Our focus this week is on rules to trade by. Last year, I had the less than desirable task of having to sit through eight hours of traffic school. I tried being a good sport about it and got through it fine (the instructor made it bearable). As the class progressed, I began to draw strong parallels between being a safe driver and a profitable trader.
For one, being a safe driver requires following a set of rules (usually imposed by our states or municipalities); in trading however, we create our own set of rules. In like manner, both activities’ transgressions carry with them a commensurate penalty.
Can you imagine driving around without stop signs, marked boundaries or road signs? If you did that for any extended period, the likelihood of you becoming involved in an accident would be almost certain. Similarly, a trader who enters the market without a concrete set of rules will at some point, experience a collision of his own.
In my many years in this industry, I have yet to meet a consistently profitable trader that did not have a “golden set of rules”. I believe it is imperative for someone starting out to create a set of rules before embarking on their trading journey.
Trading rules should be designed and implemented to minimize losses, maximize profits, and give the trader boundaries. They must also be very personal. By this, I mean the perimeters set by a trader will have to comply with an individual’s style of trading, temperament for risk, and size of account. For these reasons, it is important that when you begin to formulate your rules, you have a trading philosophy, as well as having done some serious introspection.
Risk management is the cornerstone of any professional’s trading plan, therefore, the first rule for any trader should be one that addresses risk. A good rule in this respect might be one in which we determine risk per individual trade. In a futures account, this should not exceed more than 2% of the equity (account balance). In addition, a daily loss limit, and restricted number of trades per day should also be complied with. This will serve to stifle the need to trade to get WHOLE, and will make a trader more discerning in the trades he or she will make. The natural tendency for new traders is to trade themselves out of the hole, or trade actively. However, more times than not, this will only tend to exacerbate losses.
One of my personal rules is never to allow a big winner to turn into a loser. I define a big winner when a profit is three times the initial risk. This rule is helpful in managing risk, but also, in keeping capital preservation in the forefront of a trader’s consciousness.
In order to maintain favorable odds, and shift the focus away from being right most of the time, perhaps another rule might focus on trading only with favorable risk-to-reward ratios (preferable 1-to-3 or more).
It’s also important to know when not to trade. Other rules might speak to trading environments, times of the day, etc. For example, if your trading style is trend following, perhaps you avoid range-bound markets. Conversely, if you trade using oscillators, sideways patterns may be your bailiwick. Maybe you don’t trade the first fifteen minutes, or extended hours, and so on.
Indeed, crafting your individual rule-set is the easy part; CONSISTENT implementation, though, is the major challenge. Still, adherence to the rules must be the focal point, not making money. Traders who undergo protracted drawdowns are usually those who have veered away from following their rules, or even worse, those who have NO RULES.
In summary, having a plan and a set of rules to trade by is important, yet execution is the critical component in extracting money from any market, on a regular basis.