Rules Based Trading

There are numerous questions that need to be answered when it comes to trading. How much to buy or sell, where to trim profits, should I use the leverage of options or stick to stock, etc. Creating a set of trading rules can alleviate some of the cognitive load associated with trading related questions. For some, trading rules provide a sense of discipline while others see them more as guidelines or generalizations. Where would you categorize yourself?

Assuming you use rules in your trading, here’s an exercise that can bring new insight into analyzing your trade metrics. The next time you review your trade history (you do review it, right?) focus on the rules of the trade. Specifically, ask yourself how you responded to the rules.

For this exercise we will use two types of rules—external and internal. An example of an external rule would be one generated from your trading system. Let’s use a simple moving average cross as a buy order. An example of an internal rule would be discretionary in nature. Usually we can find these in statements like “I told myself that I’d trade smaller ahead of my vacation so I wouldn’t have to worry about positions and truly relax.”

Take a piece of paper and divide it into two columns; one for external and one for internal. Now process your prior trades to see which types of rule you followed and didn’t follow. Take it a step further to see which type of rule had larger profits or losses over time. See if there’s a correlation between length of trade and type of rule. Perhaps there’s a common thread between losing trades and not following your internal rules. If so, this would suggest a lack of discipline on your part which can be fixed by creating an external rule to avoid or lessen losses in the future. Have fun with the exercise but approach it with the intent to improve your trading.

Yes, you can do everything wrong in the markets and still make money. However, if it’s longevity you seek then create a rules based trading system and follow it. Hold yourself accountable if rules aren’t followed while also trying to understand why the rule wasn’t followed. Perhaps the simple moving average cross isn’t what it used to be. The markets change and thus systems will need to be tweaked as they do.