How to create a trading plan and manage risk

Whatever your long-term investment aims, it’s essential to have a trading plan to help you stick to the straight and narrow.

Successful investors stick firmly to a chosen strategy, refining it as they go along with knowledge gleaned from successful – and unsuccessful – trades. In fact, the unsuccessful ones can often teach us far more.

That is not to say that in a year’s time, or two years, or five years, you shouldn’t revisit your trading plan and ask whether it is still right for you. In fact, carrying out a periodic reassessment at predetermined times should be part of your plan.

What you mustn’t do is jump from one strategy to the next on a whim, or just because you’ve had a few setbacks.

Any investment needs to measured over a fixed period of time, at least six months to a year, preferably longer.

It’s important to remember no trading plan is going to be 100% successful – you just need to make sure you are getting more winners than losers, and if not, you need to analyse why.

Before you start it's important to establish your risk appetite Photo: Shutterstock

Risk appetite

Firstly it’s important to establish your risk appetite – it’s a fundamental part of your trading plan.

Are you risk averse, just seeking to make a modest but steady return on a ‘safe’ stock or fund, in the absence of good savings rates at banks and building societies?

Or are you perhaps more of an adventurer, prepared to take a higher risk of losses in pursuit of double-digit returns?

Or you might prefer a middle course, putting a small amount of your investment pot into higher risk investments, but hedging that risk by putting your remaining cash in those steady earners.

Risk pyramid

One way of looking at your investment risk options is by creating a pyramid sliced into three layers. At the base are your safest investments – savings accounts, ISAs, government bonds, corporate bonds from big blue-chip companies, and so on.

Create your own risk pyramid detailing what percentages you will allocate to different risk strategies Image: Capital.com

In the middle slice you have investments that are still fairly safe, but more volatile – though equally, likely to earn you a bigger return. These will include mutual funds, closed-ended funds such as investment trusts, shares in big-name, blue-chip companies such as Apple, Microsoft and McDonald’s in the US Dow 30, and Astra Zeneca, Unilever and easyJet in the UK’s FTSE 100. Interestingly, Amazon, Facebook and Google aren’t in the Dow 30 as too many high-value stocks would distort the average – but all can be regarded as blue-chips.

In the top slice you have the riskiest investments. Currency trades, CFDs on currency and stock movements (see below), and other short-term trading techniques.

The shape of the pyramid – tall and thin or fat and wide – will depend on your own personal risk preferences.

Timescale

The next big question is timescale, which is closely tied to risk. Are you looking for a short-term investment? Perhaps you’ve been left a £10,000 bequest and want to make the most of it rather than leave it in a building society account earning a meagre 2% interest.

The next key factor to establish is timescale, which is closely tied to risk Photo: Shutterstock

You weren’t expecting it, so you can afford to be adventurous in a bid to make the most of that cash.

Alternatively, you could be looking to self-invest some of your pension pot, rather than simply keep it in your workplace scheme. In that situation, you would most certainly be looking at a much longer time horizon, and investing in a fund (or funds) where you are unlikely to get any nasty surprises.

Risk management procedure and personal strengths

As well as risk aversion, it’s also important to establish your other personal strengths and weaknesses.

You need a cool, calm head for investing of any kind, but it’s critical for short-term investing. Be honest with yourself – if you think there’s a chance you might panic or be tempted to gamble, than stick to longer term investing.

Play to your strengths. If you have a particularly good knowledge of certain types of stocks – say tech companies – then it might make sense to focus your strategy on that.

Do you follow the news and keep your finger on the political pulse, either in your own country or overseas? If so, then you may be well-placed to ride currency pairs (forex) – speculating on whether a currency is going to rise or fall.

Bear in mind, however, that currency movements are always highly volatile, and screening out the noise can be tricky. But big events such as the Brexit referendum, or Macron’s resounding election win in France, will always produce a strong response.

It's essential to set targets, and decide how much of of your cash you are going to allocate Photo: Shutterstock

Setting targets

Once you’ve established the basics, it’s time to start setting some targets. How much of your cash are you going to allocate to each of those pyramid slices?

If you’re running active positions at the riskier end of the spectrum, how many trades are you prepared to have open at any one time – and how much are you willing to risk losing?

In these situations it’s worth setting a maximum loss limit – the most you are prepared to lose in one hit (see the 2% rule below).

Trading style

Fundamental analysis

Another factor to take into consideration is your trading style. This governs your overall approach to trading: are you planning to make trades based on external factors – the news, essentially? This is known as fundamental analysis. Here you will be making decisions about trades based on a number of events such as:

• Central bank forecasts
• Economic analyses from global bodies such as the International Monetary Fund (IMF)
• Official government growth and employment figures – in the UK released by the Office for National Statistics
• Geopolitical factors such as government stability, military tensions or economic sanctions imposed on a country

Technical analysis, and takes a more mathematical approach to trading Photo: Shutterstock

Technical analysis

The other approach is known as technical analysis, and takes a more mathematical approach to trading:

• Analysing patterns of behaviour in stocks or currency (forex) movements;
• Making decisions to trade based on predetermined theories or formulae such as momentum investing, averaging down or the Martingale theory.

Momentum investing, for example, involves riding the coattails of a rapidly rising or falling stock.

Analysts have established a so-called momentum effect where share prices tend to keep trending up or down for a period of time before changing direction. The trend can continue for anywhere between three months and a year.

The underlying cause is psychological – investors don’t want to miss out on a trend, so they pile in, or out, reinforcing the direction of movement and sending prices even further up or down.

A classic example of this is the phenomenal price rise of Bitcoin in 2017, from just under $900 at the beginning of January to nearly $19,000 in December – but while the momentum was mostly upwards, there were also some unexpected and horrendous falls.

Such strategies can bring rich rewards – but they can also lead to big losses.

CFDs allow you to trade a derivative of the actual stock Photo: Shutterstock

Trading CFDs

If you are looking at making regular technical trades, you will probably want to use a trading system that allows you to buy and sell contracts for difference (CFDs).

CFDs allow you to trade a derivative of the actual stock, rather than buying the shares themselves. You then pay a percentage of the deal, known as a margin – usually around 5% – to the trading platform you are using.

The other main advantage is that you can just as easily trade on a ‘sell’ (known as shorting) as a ‘buy’, and you can also set automated stops to prevent heavy losses if things don’t go the way you hoped.

These stops can be moved once the trade has started, so that if, for instance, a stock is rising, you don’t allow it to fall back too far before the stop kicks in.

You do need to allow for volatility, however, or your trades will be stopped out too easily by a random spike.

You should also remember that despite setting stops, it’s still easy to run up big losses – don’t attempt these short-term strategies unless you can afford to take a hit.

Timing is critical – knowing when to sell a stock is vital Photo: Shutterstock

The 2% rule

One of the golden rules in short-term trading is never to risk more than 2% of your account in a single trade.

So if you have £5,000 in your account, never put yourself in a position where you could lose more than £100.

If you’re trading CFDs, use stops to ensure that your losses are never greater than 2%. The initial amount you place to open an order can quickly rack up a big loss if you’re not careful.

And don’t forget, the bigger your losses, the greater the return needed next time just to get back to your original starting position. If you lose 25% of your ‘bank’, you need a 33% return to restore your losses; if you lose 50% of your bank, you need a 100% return to break even.

Longer-term investing

If you’re highly risk averse or simply want to focus on the longer term – for instance if you’re investing your pension portfolio – then you need a completely different strategy.

Here you will want to focus on the bottom two slices of that pyramid we talked about earlier. Depending on the size of your pot, and your age, you will want to put some of your cash, say, in government bonds, and another large chunk of your money into mutual funds and investment trusts.

Funds and trusts are basically baskets of stocks, managed by experienced industry professionals, with a team of researchers and analysts at their disposal.

Investing in funds spreads the risk of one or two stocks performing poorly Photo: Shutterstock

By taking this approach you are spreading the risk of one or two stocks performing poorly and maximising the potential gain by investing in several likely winners.

There are hundreds of funds out there to choose from, and again you can tailor your choice of fund depending on your risk profile. If you’re cautious you can choose what are known as ‘trackers’ – funds that track the index in terms of their investment profile, and so should always generate a reasonable return (providing the index is doing well).

At the other end of the spectrum you have ‘active’ funds, where the manager and his or her team will actively seek out what they think are the companies with the best financial potential.

Reviewing performance

Whether you are buying individual stocks or funds, you need to regularly review their performance, selling those that are consistently underperforming and looking for new ‘buys’ that meet your criteria.

That doesn’t mean you should be looking to sell the moment your holding hits a downward spike – it only takes a brief look at a graph of share price movements to see how volatile they can be on a daily or weekly basis.

You should be reviewing your holdings on a monthly or quarterly basis – ideally, you’re looking for steady upward growth.

Doing your homework on your investments is really important Photo: Shutterstock

Doing your homework

Doing your homework is really important. For instance, after the Brexit referendum the FTSE 100 briefly fell – but then, as the pound fell, the FTSE 100 started rising. The reason? Many of the big FTSE 100 companies make their earnings in US dollars, so the cheaper the pound, the more money they were bringing home.

You should also beware of overreacting – although shares in many UK companies tanked after the referendum, they had mostly recovered within two or three months.

There’s many an investor who has sold a falling stock after a dose of bad news, taking a hit in the process, only to see the stock recover a few weeks later.

If, conversely, your stock is rising too rapidly, you also need to consider whether to sell. It’s safer to sell on the way up than on the way down – falls can be much larger and more dramatic than rises; it all comes down to psychology again; the fear factor.

Discipline and record-keeping

Whatever your investment approach, it’s particularly important to be disciplined in your approach – don’t breach your personal limits, either in terms of total cash allocation to a particular strategy, or your allocation to a particular trade.

Keep an up-to-date account of every single trade – the dates, the amounts, price movements, the gains, the losses – ideally in an Excel spreadsheet. Make notes, too, of particularly successful – and unsuccessful – gambits.

It's important to keep a monthly check of how your investments are performing Photo: Shutterstock

If you’re a short-term trader, keep a daily note of your trades – what happened and why; what worked and what didn’t.

If you’re a medium- to long-term investor, keep a monthly check of how your investments are performing, but don’t be tempted to sell just because of what are (to you) short-term price movements; you should be looking at 1-2 year time horizons, or even longer for some types of investment (infrastructure funds, for instance).

Investing at any level should never be seen as gambling, but rather a careful and calculated strategy for returning a healthy level of interest to your capital.

Practice makes perfect

Before you start trading for real, it makes sense to practise. Many companies offer demo trading accounts, where you can ‘play’ with stocks and shares or CFDs without the risk of losing any money.

It’s a great way to get a feel for how the process works – whether it be how stocks and currencies react to news events, or just getting to grips with the mechanics of the trading platform, which can seem a little daunting at first.

With a demo account you can practise to your heart’s content, seeing whether what you think are buying signals actually stack up – or if what you thought of as good news sends stocks tumbling.

Never forget you’re in this to make money, not lose it. Start the investment process cautiously, tread carefully, always be open to learning, and never, ever trade more than you can afford to lose.

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