11 Rules for Trading the Markets

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Today I'll share some of the rules of trading that I have gleaned over a 30 year career studying, following, trading, and coaching in the markets.

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Staying In Bounds

The key to being a successful trader in the financial markets is discipline. Whether on a proprietary (prop) trading desk, an institutional or retail trader at a broker/dealer looking to trade a hedge, or a day trader flipping in and out of stocks, a sure-fire way to get your head handed to you is by simply "winging it" or trading on a whim.

Trading the markets is a humbling business. Those who go into it with an ill-advised level of hubris will soon realize Mr Market will seek you out and punish you for your lack of respect. Hubris, or arrogance, is not to be mistaken with a healthy level of confidence that only comes from years of following the markets, studying the price action, developing a disciplined strategy, and adhering to a well devised plan in all market environments.

Confidence, when coupled with discipline, will serve you well when navigating what the markets throw at you day in and day out. Developing and following a set of trading rules will provide the needed discipline that will set you up for success and keep you in the game.

In this article, I'll share a some of the rules of trading that I have gleaned over a 30yr career studying, following, trading,and coaching in the markets. While my sector of focus has been the U.S. bond market, these rules can apply to any sector provided they are adapted to the nuances that drive the flows in a particular market.

Rule # 1 - Take Emotion out of the Equation

Fear, greed, anger, over confidence, anxiety, worry, hope, excitement, and frustration are all emotions that cloud our thought process. Many of these emotions tend to cause us to take action in the market at inopportune times - selling at lows just as the market is ready to turn back in your direction or buying at highs just when the market sets a near-term top.

How do you take emotion out of the equation? By developing and following a rules-based trading model. This list of trading rules and a disciplined trading model are complimentary and go hand-in-hand. The list of trading rules relate to the mechanics of the trade while the rules-based trading model is used to incorporate the tools you rely on to identify the set-up and the optimal location to enter and exit a trade.

Together, if followed, they help to eliminate irrational, emotional decisions.

Rule # 2 - Always Know the Trend

Whether the market is trending higher or lower should be the basis of your short-term directional bias. If it is trending higher, you should be a better buyer as the market moves to support. If the market is in a downtrend, you should be a better seller when it moves up to levels of resistance.

The prevailing trend should inform your bias in the market. It will also let you know when you might be initiating a counter-trend trade (ie. buying in a downtrend). While it's an overused cliche, the trend is truly your friend. Identifying it early and transacting at support (buy) and resistance (sell) will keep you on the right side of the trend and will set you up to catch profitable moves.

Rule # 3 - Use Stops

Place stop-losses at appropriate levels based on your tolerance for risk and the risk-reward set up for a particular trade.

A well placed stop is a necessary risk management tool, provides the required discipline to limit losses, and takes the emotion out of the trade.

A well placed stop will allow for some degree of fluctuation in the event a trade goes against you for a time but won't be executed before the market heads back in your direction. A well placed stop will be executed if something in the market has shifted and the tide has turned.

Market professionals typically won't physically enter a stop with a broker or counter party because they want to maintain the flexibility to manage the position knowing the specific catalyst that moved the market. They will have a mental stop, however, and will execute at or around that stop based on market conditions and developments.

Novices or day traders would be wise to enter those stops with their broker or in their trading account upon entering a trade.

Rule # 4 - Use Trailing Stops

A trailing stop moves with the market and is used to preserve profits.

For example, after buying a security and placing a trailing stop below the market, the market moves higher. The stop will follow the market higher at a predetermined interval (which can be adjusted) as the market advances and the gain builds. The stop will only move with the market when the market is moving in your favor. Otherwise, it remains stationary. If the market turns against you beyond the stop, it will be executed and you book the profit.

Rule # 5 - Never Let a Profit become a Loss

Just don't. When the market turns, you'll know it. Hanging onto a winning position as your profit evaporates because you can't stand to take a smaller profit than before is foolish. Holding on while you hope the market will rebound to your previous profit is never a good strategy. The use of stops will help here. No profit is a bad profit. Be disciplined.

Rule # 6 - Resist the Temptation to Trade the Economic Data

It is never advisable to put on a trade because you have a hunch about a data release. Trading is about calculated risks. You have no way of knowing how a specific number will print. In this Covid-19 environment, the markets haven't been reacting to the data all that much anyway.

However, if you have a view of the market and are already positioned in a trade that expresses that view heading into a report, it's entirely reasonable to maintain that position through the data provided you maintain that view. In other words, your market view shouldn't be based on one data release and one data release shouldn't change your overall market view.

Rule # 7 - Don't Trade in a Vacuum

If you are a market technician who rely on technical analysis and charting, you must also be aware of the fundamentals because supply considerations, the state of the economy, monetary and fiscal policy, financing considerations, earnings, financial analysis, quarterly results, etc can all impact the price action in the markets. Conversely, someone who focuses mainly on the fundamentals must also be cognizant of how the technicals stack up.

The two disciplines compliment each other. When they are aligned, it can lead to powerful moves. It will also breed confidence.

Rule # 8 - Never Buy into a Flight-to-Quality

This one is for those involved in the sovereign debt markets. I'll repeat it: Never buy into a flight-to-safety because it can evaporate just as quickly as it materializes.

This is less relevant when there is a persistent safety bid due to an ongoing or developing geo-risk, etc. That bid can last as the situation plays out.

What this rule refers to is something that comes on suddenly and unexpected like a terrorist attack, a market crash, or an assassination of a head of state. The knee-jerk flight-to-quality, once it has run its course, tends to reverse quickly leaving those who bought on the way up out on an island. It's a much better proposition to sell or take profits into a flight-to-quality if you must do anything at all.

Rule # 9 - Never add to a Losing Position

Why throw good money after bad? It's just dumb.

Rule # 10 - Have Humility

The market(s) is always right, and it can steamroll you if you aren't careful. Know what you know and what you don't know. Stick with what you know. Stay in your lane. Polish your craft in a sector where you have learned all of the nuances that drive the flows. Never think you know all there is to know. Always be learning.

Rule # 11 - Rules are Made to be Broken

If you are a seasoned veteran of the markets, rely on your expertise and the intuition you have developed during your career. Trust but verify your instincts. There are times when some rules may not apply to current market conditions.

Know, however, that you re going against the grain. Be quick to rein yourself back into the fairway before you spiral out of bounds.

If you are a novice, adhere to the rules.

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This article is part of my LinkedIn Newsletter Series: Indicators and Insights – Perspectives on the Top Financial Market Movers with a View of What's to Come.

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