Know Your Rules

It is often said that the best traders often have a well-researched system. Famous trading psychologist Brett Steenbarger (2003) wrote, “One unexpected finding from our survey, however, was that a disproportionate number of the successful traders—about half—reported utilising mechanical trading systems.  Of the unsuccessful traders, none were mechanical traders.  When I subsequently interviewed the successful traders, it turned out that even the ones that were not systems traders were basing their trades on patterns that they had carefully researched.  Conversely, almost to a person, the unsuccessful traders lacked such grounding in patterns and research.”

It is important to have a system, but it is equally important to gain understanding about the system so that you know how to use the rules effectively. Curtis Faith, the most successful student of legendary trader Richard Dennis, wrote about how he gradually went from “sticking to the rules” to simply “eyeballing the chart” as he became experienced (Faith, 2010). He and other students of Dennis used a eleven-week breakout trend-following system: they bought when the price got above the eleven-week high and exited when it dropped back below the 4-week low, and vice versa. In the beginning, Faith studiously plotted all the data and checked the rules everyday. (Click here for more information about the exact system.)

Then, as he gained experience, he realise that all he had to watch for was breakouts of the eleven-week range and ignored everything in between. After some more time, he had another insight that there was nothing magical about the eleven-week high or low. It was the key support/resistance level that had been in place for a eleven-week-ish period – against which a breakout would mark an important psychological shift of the market.

Once he realised that, he was no longer dogmatic about the rules. He simply eyeballed the chart and whenever he saw a breakout against an important level, he would go for it even if that was not completely qualified by the rules. In other words, upon the realisation of the logic behind the system, Faith was no longer limited by the artificial rules that might otherwise prevent him from making a high probability trade.

Currency trader Dirk du Toit (2009) once expressed an opinion that the reason to enter or exit a trade is all about your feeling on the trade. At first I was taken aback by the comment because it sounded so undisciplined and emotional, but now I was able to comprehend its true meaning. The purpose of a system is to obtain a probabilistic edge, but since market conditions change constantly, there will be times when: a) the signalled trade doesn’t seem to have a high reward-to-risk ratio, and b) the rules seem to have failed to identify a trade with high winning probability. As long as you can protect yourself with sound money management, it is up to you to exercise discretion as a trader to break the rules sometimes.

REFERENCES:
Du Toit, D. (2009). Bird watching in lion country (2nd Edition). Commercial material available on 1st August, 2016: http://www.bird-watching-in-lion-country.com/
Faith, C. (2010). Trading from your gut: how to use right brain instinct & left brain smarts to become a master trader. Upper Saddle River: FT Press.
Steenbarger, B. (2003). Trading by Rules: A Psychological Perspective. Retrieved on 1 August, 2016, from: http://www.brettsteenbarger.com/Trading%20by%20Rules.doc