Today I am going to write about aspects of a discretionary plan. Discretionary plan are first and foremost a reflection of our beliefs about the nature and structure of markets. Someone who believes in the market efficiency theory will use a different plan to someone who believes they are chaotic.

I believe that markets are chaotic. Consequently, I believe:

• Markets have a discernable structure
• They rhyme rather than repeat i.e. there are patterns we can exploit but these patterns are repeated’ similarly rather than exactly’.
• The market rhymes because the patterns are a reflection of the emotional tug-of-war between the buyer and the seller.
• The context in which the patterns occur are critical to the plan.

A discretionary plan is also a reflection of our psychology including our appetite for risk; this refection is articulated in our trading philosophy. In Trader Vic–Methods of a Wall Street Master by Victor Sperandeo, I found a statement that mirrored my values:

1. Preservation of Capital - this is the overriding principle
2. Consistency of Returns - this goes hand-in-hand with (1)
3. Superior Returns - only when (1) and (2) have been secured

My plan and results reflect the three characteristics; for example I use the Rule of 3 not because it increases my bottom line. Indeed, in a strongly trending market, the rule reduces my profits. I use the rule because it smooths my equity curve.

I believe a discretionary plan has certain critical elements:

• A way of identifying the trend of a timeframe and when the trend changes or is likely to change. Once we identify that a trend is likely to continue, or that it is likely to change, we have our strategy. That strategy is rooted in the timeframe we are trading and includes the effects on our the trend by higher time frames.
• Tools to identify price levels where a trade may take place (zones) . As my nature favours a responsive trade, I look to buy support in an uptrend and sell resistance in a downtrend. I very seldom buy/sell breakouts of my timeframe.
• Chart patterns that indicate a zone has held (setups) and entry patterns that tell me ‘now is the time to take a trade’ (triggers). The setup and trigger define the price stop placement. In addition to the price stop, I look to define the qualitative conditions that will cause me to exit a trade.
• Chart patterns that define the core profit target in the Rule of 3. This core profit target versus the stop defines the Risk:Reward expectancy: I need to see around 2:1 or better to take a trade.
• The relationship between the price stop, my risk assessment of the trade, and money management plan govern my position size. I have three sizes: normal, 1/2 above normal and above normal (usually 1.5 or 2.0 times normal).
• A set of rules (Rule of 3) that govern my subsequent trade management i.e. the management of the trade once it starts to move in my favour.

What tools do I use?

• TREND: Barros Swings and the Ray Wave
• ZONES: Statistics of waves, MIDAS (see www.tradingsuccess.com ‘ free section’ for Paul Levine’s lectures on this tool), and various ratios.
• SETUPS: Negative Development and Contraction
• TRIGGERS: Intra-day volume on Market Delta software
• INITIAL QUALITATIVE EXIT STRATEGIES: Based on Market Profile and Wyckoff
• INITIAL PRICE STOPS: Barros Swings and The Ray Wave

Once you have your tools, you need to create a plan. I have found that classifying the rules under ‘Buy & Sell’ and giving a setup and trigger a separate rule number, is the best way of creating a data base to assess the efficacy of the rule. I’ll discuss this farther in the blog on ‘Stats to Keep’.

A couple of final comments. I believe all traders should have a passing acquaintance with statistical and probability theory. This comes from someone who was mathematically a complete dunce until well into his mid-30s. “Salvation” was found in two books by Derek Rowntree:

1. Statistics Without Tears
2. Probability Without Tears

Finally if you see yourself as a serious trader (as against someone having a ‘flutter’ i.e. a gamble for pleasure), you owe to yourself to back test your setups and triggers. Generally because a discretionary trader relies so much on context, it is difficult for most back testing programs to test the trading rules. However, you can certainly test the setups and triggers. In back testing, you are looking for evidence of robustness and if you lack the skills to do it yourself (like me), then find someone who’ll do it for you.

In these plans, I look to prepare for Murphy’s Law: “if there’s anything that can go wrong it will’ (BTW did you know there is a whole web site dedicated to Murphy’s Law? www.murphys-laws.com).

The important point here is to prepare for these contingencies before they happen.

Let’s take the most difficult problem first.

• What happens if your internet connection goes down? Now that may be from a baby inconvenience from ‘my modem’ has stopped working to a granddaddy of a disaster where ‘your whole country’s ISP service goes down’. Don’t say that can’t happen - it happened to me when an undersea earthquake brought down all of Hong Kong’s connections. In my case, my contingency plans swung into action. I told a colleague of the problem and he placed interim stops and profit targets and the next day I was in Singapore where there was no problem.

• In the same vein, let me ask you if your broker takes phone orders? If he does, what types of orders will he accept? IB, for example, will take only market orders.

• This brings me to the next major problem: what happens if your broker’s platform goes down? Or worse still if his access to the exchange goes down. Allied to this is the problem of what will you do, if the exchange on which you are trading goes down (e.g. as a result of a terrorist attack)?

Think about this. It may be your account size does not warrant precautions, but then again it might.

The three ‘disasters’ above head my list because to a large extent, the ability to protect yourself depends on others: a friend, having other accounts, hedging on a different exchange etc. The next two on my list are more within our control to remedy but are no less stressful:

1. Having the market gap against you, big-time! I am not talking about say a 2% gap on the ES but something extraordinary like Oct 1987. If you have a 10% gap against you, what will you do?
2. The last one: you find you have an open position, an open position you were unaware of and it’s against you by 5%, 10% or more, what do you do in the circumstance?

My solution to both problems is to cut the position. This leaves me free to decide on my next course of action.

By the way, problem (2) did happen to me. I forgot to cancel a GTC stop order when I went on a holiday. Though I have someone who checks my positions daily, he, unfortunately, was having marital problems and failed to check the open positions during the break. I came home and found I was short the Hang Seng in raging bull market and down 10%. I cut the position and I was thankful I did: it finished lower the day I cut it and again the next day. But three days later, I’d have been down close to 13% and the loss would have increased the longer I held it.

The solution to major and minor disasters is preparation. Think them through and then rehearse them in your mind so that your responses are automatic. In the long run the preparation you put in may save your life.

Tomorrow I’ll start the posts on trading plans.

My starting point each September 1 (my year runs Sept 1 to Aug 31) is my business plan.  Since I treat trading as a business and we all know most, if not all successful businesses, have a business plan, I thought this the appropriate place to begin Success Routines and Habits.

I prepare my Business Plan in the first two weeks of September and I give priority to the task.  Below are my headings; they are far from being cast in stone and the same can be said for the plan. It’s reviewed and revised quarterly. The plan serves as a guide only. In the recent past, I can’t remember when I did not make some mid-stream correction.

HEADINGS:

• Vision & Mission Statement. To me this is the crux of the document. What we want to become and why must align with our values otherwise all the plan will be is wallpaper and will be as much use.
• Goals
• Expenses
• Projected Income
• Trading Plan
•    Rules
•    Trading Timeframe
•    Markets
•    How do I know when plan is not working?
•   When will I take an enforced break?
• Risk Management Plan
•    Position Sizing per trade
•   Position Sizing Portfolio
•   Initial Risk Exposure per trade
•   Initial Risk Exposure Portfolio
•   When and how to Pyramid.
•   When and How to make Profits available to trading capital.
•    Maximum Loss per trade
• Ongoing education in Plan, Risk Management and Psychology
•    Time Allocation
•    Dollar Budget
•    Areas to Focus on within each area (Plan, RM and Psy)
• Focus and Review Plans
•    Especially if there are important life-style changes e.g. changing jobs, having a child etc
• Disaster and Contingency Plans

A few years ago I attended a seminar by Van Tharp (www.iitm.com; also his blog at: www.smarttraderblog.com) on Business Plans. At the end of the seminar, we all had to do a business plan. I have attached this as one of the better ones submitted to give you an idea of the form the plan can take.

businessplan.doc

I trust you all had a great Xmas!

Over the next few blogs, I’ll be considering the routines and habits we need for trading/investing success. In this post, I’ll be examining the pre-conditions that are necessary.

Routines and habits are actions. There are 5 pre-conditions to effective action:

1. The quality of our preparation and planning
2. The will to execute our plan
3. Our willingness to act beyond our comfort zone
4. The effectiveness of the review of our results: we seek to improve the results that lead to our goals; and we seek to change or replace the actions whose consequences lead away from our goals.

But effective action is only one half of the power equation. Actions are the direct result of the decisions we make. Our decisions are dependent on:

• Our internal landscape: our experience, intelligence, attitudes, beliefs, and values.
• Possessing certain values that are critical: honesty, integrity and accountability.
• Our willingness to look behind our closed doors. We all have areas of our past that we’d rather not examine. But here’s the conundrum, to the extent that they remain hidden from our conscious minds will be the extent to which they control actions, usually with adverse consequences. So by having the courage and fortitude to endure the emotional pain that comes from such an exploration, we’ll achieve a self-awareness that leads to more effective action.

Armed with the pre-conditions, we’ll examine routines and habits from the 3 perspectives: Intellectual, Emotional/Psychological and Physical.

First in this series begins tomorrow when I look at one aspect in the Intellectual camp: the Business Plan