Wednesday, August 12, 2009

Developing Trading Rules and Building Trading Discipline

In past posts, I have made the case for rule-governed trading (see here for a generic example) as a cornerstone to disciplined trading.

Many violations of discipline occur simply because rules are not formalized and made explicit. A great example is the dieter who doesn't actually measure portions of food and count calories. It's difficult to overeat and gain wait if you stick to portion control. But if you never have rules for portion sizing, it's easy to lose count of calories.

Some of the most effective trading rules come from tracking our successful and unsuccessful trades. Many times we will see common threads among the good and not so good trading outcomes. These commonalities can form the basis for trading rules.

For example, you may find that trading certain patterns at certain times of day does not prove profitable. That could lead to a rule to avoid trading that pattern--or avoid trading altogether--at those times of day.

Similarly, you may find that, if you reach a profit target by a certain time of day, it is profitable to hold a portion of your position to reach the next target. That can become a money management rule.

Conversely, you might find that you should take full profits upon hitting your first profit target if indicators are suggesting a range market. That, too, becomes a rule for managing your capital.

Some must rules?

* Rules for position sizing to limit risk;

* Rules for ensuring that each trade has a favorable reward-to-risk basis;

* Rules that tell you when to not trade;

* Rules that tell you when to add to trades and when to ride them;

* Rules that stop you out of losing trades;

* Rules that tell you when to take a break and reduce risk (trade size) in a slump;

* Rules that tell you when to take profits in a trade;

* Rules for preparing yourself for the trading day and week.

The idea behind rules is to turn your best trading into near-mechanical habit patterns. Over time, you refine your rules and steadily evolve toward becoming the best trader you can be. For more on the topic of disciplined trading, see these posts from the archive.