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10 rules of successful trading

January 13, 2009

Unlike investors who need markets to move up in order to profit from their investment, traders don't depend only on bull markets. They can profit even in down trends.

This is a crucial advantage traders enjoy over investors -- the ability to make money whether the market is moving up or down. This fact should not, however, lead you to believe that trading is easy; it requires both a skill-set and rigorous discipline.

Many people take to trading in the mistaken belief that it is the simplest way of making money. Far from it, I believe it is the easiest way of losing money. There is an old Wall Street adage, that 'the easiest way of making a small fortune in the markets is having a large fortune'.

This game is by no means for the faint hearted. And, this battle is not won or lost during trading hours but before the markets open but through a disciplined approach to trading.

1. Always have a trading plan

Winning traders diligently maintain charts and keep aside some hours for market analysis. Every evening a winning trader updates his notebook and writes his strategy for the next day. Winning traders have a sense of the market's main trend. They identify the strongest sectors of the market and then the strongest stocks in those sectors. They know the level they are going to enter at and approximate targets for the anticipated move.

For example, I am willing to hold till the market is acting right. Once the market is unable to hold certain levels and breaks crucial supports, I book profits. Again, this depends on the type of market I am dealing with.

In a strong up trend, I want the market to throw me out of a profitable trade.

In a mild up trend, I am a little more cautious and try to book profits at the first sign of weakness.

In a choppy market, not only do I trade the lightest, I book profits while the market is still moving in my direction.

Good technical traders do not worry or debate about the news flow; they go by what the market is doing.

2. Avoid overtrading

Overtrading is the single biggest malaise of most traders. A disciplined trader is always ready to trade light when the market turns choppy and even not trade if there are no trades on the horizon.

For example, I trade full steam only when I see a trending market and reduce my trading stakes when I am not confident of the expected move. I reduce my trade even more if the market is stuck in a choppy mode with very small swings.

A disciplined trader knows when to build positions and step on the gas and when to trade light and he can only make this assessment after he is clear about his analysis of the market and has a trading plan at the beginning of every trading day.

3. Don't get unnerved by losses

A winning trader is always cautious; he knows each trade is just another trade, so he always uses money management techniques. He never over leverages and always has set-ups and rules which he follows religiously.

He takes losses in his stride and tries to understand why the market moved against him. Often you get important trading lessons from your losses.

4. Try to capture the large market moves

Novice traders often book profits too quickly because they want to enjoy the winning feeling. Sometimes even on the media one hears things like, "You never lose your shirt booking profits." I believe novice traders actually lose their account equity quickly because they do not book their losses quickly enough.

Knowledgeable traders on the other hand, will also lose their trading equity  --  though slowly  --  if they are satisfied in booking small profits all the time. By doing that the only person who can grow rich is your broker. And this does happen because, inevitably, you will have periods of drawdowns when you are not in sync with the market. You can never cover a 15-20% drawdown if you keep booking small profits. The best you will do is be at breakeven at the end of the day, which is not the goal of successful trading.

A trading account that is not growing is not sustainable. Thus when you believe you have entered into a large move, you need to ride it out till the market stops acting right. Traders with a lot of knowledge of technical analysis, but little experience, often get into the quagmire of following very small targets, believing the market to be overbought at every small rise  --  and uniformly so in all markets.

Such traders are unable to make money because they are too smart for their own good. They forget to see the phase of the market. Not only do these traders book profits early, sometimes they even take short positions believing that a correction is "due". Markets do not generally correct when corrections are "due".

The best policy is to use a trailing stop loss and let the market run when it wants to run. The disciplined trader understands this and keeps stop losses wide enough so that he is balanced between staying in the move as well as protecting his equity. Capturing a few large moves every year is what really makes worthwhile trading profits.

5. Always keeps learning

You cannot learn trading in a day or even a few weeks, sometimes not even in months. Successful traders keep reading all the new research on technical analysis they can get their hands on. They also read a number of books every month about techniques, about trading psychology and about other successful traders and how they manage their accounts.

I often like to think about traders as jihadis; unless there is a fire in the belly, unless there is a strong will and commitment to win, it is impossible to win consistently in the market.

6. Always be alert to opportunities of making some money with less risky strategies as well

Futures trading, for example, is a very risky business. The best of chartists and the best of traders sometimes fail. Sure, it gives the highest returns but these may not be consistent  --  and the drawdowns can be large.

Traders should always remember that no matter how good your analysis is, sometimes the market is not willing to oblige. In such times the 4-5% that can be earned in covered calls or futures and cash arbitrage comes in very handy. It improves the long term sustainability of a trader and keeps your profit register ringing.

Traders must learn to live with lower risk and lower return at certain times in the market, in order to protect and enlarge their capital.

Disciplined traders have reasonable risk and return expectations and are open to using less risky and less exciting strategies of making money, which helps them tide over rough periods in the markets.

7. Treat trading as a business and keep a positive attitude

Trading can be an expensive adventure sport. It should be treated as a business and should be very profit oriented. Successful traders review their performance at regular intervals and try to identify causes of both superior and inferior performance.

The focus should be on consistent profits rather than erratic large profits and losses. Also, trading performance should not be made a judgement on an individual; rather, it should be considered a consequence of right or wrong actions.

Disciplined traders are able to identify when they are out of sync with the market and need to reduce position size, or keep away altogether. Successful trading is like dancing in rhythm with the market.

Unsuccessful traders often cut down on all other expenses but refuse to see what might be wrong with their trading methods. Denial is a costly attitude in trading. If you see that a particular trade is not working the way you had expected, reduce or eliminate your positions and see what is going on.

Most disciplined and successful traders are very humble. Humility is a virtue that traders should learn on their own, else the market makes sure that they do. Ego and an "I can do no wrong" attitude in good times can lead to severe drawdowns in the long term.

Also, bad days in trading should be accepted as cheerfully as the good ones. So disciplined traders maintain composure whether they have made a profit or not on a particular day and avoid mood swings.

A good way to do this is to also participate in activities other than trading and let the mind rest so that it is fresh for the next trading day.

8. Never blame the market for your reverses

Disciplined traders do not blame the market, the government, the companies or anyone else, conveniently excluding themselves, for their losses. The market gives ample opportunities to traders to make money. It is only the trader's fault if he fails to recognise them.

Also, the market has various phases. It is overbought sometimes and oversold at other times. It is trending some of the time and choppy at others. It is for a trader to take maximum advantage of favourable market conditions and keep away from unfavourable ones.

With the help of derivatives, it is now possible to make some money in all kinds of markets. So the trader needs to look for opportunities all the time.

To my mind, the important keys to making long term money in trading are:

Keeping losses small. Remember all losses start small.

  • Ride as many big moves as possible.
  • Avoid overtrading.
  • Never try to impose your will on the market.
  • It is impossible to practice all of the above perfectly. However, if you can practice all of the above with some degree of success, improvement in trading performance can be dramatic.

9. Keep a cushion

If new traders are lucky to come into a market during a roaring bull phase, they sometimes think that the market is the best place to put all one's money. But successful and seasoned traders know that if the market starts acting differently in the future, which it surely will, profits will stop pouring in and there might even be periods of losses.

So do not commit more than a certain amount to the market at any given point of time. Take profits from your broker whenever you have them in your trading account and stow them away in a separate account.

I say this because the market is like a deep and big well. No matter how much money you put in it, it can all vanish. So by having an account where you accumulate profits during good times, it helps you when markets turn unfavourable.

This also makes drawdowns less stressful as you have the cushion of previously earned profits. Trading is about walking a tightrope most times. Make sure you have enough cushion if you fall.

10. Understand that there is no holy grail in the market

There is no magical key to the Indian or any other stock market. If there were, investment banks that spend billions of dollars on research would snap it up. Investing software and trading books by themselves can't make you enormously wealthy.

They can only give you tools and skills that you can learn to apply. And, finally, there is no free lunch; every trading penny has to be earned. I would recommend that each trader identify his own style, his own patterns, his own horizon and the set-ups that he is most comfortable with and practice them to perfection.

You need only to be able to trade very few patterns to make consistent profits in the market.

No gizmos can make a difference to your trading. There are no signals that are always 100% correct, so stop looking for them.

Focus, instead, on percentage trades, trying to catch large moves and keeping your methodology simple. What needs constant improving are discipline and your trading psychology.

At end of the day, money is not made by how complicated-looking your analysis is but whether it gets you in the right trade at the right time. Over-analysis can, in fact, lead to paralysis and that is death for a trader. If you can't pull the trigger at the right time, then all your analysis and knowledge is a waste.

[Excerpt from How to Make Money Trading Derivatives by Ashwani Gujral. Published by Vision Books.]

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