Trading Academy

The Time Tested Trading Rules

There are a few trading rules that have stood the test of time and enable traders to trade profitably, yet a lot of people fail to follow them.

The rules are no secret to anyone as you will find them in many trading books and other materials. The rules like ‘cut your losses’ and ‘follow the trend’ have worked for hundreds of years yet most people ignore them!

Many people have heard of these before however you can never read them too many times. Read them often – print them out and pin them up somewhere. These rules need to implanted into your sub-conscious so you never think about doing anything else.

The following lists some of the most important trading rules.

Cut Your Losses

One of the most important things in achieving success in the long run is that you do everything in your power to ensure that you never let your losses get out of hand. They will devastate you emotionally and your trading capital, and you will violate the primary aim in trading, which is to preserve your capital.

If you were to force successful traders to attribute their success to only one thing, many would select this rule as being the most important thing they do.

Let Your Profits Run

Hand in hand with the first rule is the concept of letting your profits run. You are likely to have a plan that produces profitable trades in less than half of all of your trades, therefore you need to ensure that when you achieve a profit, you obtain the most out of the move in the position.

Some up trends take time to develop and you must see the high in the stock achieved and a reverse in direction, before you consider closing the position. Your few profits must outweigh your potentially many small losses over the long run.

Follow the Trend

In an environment where you will find no friends, the trend may be the only thing that resembles a friend for you. Always trade with the trend! Never attempt to identify the bottom in the stock and time your entry using that approach, as you are likely to be run over as the stock continues on its way down. There are often great forces at work and momentum when a stock is trending in either direction, especially down so don’t try to fight it.

Why buy something that is heading in the wrong direction and hope that one day soon it reverses, and starts to head back up past your entry level?

Don’t Overtrade

You can easily convince yourself that if you don’t trade today, then how can you look at yourself in the mirror and call yourself a trader. Don’t trade for the sake of trading and never force the action. If you are not comfortable with any of your potential trades, then don’t trade.

It is a mature decision to refrain from opening a position when conditions aren’t quite right.

Never Blindly React to a Tip

Who hasn’t reacted to a tip they heard from somebody about a stock that is supposedly going to the moon and never coming back? Never react to a tip, as they are rarely any good. What is worst about a tip is if you buy a stock as a result of one, and that stock starts to head against you, you are more inclined to break the rules and not cut your loss because of the ‘reliable’ information you have heard about the stock’s future.

Have confidence in your own plan and never worry about tips of any nature regardless of whom they are from.

Always Trade Liquid Stocks

Liquidity is your ability to trade in a stock without adversely affecting the market price due to insufficient buyers and sellers in the market for that stock. You never want to be stuck with a stock that you need to exit from just because there are insufficient buyers in the market.

It is a horrible feeling of helplessness. Always demand liquidity in your stocks before you consider trading them. Degrees of liquidity will vary from person to person due to different trade sizes.

Keep Positions Small

Your failure to understand and therefore manage risk when trading will severely degrade your chances of long term success. If you want to completely avoid risk, then don’t commit any money to any financial market, however for traders, that is not a viable option.

Managing and controlling risk therefore, is crucial and one of the most effective ways of doing this is to ensure you have and adhere to a sound position sizing model. Your position sizing model will ensure that you do not commit too much of your trading capital to a single position, therefore spreading your risk across several positions.

Don’t Buy Something Just Because it Looks Cheap

If a stock is cheap, there is probably a very good reason for it. Consider only buying stocks that are trending up and not stocks that look like they might start to trend up any day soon. Even if a stock looks cheap, who is to say it will not get cheaper or ever increase in price again? Don’t try to pick the low in a stock – look for stocks that are trending up.

Keep it Simple

Ever since I created my first website dedicated to trading many years ago, I have had a section titled ‘Trading Rules’ which has listed the above eight rules in various forms. Whilst I am still happy with the above list, there is no doubt now that a ninth needs to be added in here.

Over the years, I have had the pleasure of speaking to thousands of traders from many countries and during this time, I have learnt many things. Based on this, I am convinced that generally people fail at trading for two main reasons.

First, the majority of actions required for success are counter intuitive and if people are not aware of this, they often consistently make poor trading decisions. Second, when people realise that trading is not as easy as they thought it would be, they tend to overcomplicate their trading plans which often causes further problems. Software now available with a myriad of technical indicators probably doesn’t help this situation.

This rule relates to the latter reason above. A trading plan needs to be simple as it makes it easier for us to follow it. Furthermore, simple approaches have proven over time to work.

When you think about it, the other rules listed here are based on very simple concepts. For example, after you enter a trade, if the price moves down to your pre-defined initial stop loss point, then close the trade and cut the loss. It sounds simple because it is. The others are just as simple. Don’t overcomplicate your trading plan – it doesn’t need to be.

Summary

The bottom line is that humans are naturally inclined to break the time tested trading rules. If this is the case, then those who do succeed trading are totally committed to their trading and are able to focus on the task at hand. They are able to exercise great internal control and discipline.

If you were to isolate the reasons why people do not follow the rules, you would most likely conclude that it is a lack of discipline and involving too much emotion in the decision making process.