4 Simple Trading Rules of the Pros

05/03/2011 7:00 am EST

Focus: STRATEGIES

Trading is often made more complicated than it needs to be. Below are four simple trading rules that, if followed, will keep you out of trouble and keep your trading account growing.

Stick with the Plan

This may seem like a common-sense statement, but the reality of market timing is that the majority of timers "think" they can stick to a timing strategy, however, when the market moves against them—as it always does as some point—they are swayed by financial news stories, the desire to be "with" the crowd, and their own emotions, often exiting the strategy at exactly the wrong time.

Think about it. Let's use a fictional market timer named “Mark” for this example.

Mark has a strategy that he knows has, over many years, outperformed the stock market. Mark knows going in there will be times when the strategy will lose. He sees this in the historical trades. He accepts this…or at least he thinks he does.

But then, the market turns against Mark's first buy or sell signal and he is down 2%, then 4%. Mark is counting the dollars. He wakes up during the night with feelings of dread. Maybe this time it is different.

The next day, Mark exits the strategy and immediately feels better. He starts searching the Internet for a better timing service. They are easy to find. We have personally seen some that "guarantee" 800% and 1000% returns. Much better than that 4% loss.

Of course, the day after Mark exits the strategy, the market reverses, and within a few more days, the strategy is now back in positive territory. Mark cannot enter, because he has lost 4% and knows it is not wise to enter in the middle of a trade.

Mark is now feeling upset again. The initial feelings of relief when he exited the trade are gone, and Mark is starting to feel he is missing out all over again.

After watching the market continue to advance, Mark finally makes a decision and re-enters the position after it has a nice 10% gain. Mark is feeling good again as the market has obviously turned and he is back on board.

Immediately, the market takes back 4%-5% of those gains, and Mark now has a loss—one that never should have occurred—of 8%-9%.

Those who stayed with the strategy from the initial buy or sell signal are in positive territory and have a nice gain. Mark, however, exits again, with double his original loss, and quits market timing for good.

None of this needed to happen. When you start following a strategy, plan to stick with it for several years. That is how the smart money makes profits. They do not let emotions rule their trading decisions. They stick with the plan!

Trade with the Trend

All of my timing strategies are based on trend trading. We know that the financial markets are usually in a trend, either up or down. So we enter the markets "after" we have identified a trend.

It is great to catch a reversal. It is also very difficult. Let me rephrase that.... it is almost impossible. We read stories of those who have perfectly caught a reversal, but they are news stories because it is so uncommon.

It is much easier to wait for a trend to begin and then jump on board. If the trend fails—and some do—a well-managed timing strategy will exit to cash, or reverse position with only a small loss (or even a small gain).

When the trend keeps going, that same well-managed timing strategy rides the trend as far as the trend goes. This is where the power of trend trading is seen. By never missing a trend, and staying with each trend, trend-following market timers make huge profits over time.

Finally, one of the most dangerous trading methods is to take a contrary position and pray for a reversal. Such trades rarely work out, yet many, many traders try them. And many, many traders lose a lot of money.

NEXT: 2 Common Pitfalls to Avoid

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Let Profits Run and Cut Losses Short

The second part of this rule (cut losses short) is the toughest one.

It involves admitting that you were wrong. But in market timing, as in all trading, it is a rare moment indeed where you will eventually be proven right after first being proven wrong.

My trading strategies are designed with strict risk management right from the start. I never let losses grow. If I get a buy or sell signal, and my indicators reverse, I reverse position (or go to cash) immediately. If you looked at my trade histories, you will see that I rarely take a loss of more than a few percent.

There is a reason for this. It is easy to make back a small loss. However, large losses are not only hard to make up, but the psychological pain you experience from them could cause you to quit the strategy. And quitting with a loss not only guarantees that you will lock in the loss, but it is likely to have a detrimental effect on your buy and sell decisions for a long time thereafter.

The opposite, of course, is letting your profits run. This may be counter to what you have heard others suggest, but I never set a profit target. As far as I am concerned, when I have a profitable trend going, the sky is the limit. I will stay with that trend as long as it is profitable; 20%, 50% 100%. I never limit profits.

This is why small losses do not concern me. I know that when I have our next profitable trend, I will ride it to the end.

Never Make Timing Decisions Based on Tips

A tip is rarely more than opinion, and frequently a bad one at that.

Even if the tip comes from a friend, don't take it. If you have a hard time with this, go back to "The Trend Is Your Friend" section above.

Burn this into your head! Unfortunately, in market timing, a "friend" is not always a friend.

This is another (of many) reasons why I follow non-discretionary timing strategies. There is always a reason to doubt a trade. There is always someone who knows, absolutely, that the trade is wrong. In fact, they are often willing to go into great detail why you are making a bad trade.

Why would they do this? Simple; it’s to prove to themselves that their trade is the more correct one.

Again, this is all just emotions at work. And allowing emotions to have any say in your market timing (or any trading) decisions guarantees that you will have even more emotions to deal with. The emotions are caused by losses.

Stick to the timing plan; trade with the trend; cut your losses short and let your profits ride; and never, but never, listen to others. Successfully following and profiting from a timing strategy can be accomplished only by you and you alone.

By Frank Kollar of FibTimer.com

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