Home › Market News › What You May Not Know About Rule-Based Trading
Frequent readers of this blog may recall that we often utilize real-life examples from my consulting with struggling traders. Today’s story is about a trader who had the uncanny ability to read market flows without having any kind of sophisticated charting, serious training, impressive education, or considerable preparation. It was amazing how this guy was able to see what few else could. However, even while many traders were envious of his abilities and often requested his advice, this trader, at his best, was only marginally successful in terms of growing his account.
When a mutual friend introduced me to this trader, our conversation quickly went to his struggles with translating his natural abilities into trading success. Very quickly, the solution was obvious. But, unfortunately, the unprogrammed personality that somehow made him a market savant was also a double-edged sword, and his free-spirited way generated a certain amount of reckless behavior.
Clearly, all traders with long-term success have grasped one key truth: there is a substantial difference between having a good indication of market direction and making sound trading decisions.
Unfortunately, I was never able to follow up on this trader’s long-term performance. However, we did discuss how implementing rules and sticking to them would greatly enhance his potential.
Today’s article begins a two-part series that addresses the necessity of having rules, the characteristics of rule-based trading, and the methods to help ensure the following of rules.
First, I don’t believe it requires a tremendous amount of substantiation to determine that rule-based trading is best. There is no way to backtest your trading system without rules, nor is there a way to evaluate your performance. Rules create variables that govern behavior, which in this case involves the actions of the trader. Without rules, there are no criteria for making adjustments to a trading plan.
Furthermore, disregard of rule-based trading is the critical component of blowing up an account. This type of ordeal is one that most traders have experienced, and not using rules is the ideal recipe for such an encounter.
Think about it; we frequently hear about the rise of computer trading. This reality has developed not only because of convenience and the lightning-quick execution of the program but also because algorithms don’t compromise rules. When coded correctly, the program will do exactly as told. This is quite a contrast from human traders, who often find a reason to negotiate established principles.
An excellent first component to determining your rules should be your experience level. The more experienced you are, the more flexibility you can implement in employing your rules. In contrast, the less experienced you are, the more rigid you should be implementing your methodology. Furthermore, I suggest that it is critical for those with limited experience to structure your trading around a more conservative set of mandates.
Another primary consideration when creating a rule-based trading program is your account size. Yes, in this case, size does make a critical difference. One reason for this is psychological. Traders with small accounts are more prone to vulnerability over the emotional fluxes of the market. Worded more simply, the less money you have, the greater the fear. As a result,
if you are trading a small account, you cannot trade in the same way you would. Your system will likely have to account for fewer contracts, meaning you have to manage positions differently than you would with a larger account which can accommodate several contracts that can scale out. In this sense, it is important to recognize that rules cannot be “one size fits all” since each trader’s account size and emotional capability are different.
An incredibly important rule is to measure your risk to reward in terms of long-term sustainability. In my experience, I have been overwhelmed observing traders who fail to consider the effects of their risk election. For example, if you implement a strategy whereby you risk a factor of 2 to earn 1, you must be accurate 70% of the time to squeeze out marginal success.
If and when you go on a five-trade losing streak, then you would have to uptick your winning percentage to 80% just to return to profitability after thirty more trades. When traders are working from a hole, it’s challenging to remain motivated.
However, if a trader employs a ratio of earning a factor of 2 while risking 1, then favorability is greatly enhanced. In such a case, a 40% win rate on trades will produce account growth, and after a five-trade losing streak, still, a trader could get back to even after twenty more trades without adjusting the winning percentage.
For those looking to the “holy grail” of trading, I’m convinced that it begins with a favorable risk to reward ratio.
An additional factor to consider when developing your rule-based trading approach is the time of day that you trade, and equally important, the time of day to avoid trading. Again, a data inventory of your trading performance along with a detailed analysis will generate very useful findings. For example, one trader I knew utilized a spreadsheet that accounted for the time of day of all his active day trading for two years.
The results were astonishing. Two-thirds of his losses came within specific time windows of the day. Furthermore, he discovered that those trades were also ones that he held the longest. The point is, he quickly assessed that if he eliminated those time blocks from his trading, not only did he have the opportunity to double his account growth, but he could also save hours of mental capital throughout the week that could be useful in other ways.
Some traders do better when a market is in its “overnight hours;” meanwhile, others perform better during regular hours. Some prefer to target the open and close when a significant influx of volume and volatility hits, while others do better during the slower periods of the day. To create this trading rule, it’s all about determining what works with your system and personality.
This idea goes along with the previous rule component but warrants its treatment. Another true story goes as follows. A new trader had heard some “expert” claim that a trading system shouldn’t worry about news, including scheduled economic calendars. Instead, if traders paid attention to price alone, they would focus on the only thing that truly matters. While there is some merit to this advice, experienced traders know that this is a reductionist view and that real life does not line up with this claim.
I have found too many traders who allow themselves to lose money because they ignore the economic calendar. Not only do they get chewed up and spit out on the sudden volatile reaction to the news, but they fail to incorporate into their trading plan how the news can potentially affect price action for hours and maybe even days to come.
Traders should seriously consider whether their system can accommodate a news-driven market, even in terms of the sudden but short-lived effects of some economic reports. It is better for some to sit on their hands during such periods, while others enjoy a system that benefits from volatility and may find that news events offer their best opportunities to profit.
Again, how you trade during the news events will be determined by your response to other variables mentioned in this article, including your experience, account size, and risk profile.
These are just five criteria for selecting trading rules. Other important variables will be discussed in a subsequent article and methods to help you stick to your rules. One important thing to remember is that while you can use other people’s rules as a guide, you must ultimately implement rules unique to your strengths and growing edges. So stay tuned for the follow-up post, and until next time, trade well!