for most others. However, you don’t have to trade all the time. You should only trade when you have an edge. To do otherwise is simply gambling.

Trader Types

Traders can be classified by what they trade (e.g., stocks or futures), what they use to identify and time potential trades (e.g., technical or fundamental analysis), or whether the trading decision is made at the discretion of the trader (discretionary trading) or by a mechanical or computerized trading system (systems trading).

Consider your personality style, capital, risk profile, and expertise when deciding what type of trader you want to be.

Trading Thesis

Trading ideas originate from a trading thesis. Your trading thesis may be right or wrong. For instance, you might believe that excessive monetary creation by the Federal Reserve has created a bond bubble that will burst, sending bond prices and the U.S. dollar sharply lower and commodity prices higher. The next step is to trade on this belief. If you are a systems trader, your program spits out trades for you to take. If you are a discretionary trader, you will have to decide on a case by case basis what trades to implement. No matter what type of trader you are, before you start to trade, you must have a solid trading game plan in place. Moreover, no matter if you are right or wrong, you need an exit strategy for profits and losses.

Making a Trading Game Plan

A successful trading game plan should anticipate market shocks, but exploiting market shocks need not be the principal focus or the core of a viable trading strategy. Indeed, for many traders trend following is the principal focus. Some strategies seek to minimize volatility or risk. Other strategies seek to profit from volatility and have a riskier profile. No matter your profile, developing a trading game plan and sticking to it is key to successful trading. As the old trading adage says: “Plan your trade and trade your plan.”

A good approach to developing a trading game plan is to consider the principal elements of the trading decision process: trading thesis and trade identification, trade selection, trade execution, trade monitoring and contingency plan, and trade completion and evaluation.

Trading Thesis and Trade Identification

The first step is determining what you think will happen. This is the stage where you develop a trading thesis and identify potential trades. A trading thesis is the underlying reason you get into a trade. If you don’t have a trading thesis, you shouldn’t make the trade. You should be able to tell yourself:

“I think the market is going up/down because ______ and the move will likely occur within ______ (time period).”

Be skeptical if you end up saying: “The market is going up because I saw an article online, heard a rumor, or feel good today.”

Having a sketchy reason for getting into the trade doesn’t mean the trade has to fail. You might be right (probably coincidentally), but it does call into question your judgment and planning for what comes next. When you start trading solely on the basis of rumors or news articles, exiting the trade might become psychologically more difficult.

The answer to, “What is going to happen?” does not have to be an absolute. Believing that “there is a 30% chance the peso will be significantly devalued within 2 months” is a trading thesis. We operate in a world of probabilities with very little certainty. The important question, then, is how can you make money off the scenarios that exist?

Trade Selection

Given your underlying thesis, you need to determine the best way to act on it. There are more possible trades to make and many ways to trade a single event. Select trades with the highest upside and lowest risk. To some extent, what constitutes “low risk” varies by trader.

A subset of trade selection is market knowledge. Knowing the market is crucial to trade selection. As discussed earlier in the book, those who merely followed Apple’s earnings guidance for its fiscal third quarter 2012 earnings would have been surprised that Apple stock fell when earnings results were released. Although earnings beat Apple’s estimates, they fell short of analysts’ estimates and the stock fell over 4%.

In stocks, currencies, bonds—any market at all—you need to know what is expected and already “priced in” the market. Even a 100% accurate trading thesis might be nearly worthless if it is already priced in the market. Beyond knowing what is priced in for an individual stock, understanding the market zeitgeist as a whole is crucial to trade selection.

A bearish or bullish market influences the magnitude and duration of the expected response and the size and expected trade horizon of any trade. The same applies to market sentiment. When good news hits a bearish market, the rally might be short lived and smaller than it would otherwise be. When bad news hits a bullish market, the decline in price might be short lived and smaller than it would otherwise be.

Choice of Security

The expected behavior of market prices to a shock impacts the choice of which security to trade. For instance, if you believe that a stock might rise in price, you could buy a call option or purchase the underlying stock. The choice entails different levels of risk and potential return. Similarly, the news from a U.S. employment situation report might impact the stock, bond, and foreign exchange markets differently. Deciding which security will be impacted the most is important in maximizing profits from the trade. Other important factors include liquidity and geopolitical risk. On the liquidity side, if you cannot easily enter or exit your position, the costs are higher and profitability is going to suffer. One interesting case in Chapter 3, “Fads, Fashions, and Bubbles,” involved Palm’s spinoff from 3Com. It illustrated the occasional difficulty of putting on and profiting from short positions.

Geopolitical risk can sometimes affect which means you use to profit off of a catalyst. For example, some European governments threatened to go after speculators selling sovereign debt they didn’t own or buying sovereign credit default swaps when they didn’t own the underlying sovereign bonds (that is, naked long credit default swap positions). This threat created another risk for speculators. Given the threats of government action against buyers of credit default swaps who don’t own sovereign bonds, speculators interested in profiting from the euro sovereign debt crisis might short the euro currency instead.

Size

After you select a trade, you need to size the trade to determine how large of a position to put on. The choice depends on a number of factors including the risk preferences of the trader but fundamentally it depends on your degree of confidence in the trade. It also depends on the risk of the trade. If the trade is highly skewed in your favor, you can put a larger position on than if it is only slightly in your favor. The greater the odds (or payoffs) are in your favor, the larger size you can put on.

Trade Horizon

Another decision to make is the expected trade horizon, or how long you expect to keep the position open. If you are a trend follower, then you might keep the trade on as long as the trend continues. If you are trading off market shocks, the length of time depends critically on how long the impact is expected to last. That is, how long do you think it will take before what you think will happen actually happens?

Risk Control—Stops

Consider the following thought experiment. There is a stove in the room. You don’t know whether it is hot or cold. You think that it is cold and place your hand on it to determine if it is. It turns out that it is burning hot. How long do you keep your hand on the hot stove? Do you wait until your flesh has been burned? Do you wait until you can no longer stand the pain? Do you wait until it smells like barbecue and then realize that your hand is the source? Do you wait until the stove cools down to prove that your initial thought that the stove is cold is proved correct? Or do you remove your hand immediately? Does keeping your hand on the hot stove make you a better person for demonstrating “stick-to-it-tiveness”? Losses are the pain the market inflicts on traders who are wrong. Losses are a message from the market telling you that your trade is wrong. Listen to the market. Unlike exercise, you do not necessarily have to experience pain to obtain gain from trading, and, in contrast to exercise, the more pain you experience on a trade the less gain you are likely to obtain. Risk capital is essential to trading. Wasting it by letting losses grow on a trade means there is less risk capital to devote to other potentially more profitable trades. Sticking to your position is an admirable trait in many aspects of life. It can be deadly in trading.

Just like your brain immediately sends a message to your hand telling you to take it off the hot stove, you need a mechanism that helps limit your losses when you are wrong on a trade. One mechanism is a stop-loss order. A buy stop is placed above the price at which you shorted the security. A sell stop is placed below the price at which you bought the security. How far above, in the case of a buy stop, or how far below, in the case of a sell stop, is an important decision. A stop placed too far away from your entry point might not offer you sufficient protection if the market moves against you, resulting in too large of a loss. Tight stops (too close to your entry price) might result in being stopped out too frequently as the market bounces around. Remember that you can always reenter a trade if you are stopped out.

However, during flash crashes, stop-loss orders can create significant losses. Here’s an example:

In 2008, UAL was subject to a false bankruptcy story and fell 76% intraday. It later recovered and ended the day down 11%. It’s easy to imagine a scenario where some long-term investors placed stops after, say, a 20% fall. Theoretically, those investors would have lost 9% more of their money by the end of the day (as the stock closed down 11%) than investors without stop-loss orders. In reality., they probably lost much more as stop-loss orders are executed at market prices; the stop generates the execution but does not fix the price. If prices fall sharply and don’t trade at the stop price, you are stopped out at the new, sharply lower market price and not the stop price. In the face of such a sharp fall, it’s possible they sold out at the bottom of the 76% fall—only to see prices rise back most of the way. Moreover, none of the trades made during the UAL flash crash were cancelled by the exchange. Stops have the benefit of ensuring you cut your losses short in most scenarios—so they are usually quite valuable. However, in some rare cases, they can significantly magnify losses.

Crowded Trades

Crowded trades are important to understand because the crowded nature of the trade fundamentally alters the risk/reward ratio. To be sure, there are always two parties to every trade, so someone has the opposite position, but in crowded trades, the positions on one side of the market may be characterized by a “herd mentality” in getting in or out of the trade. As a result, an adverse price move might precipitate an exodus of fellow position holders from the market. Crowded trades may be more difficult to exit profitably when a stampede of similar sell (or buy) orders hits the market. The snowball effect of a crowded trade, climbing inexorably higher (or falling lower)—“everyone is buying (selling) this stock”—disguises the danger. Easy come, easy go. The more crowded the trade, the larger the potential reaction when everyone tries to exit at the same time.

Crowded trades have the potential to move suddenly and adversely against you. This adds an extra dimension of risk that you must consider. Furthermore, they also present large opportunities if you can predict the top or bottom.

Correlated Bets

Diversification is essential in trading in the absence of one-sided bets. You want to make sure that your trades are truly separate bets instead of just one gigantic bet. This may be especially problematic when trading currencies. For example, if you are negative on the U.S. dollar and expect commodity currencies to rise, separate bets on the Canadian and Australian dollars may actually be the same bet. Again the basic idea is to obtain diversification before putting the bets on.

Risk On/Risk Off Markets

There was a period of time during 2010–2012 when financial markets were characterized as either being risk on or risk off. During risk-on periods, traders gravitated toward riskier positions. During risk-off periods, traders engaged in a flight to safety. This caused rapid changes in market prices. Understanding whether the market is risk on or risk off is crucial to understanding which assets will appreciate, which assets are safe, and which assets should be avoided.

Trade Execution

After you have selected the best trade or trades, you must decide the best way to execute them. How will you get in at the lowest price if you are buying (or out at the highest price if you are selling)? Are you going to buy on a dip (sell on a rally) or get in as soon as possible to catch an imminent move?

Entry timing is often more difficult than exit timing because if a position is losing money, that alone may be sufficient to prompt your exit. Determining the best time to enter a position is harder. You must address problems such as whether to enter all at once or gradually. Do you add to winning positions? The timing of exit for winning positions can be problematic because you don’t know how large the ultimate gain is in advance.

This is sometimes less of a problem when trading off of market shocks; if the effect is expected to be short-lived, your trade horizon is easier to determine. The problem arises when a market shock creates a trend.

Trade Monitoring and Contingency Plan

Monitoring your trades and the market as a whole is vital to ensuring that your plan continues to work and, if it doesn’t, that your position doesn’t worsen beyond the predetermined exit point. Your trading game plan needs to anticipate every contingency.

That’s not as difficult as it sounds. Basically, a stock can do one of three things: It can rise, fall, or stay the same. Develop a plan for each possibility. Many traders think only of the profit potential, or worry obsessively about losses, or, most commonly, don’t develop a strategy to employ if the stock doesn’t move—or moves opposite to their position. If you’re trading wisely, you need a plan for all three possible outcomes.

Behind these three possibilities are a multitude of decisions to make: Will you buy more if the stock rises? If so, how much? In general, you want to avoid pyramiding—adding ever-greater amounts as price moves in your favor. When do you exit? Will you sell (if you are long) after you make a 10% profit? How long will you put up with losses? How large of a loss are you willing to suffer before exiting the position? Are you so convinced the stock will turn around that you will buy more if its price goes down?

Trade Completion and Evaluation

Trade completion and evaluation is (hopefully) the fun part, where you take some money out of the market. Sometimes you’ll take a loss. But, if you followed your trading game plan correctly, the loss is manageable. What’s important whether you make or lose money in the market is evaluating what went right and what went wrong.

Look back and go through every step.

Was your trading thesis right? If it was right but you still lost money, the problem may be in your execution, timing, or the manner of trading. If your thesis was wrong, evaluate why things happened differently than you expected.

Did you select the right trade to make? Would another trade have made even more money? Would another trade have lost less money? Even if your trade made money, it is important to evaluate whether another trade would have made more money with the same or lower level of risk.

If you selected the best trade, did you execute the trade correctly? If so, did you monitor your trades? Did you have a contingency plan for losses, gains or no change in the market? Was your contingency plan realistic? Did you set your stops too tight? Did you set your stops too wide? If you were stopped out, did you fail to reenter the market when conditions were favorable for your original trade? Were you able to overcome what Paul Jones has called the “pain of gain” and hold onto a winning trade or did you take a quick smaller profit only to see the stock go on to double soon after. Did you surrender the chance to take a 50% gain by waiting for the stock to double? Did you hold on to the stock too long?

Spend as much time evaluating winning trades as you do losing trades. You should ask yourself how much of your trading performance is the result of luck and how much is the result of trading skill or chance events. Even a winning trade might not have been the best you could do. It’s possible you missed most of the move or that failure to look at market sentiment meant you surrendered some of your gains. Evaluate why you won or lost. One way of forcing yourself to evaluate trades is to keep a contemporaneous trading diary. A good trading diary should list the reasons for entering a trade (as well as the predetermined exit points) and list the reasons for exiting a trade. That information will allow you to honestly evaluate your trading performance.

The Message in the Behavior of Market Prices

The market reaction to a shock contains important information for traders. A muted response to good news should make you wonder about market sentiment. The same is true for a muted response to bad news. With trading, you are always getting feedback from the market, telling you whether your decision is correct or not. The key lesson is that it is important to listen to the market.

Another thing to observe is whether there is a differential speed of response to new information. For instance, as mentioned in Chapter 4, potential market-moving news in the videogame industry sometimes appears to be more slowly incorporated into stock prices than news in other market sectors. Similarly, Chapter 2 discussed the seemingly delayed reaction of the CME Group stock price to news in the U.S. Department of Justice letter suggesting futures exchanges divest their clearinghouses.

Trading After a Market Shock

Trading after a market shock requires looking at the problem differently than trading before it. For example, consider the release of the monthly U.S. employment situation report. After the news has come out, you already know what happened and have observed the immediate reaction of the market. The relevant question is how long will the news continue to impact the market? In many cases, it may be too late to trade directly off of the news. However, markets rarely go straight up or down and stay there. This opens up other trading opportunities. A relevant question is whether the market has overreacted or under-reacted to the news because this determines potential bets to place and may provide some guidance with respect to the magnitude of the expected price move and its duration. When trading off shocks, not only is the shock important, but so are the aftershocks.

Shocks: Scheduled and Unscheduled

You can trade scheduled news events or easily anticipated news events by putting on positions in advance of the announcements. Unscheduled events are more difficult to trade and by their nature entail accepting a longer trade horizon. Trade size should be smaller. This last consideration is violated when the distribution of returns is skewed in your favor and the risks are low. The old adage “don’t put all of your eggs in one basket” doesn’t apply when the risks are miniscule but the rewards are great.

All potential trades have to be considered within the framework of market conditions and market sentiment.

Trading Maxims

Beyond making a trading game plan, other important principles apply to trading as a whole.

Control Yourself, Because You Can’t Control the Market

The markets cannot be controlled. At best, they can be predicted, and even then, with a generally low rate of accuracy. You can react and plan, but not shape events, so you need near-total control over yourself

Despite the image in pop culture of swashbuckling traders making millions in seconds, often from dumb bets, the reality is much more mundane. Most traders slowly accumulate and protect their wealth. Successful traders avoid making dumb bets. Successful trading is not gambling with even odds but taking calculated risks.

Building a fortune usually takes years, but wiping it out can take only minutes. Control, especially loss control, is the key to successful trading.

Get Prepared to Play, Don’t Play to Prepare

Larry Hite made a fabulous point in Market Wizards. He noted that in any game or situation you can analyze a positional advantage. He persuasively argued:¹

“The speculator can choose to only bet when the odds are in his favor.”

Simply stated, you don’t have to trade, so you should do so only when you have an advantage. That, as Mr. Hite so convincingly put it, is your key advantage as a trader or investor.

You do not, and in fact should not, do anything until the odds are in your favor.

You can pick and choose your battles. Choose the ones you are likely to win.

For instance, you can’t beat the machines at speed, so don’t even try. Wait until you find the trade you want to make. When it comes to your capital, discretion truly is the better part of valor.

Limit Risk—Not Reward

Reward is irrelevant if risk is not considered as well. This is an obvious but underappreciated concept, and one you cannot ignore.

Large lottery games produce enviable returns for the winners. Mega Millions had a $640 million jackpot in early 2012.² A couple in Britain won 161 million pounds in the EuroMillions lottery.³ Those are very large sums of money. But, you don’t see any hedge fund managers buying lottery tickets (openly at least). Why is that? Because the expected return on each ticket is so low. Except in extremely rare occasions, a lottery ticket is a losing bet. Although you might make money on losing bets, eventually statistics will catch up with you. Everyone knows the lottery, like roulette or slots, is rigged against the individual player.

What many traders fail to do, however, is to incorporate that knowledge into their trading strategies.

Thinking only of the reward without accurately assessing risk leads to “buy high, sell low” behavior. Sometimes, evaluating risk is difficult—but that begs the question, why trade that security anyway? If you don’t have a good idea of what you’re investing in, and the risks you are taking, why do it at all?

Another trap traders fall into is failure to re-evaluate risk after market conditions change. Even if your initial estimate of risk was correct, the market is always changing. Failure to adapt to a new risk profile and change tactics accordingly is a fatal flaw.

What once started as a promising trade can quickly go sour—that’s a fact of trading life. Changing strategies and adapting is nothing to be ashamed of. Holding on to a losing position because you can’t let go is a flawed strategy.

Moreover, you need to be cognizant of existing market conditions and sentiment as that might influence the magnitude of the expected gain from a trade, the duration of the trade, and placement of stops.

Learn from the Past—Don’t Live in It

You need to learn from your mistakes, but don’t dwell on them. Understand how they got you to the position you are in, but don’t view your future trading opportunities through the lens of past mistakes.

At any given moment, the question is: How can I make money, given my current situation? It is not: How can I make up for the mistakes I’ve made in the past? If you’re not in the right emotional state to trade, take a break. Remember, one of the great advantages you have is the freedom to get in and get out of trades when it’s most advantageous to you.

Many traders facing losses are immobilized and incapable of making clear decisions. I’ve lost 20%. I’m down, I’ve lost money. Funny how these traders focus precisely on a fact that is not relevant, or at least not helpful. Compared to the past, you have lost money. But you are in the present now. You cannot go back in time; you have what you have, nothing more and nothing less. Yet you could very well have less should you let the losses of the past cloud your thinking and drown your ability for decisive future action. Focus on how to make money from your present situation, not on how much you could have had, if things had been different. Trading, by its nature, is a bet on the future. Learning from the past is valuable—getting trapped by it is worthless.

There Are No Martyrs in the Market—Only Casualties

Limit your losses. Again: Limit your losses.

Holding a trade to get even, doubling down on losing trades, being paralyzed by fear of loss—these are fast ways to go bankrupt. When you lose, bite the bullet, admit you were wrong, and save your capital to fight another day. There are no martyrs in the market, only casualties. You are never rewarded for increasing your losses. In fact, being able to admit that you are wrong is the mark of a great trader.

Don’t Bet More Than You Can Afford to Lose

Not betting more than you can afford to lose is of paramount importance. Not only can it put you and your family at financial risk, it’s also a bad trading strategy. That’s because the fear of loss clouds your decision, making it harder to make tough, but necessary calls.

Ed Seykota, a high-profile trader argues:

“Here’s the essence of risk management: Risk no more than you can afford to lose, and also risk enough so that a win is meaningful. If there is no such amount, don’t play.”⁴

Hope Is Not a Plan

If you get into a trade saying, “I hope the stock goes up today,” get out. Hope is not a trading plan. You might hope your plan works out, but hope without a plan is a hindrance, not a help.

Endnotes

1. Schwager, J. D., Market Wizards. New York: Simon and Schuster, 1989, Interview with Larry Hite, page 183..

2. “Mega Millions Makes History with $640 Million World Record Jackpot.” Mega Millions. March 30, 2012. http://www.megamillions.com/mcenter/pressrelease.asp?newsID=4AA5E778-C8B7-48AF-A9B8-201E11810209.

3. Stevens, J., “£148m! British ticket holder comes forward to claim the nation’s second-biggest EuroMillions payout ever.” Mail Online. August 10, 2012. http://www.dailymail.co.uk/news/article-2186843/EuroMillions-winners-Numbers-come-mystery-Brit-wins-second-biggest-payout-jackpot.html.

4. Covel, M. W., Trend Following: Learn How to Make Millions in Up or Down Markets. Upper Saddle River, New Jersey: FT Press, 2009, pp. 63.