First steps

Let us now look at the first steps you have to take to begin building a trading plan with a strict set of rules:

• Percentage of money to invest in each trade
• Stop-Loss
• Take Profit
• Risk/Reward

Percentage of Money for Each Trade

The first thing you have to decide is the percentage of money to allocate to each trade (position sizing). From my experience, position sizing is the main thing that prevents most traders from being consistently profitable. It is an important allocation because it encourages traders and investors to use proper diversification, which can help you obtain reasonable returns whilst minimising risks.

It has to be a percentage that makes you feel comfortable, and which allows you to work in a relaxed and stress-free way. This is vital, because it tells you not only which part of your capital you are risking, but also whether or not you can open a trade.

If, for instance, the broker requires more margin than you had planned in order to open a trade, you will not be able to open it, because you would risk more than you had budgeted, and this must never happen.

This situation can happen, for example, when you trade options (on some futures) or commodities (in spread trading). It is essential in these cases that you do not let yourself be driven by enthusiasm or by the desire to trade. You have to remain anchored to the rules you gave yourself; otherwise, your anxiety, stress and fear will only build.

Stop-Loss

The next step is to determine your maximum tolerable potential loss and, on this basis, decide where to place the stop-loss. A stop-loss is an order that closes an existing position when your trade goes in the opposite direction to what you had expected.

In practice, it is a stop order you set on the platform. That is, an instruction to trade when the price of a market reaches a particular level that is less favourable than the current price. This means buying if the market hits a specified higher price, or selling if it hits a selected lower price.

Important. The stop-loss must be set on equity. Only in this way can you have a maximum tolerable potential loss, which in turn keeps your emotions to a minimum.

The purpose of the stop-loss, therefore, is to end a position that keeps losing value. It prevents a loss from exceeding a given level that you have deemed unacceptable.

Thanks to the stop-loss, you can also determine the number of contracts you can trade. For example, with a trading account of $50,000 and a maximum loss of 2% (that is, $1,000), if you set a stop-loss of $500 per contract, you can trade at most two futures contracts (but only if that respects your position sizing).

Take Profit

Once you have decided the maximum loss for your trade, you also have to determine how much you want to earn, and accordingly, decide at which level to place the take profit.

A take profit is a type of order that enables you to close a trade upon reaching a predetermined gain. In practice, you use a limit order on your platform. That is, an instruction to trade if the price of a market reaches a particular level that is more favourable than the current price.

The limit order level is the maximum price at which you are willing to buy or the minimum price at which you have decided to sell to close an existing trade. There are several ways to identify a potential target, for example, based on a predefined economic value or near a key price level.

Important. An appropriate investment goal should be measurable and attainable. Success should not depend on outsize investment returns.

Defining goals clearly and being realistic about ways to achieve them can help protect traders and investors from making common mistakes that derail their progress.

Risk/Reward Ratio

Once you have decided on the stop-loss and the take profit, you can calculate the risk/reward ratio of your trade. The risk/reward ratio (R/R) is used to assess the profit potential of a trade relative to its potential loss. It is no coincidence that the word “risk” precedes the word “reward.”

If the ratio is greater than 1.0, the risk is greater than the profit potential on the trade. If the ratio is less than 1.0, the profit potential is greater than the risk.

Each of you will have your own view on the risk/reward ratio: 1.0, 0.8, 0.5 or lower. The lower the ratio is, the more you earn on each winning trade, but fewer trades will reach the target. Conversely, if the ratio is 1.0 or close to it, you will earn less, but you will also see a larger number of trades hitting the target.

You have to decide which ratio to use, according to your trading style. The important thing is that your risk/reward ratio should never be more than 1.0: if you risk $100, you have to aim to earn at least $100.

There are enough favourable opportunities available in financial markets that there is little reason to take on more risk for less profit.

Therefore, the four aspects you saw in this post are the basics of a good trading plan. However, they are not the only considerations, and you will see this in the next post, where I will show you how to create your trading plan.