Road Rules Applied to Trading

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Recently I had the less than desirable task of sitting through eight hours of traffic school. I was a good sport about it and was able to get through it without falling asleep from boredom (the instructor made it bearable). As the class progressed, I began to draw 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. Similarly, in both activities transgressions carry with them a commensurate penalty.

Can you imagine driving around without stopping at the red lights or stop signs, or not driving in your marked lane? If you did that for any extended period, the likelihood of being involved in an accident, or worse, would be almost certain. In much the same way, a trader who enters the market without a concrete set of rules will eventually experience a collision with the market gods that won’t look pretty. If you think about it, isn’t running a stop sign analogous to a trader that doesn’t use stops. Sure, he can get away with it for a while but it’s only a matter of time until things will end badly in both scenarios.

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 trading 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 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, size of account and long term objectives (their motivation for trading). 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 how much money is permissible to lose on each trade based on the account size and trader’s comfort level. 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. Limiting the number of trades per day will make a trader more discerning in the trades he or she will take. The natural tendency for new traders is to trade frequently. However, more trades means less quality.

One of my personal trading 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 helps 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. There isn’t a trader I know that has ever lost money by waiting. Other trading 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 work for you. Maybe you don’t trade the first fifteen minutes, or extended hours and so on. Whatever your style, you must always understand the levels where supply and demand is out of balance in order to find high quality opportunities.

Indeed, crafting your individual rule-set is the easier part of a trading plan; CONSISTENT implementation, however, is the challenge. Still, adherence to the trading rules must be the focal point, not making money. Traders who undergo protracted draw-downs are usually those who have veered away from following their rules, or even worse, those that don’t have any RULES.

In summary, having a plan and a set of rules is important, however, execution is the critical component in extracting money from any market on a regular basis. Just like consistently following the rules of the road will make you a safer driver.

Until next time, I hope everyone has a great week.

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