TradingSt.com : Trading Strategies : Basic Trading Rules

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Basic Trading Rules

 

Cut your losses

When a particular trade or position is making losses, minimize that loss by closing that trade or position. Minimizing loss can be done gradually, closing the trade or position part by part. This way, if there is any rally or better price while closing those can be lower the loss. However, if the loss is caused by some event in the market or the position (some bad news), the trade or position should be closed as soon as possible.
 
Do not hope that the position will rebound and all the losses will be recouperated. Such hopes are psychological bias and can blind any rational thinking. The position might rebound or might not rebound. If it rebounds the timing is also unknown. Nobody knows when it will rebound. There are so many ifs and most of them will result into losses. So, why play with fire?
 

Let your winners run

Do not close the winning trade by taking early profit. Keep the trade run until the market moves against the trade. Only then take the profit. By doing so any the whole trend can be captured and profited from. Markets and positions go up and down randomly, with around 50% up days and around 50% down days, while the quantity of up or down movements dictate whether the market or position is going up or down in the long term. Therefore as long as ups and downs are all within a limit there is no need to close the position, except when it is outside this limit. This limit has to be a preset limit, so that there is no chance of psychological bias making irrational judgements. As soon as that limit is hit, the trade or position needs to be closed to take in whatever profit is available. This preset limit can be a low mark for last N days (30 days, 14 days, 7 days, etc.), or a technical indicator like stochastics, relative value index, Bollinger band, Williams %R, etc, or some other limit. Whatever limit is chosen, has to be fine tuned from time to time, as market changes every day and evolves into something new. So, this limit has to be constantly tuned into the appropriate one for the market and sector. 
 
However, if there is a chance that the market might crash soon or the position might have some really negative news soon, it is better to close out the trade and reduce the risk exposure. Such risk exposure is particularly high during the weekends or when the market is closed. 
 

Do not overtrade

Do not trade just for the sake of trading. Sometimes, it is important to have all the assets in cash, or large part of it in cash. Sometimes, it is important to get away from a market or asset class and invest in a different market or asset class. 
 
The more one trades, the more one incurs transaction cost, including brokerage fee, bid-ask spread, and so forth. One certain way to increase profit is to reduce transaction costs, and that can be done by eliminating unnecessary trades. However, this does not mean that one should not trade frequently. The frequency of the trade is dictated by the strategy. High frequency strategies require thousands or millions of trades to make some money out of very tight bid-ask spreads. Whereas long term investors like mutual funds and pension funds, invest into a stock and hold onto it for years. Hedge funds and proprietary trading shops trade everyday, with varying degree of trade frequency based on strategy. Whatever the strategy is, it is important to reduce unnecessary trades, and only invole into ones that maximizes the profit.
 

Know what others don't know (but will know soon)

Everybody has some opinion about where the market and the economoy is going - up or down. Unfortunately very few people have the intuition to know the future. Even those people are wrong many times. So, it is important to only take the most important information out of all the garbage. It is important to seek the truth beyond the facts and statements. Nobody can make money from the knowledge everybody has. Nobody can also make any money from knowledge that nobody has and few will ever have. Money making knowledge are the ones that nobody has right now, but will have soon. When everybody have that knowledge the trade can be closed and profits reeled in.
 

 
  1. Basic Rules
    1. Cut your losses
    2. Let your winners run
    3. Do not overtrade
    4. Know what others don't know yet (but will know soon)
  2. Myth Busters
    1. Traders, analysts, portfolio managers can manipulate the market
    2. Experts know what will happen in the market
    3. Analyst estmates and guidances are accurate
    4. It is possible to learn about the market from the media
    5. Some people can tell the future
    6. You can buy low and sell high
  3. Generic Trading Strategies
    1. Trend following
    2. Mean reversion
  4. Analysis - Fundamental, Technical, Quantitative
    1. Fundamental Analysis
    2. Technical Analysis
    3. Quantitative Analysis
    4. Financial Analysts
  5. Stock Picking and Trading
    1. Fama-French Factor model for stock picking
    2. Buy cheap, sell pricy - value investment
    3. Trading Different Sectors and Markets
  6. Options and Volatility Trading
    1. Naked Options Trading
    2. Straddle, Strangle, Collar, and others
    3. Volatility Trading
    4. Hedging Delta and Gamma
    5. Option Price and Model
    6. Looking beyond model
    7. Exotic options
  7. Futures, Swaps, and other derivatives
    1. Futures
    2. Swaps
  8. Bonds and Fixed Income Trading
    1. Fixed Income
    2. Government Bond
    3. Corporate Bond
  9. Convertible Bond Trading
    1. Convertible Arbitrage
    2. Credit and Default
  10. FX Trading - Currencies
    1. Carry Trade
  11. Commodity Trading
    1. Energy
    2. Precious Material
    3. Industrial Material
    4. Agricultural
  12. Mutual Fund Trading
    1. ETF
    2. Index Funds
  13. Index Trading
    1. Index proxies
    2. Index picking and allocation
  14. Long Short Trading
    1. Long only or Short only trading
    2. Long and Short Trading
    3. Market Neutral Trading
    4. Pair Trading
    5. Statistical Arbitrage
  15. Event-driven Trading
    1. Trading on News
    2. Volume Trading
  16. M&A Trading - Merger Arbitrage
    1. Merger Arbitrage
    2. Trading on News
  17. Structured Trading
    1. Structured Investment
    2. CDO, SIV, MBS, ABS
  18. Economics Trading
    1. Macro Trading
    2. Global Macro Trading
    3. Micro Trading
    4. Econometrics Trading
    5. Central Bank Trading
    6. Economic Data Trading
  19. Statistical Trading
    1. What goes up, comes down
    2. Mean Reversion
    3. Probability of price
    4. Martingle, Kelly Criterion
  20. Quantitative Trading
    1. Quantitative models
    2. Pure Arbitrage
  21. Behavioral Trading
    1. Trend Following
    2. Herding
    3. Political Trading
    4. Monday, Friday, December and January
  22. Boom, Bubble, Burst trading
    1. Boom and Bubble
    2. Burst
    3. Log periodic power law
  23. Trading Rocket Science
    1. Artificial neural networks
    2. Genetic algorithms
    3. Hidden Markov model
    4. Random walk theory
  24. Passive Trading
    1. Index Investment
    2. Asset Allocation
  25. Other Trades
    1. Real-Estate Trading
    2. Hedge Fund Investment
  26. Trade Execution
    1. Trade Timing and Cost
    2. Algorithmic Trading
    3. Dark pool
    4. Smart Order Routing
    5. Broker, Broker-Dealer, Prime Broker
    6. Clearing
  27. Risk Management
    1. Market Risk
    2. Credit Risk
    3. Interest Risk
    4. Value at Risk
  28. Most Importantly, Allocation
    1. Asset Allocation
    2. Portfolio Management

 
This book is for the individual investors. Often times they receive information from websites, media, brokers, people they know and many other sources; sometimes even from questionable sources like spam emails or biased parties. Many times these partial and questionable information leave them with losses that they could have avoided had they had more detailed knowledge and information. The purpose of this book is to provide that information.