TRADETHINK ARTICLES

Trade to Win Four Cardinal Rules of Trading

February 1, 2008

By Chris Morse

Trading commodities can be very exciting, challenging and potentially profitable. It is widely accepted in the trading community that rules based trading is an essential element to ones success. Using a quality trading system can be of great assistance to ones goal of consistency and discipline in searching the vast number of markets for trade opportunities. Quality trading systems will always employee the “Four Cardinal Rules of Trading”.

Rule I: Trade with the Trend

The trend is your friend! Commodities are unlike stocks in many ways. With stock trading one will try to buy low and sell high, or the stock trader investor is looking for value. Commodities are supply and demand driven and will buy strength and sell weakness. One of the simple ways to determine strength or weakness in a market is to first identify the direction of the trend. If the trend is up they look for a buy or long trade, if the trend is down look to go short the market. Trading systems will find the current trend direction. Then select the best potential trade for you by choosing which market to trade and even the best entry price for you to enter a position.

Rule II: Let Your Winners Run

If I had to choose one area of trading where most fail it would be in not letting their profits run. People want to take profits way to soon and miss out on the big trades. In order to have a fighting chance in this game we call trading you must have the wherewithal to stick to your guns. If a trade is moving in your direction why on earth would you want to pull it? Many traders are by nature trigger happy. Being trigger happy can be fun and exciting, but is seldom profitable.

The average individual/trader is controlled by fear and greed. On the greed end the trader will want to take those profits off the table too soon and run like a school girl. It is the trader that runs away who supply the professionals the ammunition to hunt them down and wipe them out again and again. A trading strategy that will keep you in a trending trade moving in your direction is essential for success.

Rule III: Cut Loses Short

For many taking a trading loss is psychologically and financially draining. In truth being able to take a loss or series of losses can be essential to being successful at trading the markets in the long run. The commodities markets typically only trend about a third of the time. This means that the markets are choppy and range bound the other two thirds of the time.

In trend trading to be successful 35% to 40% of the time is an exceptional feat. It is comparable to a professional baseball player having a .350 to .400 batting average!

In order to win one must be able to lose. The key to being a good loser is to know when to cut your loses. A systematic amount of risk can be placed on a trade when it is entered. You can use a hard dollar stop, percent of equity or a percentage of volatility to determine how much to risk on a trade and when to cut your loss. Knowing when you are going to take a loss before you enter the trade is key to your trading discipline. One must develop the ability to exit gracefully while under direst to be a success. An automated trading system like TradeThink sets protective stop loss levels for the trader.

Rule IV: Manage Risk

To be able to manage risk is paramount to success in trading. Risk or “trade risk” is managed primarily through hard dollar stops and trailing stops. You must not only be concerned with your initial downside risk on a trade. Managing profit on a winning trade is extremely important “let your profits run”.

The pinnacle of risk management is in sizing your trade “position sizing”. When you follow a disciplined set of trading rules that result in a positive expectancy trading system it is only prudent to compound your returns on the way up and reduce your trade size on the way down. This is position sizing. Positions can be sized based on a percentage of trading equity or individual trade risk. TradeThink provides all of its clients with a proprietary position sizing model “PPSM” for use with trading its systems. A position sizing model will do the risk calculations for how much to place on a particular trade. The benefit of position sizing or managing risk is to smooth your equity curve and make positive expectancy of returns exponential.

Summary

While the “Four Cardinal Rules of Trading” are not a certain guarantee of trading success. They are key ingredients to the road traveled by successful traders.

About the Author

Chris Morse is the Developer of the TradeThink trading system. He has been involved in the development of trading strategies for nearly ten years. Mr. Morse developed a very robust system which is now in private use at one of the largest FCM's and has earned sizable returns for the last 3 years. Mr. Morse now focuses his time exclusively on developing and managing his systems.