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Approach Trading like a Hedge Fund

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Plan the Trade and Trade the Plan

Have you ever wondered what makes Hedge Funds and other institutional investors and professional traders so successful?

 

Put very simply, they approach trading and investing as a business. Unlike novices and amateur traders, these institutions have established systems and processes, and, perhaps most importantly, a plan for their trading businesses.

They have looked at every aspect of the business, and worked at safeguarding their interest so that they are able to stay profitable for the long run.

So whether you want to be a full time trader, value investor or positional trader, you have to approach this business from the same point of view.

If you were starting any other business, would you start buying and selling your products without a plan? Of course not!

Yet most of the people who want to get started in the market, just open a trading account, transfer some money, and start trading.

The result?

They land up losing their trading capital. And then they turn around and say that “investing is risky”, “trading in the markets is a losing proposition” or some such statement.

The fact is, they were not prepared. They had no plan and no system to take care of their trading business.

But if you want to succeed in this business, you have to have a plan.

So what should a business plan for the business of trading look like?

Let’s work on putting together a trading business plan along the same lines as a regular business plan.

Objective

The first thing that we do while writing a business plan is work on the objectives – the Vision, Mission and Value Statements. This is the part that is supposed to put down in words why we are in the business in the first place. What is it that we want to achieve and how are we going to go about achieving it?

Like in all businesses (apart from not-for-profit organisations) the goal in the business of trading is to make money. But the how and what is very often less important than the why. So I always encourage my students to work on why they want to make money from trading.

We use the 4 whys principle to understand this better.

  1. I want to make money by trading in the stock market – why?
  2. Because I want to be financially free? – why?
  3. Because I never want to work for my money – why?
  4. Because I want to spend more time with my family / travel the world / work for world peace …

So if you start from the 4th why and work backward, according to Simon Sinek (“Start with why”, Penguin, 2011) you will align with your passion and are more likely to find success.

In the Objectives section of the business plan, therefore, I encourage you to put down your reasons to make money and achieve financial freedom.

Perhaps you want to travel around the world, perhaps you want to focus on your passions – music, painting, cycling, etc., or you have loftier goals like cleaning up the planet, fighting for peace, or child rights. Stating this as your mission will make you connect and stay connected with your business like nothing else.

Now, I know this may sound a little extreme, but trust me, having your dreams spelled out in front of you will drive you towards action. In fact, with the longer-term benefit of your actions stated right from the start, you are more likely to make rational and pragmatic decisions that focus on the long term rather than the short term.

Risk Management

Once we have established the Objectives, we move on to the Financial Plan.

In the business of Trading this is called the Risk Management Plan. Just like in a Financial Plan, in the Risk Management Plan as well, we are talking about Revenue, Costs, and above all the Profitability.

So we define how many trades we are likely to take (turnover), how many are likely to be profitable (revenue), and how many are likely to be loss-making (costs).

The adage, ‘losses are a cost of doing business’ holds true.

So it will look something like this:

Number of trades per year = 100

Expected success ratio = 50%

Risk to Reward Ratio (defined) = 1:1.5

Risk per trade = 1%

Revenue = 50 x 1.5% = 75%

Cost = (100-50) x 1% = 50%

Profitability = 75% – 50% = 25% per annum

In this way we have defined our Risk Management Plan a.k.a. the Financial Plan. Learn more about Risk Management here.

Trade Management Plan

Now, once we have defined why we are running a Trading Business, and how we are going to be doing it, we next need to define what we are going to trade.

The Trader Management Plan will define the products you will be trading in – stocks, bonds, futures, options, forex, commodities, as well as the entry and exit mechanism.

Obviously, this section needs to be as detailed as possible. And once you have decided which product(s) you will be trading in, the Market Timing Strategy comes under focus.

Now, when I started out in the trading business, I figured that if I knew what stock to buy, what price to buy it at and what price to sell it at, I can become successful in trading. In other words, if I had my Market Timing Strategy, I can become a successful trader.

Unfortunately, as you have probably already realised, that is not the case.

However, the Market Timing Strategy is something that is critical to your Trading Business.

In fact, the more well defined it is, the more objective it is likely going to be. This means that you are more likely to take a rationale approach to trading. If you want to know why this is important, have a look at this article [Psychology of Trading article link].

So if you are focusing on Value Investing, your Market Timing Strategy will look something like this:

  1. Identify top 5 stocks to invest in
  2. Prepare an investment thesis
  3. Calculate valuations
  4. Identify support area / ideal market price for entry

If you are focusing on Intra-day Trading or Swing Trading, you may have a Market Timing Strategy that looks like this:

  1. Identify 50 stocks to watch
  2. Enter trade if fast moving average crosses over slow moving average and:
    1. Either a bullish candle pattern is formed or
    2. Market price corrects more than 50% or
    3. Consolidation pattern is formed

Obviously, these are simplistic examples and your trading plan should be more detailed. The more details you add the better.

Trade Journal

The Trade Journal is one of the most powerful things that I learnt to do right in the beginning of my trading career. It is not a surprise though to see that not many people follow this principle.

You see, most people take the result of their trade to heart. If it is a winning trade, they feel that it is their own personal victory. Likewise, if they have a losing trade, they feel they have failed.

And so, recording these failures is like a confirmation of how bad they are.

But to succeed in the business of trading, you have to see winning and losing trades for what they are.

Trust me, when you record your trades, ALL your trades, you get a realistic sense of where you stand – what you are doing wrong and what you are doing right.

It’s like the financial report.

Most of us hate seeing our financial statements. But the Profit and Loss Statement, the Balance Sheet, and the Cash Flow Statement are an integral part of any business.

In fact, if a business is not focusing on its financial statements, it is likely to run aground very soon.

And so it is for the business of trading.

The more you keep an eye on your performance and make corrections accordingly, the more likely you are to succeed.

The Trade Journal is a very powerful tool and can not be ignored.

In this section therefore, you will define what you plan to track, how often will you analyse your Trade Journal, and how will you get it audited.

By audit I don’t mean hiring a Chartered Accountant to come in and go through your books.

What I mean by audit is to have someone you trust, a professional or a senior trader, have a look at your trades. He / she can go through your performance and give you advice on how to better your trading style.

Without the numbers, you are likely to get more generic advice, so it makes so much sense to have these numbers with you.

Your Trading Journal is like a barometer of your trading abilities. Make it a regular part of your trading day, and you will see benefits in many, many ways.

Trade Plan

And finally, the Trade Plan!

This is what your plan for every trade will look like.

“Plan the Trade and Trade the Plan”

What this means is that you will design every trade BEFORE you enter it. BEFORE the markets open and BEFORE the price has moved in your trading zone.

Why is this important?

It is important because when you are seeing those price movements. When you are watching those red and green candles form. You will feel your heart race. This feeling is the anticipation of what is about to come. It is the feelings of greed and fear that tend to dominate us as we watch the open market.

If you decide to do your analysis at this point, you are likely to make the same emotion-lead mistakes that plague all amateur traders.

You will see a series of red candles and be too afraid to take the trade because you don’t want to get stopped out. Only to see the market turn at your planned entry point and reach your target.

Or you will see a series of green candles and jump in without thinking. You don’t want to miss the rally. Only to get stopped out immediately.

If you are nodding your head in agreement, don’t worry. We have all been through it. But you don’t have to go through it anymore.

“Plan the Trade and Trade the Plan”

You will create a Trade Plan that looks something like this:

Script Name:

Entry Price:

Stop Loss Price:

Target Price:

Volume:

Reason for entry:

That’s it!

You don’t have to make it overly complicated.

Now, comes the hard part.

You will put these orders in your broker platform BEFORE the market opens. Then shut your computer and go home.

You see, there are only two things that can happen now.

Either you will get an entry or you won’t.

If you don’t get an entry, it doesn’t matter.

But if you get an entry, there are only two things that can happen.

Either you will make a profit or you will make a loss.

If you make a profit, fine. If you make a loss, fine. You know that’s just the cost of doing business.

Now, I know this all sounds logical but it is perhaps the hardest thing you will ever attempt to do.

But until you realize that both these scenarios are part of your business and that you can not get influenced by either of them, you will not be able to succeed in this business.

And that’s how it is done.

“Plan the Trade, and Trade the Plan.”

I hope by now you are convinced that the only way to be profitable like the professional traders and institutions, is to do what they do. The professionals don’t leave things to chance, they don’t ignore things just because it makes them uncomfortable, and they certainly don’t trade without a plan.

Do your self a favour. Be a Professional. Have a Plan.

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