Tuesday, November 27, 2007

A Schematic for Rule-Governed Trading

Suppose you’re establishing a long position in a stock market index because you think the market is strong and will move higher. Let’s unpack the meaning and implications of your position:

1) Because you are buying, you believe that the recent price low (L1) is a candidate swing low for the market;

2) Because you identify the market as strong, the market must be stronger at L1 than at the next previous swing low point L2;

3) Because you think the market is strong, your long position should, at the very least, test the swing high price prior to L1 (H1) and, in a strong market, should exceed H1;

4) The strength of the market should be quantifiable with such indicators as Cumulative NYSE TICK, AD Line, sector behavior, and new highs/lows, such that, if L1 is indeed a swing low for the market, we should not obtain weaker readings on these indicators going forward than the levels obtained at L1;

5) Similarly, if the market is indeed strong, we should see indicator levels exceed those registered at H1;

6) By quantifying strength and weakness of indicators at candidate swing highs and lows, we create natural stop loss criteria, such that we exit a long trade if indicators are weaker at present than at L1;

7) By using prior swing highs and lows as initial price targets, we can ensure that our entries are sufficiently close to L1 to ensure a favorable ratio of reward:risk;

8) By observing similar patterns of candidate highs and lows at higher time frames, we can obtain longer-term price targets;

9) The above rules limit trading to pullbacks in uptrends, bounces in downtrends, and retracements of moves within a range; you are always fading shorter-term moves and going with the longer-term patterns;

10) The above rules provide a set of yardsticks for assessing the quality of one’s trading, including maintenance of stops; holding winners to targets; entering with favorable reward:risk; and entering in direction of longer-term trend.

This is a beginning sketch of a rule-governed, discretionary approach to trading. If I were mentoring a trader, I would first have them follow such a rule-based approach religiously, so that they learn proper discipline and execution. Only after sustained experience managing winning and losing trades would I then allow the student trader to revise and extend the rules to develop his or her own trading style.

More important than the specific schematic is the ability to trade in a rule-governed manner that addresses the trading universals: limiting losses, letting winning trades run, not fighting market direction, etc. Necessary additions to the schematic are rules concerning the proportion of capital to be risked on any given trade (and during any given day) and other rules for money management, including when to add to positions, when to scale out of trades, and which markets/instruments to trade.

Can you really expect yourself to stay disciplined when you haven't made your rules explicit?

RELEVANT POST:

Understanding Lapses in Discipline
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3 comments:

Brandon Wilhite said...

This is a really good post illustrating the type of thinking that is necessary for good trading. I especially like how you reason out the implications of your assumptions/hypothesis about what the state of the market is and therefore where it should go. IMHO, this is a really excellent exercise for traders to undertake.

BW

Colin said...

Brett,

More importantly, every trader should make a print out of the following rules (or a personalised list), and stick it next to his monitor/workstation. Use color to keep ones attention. My trading improved out of sight when I added a physical (not just a word document that I never opened!) checklist to my workspace. Sometimes, us humans are really bad, but we can still trick ourselves.

Regards
Colin

Brett Steenbarger, Ph.D. said...

Hi Brandon,

You hit it exactly: the idea is to go through a reasoning process prior to trades that makes decisions more rule-bound and more automatic. Thanks for the comment--

Brett