Thursday, January 22, 2015

Best Practices in Trading: Using Rules to Achieve Consistency of Performance

Think of the successes of great sports teams or businesses.  In so many cases, consistency in execution is a common feature.  The great football team doesn't just block and tackle well; they do so every play, every game.  A business like FedEx or UPS doesn't just deliver on time; they hit their time targets consistently.  How can traders achieve high levels of consistency?
The answer is by turning trading practices into trading rules.  Rules are what turn best practices into habits--and habits are what give us consistency.  Contrary to popular conception, discipline is not about forcing yourself to do the right thing.  It's about turning right things into habit patterns.

Today's best practice comes to us from reader Markham Gross (@MarkhamGross), who is the founder of Anderson Creek Trading, LLC.  He explains how the use of rules and systems bring consistency to trading:

"A trader or investor cannot control markets or the outside world.  All that is under the trader's control is his or her reactions to what is happening in markets or what is perceived to be happening in markets.  Therefore, systems should be applied.  The best systems are often simple.  Spreadsheets can work as an implementation tool and some light programming skills will also go a long way.  Systems should be comprised of specific rules for when to enter, exit for loss, exit for profits, and size of the positions.  These rules can match the trader's personality and temperament.  They should be testable.  Although there are limits to backtesting, performing some backtests will help the trader know what to expect so they are not surprised by normal drawdowns.  To approach the market without rules on a daily or weekly basis would be a mistake."

What I find in my work with traders is that many of the best work in a hybrid fashion:  they make decisions on a discretionary basis *and* their decisions are guided by explicit and tested rules.  For example, one trader I worked with years ago examined price breakouts that tended to continue in the direction of the breakout versus those that reversed back into the prior range.  He found several factors differentiated breakouts from fakeouts, including the volume of the move, where the move stood with respect to longer time frame activity, and the time of day of the breakout.  He turned these factors into a checklist, so that he only took breakout trades that scored highly on his criteria.  Those rules not only helped him find winning trades, but kept him out of many losers.  

When that trader first generated the rules, he used the checklist everyday to guide his actions.  Eventually, the criteria became solid trading habits and he implemented them routinely.  Repetition is the mother of habits and habits are the backbone of discipline.  Turning your successful strategies into rules is a great way to ensure that your best practices become robust processes.

Further Reading:  Success as a Habit