header image
5-things-to-know about-Rule-Based-Trading-Strategies

Here's a question...

Would you drive a car on the road without understanding the road rules?

​I'm guessing you probably wouldn't, unless you wanted to dramatically increase the chances of a crash.

So why is it that we still see so many new traders, rushing into the markets with no trading rules in place?

Laziness, ignorance?

Who knows, but one thing is certain... if you trade without any rule based trading strategies in place, then you are positioning yourself for disaster.

You might get really lucky and be successful for a while. It certainly happens. But ironically this usually sets you up for bigger falls down the road and before you know it...

rule based trading strategies

​BOOM!

Your account has been well and truly blown up!

So in this article I’m going to delve into:

  • Why the vast majority of amateur traders avoid putting clear trading rules in place to guide them.
  • The differences between trading and gambling and why you can lose a lot more money trading.
  • Why having rules in place leads to responsibility for your actions and better outcomes.

The Attraction of Trading

Here's something you should always keep in mind and repeat to yourself every time you are about to take a trade.

"I have the potential to do unlimited damage to my account!"

It's so true and yet probably one of the most misunderstood and overlooked aspects of a successful trading mindset.

If more traders fully understood this, there would probably be less resistance to the idea of having rules in place, to govern their decisions.

To understand why we see such resistance to any kind of rule based trading strategy.

We first need to look at some of the reasons why people become attracted to trading in the first place.

  • ​An easy way to get rich (or so it seems)
  • The ability to work when you want to.
  • The freedom to work from wherever you choose.
  • Requires no higher level of education (college degree, etc)
  • No one to answer to but yourself.

As we can see from this list. Trading is attractive because of the potential freedom that it offers.

The problem is, this focus on the freedom throws up an interesting paradox.

Most people attracted by this sense of freedom, don't want to be harnessed by any rules.

This is why amateur traders reject the notion of something as simple as a trading plan. It represents to them, conventions and rules.

Usually, these are the very things that they are trying to get away from in their Daily lives!

If you are finding this article interesting make sure you sign up for my newsletter below. You won't get spammed and I don't on sell my list to anyone. You'll get notification of all my free content as it goes up and instant access to my FREE 3 part trading mini-course!

The Trap of Unlimited Freedom.

Let's have a look at another big problem that can be triggered by this freedom that everyone desires.

Its not a problem that most new traders would see immediately, but unlimited freedom gives you the ability to lose everything.

Stock market loss

Which makes sense when it's estimated that about 90% of traders wipe out their whole account in their first year of trading.

Losing everything in the markets is not that hard to understand or do. Especially when you realize that there are no boundaries or limits other than those that you set yourself.

Successful trading is reliant on 2 key attitudes:

  • Restraint
  • Self Control

The problem is, when it's only you in control, and there is no acceptance of the need for rules, poor decisions end up being rationalized.

The next thing that happens is that Hope and fear kick in and before you know it you're trapped in a losing position.

I'm sure we've all been there at some time or another and know exactly how that feels eh?

Trading in its simplest terms is really only about 2 things.

Identifying buy or sell signals!

But without a set of rules governing which of these signals you act on and which you should ignore. How can you ever hope be able to keep track of and learn from your mistakes?

Learning from these mistakes is the very thing that hones your trading edge. Over time this constant refining of your methods make you a better trader.

The Potential for Unlimited Loss.

To fully understand why trading losses can be so large you have to understand the structure of the market as a whole. Think of the market in terms of being like a river. The data within it flows and meanders along in a state of continuous movement. 

Even when closed, the markets never really stop.

This can frequently be seen in the differences between the closing price of one day and the opening price of the next.

Markets as such, really have no defined beginning and end points. No real boundaries. Once you enter a trade its like jumping in this river and the only person who can save you is yourself.

Let's compare this to gambling.

If you go to a casino and play any of the games they have on offer, you get to decide in advance how much you can lose.

gambling-on-the-stockmarket

We'll use roulette as an example.

The moment you put your chips on a number, you are choosing to accept a potential loss before you play. You know exactly what your position will be once that wheel has turned.

You’re either going to win X amount if the ball lands on your number, or lose X amount if it doesn't.

Everything's crystal clear and you get to choose just how much you are comfortable losing.

Now with trading its a completely different story...

There is no way to know in advance exactly how much you can win or lose.

Diligent traders can set targets to take profits, and place stops to try and limit losses. But these targets are only ever estimations or best guesses. Ultimately, the market can and will do exactly what it wants.

Large unexpected moves up or down can play havoc with risk management methods. That's assuming there are even any in place of course.

If there aren't...

Then the potential for unlimited loss is huge.

stock-market-crash

This is where the need for rule based trading strategies is essential.

If there are no rules in place, traders will justify, rationalize and distort logic. In fact, they'll do just about anything to convince themselves that they can't lose.

This makes accepting there is a risk, let alone calculating it, irrelevant.

Which brings us to another important difference between losing money gambling and losing money trading.

When you are gambling, in order to continue losing money, you have to make a decision to keep participating in each new game. This means that at anytime you can decide that you don't want to lose anymore.

You can do this by choosing not to act and start another game, or you can just simply walk away and you stop losing money.

Trading however, doesn't work like this, losses don't stop until you choose to exit your position.

The market itself won't take you out of a bad trade.

If you just walk away from a losing position the losses don't stop. They keep mounting up.

It is this difference which gives you the potential for unlimited loss.

​To help you trade in a safer more profitable manner, sign up for my FREE 3 part trading mini-course below. You'll also get notifications of any future posts as they go up too.

Acceptance of Responsibility

When you trade without a well defined set of rules structured into some form of plan. You are essentially trading in a random manner.

The problem with this random approach is that any winning trade falsely makes you think you have a great method. But when you get the inevitable losing trade, it's all too easy to avoid taking any responsibility for the outcome.

In this instance naturally the blame is always put on other factors. Anything will do of course, except your own actions. To accept any blame means facing responsibility and acceptance for the loss.

Something, that most traders would rather avoid.

If however, a trade is planned and acted upon within a defined set of rules, rather than just put on in a random manner. Then it becomes impossible to blame external factors.

You are then forced to accept responsibility if your rules haven't worked or if you deviated from them. You also get valuable feedback about what’s actually working and what isn't.

Over time, this enables you to hone and tweak your trading and give you a consistent edge.

This trading edge repeated over and over is what leads to consistent winning trades.

​Random Rewards

There are of course many ways that traders can lose money in the markets but one reason why so many people fail really stands out.

It takes effort and discipline!

Unfortunately most amateur traders look on it as a lot less effort to take the random approach. They become blinded to any kind of rule based trading approach because they do have the odd large winning trade now and then.

As I pointed out at the beginning of this article if a trader gets lucky early on in their trading career it tends to be disastrous for the longer term.

It generally leads to overconfidence bias and feelings of invincibility. This leads to taking on larger and riskier positions and can reinforce the notion that rules are pointless and that you can be successful without them.

Trading in a random manner can also lead to a situation where random wins can become addictive.

Psychologist B.F Skinner in the 1960's performed an interesting experiment with rats to show how random rewards influence behavior​.

​He conditioned rats in the lab to respond to light or sound by pressing a bar that would caused a food pellet to tumble into their cage. Skinner termed this learning procedure "operant conditioning."

​What was interesting though was that if the rats just pressed the bar and got their reward they carried on pretty normally. They would occasionally press the bar when they needed food.

​However, if food was delivered after a random number of bar presses, the rats became hopelessly addicted to pressing the bar.

They forgot about everything else in their lives and would press that bar to the point of exhaustion.

This is addiction to random rewards is the same mindset that causes people to lose a lot of money on slot machines. They are modeled on this behavior.

Slot_machine

So you can clearly see from this that if you choose to trade randomly, you are setting yourself up to become addicted to the random reward themselves.

This leads to over-trading, chasing losses and a complete breakdown of any trading disciplines.

This is why we see so many traders have early successes and then over time give everything back to the markets.

​Sign up for my FREE 3 part trading mini-course below. You'll also get notifications of any future posts as they go up too.

Conclusion

It should be pretty obvious by now that its virtually impossible to avoid disaster if you don't have any rule based trading strategies or a plan in place.

Its really important to start taking steps to identify what rules you already do use (there are always a few).

Try to collate what you already do into some form of rule based system that you can follow. Test it out for a while by paper trading it just to get an idea of what kind of outcomes you can expect.

When you do take trades, keep detailed records. Some of the data might include:

  • Why you took the trade
  • What factors triggered your entry.
  • Your mindset at the time
  • Where your stop loss was placed and why.
  • Why you exited the trade.
  • How much profit or loss you made

Incorporate all this data into a spreadsheet so that you can start to see a pattern of your trading emerge over time.

Personally I take a screen shot of the chart when I take my entry and put notes on how I felt at the time, my criteria etc. I also do the same when I exit the trade.​

This data is invaluable in helping me to see what works and what doesn't.

What you have to remember at all times, is that trading is a business and has to be treated like one in order to be successful.

As the old saying goes "If you fail to plan, you plan to fail " and  nothing is truer than that when trading.​

How do you plan to implement what you have learned in this article? And if you’re already using a trading plan or have a set of rules that you follow, how has it impacted on your trading and profitability?

4 Comments… add one

Related Posts

4 comments… add one
Shaun March 9, 2016, 18:23

Very sensible and great points. I have done a little bit of trading in the past and if only I had followed these suggestions :(. Thanks for a great article!

Peter March 11, 2016, 07:25

Thanks Shaun its something I’ll continue to elaborate on in the future.

Brenton March 9, 2016, 23:53

A quick overview of some of my trading rules
1) Uptrend present on monthly and weekly charts
2) The day has bullish momentum- more advancers than decliners
3) The trade is entered on a close above previous strong resistance on increasing volume
4) The depth of market indicates more buyers coming in than sellers- demand must out way supply to drive up bids
5) Positioning sizing and money management a bit too complex to go into but essentially 2% rule
6) Trades are managed and exited on trigger of trailing stops below new support

All in all works pretty well in bullish markets

Peter March 11, 2016, 07:24

I could imagine that would work really well Brenton and that is exactly the kind of criteria you have to have in place. It really takes a lot of the guesswork out when you can essentially sit back and wait for a trade to come to you. I think the biggest mistake traders make is chasing trades because they have to buy something. Great reply thanks.

Leave a Comment

UA-60198085-1