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Article Traders and Mistakes Part 3: Rule-Based Discretionary Traders
by Van K. Tharp, Ph.D.
Trading Tip Should the Flash Crash Change the Way You Use Stops? Part 4
by D.R. Barton, Jr.
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Traders and Mistakes Part 3:
Rule-based Discretionary Traders
Chances are you’ve never heard of a rule-based discretionary trader. They are rare, but they are among the best traders in the world. I can safely say that anyone who graduates from my Super Trader program has become either a rule-based discretionary trader or a mechanical trader.
Here are some rules that such a trader might have:
- Look at a small universe of stocks that behave well according to my rules. (In other words, not every stock has to behave according to your rules; you just find stocks that do).
- Look for a strong overreaction to the downside. (This would have a very specific description—e.g., market closes down for six straight days).
- Look for moves with a high probability for a continuation in my favor. (This might be one or several rules that are clearly specified).
- Have a likely target in mind based on a prior swing high so that the difference between the entry price and the high is my likely target.
- Place a stop below the most recent low of the last down day so that the difference between that low and the entry price is the risk of the trade.
- Make sure that the reward-to-risk ratio of any trade is at least 3 to 1. If it’s not, look for another trade.
- Raise the stop when the market makes a new level of support and rises to a new high. Make sure that the ongoing reward to risk in the trade is always above 1 to 1 to allow for profits bigger than 3R.
- Never have more than four active positions at a time so that every trade can be carefully managed.
- Never risk more than 0.5% of equity per position.
- Never have more than 1% open risk in my account at any given time.
- Evaluate my mistakes each evening and work to make my trading efficiency 95% or better.
- Re-evaluate my rules if I’m not up by at least 5R at the end of the month.
Notice how every aspect of trading is covered by these rules. They allow for some discretion (i.e., what constitutes a 3 to 1 reward-to-risk trade and the ability to stay in the trade after it reaches your target), but at the same time there are clear guidelines for the trade. In addition, the trader could add a few other discretionary rules to improve his/her performance:
- I can re-enter the trade once if the reward-to-risk potential is still at least 3 to 1.
- I can add a second position to the trade the first time I raise my stop if the new reward-to-risk ratio is at least 5 to 1.
- If something really bothers me about the trade and I can document it, I don’t take it.
The rules I’ve given are just examples. I’m not even saying that they are profitable rules, although I’ve seen similar rule sets that are exceptionally good.
At the end of the day, this trader can do a daily debriefing and ask, “Did I make any mistakes? Did I follow my rules?” Based on his answers to those questions, he can 1) record any mistakes, 2) assess the impact of the mistakes in terms of R-multiples, and 3) take corrective steps to avoid those mistakes in the future. These tasks are critical to developing strong, consistent performance. Can you see how these steps are impossible for the no-rules discretionary trader?
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Should the Flash Crash Change the Way You Use Stops? Part 4
Last week we looked at the peak-end rule popularized by Nobel laureate Daniel Kahneman.
Kahneman and his colleagues found that people remember and quantify past experiences (whether pleasurable or painful) based on just two factors: the peak level of pain and the pain associated with the last (i.e., the most recent) event.
This means that decisions are based on emotional recollections that are either the extreme or the most recent, not an average of every event.
It is easy to imagine the effect of peak emotional states when it comes to investing and trading decisions. One huge win or devastating loss can color our thinking and decision making for years.
Indeed, many investors and traders spend countless hours trying to recreate that one monster winner or working on ways to avoid the loss that nearly busted the account.
Peak Pain or Pleasure—Now What?
Peak pain in trading and investing is almost always a combination of psychological errors and position sizing errors. Between those two sources, I think there are three primary types of peak pain trading experiences:
- A breach of stops. Moving a protective stop (repeatedly even) or just eliminating it altogether has led to more account blow-ups than perhaps all other issues combined. Simply stated, exit discipline is vital to staying alive as a trader.
- Too big of a position. Often, such a breakdown in stop discipline accompanies a position sizing violation (e.g., entering a position that is too big from the start). Then, the trader seems forced to wait for the trade to recover.
- Adding to a losing trade. Nearly as often, big problems happen when traders add to a losing trade in hopes of conjuring a more favorable breakeven point. How do you think that typically works out?
Avoiding these peak pain experiences simply involves sticking to a written plan that must include the stop loss point for each strategy and a position sizing model for each trade/investment.
Every trader already has at least one painful experience in their memory banks. Has anyone ever been hit by an “outsized” gap against them? Sure. Is it likely to happen again in the future? Absolutely. How big of a problem is it, though, if there’s a plan in place with appropriately sized positions? Even a big gap should cause only moderate harm rather than devastating damage. While a recent painful loss may tempt us to change our plans, we have to ensure that we make plan changes based on a statistically significant sample of events and not one very painful experience.
In a similar vein, trying to recreate pleasurable trades causes us to concentrate on the events that seemed to cause the original great trade. This means we often go back to the same stock or sector, effectively ignoring other better candidates. It also can lead us to concentrate our efforts searching for the same perfect confluence of events that may not happen again for quite some time.
The Role of Personal Responsibility
It’s a common occurrence for a painful trade to leave us wanting to change trading rules based on that single event. We can make the situation even worse, however, by trying to avoid personal responsibility for the painful trade. If we blame the bad experience on the markets, a news event, the market maker, some floor trader, our broker or anyone else rather than taking full responsibility ourselves, we will most likely try to avoid the situation or alter systems or strategies instead of working on our personal discipline or other psychological issue that were actually the problem.
Think back to a highly-memorable painful trading experience of your own. Were you responsible for the outcome or did it just happen to you? If it seems to be the latter, try to think very objectively and consider each decision point in the process where you could have made a more constructive choice. Where could you have done something differently that would have reduced the pain of the final outcome? In almost all instances, there is at least one area (and sometimes several) where you could have made a different, more useful decision that would have reduced the financial and emotional impact of the event. Once you’ve identified one or more decision points, own your part in creating the result you got. Take responsibility and dig for creative ways to avoid that decision breakdown in the future.
Next week we’ll look at how recent emotional events can affect us and some solutions for dealing with the recent event bias. I’d love to hear your thoughts and comments on any part of this series! Please send your correspondence to drbarton “at” iitm.com.
Risk per Trade
Q: In your book, Trade Your Way To Financial Freedom, you state that one of the reasons that many traders go bust is that they don't practice correct position sizing strategies and that most of the beginners are under capitalized. If you are trading equities or stocks, is there a minimum value a trading account should have before you should trade? Once you have enough equity to begin trading, if you use a percent risk model for your position sizing method, what is a good starting percent risk per trade?
A: Account size depends upon what you are trading and how you are trading.
There are effective ways you can trade stocks with a smaller account size than you could trade futures. As for a percent risk percentage size, I usually give 1% risk as a guideline for safety; however, 0.25% is safer if you are a beginner and don't know what you are doing yet.
You can answer your own questions but the answers depend entirely upon your objectives. Your objectives are unique to you. How well have you thought through your objectives? Once you have done that thoroughly, you will find the answers to your "how" questions easily.
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