Rule 5 and 6 of my 10 Favorite Trading Rules
For the last couple of weeks I have been posting some of my favorite trading rules. These are rules that may seem obvious to you. But nonetheless, they are rules that every trader or investor should review from time to time. Here are the next two rules:
Rule #5: Leave a bad party.
Sometimes, when reviewing our trading or investing in hindsight, we are able to see stupid mistakes that we should never have made in the first place.
If you're "in a bad head", meaning your mind might be playing tricks on you or you sense that your emotions may be driving your trading decisions, then you should walk away for a while.
You must be able to identify whether it’s the law of probability, not working at the time, or if there is something wrong with your head at the time (which happens to everyone at some point).
Every trading approach will generate losing streaks. You might have 10 bad trades in a row. It happens, just as you can flip a coin 10 times and see it land on heads every time.
Signs of a bad head include (but are not limited to) over concentrating positions (committing too much money to any position) or over leveraging in any way.
If you are investing a lot less capital when you have less confidence in a position, and more capital when you are more confident about the position, it’s a bad sign. You’re not being objective.
I’ve read an large number of “behavioral finance” studies and the studies show it’s the people who are overly-confident who lose more frequently and lose more money. Overly-confident Wall Street veterans lose more or make less than unconfident “average Joes”.
NOTE: “People who are not confident aren’t necessarily skeptical or insecure. They are often just people who control their emotions and view investing as a business.
Deciding on your position size based on your confidence level is a losing bet.
Sometimes it makes sense to cool it.
When you find yourself doing that, just step back and try not to even think about the financial markets. Clear your head. Everyone needs this at some point. There’s no shame in it. It’s always hardest to step away from the markets when you’re feeling overly emotional so you’ll always say “just one more trade” or “I don’t need to” when you really do need to.
Just chill out. Take a break.
Then, step back into the market slowly. It will still be there. In fact, chances are, you’ll come back when the market is showing you a clearer and easier picture. Start by trading smaller amounts, when you get back in, and get your rhythm back.
Rule #6: Cash is a trade too.
Financial markets are all about relative strength. The easiest way to understand this is to use the currency market as an example. The value of the U.S. dollar may advance when compared to the Euro, but on that same day it may decline in value compared to the Swiss franc.
One is simply outperforming the other. If you held on to cash and the price of goods increased (inflation) then the value of your cash has gone down. Stop here. Reread that and think about it before moving on.
If you hold cash when you want to invest in stock and the stock market drops 50%, then the value of your cash, relative to what you can buy stocks for, has increased by 100%.
Imagine if you had to trade food for other goods. Imagine if you could go to the grocery store and pay for food with stock certificates.
This is the reality of the financial markets. The dollar bill is legal tender. It’s a place to store value – so is gold, bread, Yen, art and water.
Sitting in cash is just like holding a stock certificate. Currency fluctuates just like Treasuries. So don’t feel like you’re missing out or like your money isn’t “working for you” just because your value happens to be stored in cash at the time. It's a huge mistake.