In 490 B.C. the Persian army invaded the plains of Marathon and met the forces of Athens in what was perhaps the single most important battle in Greek history. The Athenian army took the offensive against the vastly larger Persian forces while they were still preparing for battle. Against great odds, the Greeks prevailed. According to legend, a Greek soldier named Pheidippides ran from Marathon to Athens with the message, “ Rejoice! We conquer! ” He immediately collapsed and died from his efforts. Today, in the United States alone, Nearly half a million runners participate every year in the 26.2 - mile Race that commemorates Philippines’s valiant feat.
In preparation for this event, runners will lay out a schedule that covers diet, running mileage, hill workouts versus speed training, sleep, recovery days, and hydration. Entire web sites, books, and software packages are devoted to making sure the runner doesn’t overlook any detail that could hinder performance when race day finally rolls around. Depending on the experience of the runner, weeks or even months are dedicated to planning and preparation for the marathon. If you scour through all the articles and books written on marathon competition, almost all will include, or at least refer to, some type of training plan. And yet, for all the preparation, most runners will be finished with the event just a few hours after the starting gun fires. Of course, they’ll all walk away with a space - age marathon blanket, T - shirt, goody bag, and sore legs that won ’ t be back to normal for at least two weeks.
Why is it that the same person who wouldn’t dream of running a marathon without a complete plan will manage their finances without so much as a thought about how they’ll achieve their objectives? Take it a step further — many of these same people run through their investments without even defining their objectives! The reason we open this book with a discussion of a trading plan is that it will set the foundation for everything we do. One of the fatal flaws of trading is that it lets us enter the game without a trading plan. Worse, we may even be successful for a time.
It is not at all uncommon for a new trader to place a trade and make a profit. The new trader is especially careful to analyze the trade prior to opening the position. Then they step through the trade with the care that one takes when treading new territory. Before they know it, the trade is profitable and they close the position with a net gain. They start thinking, “ Hey, this is easier than I thought! ” and they move to the next trade. Before long, they’re taking positions with more confidence and the assumed risk increases with each trade. This same trader may have a stretch of profitable trading but then falls into a losing pattern. Or they experience “ The Trade ” ; the single trade that cures them of any remaining vestige of confidence as it falls below every support and drains their account into a maintenance call. The problem is that this trader may not even realize that they have fallen into a period of net losses or, if they do recognize it, they don’t understand the reasons for their change in fortune. As a last resort, they’ll change their trading style; opening exceptionally large positions to try to exact revenge on the market, trading options without proper training or becoming a long - term investor by holding on to positions that were originally meant to be short - term trades. All of this is the result of not having a trading plan and holding yourself accountable to the objectives that you’re trading toward. In this chapter, we’ll discuss in detail some of the key components of a trading plan and then conclude with a trading plan checklist.
Trading Is No Longer a Team Sport
Retail trading really came into its heyday in the mid - 1990s with the explosive growth of day trading. In 1997, two guys from Houston, Chris Block and Jeff Burke, made the cover of Inc . magazine with the teaser headline “ Bad Boys of Wall Street. ” The article started with this opening line: Their aim: move fast, make money, have fun. Who knew they would threaten a whole industry in the process? With talk about fast cars, new offices, and armies of traders who were practically siphoning money from the market in mere seconds, the phenomenon of retail day trading was launched. One example refers to Jeff Burke’s biggest day in the market when he made $ 50,000. $ 50,000 in one day! People were flocking to the Block Trading headquarters in Houston and dropping $ 25,000 just for the right to lock down a city for opening a franchise at some point in the future. Block Trading is no longer around, but there are some lessons to be learned from those early days.
First of all, in the mid - 1990s the state of technology required that people find a retail trading office to trade. Sure, there were some choices that allowed for trading remotely, but the quality of information and trade execution wasn’t nearly as high as what was available in a trading office. These offices created an atmosphere of anticipation and played on the trader’s ego. They were often dimly lit with the shades pulled over the windows. Multiple television monitors constantly played CNBC and other networks for immediate market commentary. Other monitors displayed real - time news feeds, which scrolled through headlines too fast to allow for any analysis but served to let the traders know they were still plugged into the action. Banks of trading computers sat side by side, with traders coming and going throughout the day. It wasn’t unusual to see a highly respected heart surgeon trading next to a college dropout and the two of them speaking to each other as colleagues. Occasionally, a trader would enter the room with one of the subscription - based split pagers. These creative devices did exactly what the name suggests. Whenever news hit the wires of a company announcing a stock split, the pager would send an alert with the information. For a time, the fortunate trader could take a position before the news was fully digested by the market and then sell into the crowd’s buying.
The technology also allowed traders on the floor to access Level 2 data. In addition to the National Best Bid and Offer (NBBO), with Level 2 you could see all of the price and volume levels below the high bid and above the low offer (see Figure 1.1 ). This was something that most brokers hadn’t seen at that time. Finally, these traders often traded before the market opened at 9:30 A.M. and traded well past the market’s close at 4:00 P.M. Using the new kids on the technology block, electronic communication networks (ECNs), retail traders could buy and sell to each other even when the rest of the market was closed. Finally, these rooms were often separated from the lobby area by an attentive gatekeeper, who let only the chosen traders through a door that bore the sign, “ Trading Room — Traders Only. ”
While these retail trading rooms had many faults that are outside both the scope and objective of this book, there was one key benefit that they provided to the trader. An esprit de corps developed between traders because they were trading day after day with the same people. This camaraderie caused traders to help each other through education and accountability. One of the common practices of day traders in these retail offices was to call out fills. Let’s say several traders wanted to buy 1,000 shares each of Microsoft. The first trader to get his buy order filled would call out the details of the fill: which market maker filled his order, how many shares they sold, and whether the order was filled on the bid or offer. All of this information would be helpful to the other traders as they managed their orders. For example, if a key market maker (often called the Axe) fi lled the order very quickly on the bid, that told the other traders that there may be heavy selling pressure and they could lower their buy order or cancel it altogether in anticipation of a price drop. The point to be made here is that the group of traders as a whole had more information than individual traders alone.
The mechanics of a trade were also much easier to learn in the retail trading rooms. There are seemingly endless details that a new trader must learn about the trading software, types of trades, when to place trades, position sizing, and so forth. In the isolation of one’s own home office, finding the answers to these questions or learning the nuances of the minor details can be difficult at best, impossible at worst. However, in the retail trading offices, these issues were discussed throughout the day, and a new trader would very quickly pick up the salient points of the game.
Besides the learning environment that trading floors offered, the accountability that naturally resulted from trading elbow to elbow was another significant benefit. If you took a position and called out the fill as we described a moment ago, everyone around you knew what you were trading. That meant they knew if you were making money — or losing money! There was a peer pressure that grew if you stayed in a losing position. Nobody likes to have to admit that they’re losing money, so it was easier to close out a position for a small loss than to hold on to a loser and have to continually explain to your fellow traders why you thought this trade was going to be different. In today’s trading environment, we trade with almost total anonymity. Often, a trader ’s own spouse isn’t aware of the activity in the trading account. This situation makes it very easy to rationalize bad trades in our heads and continue holding a bad position.
To accommodate these deficiencies in the contemporary trading environment, a trading plan needs to include both points: education and accountability. It’s imperative that the trader recognize that while the market is generally simple to enter, there are many facets of trading that require a sequential education plan. For example, any new trader can step in and place a buy order, followed by a sell order. But understanding how to properly analyze chart patterns prior to entering the trade isn’t intuitive. Learning to read a chart is very similar to learning a new language. Both require some formal education followed by practice using the new language. The market is also constantly changing, and the education plan should include continuing education. In the past decade we’ve seen such changes as decimalization of pricing, increasing interest in options trading, and expanded capabilities of trading software platforms. If you hide your head in the sand and fail to advance with the market and technology, you will eventually be left at a disadvantage.
When a trading plan is developed, it becomes the benchmark for accountability. The plan will become the surrogate for the trader who once sat by your side and knew if you were following your defined strategy. Let’s assume that your plan is to be a day trader. By definition, a day trader opens the day and closes the day in cash. Long or short positions are opened and closed during market hours, and the price moves are measured in minutes or hours. Because your plan includes a strategy for your time horizon, you’ll know when that strategy is broken. We’ll take a look at an example of how this would work. After analyzing the opening of the market, you see that the stock price gapped down and dropped to support. You decide to buy the stock on support based on the expectation that it will bounce off support in the next hour and you’ll capture a profit from the quick rally. After entering the position, the stock languishes on the support line for the rest of the day. It neither bounces up to new highs nor drops below support to new lows. At this point, you have a decision to make. Based on your trading plan, you should exit the position and close the day in cash. You could always reestablish the long position tomorrow if the stock is still holding on to support. However, you decide to hold the position overnight by rationalizing that it could gap up tomorrow in the same way it gapped down today and you don’t want to miss the move. This type of decision is really based on hope rather than any proper analysis. The worst - case scenario occurs the next day when the stock gaps down below support. Having rationalized the first departure from the trading plan, you now continue with reasons why the drop shouldn’t continue. Two weeks later you find that you ’ re spending every moment in the market staring at this open position as the stock continues on its downward course, searching for any semblance of support that you can hang your hopes upon. How did you get here? Simple — you broke the rules that you established in your trading plan. Even if the position had not moved into a loss, it didn’t reach your objective (a bounce off of support) in the time frame that your strategy requires. Most traders find themselves in this situation because they don ’ t have a trading plan, though, not because they ignored their trading plan.
The point here is that a trading plan will highlight for you the proper course of action and help to hold you accountable to your decision. Before we move on, we should take a closer look at the issue of trading time horizons. When The Market Guys present at trading expos, we’ll often jokingly advise people to avoid becoming investors because they’re bad traders. But the painful truth is that many people have long - term positions in their portfolio that were originally meant to be short - term trades. In fact, the U.S. Internal Revenue Service recognizes “ worthless stock ” when a stock price has dropped to the point that there is no reasonable hope of recovery. Isn’t it ironic that the IRS will recognize the truth in a trade before we will? Don’t raise your hand as you read this paragraph (especially if you’re reading this on an airplane or sitting next to your wife at an antiques auction), but how many of you still have Webvan Group (see Figure 1.2 ) somewhere in your account? At what point should you have recognized that maybe this stock wasn’t going to return to its previous highs? At one time, this stock was a popular trading stock among retail day traders. Many of these traders made good profits over time on this stock, too. Somewhere along the way, though, the position they bought didn’t behave the way it had in the past. For the unfortunate trader who held the position in the hope that it would recover, the stock never met their expectation. By the end of 2001, the price had dropped below a penny and has rested comfortably there ever since.
The reason we’re spending additional time on this point is that it is one of the most common mistakes made by novice and experienced traders alike. As long as the position is open, there is hope for recovery, however remote. Once the position is closed, we’ve locked in our loss. There is a misleading belief that a loss isn’t a loss until the trade is closed. Nonsense! Don’t ever use this fool’s logic on yourself. Whether a trade is open or closed, if the stock price is lower now than when you bought it, you have a loss! One of the characteristics of trading options is that it forces you to admit your loss by a predetermined date when the option expires. Stock traders can fool themselves ad infinitum because a stock doesn’t expire unless the company finally declares bankruptcy and reorganizes. Your trading plan should define your time horizon — whether it’s intraday, short - term swing trading over one to two weeks, or position trading over a number of months. Your analysis of the trade should be based on that time horizon, and then you need to be diligent in holding yourself accountable to that plan. If you’ve opened a position and found that the trade has started to exceed your time horizon, close the trade and find a new position. You may not be losing money in the stock itself, but if you’ve locked your cash into a nonperformer, you’re experiencing a loss of opportunity. Remember, you could always place your cash into a certificate of deposit and get a nominal interest return.
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