In this article we cover the few important rules that should never be
broken in trading. If you can apply these rules consistently, and with
discipline, you will be well on the way to being a profitable trader.
The rules we cover are:
• Have specific goals and objectives
• Be consistent and disciplined
• Let profits run
• Cut losses short
• Never add to a losing trade
• Don’t take too much risk
• Only trade positive expectancy systems
• Minimize all trading business costs
• Be well educated
• Don’t trade scared money
Each of the rules will now be discussed.
2 The Golden Rules of Trading
The following sections outline a set of rules that can significantly
improve your chances of success if they are understood, practiced, and
implemented consistently in your trading. These rules have been learned
the hard way, by study, research, trial-and-error, and the inevitable
mistakes that everyone makes when they start a trading business.
We hope that you can learn from the work we have done, and benefit from
our experience. The rules will now be discussed.
2.1 Have specific goals and objectives
Few things are more important to your trading success than having set
(i.e. written) goals and objective for what you are aiming to achieve. It
is amazing to me how often we hit our targets, meet our objectives, and
reach our goals only when we articulate them and write them down.
For any business to be successful it must have measurable objectives that
are actually achievable. In trading (obviously) the primary objective is
to make money, but it is important to have other objectives that are not
purely cash-related. We must always remember that reward and risk go
hand-in-hand in trading and that we cannot expect to achieve high returns
without planning for high risk (i.e. draw-downs).
Your objectives and goals will be very specific to you, but they must have
the following characteristics to be useful:
• Be measurable (in
completion and timeframe)
• Be achievable
• Be worthwhile
• Be positive
As an example, here are some of our current objectives (this is only a
partial list):
• Develop 2 new positive-expectancy trading systems each year
• Make fewer errors implementing our trading systems each year
• Achieve a return to maximum draw-down ratio of 1.5:1
• Take 2 weeks vacation each year
Note that only one of them is about making money, and that has a
measurable objective that is relative to draw-down, not absolute (i.e.
make 100% per year). If you know what you are trying to achieve, and when
you are trying to achieve it, the whole business will be focused on
meeting
your objectives and help guide you to only pay attention to things you
really want to achieve with your limited time and resources. This will
also give you a way to measure the success and progress of your trading.
Generally traders with well-defined objectives will be much more
successful than those that do not have pre-defined goals.
2.2 Be consistent and disciplined
In order to realize the full potential of your trading systems it is
critical that you take every trading entry, adjust every stop, and close
out every trade as and when your system says you should do. This takes
extreme confidence in your trading systems, good robust reliable
technology, and the mental discipline to stick to your trading plan
whatever happens (assuming it is complete).
An underlying assumption about being consistent and disciplined is that
you have a pre-defined plan for every situation you may face in your
trading, so that you know how you are defining what being consistent is.
Your plan needs to include at least the following items:
• All your trading rules for entering, adding to, and exiting positions
• What you will do if your trading computer, internet connection, broker,
power, telephone
etc. fails
• What you will do if you are unable to trade
• What you will do if you lose X% of your account
• What you will do if all the markets are closed and you can’t exit your
positions
Unless you write the answers down to all these issues, you cannot be
consistent and disciplined in your approach to trading and if you lose
money you will not know whether it is because you didn’t follow your plan,
because your plan is incomplete, because your systems do not work, or
simply because you are going through a losing period.
2.3 Let profits run
This simple rule is the key to being a successful trader. It is three
simple words that are very hard to actually implement. When we get a
profitable trade our natural fear of losing the unrealized cash kicks in
and we truly want to close it out now and take the money. Most trading
consists of long periods of small winners and losers followed by a few
huge winners that make the difference between overall profitability and
simply breaking even or losing due to trading costs(commissions, spread,
and slippage).
It is our ability to let the huge winners become just that - huge - that
determines how we will perform overall during the year. The key to letting
winners run is to have trailing stops that are outside the daily noise of
the market so that they are not tight enough to get stopped out during
‘normal’ trading. This means being prepared to give up a significant
portion of a winning trade’s open profit and is the thing that makes this
so hard to implement. In fact, we should be adding to a winner and
widening stops rather than working out how tight our stops can be to
capture maximum profit. The trade has already shown you that it intends to
be a winner, and the chances are it is a low-risk idea to add to the
position now rather than ‘strangle it’ with stops that are too tight.
It is very important that your position management rules allow for large
winning trades, and that the rules are pre-defined and understood before
you place the trade. This will allow you (if you have confidence in your
method and discipline) to stick to your rules when you do get the big
winner.
2.4 Cut losses short
This is the sister rule to the previous one, and is usually just as
difficult to implement (although it
is very easy to define). In the same way that profitability comes from a
few large winning trades, capital preservation comes from avoiding the few
large losers that the market will toss your way each year. Setting a
maximum loss point before you enter the trade so you know before-hand
approximately how much you are risking on this particular position is
relatively straightforward. You simply need to have a exit price that says
to you ‘this trade is a loser and I will exit before it gets any bigger’.
Due to gaps at the open, or limit moves in futures we can never be 100%
certain that we can get out with our maximum loss, but simply having the
rules, and always sticking to it will save us from the nasty trades that
just keep on going and going against our position until we have lost more
than many winning trades can make back.
If you have a losing position that is at you maximum loss point, just get
out. Do not hope that it will turn around. Given that trades are either
winners or losers, and this one is shouting ‘Loser’ at you, the chances
that it will turn around and become a large winner is tiny. Why risk any
more money on this losing trade, when you could simply close it out
(accept the loss) and move on. This will leave you in a much better place
financially and mentally, than holding the position and hoping it will go
back your way. Even if it did do this, the mental energy and negative
feelings from holding the losing position are not worth it. Always stick
to your rules and exit a position if it hits your stop point.
2.5 Never add to a losing trade
One of the few trade management rules that we can state we never break is
‘Never add to a losing trade’. Trades are split into winners and losers,
and if a trade is a loser, the chances of it turning right around and
becoming a winner are too small to risk more money on. If indeed it is a
winner disguised as a loser, why not wait until it shows it’s true colors
(and becomes a winner)before you add to it.
If you do this you will notice that nearly always the trade ends up
hitting your stop loss and does not look back. Sometimes the trade turns
around before it hits your stop and becomes a winner and you can count
yourself very fortunate. Sometimes the trade hits your stop loss and then
turns around and becomes a winner and you can count yourself unlucky.
Whatever the result, it is never worth adding to a loser, hoping that it
will become a winner. The odds of success are just too low to risk more
capital in addition to the initial risk.
2.6 Don’t take too much risk
One of the most devastating mistakes any trader can make is risking too
much of their capital on a single trade. One thing is certain in trading
and that is if you lose all your capital you are out of the game. Why risk
so much you could be prevented from continuing? There is a saying in
poker than going all-in (risking all your chips) works every time but
once. This is true of trading.
If you risk all your account on every trade it only takes one loser to
wipe you out (and no trading method is 100% accurate), so you will be out
of the game at some point – it is only a question of time.
In general, we only risk 1-3% of the available capital allocated to a
system on any individual trade. This is calculated using the size and, the
difference between our entry price and our maximum stop price, and the
amount of capital allocated to the system. With the win probability
and ratio of size of winning trades to losing trades we are almost certain
never to lose all of our trading capital. In fact, the chance of us
hitting our maximum drawdown for the year is tiny.
All trades should be of a size that almost seems insignificant. If you are
worried about the size of a trade then it is too big and you should reduce
the size immediately. Remember that longevity is the key to making money
by trading – slowly over a long time with minimal risk, is always
preferable to rapidly with too much risk.
2.7 Only trade positive expectancy systems
If you have a positive expectancy trading system, the only factors that
determine how much money you will make per year are the number of trades
the system generates, how much capital you allocate to the system, and how
accurately you implement the trading signals. If you do not know whether
your trading system is positive expectancy then why are you trading it?
Expectancy is calculated using the profit or loss on each trade (net of
trading implementation
costs) divided by the initial risk (using your stop loss) and then taking
the average of this number of a series of trades. Systems that have
positive expectancy will make money on average and those with negative
expectancy will lose money.
Successful traders only trade systems where the odds of success are in
their favor (i.e. the system is positive expectancy) so they know that
making money is the result of accurately implementing the system and not
just pure luck.
2.8 Minimize all trading business costs
Some trading systems have only marginal profitability, and trading
implementation costs (commission, spread, and slippage) can be the
difference between profitability and making a loss. With the easy
availability of modern electronic brokers, and fully-automated trade
processing and
execution, it is definitely worthwhile looking for a very low cost way to
implement your trading system. High commission, wide spreads, and large
amount of slippage can be reduced considerably simply by carefully
choosing a broker. This can be the difference between a system
(especially a high frequency one) being useable or not. Paying too much
for trade implementation is an avoidable way to lose money.
2.9 Be educated
In order to compete at the highest level in the trading business and be
one of the few truly successful participants you must be well-educated
about what you are doing. This does not mean having a degree from a
well-respected university – the market doesn’t care where you were
educated.
Being well-educated means that you have thoroughly researched and tested
your trading ideas and know why your trading system worked in the past and
is continuing to work now. It means understanding all the technology and
applications that your system needs to perform accurately.
It means understanding your goal and objectives and how trading will
achieve these. It means understanding yourself and how your personality
affects your results. It means understanding the markets and instruments
you trade.
In order to succeed you really need to become an expert in your own
trading business to understand how it all fits together, when it is
broken, and how it can be improved. As with all worthwhile endeavors, this
takes commitment, hard work, dedication, and more hard work.
2.10 Don’t trade scared money
Lastly, no one ever made any money trading when they had to do it to pay
the mortgage at the end of the month. Having a requirement to make X
dollars per month or you will be financially in trouble is the best way I
know to completely mess up all trading discipline, rules, objectives, and
leads quickly to disaster.
Trading is about taking a reasonable risk in order to achieve a good
reward. The markets and how and when they give up their profits is not
under your control. Do not trade if you need the money to pay bills. Do
not trade if your business and personal expenses are not covered by
another income stream or cash reserve. This will only lead to additional
unmanageable stress and be very detrimental to your trading performance.
3 Summary
In this article we have covered the rules that we believe should never be
broken in trading. If you work on never breaking them, your trading should
improve dramatically.
We sincerely hope this information has helped you to improve your trading
performance.
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