19 Trading Rules to Beat the Markets
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Since entering the financial markets in 1969, Martin J. Pring has become a leader in the global investor community. He is the chairman of a conservative money management firm, Pring Turner Capital. He is known for developing economic indicators and also well known for his contribution in educating traders and investors. In fact some of his books are requirements for those seeking the CMT (Chartered Market Technician) designation. In one of these books, Investment Psychology Explained – Classic Strategies to Beat the Markets, he lists 19 classic trading rules. Below is a summary and my interpretation of his rules and how I think they can be applied. Rule 1-10 are psychological management rules while 11-19 are risk management rules.
Rule 1: When in Doubt, Stay Out – Sure, you can’t ever get rid of all uncertainty. However, if you are going to do the research and come up with a trade idea, you need to have confidence in the reason you are entering the trade. Otherwise, you will not have the conviction to stick with a trade and might get “shaken” out by noise. On the other hand if you do have a sound reason to enter the trade, but that reason becomes invalid, you no longer have the justification to stay in. In this case, an exit is warranted because otherwise it is simply a gamble. You are not in this business to gamble, but to invest or trade into sound market research and analysis.
Application: make a list of setups, or events that need to happen before a trade should be considered.
Rule 2: Never Invest or Trade Based on Hope – This complements rule 1. If you are not confident in your analysis and reason for trading, you invite hope into the picture. When you start praying to your God or lady luck, you have become a gambler, and not a trader/investor. Because in both gambling and investing, there is uncertainty, there is a thin line between the two “fields”.
Application: Try to be as mechanical as possible when it comes to entry and exit methodology. Don’t leave room for hope when the market is against you and hit your stop level.
Rule 3: Act on Your Own Judgement or Else Absolutely and Entirely on the Judgement of Others – Basically, what Pring is saying here is to have consistent method in your trading, and have confidence in it. Your sources of information from which you derive a strategy should be sound, and if you trade frequently, they should not vary from trade to trade. You don’t scrap all your analysis just because some analyst somewhere offers his or her expert opinion. If you try to resolve what all these “experts” are trying to say, you might end up with analysis paralysis. Find a consistent method and stick to it, otherwise keep working on your method, OR let a professional manage your account. (In this scenario, make sure you do the research on your money manager).
Application: Make a checklist of resources that you based your information on. ie. economic releases, technical analysis, opinions of analysts you follow consistently. If someone offers analysis you have not encountered before, take time to work it into your routine decision making instead of just taking it face value.
Rule 4: Buy Low (into Weakness), Sell High (into Strength) – This is probably the first thing anybody hears about in trading. It does not mean pick a top or bottom. It does not mean trade against the trend. It is also much harder and more complicated then it sounds. In the end, the idea is to avoid chasing the market. Let the market come to you.
Application: In a range bound market, define areas of support and resistance. Look for selling opportunities at resistance and buying opportunities at support. In a trending market, say bullish, only look to buy on dips. Vice versa during a bearish market look to fade rallies. Again, this is just a general concept and the actual decision to trade should be determined along with other factors.
Rule 5: Don’t Overtrade – The only reason to trade is if the market is giving you the signals you believe to provide trading opportunities. However, there will be times when being objective is difficult. Other reasons can cloud your judgement. For example if you had a disappointing week, you might pin your hopes in trading to pick yourself up. Or subconsciously trading might be an entertainment and provide emotional fulfillment.
Application: Making the trading process as mechanical as you can will eliminate some of the “garbage” factors in trading. It is also important to prepare yourself mentally and emotionally before your trading sessions. Get your mind cleared up of outside influences. Treat trading as a professional endeavor, because as soon as you don’t, it becomes gambling.
Rule 6: After a Successful and Profitable Trading Campaign, Take a Trading Vacation – This rule helps to eliminate overconfidence and addresses the fact that trading performance is cyclical. Besides, don’t you want to have a life?
Application: Knowing when NOT to trade is as much a discipline as knowing when to trade. Therefore you need to define what it is to have a profitable campaign and what it takes to return to objectivity after gaining confidence. When you feel like you’re superman, and when you start making projections into the future based on your recent period of success, you should be alarmed that you are near that peak of your cycle.
Rule 7: Take a Periodic Mental Inventory to See How You are Doing – This rule basically reminds you to stay objective, and understand that trading is a very cerebral process.
Application: Create a checklist of questions before you trade ie. Am I emotionally stable at the moment? Am I overtrading? Am I sticking to my trading plan? Can I afford the risk if the market does not go the direction anticipated?
Rule 8: Constantly Analyze Your Mistakes – Understanding yourself is very important in a world full of uncertainties. When you win, it is very likely that you attribute success to hard work, and when you lose the tendency is to attribute it to bad luck. Knowing this bias, you should look deeper to recognize mistakes in judgement.
Application: There are different types of mistakes. 1) Bad execution – Did you make a trade that is not part of your system? If so ask yourself why. Did it come from an emotional trigger like fear of missing a trade. 2) Bad trade management – It is one thing to make the wrong call, it is another to allow the bad call to become a major drawdown. Ask yourself if the mistake was contained. Were you hoping the market comes back? Did you exit due to despair after loss of hope? If so, you probably entered the trade without enough consideration of the risk and only looked at the prospect of profit. Lack of preparation therefore can lead to inability to manage your loss. 3) Systematic – Only when you can rule out the first 2 types of mistake, can you truly be objective in analyzing your method. If losses are piling up despite sticking to your plan and containing losses, it is time to get back to the drawing board. Step away and look at your trading strategy.
Rule 9: Don’t Jump the Gun – Be disciplined. That’s all. If you have a specific trading strategy, you have to wait until the signals are there. Otherwise, what’s the point of having a strategy. Unless you have been in this profession for 20 years and still surviving, don’t rely on “intuition”. This is something you have to build through countless trades, and the only way to gain intuition is to begin with discipline.
Application: Be as mechanical as you can. Refrain from the temptation of justifying a trade without your signals simply because you believe it is an exceptional situation. There can be exceptional factors everyday, so if you go on these reasons, you might as well not have a trading plan at all. So again, a checklist of signals required might be helpful in making the trading process as mechanical as possible.
Rule 10: Don’t Try to Call Every Market Turn – Yes we want to buy into weakness and sell into strength. But that does not mean picking tops and bottoms. It might be emotionally satisfying to be able to call the top, then pick the bottom, but to be able to do this is an unrealistic expectation.
Application: You might want to set up for counter-trend trades near some major market tops and bottoms, but trying to get in at all the twist and turns will make you overtrade and be chopped up by the market.
Rule 11: Never Enter into a Position Without First Establishing a Reward to Risk- Pring suggests trading at least 3-1 reward to risk ratio. Also, knowing what type of risk is involved helps with position sizing and limiting losses to level that won’t devastate your account. This also provides emotional preparation in the case of a bad call.
Application: Be careful not to give false expectation of reward to risk in order to justify a trade. You have to define where your trade idea becomes invalid. That is your projected stop. You also have to define where you can expect the market to go in your favor by looking at some pivots (support and resistance). Now just because you made these assessments, it doesn’t mean you should always just set your stop and limit and walk away. There will be times where you have to adjust and maybe lock in profits before the market reaches your target. Sometimes you might have to make an emergency exit before reaching your stop. While your exit might require more agility, your entry should follow a more rigid reasoning and having a minimum reward to risk is important. While 3-1 is a good reward to risk ratio, a minimum could probably be 2-1.
Rule 12: Cut losses, Let Profits Run – This is another one of those sounds easier said than done type of rule, but it is probably the most important as far as trade management is concerned. Cutting losses requires discipline and leaves no room for hope. Don’t justify staying in the trade if the market action already invalidates your reason of entry. This does not mean to abandon a trade at the first sign of failure. You will often need to give the market some “elbow space” to have a chance to go in the direction you anticipated. Cutting losses means your original reasoning is invalid AND the risk is no longer acceptable. Of course, you would have ad to establish what risk is involved before hand. Letting profit run is also a difficult task. You have to define before hand what signals you look for in exiting. If these signs are not there, letting the profit run is the prudent action. But you also have to consider locking in profits.
Application: Again, in reality this process is more difficult then it sounds. Knowing when to cut your losses and how to let your profit run will require experience with your trading methodology. Spend as much time if not more in developing exit strategy as developing your entry tactic. A trade is not over until the exit and it is the exit that defines the performance of trade, not the entry.
Rule 13: Place Numerous Small Bets on Low Risk Ideas – Statistically, the more you trade your system, the more likely the performance will reflect that of the system. There will be inevitable losses and in having few trades with large exposure, you risk being in the period of drawdown in your system. Allowing more trades means allowing more chance of your trading system to show its true nature. This means limiting the exposure for each trade.
Application: Pring and the conventional suggestion for exposure per trade (EPT) is 5%. I would say even lower EPT is better especially if you plan on having multiple positions open because there could be a period where you will actually have exposure up to 10%. If you do, make it a point to reduce that exposure at specific times. For example if you are a intraday trader, you might want to close some positions that are not looking as good as others during the end of a trading session for the region ie (end of the US trading session). Or if your positions are already in the black, you might want to move your stop close to lock in a profit and thereby reducing exposure. Remember, exposure is how much you are willing to risk and can be defined by where you place your stop.
Rule 14: Look Down, not Up – Pring reminds traders that the decision to trade is not just based on potential profit, but also potential of loss and acceptability of this loss relative to expectation of the profit.
Application: Also start a trade decision with consideration of loss. Then look at what the potential reward is. This is important because if you look at the potential reward first, you might become too optimistic and overlook the real risk involved.
Rule 15: Never Trade or Invest More Than you Can Reasonably Afford to Lose – Only trade your risk capital. Not diaper money, not grocery money. If you trade money that if lost will devastate your living standard, you will have too much emotional attachment to each trade and that can cloud your judgement.
Application: I think this is quite clear – only invest risk capital. This is why brokers will ask you about your income and such. Regulatory agencies have made it the broker’s responsibility to deny accounts to people that are not suitable in terms of having risk capital. As a trader though, this responsibility should be all on your shoulder.
Rule 16: Don’t Fight the Trend – The trend is your friend is a common saying in the trading/investment community. While there are times to be contrarian and play major tops or bottoms, it wouldn’t be wise to always be a contrarian. Most of the time you want to run with the herd. Don’t try to catch a falling knife is another saying warning you from trading against a sharp move.
Application: You might ask, doesn’t this go against the buy into strength, sell into weakness rule? f you can resolve these two rules you understand the uncertainty of the market and how you have to juggle contradicting ideas. As mentioned in the application of rule 4, trade in the direction of the trend, after noise against the trend. In order to do all these, you have to define what is a trend, and what is noise. That is a topic for another day.
Rule 17: Whenever Possible Trade Liquid Markets – A Liquid market as Pring defines it is one that has many participants with differing opinions so there are traders on each side of the market willing to take positions. In this case, your trading cost will be lower. Although forex is the most liquid financial market, especially in popular instruments like EUR/USD, the spread can widen in event of economic releases or important press conferences and speeches. Trading during these events can be costly not only because of the wider spread, but also because it is often impossible to determine how the market will react, and react to the reaction, and so forth. For the short-term trader, it is probably more prudent to stay away from these event risks, and wait for the dust to settle before getting in.
Application: Avoid trading 30 minutes before or after an important release. This means you will inevitably miss some moves. But if you look at it objectively, you are always missing moves. When you happen to be right and miss a move, you might kick yourself. But is your emotional impact the same when your opinion is wrong and instead of missing profit, you avoided a loss? You’re likely to give the latter the same weight and therefore have a faulty bias that you are always missing good calls. Now, if objectively you do find yourself to always make good calls in terms of reactions to risk events, go for it. But the wiser thing to do is probably to first see how the market reacts to them before making a decision to trade these events.
Rule 18: Never Meet a Margin Call – “Never meet it by sending in more money” is Pring’s advice. If you are meeting a margin call, something very wrong is happening. Either you are overleveraged or overtrading, or both. Also, it means you are not monitoring your EPT. Whatever the reason, adding more funds immediately to remedy a margin call is like pouring more gas into a leaking tank. You have to first fix the leak.
Application: In this unfortunate time, Pring suggests taking a vacation. Your emotional state is probably not right for trading at the moment and you will have to step away from the market to regain clarity before deciding to add more funds. If you have enough funds, and it was solely overleveraging and overtrading, you might have to make a request to your broke to lessen that leverage, and also get it in your head to limit your EPT.
Rule 19: If You Are Going to Place a Stop, Put it at a Logical, Not Convenient Place – The position of the stop should be based on fundamental and technical reasons, and not based on how much you can afford to lose. For example, if you determine that you can only expose $300 in the trade, don’t place the stop simply where the market would give you that loss. Instead, after determining the stop placement, and with the understanding of your EPT, decide on your position size.