Having a trading plan is like having a solid blueprint to build your home, or having a map when traveling to a new location. Even a professional trader won't survive in the markets without a good trading plan.
And once you've defined your goals and created your trading plan, you need to make sure it really works. So far, everything might look great, but how can you be sure that the system works when you start trading it with real money?
Evaluating a trading strategy is easier than you think. You just need to use the 10 Principles of Successful Trading Strategies. Below you'll find numbers 1-5.
Principle #1: Use Few Rules - Make It Easy to Understand
It may surprise you that the best trading systems have less than ten rules. The more rules you have, the more likely that you've "curve-fitted" your trading strategy to past data, and such an over-optimized system is very unlikely to produce profits in real markets.
It's important that your rules are easy to understand and execute. The markets can behave very wildly and move very fast, and you won't have time to calculate complicated formulas in order to make a trading decision. Think about successful floor traders: the only tool they use is a calculator, and they make thousands of dollars every day.
Principle #2: Trade Electronic and Liquid Markets
I strongly recommend that you trade electronic markets, because commissions are lower and you receive instant fills. You need to know as fast as possible if your order was filled and at what price, because you plan your exit based on this information.
When trading electronic markets, you receive your fills in less than one second and can immediately place your exit orders. Trading liquid markets means you can avoid slippage, which will save you hundreds or even thousands of dollars.
Most futures markets, all forex currency pairs, and the major U.S. stock markets are trading electronically.
Principle #3: Have Realistic Expectations
Losses are part of our business. A trading system that doesn't have losses is "too good to be true." Recently, I ran into a trading system with a whopping winning percentage of 91% and a drawdown of less than $500!
When I looked at the details, though, it turned out the system was only tested on 87 trades and - of course - it was curve-fitted. If you run across a trading system with numbers too good to be true, then it's probably exactly THAT: too good to be true.
Usually you can expect the following from a robust trading system:
1.) A winning percentage of 60-80%
2.) A profit factor of 1.3-2.5
3.) A maximum drawdown of 10-20% of the yearly profit
Use these numbers as a rough guideline, and you'll easily identify curve-fitted systems.
Principle #4: Maintain a Healthy Balance Between Risk and Reward
Let me give you an example: if you go to a casino and bet everything you have on "red," then you have a 49% chance of doubling your money and a 51% chance of losing everything. The same applies to trading: you can make a lot of money if you're risking a lot, but if you do, the risk of ruin is also high. You need to find a healthy balance between risk and reward.
Make sure your trading strategy is using small stop losses and that your profit targets are bigger than your stop losses. The perfect balance between risk and reward is 1:1.5 or more - i.e. for every dollar you risk you should be able to make at least $1.50.
Principle #5: Find a System That Produces at Least Five Trades per Week
The higher your trading frequency, the smaller your chances of having a losing month. If you have a trading strategy that has a winning percentage of 70%, but only produces one trade per month, then one loser is enough to have a losing month. In this example, you could have several losing months in a row before you finally start making profits.
In the meantime, how do you pay your bills?
If your trading strategy produces five trades per week, then you have on average 20 trades per month. If you have a winning percentage of 70%, then your chances of a winning month are extremely high.
And that's the goal of all traders: having as many winning months as possible!