Tuesday, March 24, 2009

On Trading Rules and Guidelines

Last Friday’s post, Can Selling Options Make You a Better Trader? prompted quite a few emails and comments, including a request that I share some of my trading rules.

To be perfectly honest, I used to keep a list of trading rules handy to refer to at all times, but this is no longer the case. The rules are still valid, but after five years of full-time trading, I have retrained myself in the way I think about, react emotionally to and ultimately respond to the markets.

I do think, however, that the process of developing and codifying a set of trading rules and guidelines is one of the most important exercises that a new or inexperienced trader can undertake. Also, I firmly believe that veteran traders should constantly be evaluating their beliefs about the markets they trade and the guiding principles that provide the basis for various approaches to trading.

Before I decided to make trading a full-time business, I sat down and attempted to capture most of my beliefs about the markets. I originally started out with about 80 "axioms" (beliefs would probably be a more accurate term) and as I traded, I added to this list.

Originally I grouped my axioms/beliefs into the following categories:

  • Overriding Principles
  • Market Technical Analysis & Sentiment Indicators
  • Stock Selection - General (long-term, swing and day trading)
  • Stock Selection - Day Trading
  • Stock Selection - Shorts
  • Opening a Position
  • Taking Profits
  • Taking Losses
  • Pre-Market Activities
  • Intraday Activities
  • Post-Market Activities
  • Risk Control and Drawdown Rules

After a year or so of trading, I found that I had standardized on about 15 rules/guidelines that have changed only slightly since then.

As requested, here are ten overriding principles that have survived the past five years, through bull and bear markets:

  1. Always live to fight another day
  2. Entries must have a statistical edge
  3. Patience and discipline
  4. Be a jellyfish (swim with the current)
  5. Trade only liquid securities
  6. Focus on trying to capture the middle 80% of a move
  7. Know your exit points when you open a position (and stick to them!)
  8. When in doubt, reduce position size by 50%
  9. Limit losses to 2% of total equity for any single trade
  10. Start each day with a clean financial and emotional slate

The above list is relatively generic, but it helped provide me with a framework for organizing how I would approach trading as a business, what strategies I should adopt, how those strategies should be executed, and ultimately defining what success should look like.

Trading rules are vitally important – as is knowing when they should be broken. Even more important, I believe, is the process that one goes through in order to arrive at these rules and to make sure that as new market situations unfold and new blind spots are revealed, the rules and guidelines are enhanced to maximize the opportunity for the trader to continue to grow and develop.


Anonymous said...

Fantastic! Thanks, Bill.


Eric said...

2% is a really tight stop in this market. Are you figuring that if you get timing wrong, then you are out?
What are your thoughts on something like CAN SLIM methods? From what I understand, that method would have survived this market, capping at a 7% loss. Although, you wouldn't have made any trades since 2007.

Bill Luby said...

Hi Eric,

I edited my post to say "2% of total equity" to reflect that I usually have 7-8% stops for most intermediate-term positions, 0.5-1.0% for day trades (3x that for 3x leveraged ETFs) -- and different rules entirely for options.

The 2% rule reflects my desire to never have one trade responsible for risking more than 2% of my entire trading equity, across all positions and all accounts.

While I adjust individual position stops to reflect the volatility of the underlying and the market, my 2% of total account equity rule is one I rarely break.



Jeff Pietsch CFA said...

Good one Bill, I linked.

Anonymous said...

Bill...have you ever posted a "if you want to learn options" post...kind of an idea of how to go about it?

I find that people involved in options think about things like volatility differently than your average investor/trader. Kind of like how computer programmers think about logic differently than most.

Bill Luby said...

Thanks, Jeff.

J. Finn,

Excellent suggestion. I'll see what I can do.



Anonymous said...

And I would add KNOW YOURSELF, not a rule I guess but the best guideline for newbies.

Anonymous said...

11. Live for your 5pm martini

Anonymous said...

Perhaps as an addendum to 10.

If you ever get emotional for any particular reason during market hours, stop trading until you recover your cool.

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