Tuesday, August 25, 2009

Uncovering Your Trading Rules

One worthwhile exercise is to review your good trades and identify what made them good. What you'll find are some of the "rules" that comprise your best trading: the best practices that contribute to your success. By reverse engineering your good trading, you make rules your rules explicit. Once they are explicit, you can mentally rehearse them, work on them as daily trading goals, and consciously apply them in the future.

Let's take a look at the recent trade that I posted and abstract a few of my trading rules:

1) Trade in the direction of intraday sentiment, as captured by NYSE TICK and Market Delta;

2) Start with profit targets: range extremes, pivot prices, and R1/R2/R3 and S1/S2/S3 targets. First figure out where you think the market is likely to move.

3) Execute the trade on a pullback in intraday sentiment: a drop in TICK during an uptrend; a bounce in TICK during a downtrend. Don't chase price highs or lows. Make the market show you that it is making a higher low (uptrend), a lower high (downtrend), or holding support/resistance (range).

4) Put your stop loss level far enough away that it won't be hit by random noise; that, if it's hit, it will tell you clearly that you're wrong. Size the position small enough so that you can readily weather getting stopped out.

5) Don't get into a trade unless you have at least 1:1 risk/reward to the first profit target and meaningfully higher to subsequent targets.

6) Enter your position with enough size so that you can take a piece off at your first profit target and still meaningfully participate in a further move in your direction. Enter your position with small enough size so that you can add to the trade if it proves particularly strong. If things look dicey at your first profit target, don't hesitate to take quick profits.

7) Don't look back while you're trading and second guess yourself; reviewing comes after the closing bell. Identify any lessons you've learned from your trade, but keep focused on fresh opportunity once you've closed a position.

I have other rules, of course, but these are some of the important ones illustrated by the trade I posted. Over time, I'll post other trades--including losers--to illustrate other rules.

The idea is not for your rules to match mine, but rather for you to become more aware of the rules that contribute to your success, so that you can become more consistent in following them.