While most investors are best served investing in a diversified portfolio, contributing regularly, and rebalancing to reach their goals, some investors may have the desire, time, and skill to trade securities. A trading plan creates a path that can help you make decisions through the market's highs and lows. Here's what you need to know to craft yours.
What is a trading plan?
A trading plan is your strategy for tactically buying and selling assets like stocks, bonds, exchange-traded funds (ETFs), and other investments. It can help keep you focused on your strategy even when markets are down, rather than reacting to short-term price movements.
But it's also an important guide when prices are up, as it keeps you from cashing out at times when holding onto your investments may be better for your longer-term strategy. In short, trading plans help remove some of the emotion and guesswork from your trading decision-making. This may keep you more on track to accomplish your financial goals.
Because they set the ground rules for buying and selling investments, you may have trading plans to address short-term and long-term goals. This may seem unintuitive for those familiar with the terms investing and trading, but in this case, "trading" refers simply to the act of buying and selling investments, rather than the amount of time you plan to hold them. That means short-term traders who buy and sell investments for quicker potential profits and long-term investors who plan to hold assets until retirement—as well as everyone in between—may have trading plans.
What's in a trading plan?
Trading plans can help direct your buying and selling of securities and help provide you with peace of mind.
Trading objectives Trading objectives give your money a mission statement. Why are you buying or selling securities? To diversify your portfolio? Capitalize on a market trend? Trade around an earnings announcement or other event? Act on insights from your research? Figuring out your "why" is a critical first step. Depending on your goals, seeking professional financial guidance, like coaching sessions or a financial advisor, may be appropriate.
Risk tolerance Just as important to understanding why you're buying or selling assets is knowing if you're comfortable with these trades. Your risk tolerance is an assessment of how comfortable you are with the idea of losing money. Consider your own financial ability to accept losses.
Though the stock market has historically gone up over the years and decades, it can and has experienced prolonged periods of declines. Of course, past performance is no guarantee of future results, but history shows that dips are normal. If you choose to actively trade the market, you have to understand that you may lose some (or even all) of what you trade with. Knowing your willingness and ability to take on risk will help guide how you craft your trading plan. And keep in mind that your risk tolerance may not be the same for all of your financial goals or accounts.
Time horizon For how long are you planning to trade? Generally, the longer your timeline, the more time your money may have to grow and potentially recover from tumbles in the market. For instance, you may be willing to risk less money if you are seeking to turn a profit in a day, instead of a month or year.
Tax situation The most important thing to keep in mind when selling securities is that there are higher tax rates when securities are sold that have been held for one year or less in a taxable account. In addition to capital gains taxes, keep in mind that interest and dividends can also be taxed if those investments are held in a taxable account. It's a smart idea to plan and set money aside for your taxes, so you're not stuck in a sticky situation when it comes time to foot the bill for the IRS. Normal taxable brokerage accounts may let you claim losses on your tax returns through a process called tax-loss harvesting, or using investment losses to help offset taxable gains, thereby decreasing what you owe each year. If you're considering tax-loss harvesting, be mindful of the IRS wash-sale rule, which can disallow a tax deduction in certain situations. State tax treatment of capital loss deductions and carryovers can also vary.
Depending on your financial goals and time horizon, you may be able to benefit from tax-advantaged accounts that help you reach your goals more efficiently. Retirement savings plans, like 401(k)s, 403(b)s, or IRAs, offer specific tax advantages that may lead to higher after-tax returns. Keep in mind though, we don't recommend actively trading retirement assets. And never trade more than you can afford to lose.
It may help to meet with a tax professional to understand all of the tax implications of your trading plan and whether there are certain accounts or strategies that may work best for you.
Asset type preferences It can help to research different asset types to determine what best aligns with your goals, risk tolerance, time horizon, tax considerations, and overall preferences. Assets can range from relatively conservative (such as shorter-term government bonds) to more risky (like individual company stocks). You may want to learn about mutual funds and exchange-traded funds (ETFs), which can be used for long-term financial goals and may help diversify your risk by widening your exposure across many different securities at once. You'll also want to determine what percentage of your investable funds will be devoted to each asset type.
Investment liquidity Given your intention to trade, you'll want to understand the liquidity characteristics of the investment vehicle you're choosing, that is, how easily it can be bought or sold. For example, stocks and ETFs trade throughout the day, while mutual funds generally price once per day. Certain alternative investments might have liquidity constraints, while low trading volume on publicly traded securities may mean you have to accept a lower price to fully liquidate your position. Another factor could be higher transaction costs, as certain investment vehicles may carry higher costs to buy and sell or involve more frequent trading, which could lower returns.
If your objective is based on the ability to buy and sell over shorter-time periods, it's important to think about how liquidity can impact your ability to make a profit.
Entry and exit plans Once you've finalized what investments you want to buy, you have to decide when to buy and sell. In trading terms, these are known as your entry and exit strategies.
It's important to determine this process before you start investing so you aren't making spur-of-the-moment choices based on temporary market peaks or valleys. You don't want to find yourself, for instance, investing more because prices are rising and taking on more risk than you intended. Conversely, you want to lay the ground rules for when you'll cut your losses vs. when you'll hold tight if the market stumbles and falls. For entries and exits, you may aim to target a certain price, a percentage gain or loss, or another indicator related to the particular asset.
To help manage your entries and exits, you might want to take advantage of different order types that may help you achieve a purchase price you’re comfortable with while potentially reducing your downside risk. You can also leverage advanced charting, price alerts, and other trading tools to help you decide when to act. (Fidelity’s web-based trading platform offers all these and more.)
Revising your trading plan
You may wish to change your trading plan over time. Market conditions, your financial situation, and your financial goals change, and you may want to amend your trading plan to reflect that.
Keep 2 things in mind: You shouldn't alter a trading plan as a knee-jerk reaction to temporary market events, like when stock prices take a dive. (That's a big reason why you came up with a trading plan in the first place.) And even if you decide to alter your original plan, make sure you devise a replacement to guide your trading.