Some Rules To Invest By

Eventually, however, the novice trader must reach deep into his pocket to pay for his or her losses. This should be cause for reflection, but more often than not, it turns out to be an excuse for blaming someone or something else. For the trading survivors, it is a time to refresh their understanding of the basic rules of trading.

The trading rules you'll see here come from personal experience and market insights. I use these observations as personal trading rules. Like all my trading rules, they are developed from experience to suit my specific trading style and personality and to compensate for my weaknesses.

Novice traders initially need to rely on the perceptions of others in building their own trading rules. The specific rules you finally adopt will be different. Take what is appropriate for you from these 15 rules, adding to them and modifying them to suit your trading style.

RULE 1: Understand trading discipline: Trade development.

The novice trader believes that trade development is the discipline to follow our trading approach. Better traders, however, understand it also includes meeting the challenge of cutting losses and taking profits cleanly.

Initially, the novice concentrates on formulating entry conditions and developing the discipline to wait until all the entry conditions are satisfied. The novice is better equipped for position trading based on end-of-day data, where decisions are made without the interference of intraday market activity.

Position trading techniques are the basis of many trading strategies, but this rule applies to all. "Patience is an important trait many people don't have," famed trader Tom Baldwin remarked in Jack Schwager's Market Wizards. "They end up forcing the trade, rather than waiting patiently. They forget that the reason they made money in their early trades was because they waited a long time."

The novice must master the discipline to act on his entry signals, even if it means being out of the market for a long time. Just because this is the first skill learned does not mean it is the least important. Without it, a trader cannot grow. With it, however, a trader can grow very large.

Better traders understand that trading discipline is also the ability to exit a trade under either one of two conditions -- to realize a loss or to take a profit.

Selling is more difficult, because we can never be sure which way the market will perform in the future. We buy for one reason, but we sell for many. This side of the trading process is much more complex and challenging. Unless traders develop a disciplined approach to the exit, their trading suffers.

In understanding the way discipline applies in this trading rule, we build on our understanding that a loss is not the same as losing. Until we accept this distinction, it is almost impossible to exit a trade with only a small loss. This lack of discipline rapidly destroys all our accumulated profits, assisted by the most discouraging market truism of all -- a 10% loss cannot be made up by a 10% gain. A 10% loss on $100 leaves the trader with $90. A 10% gain on this $90 trade is only $9 --a dollar less than the $10 initial loss.

There are several ways to develop the discipline required to take profits. I find the most useful is to set defined financial targets before entering the trade. You may feel more comfortable defining a set of exit conditions based on a series of chart indicators. The exact method used is not as important as actually having a predefined plan for the exit formulated before the trade is entered. It is difficult to exercise discipline if we make up new exit conditions every day. The discipline of planning builds the discipline required to exit to take profits cleanly.

Pursuing the last few ticks in a price move is trading filled with regret. Legendary investor JP Morgan is reputed to have said, "I always sold too early," but this did not appear to have a serious impact on the creation of his wealth. Nor will it destroy the average trader.

Better traders understand that trading discipline includes these three elements -- the patience to follow a plan or method, acting on stop-loss points, and taking profits cleanly without regret.

RULE 2: Understand trading discipline: Emotional development.

Very successful traders have another understanding of trading discipline that allows them to rise above the average. They do not let their emotions, their temper, or their frustrations get in the way of their trading.

A novice trader talks of losses as being caused by a mythical beast -- the market. "I was taken/beaten/dumped by the market," they say. These traders let their emotions dictate their trading strategy.

More frightening, because it is less frequently acknowledged, is the impact of anger and frustration on our trading performance. Trading rage is even more deadly than road rage.

Take a moment to reflect. How many times have your losing trades been driven by external emotions -- by anger, frustration, revenge, or the need to prove something to somebody? How many of these trades have been used to satisfy emotional needs that have absolutely nothing to do with the market? Finding the answer takes some soul-searching rather than searching through your brokerage slips.

All of us have been guilty of this. It is part of the process of moving from novice to journeyman to craftsman. Emotional discipline separates the skilled journeyman from the craftsman.

RULE 3: Accept responsibility for your actions.

Personal responsibility is unavoidable. The novice trader and the wannabe trader look for trading programs that automatically provide buy or sell triggers and claim to turn unskilled users into successful traders. Too often, a mechanical trading system developed by someone else is a convenient crutch that allows the novice trader to avoid responsibility. It is easier to blame the system than our own foibles.

Exploring and understanding different trading approaches is one of the first steps toward developing trading responsibility. Rarely is a single trading approach adopted wholesale. Each trader brings his own experience and interpretations, whether he uses moving averages, Gann swings, trendlines, or moving average convergence/divergence (MACD) triggers. Having assembled the pieces himself, the trader accepts the responsibility for the outcome.

When your broker gives you poor trading advice, accept your responsibility for your loss. After all, you took the advice and acted upon it. You chose not to initiate any stop-loss procedures.

Although you may use the proceeds of trading to improve your family's lifestyle, ultimately, you are trading for yourself. You cannot trade to meet the expectations of others. If your partner tells you how to trade, then encourage him or her to trade his or her own account. Do not let others set your trading objectives.

Responsibility and trading discipline feed off each other. It is difficult to develop true trading discipline without accepting responsibility for trading action and outcomes. This is the major obstacle standing between many traders and success.

RULE 4: Plan the trade -- trade the plan.

Everybody plans to trade, but only successful traders have a trading plan. In summary, the plan is reduced to just a few notes, small enough to stick on the side of the computer. The novice often mistakes this summary for the complete rule book.

This summary plan has many rules, including:

• Have a clear reason for being in the trade.
• Know your exit conditions in advance.
• Ride winners.
• Cut losses quickly.
• Use money management.
• Keep positions small.

Why am I in this trade? Forget the glib answer of making money. Traders are often reluctant to probe the reasons for each individual trade, even though it is an essential part of the planning process.

Why am I in this trade? A selection of good answers includes the following:

• I am exploiting this short-term rally.
• I am trading momentum.
• I am trading the long-term trend and this is the best entry point.
• A major news event will probably cause a rally. I am trading that rally.
• I am trading to rescue a position that is under water.
• I am trading the triangle breakout.

• I have spare cash, so I feel I ought to be in the market.
• Everyone else is making money.
• This recommendation sounds so good I would be a fool not to trade it.
• After the last loss, I need to get some money back.
• The stock is now worth half what it was when I bought it. I will average down.
• I need some money.
• At this price, it is a bargain, or it has to be a bottom.
• If I wait much longer, I am going to miss out.
• The margin loan facility has been cleared. What can I buy?

RULE 6: Know your exit conditions in advance.

This is one of the public rules acknowledged by everyone but to which many pay only lip service.

Rule 6 is up there with the hardest trading rules of all. Ignore it, and it becomes your worst enemy. Your first exit condition should be designed to cut losses quickly. It does not always have to be a formal stop-loss value; it can be a set of market conditions identified by a particular technical indicator.

The second exit condition should be designed to protect and lock in profits. I use set profit objectives based on the return on capital. I find it a useful way to control greed, which I have identified through experience as one of the barriers to my trading success. Your barriers may be different, so exits might be based on indicator conditions or trailing stop-loss points.

The trader who knows his exit conditions in advance is prepared for any market eventuality, so in a crisis, he can react calmly while others are losing their heads -- and their money.

RULE 7: Money management is the key to trading survival.

If a trader has every other aspect of the trading plan perfect but no money management in place, that trader will fail. Without money management at all, the wins, big and small, can be destroyed in just a few losing trades.

I use an approach where each position puts at risk only 2% of total trading capital. With a $100,000 account, the size of each position might vary from $20,000 to $50,000, but once any of the positions has lost $2,000 -- 2% of total trading capital -- then it is closed. I discussed this strategy in my May 1998 Stocks & Commodities article.

Money management is a complex topic, too much so to discuss fully here. A single money management model will not suit everyone, but without some form of money management, traders are extremely vulnerable in the market.

RULE 8: Keep trading positions small.

Traders with limited capital often think this trade-planning rule does not apply to them. On the contrary: The small trader is locked into greater risk because he has limited capacity to diversify the risk profile across the market. Although these traders readily agree it is foolish to take $1 million of trading capital and put it into a single position, they are less agreeable to applying that rule to their own trading. No, indeed; they see no problem at all in the fact that the entire $6,000 of their trading capital is in Amazon.com stock.

No matter what size our trading capital, the objective is to match position size with risk. Stable stocks attract a larger proportion of our capital, while more speculative issues are allocated less. I use a 1:2:4 ratio, with a seventh of my trading capital allocated to speculative stocks and derivatives, four-sevenths to blue-chip issues, and two-sevenths to mid-cap growth stocks.

There are many other ways to match position size and risk, and they all concentrate on ways to keep position size small relative to the overall portfolio so the risk of failure has diminished impact. Amateur traders, and amateur gamblers, bet big. Market survivors take many small positions and many small losses in pursuit of the winner they ride for major wins.

RULE 9: Trade the market, not your opinion of it.

There is only one right answer, and the market has it. If you catch yourself thinking, "The market should not have done that," then immediately examine all your open positions. We are paid for trading the market, not our opinion of the market.

This rule is mostly ignored by experienced traders. Quite suddenly, they lose touch with the market, and losing trades begin to accumulate. If trading discipline is strong, the losses don't amount to much in dollar terms, but it still hurts in emotional terms. The temptation is to add to the losing position until the market finally comes to its senses and understands the view of the trader is the correct one.

Ego grows only when we gather some success, and with it a dangerous certainty that we can actually pick the market direction. The private trader is generally fodder for larger market sharks, and those who forget these limitations become shark food. My screen saver scrolls the reminder: "I manage risk. Trade the plan."

RULE 10: Trade where the crowd is, not where it has been.

As traders, we cannot profitably catch fast-moving prices, no matter how many there are. If we run after a moving market too far, we soon run out of steam and cash.

The objective of every trade is to move with the crowd, taking a bite out of a trend or a fast-moving rally. Sometimes, we move in anticipation of the crowd movement, fading trend breaks and trading rallies from support levels.

When we trade where the crowd has been, we buy stock from better traders busily selling into market strength. On every price spike at the very top of a rally, a single buyer has tried to trade where the crowd has been. We aim to avoid this by trading in the direction that the crowd is traveling.

RULE 11: Take what the market will give you, rather than what you would like it to give you.

Frequently, the market will not behave as anticipated. Carefully calculated profit targets are nearly reached, but the momentum slides away. By monitoring open positions, we can make a better judgment about the probability of our sell or buy order being filled.

Here, we ride in dangerous territory populated by experienced daytraders and market makers. There is a fine balance between micromanaging the trade and paying too much, or accepting too little.

For the position trader, micromanagement can be unproductive. Generally, it is more useful to set the parameters and wait for the market to meet them, particularly on the buying side of the equation. If we miss out, it means we have the cash to commit to the market elsewhere.

In selling, the advice is less useful. If we do not sell, our open profits are eaten away by falling prices. If there are clear reasons for exiting the trade below our initial profit targets, then we should act on them.

RULE 12: Manage every trade, every day.

Every single open position must be monitored and managed. Many times, such management is no more difficult than peeking into a room to check the baby is sleeping well. If we lock the trade away in a bottom drawer, we cannot tell when emergency action is required.

Management comes from planning. At the end of each day, bring up a new chart of each open position and ask these six questions:

• What was my trading plan?
• Is it still valid?
• If no, then what is my amended plan?
• What were my exit plans?
• Have these been triggered?
• Are they close to being triggered?

Most days, this is a five-minute exercise. It's not much to ask, but it can be a lifesaver.

RULE 13: Always analyze winners and losers, but never agonize.

We need to learn from our mistakes as well as those of others because we cannot live long enough in the market to make them all ourselves. Learning cannot take place in an environment of self-flagellation.

Assemble the objective circumstances and conditions that characterized each trade, whether it turned a healthy profit or incurred a small loss. Study your trading errors so you can avoid repeating them. Reward your successes -- including stop-loss exits.

When we agonize over what could have been, we lose sight of the very real success of the actual trade in locking in a profit or limiting a loss. Each trade is an island in an archipelago of our own design, so we step from one to the next, but without regret.

RULE 14: Trading is about lifestyle, so we can do without stress.

For stress junkies, the market is the ultimate place to be. Stress is self-imposed and custom-ordered. If it is not stressful enough, then take an extra futures position against the trend. Need even more stress? Then find yourself a deteriorating position. Trading is about a lifestyle choice. It allows you to live and work where you choose. You control your own time. All this is incompatible with stress. As Bill Williams notes in Howard Abell's Day Trader's Advantage, in his "trading room we don't get real excited. We normally sit here with the cat and the dog in the room with classical music on."

If you cannot sleep at night, then the chances are you are trading in inappropriate ways. Better trading is about a lifestyle without stress.

RULE 15: Be humble.

Never forget where you came from. The market can send you back there very quickly. Your trading approach should work for you. Beyond that is only uncertainty and the market.

THERE IS RISK OF LOSS

These 15 trading rules come with no guarantees. They are not the financial equivalent of a dollar-proof Kevlar vest. Trading success is a constantly expanding mixture of knowledge and skill.

Treat these trading rules as guideposts on the side of the road. They show you where the road is, but they do not tell you where the road is going. These rules cannot define your destination or your fate because those are decisions between the market and you. Without rules to trade by, trading puts you at the mercy of outrageous fortune.

Daryl Guppy is a private equity and derivative trader. He is the author of Share Trading, Trading Tactics, Trading Asian Shares and Bear Trading. He speaks regularly on trading in Australia and Asia. He can be contacted via www.ozemail.com.au/~guppy.

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Guppy, Daryl [1998]. "Matching Money Management With Trade Risk," Technical Analysis of STOCKS & COMMODITIES, Volume 16: May.
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