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Stock Market Trading: The 20 Rules of Engagement


"Good traders know how to make money; great traders know how to take a loss," and 19 other truisms to trade by.

With the Dow Jones Industrial Average (INDEXDJX:.DJI), S&P 500 (INDEXDJX:.DJI) and Nasdaq (INDEXNASDAQ:.IXIC) enjoying a stellar year, it's easy to get caught up in the race toward the bigger, better thing.

Over my 23-year Wall Street career, whenever I strayed from my discipline and started reaching, chasing or otherwise pressing, it came back to haunt me.

Slow and steady isn't sexy but it wins the race for a reason; when it comes to the financial markets, performance is a marathon, not a sprint.

As you stretch your legs and lace your sneakers, I'll share the guidelines that have improved my performance, in no particular order.

(And for more of such advice on trading, investing or managing your money, check out our new MV Education Center.)

The 20 Rules of Engagement

1. Have a game plan before stepping on the field.

Map the particulars of your strategy -- including the price parameters of your purchase and risk definition of your exit -- before you enter the market. Once you've assumed risk, focus on your trade; if you're not, you're at a competitive disadvantage.

2. Manage risk rather than chase reward.

If you understand what your downside is before entering a trade, you're less likely to overthink your position or panic out of the trade. Once that is quantified, the upside will materialize and you can adapt your reward parameters, if necessary.

For more pro trading and investing tips, check out Minyanville's new MV Education Center.

3. Synch your time horizon with your risk profile.

It's critical to know why you're entering a trade and equally important to understand how long you intend to hold the risk. While these are often mutually exclusive thoughts, they are interdependent when it comes to the performance of your strategy.

4. Play within your zone.

There are different strokes for different folks and your trading style should be an extension of your personality. If you're risk-averse, play smaller in size and tighter on price parameters. If you're more aggressive, you can loosen your grip as long as you remember the next rule.

5. Discipline must always trump conviction.

Regardless of how certain you feel about any particular bet, you must defer to the principles of discipline when trading. And never fall into the trap of believing that you're smarter than the process; if you don't stay humble, the market will do it for you.

6. Respect the price action but never defer to it.

Our eyes are valuable tools when trading but if we deferred to the price action, stocks would be "better" up and "worse" down, and that's a losing proposition. Respect the volatility of the market and leave the blind ambition for someone else.

7. Opportunities are made up easier than losses.

It's not necessary to bet every day; it's only important to have a high winning percentage on the trades you choose to make. In the end, your performance will be the cumulative sum of your decisions. Sometimes the ability not to trade is as powerful as trading ability.

8. Good traders know how to make money; great traders know how to take a loss.

Let your good trades run (trailing stops are a great tool) and flatten exposure if the stop-loss is elected or the catalyst passed. There's no shame in making a mistake; there's only shame in post-rationalizing your risk.

For more professional trading and investing tips, check out Minyanville's new MV Education Center.

9. Emotion is the enemy when trading.

Take a deep breath before risking your hard-earned coin. Decisions made in an excited state often come back to haunt you. If you're personally attached to a stock, the decision-making process will be inherently flawed. Hope is not a viable investment thesis.

10. Adapt your style to the market.

Different phases in the market require different trading approaches and applying the right methodology is half the battle. In a choppy environment, hit-it-to-quit-it often generates return while trading around a core position is often rewarded in a trending tape.

11. Maximize reward relative to your risk.

If you identify the right entry through the lens of time and price, you will create an advantageous risk/reward. It is rarely smart to slap on an entire position at one price level; scaling into risk is often smart, particularly if you're new to a stock and unfamiliar with how it trades.

12. Perception is reality in the marketplace.

When it comes to the process of price discovery, it's not "what is" that matters; it's "what's perceived to be" that dictates the supply and demand in the marketplace. Identifying the prevalent psychology is extremely helpful in determining whether to ride the wave of momentum or take the other side of conventional wisdom.

For more professional trading and investing tips, check out Minyanville's new MV Education Center.

13. When unsure, trade "in-between."

Not all trades are created equal, and your risk profile should be an extension of your confidence. If your relative conviction is muted -- or when trading during a period of heightened volatility -- the size of your position should decrease in kind.

14. The reaction to news is more important than the news itself.

Most traders prefer to trade into a catalyst, but the reaction to the catalyst often provides valuable clues about the strength of the underlying stock or environment. While the old adage is to "buy the rumor, sell the news," opportunities emerge once the dust settles and the fast money trades out.

15. The only difference between being early and being wrong is whether you're there to collect.

There is a fine line between being early and being wrong -- it's called the bottom line! This is not reactive rationalization; it's proactive patience. If you provide a margin for error in your risk management protocol and properly size risk, you're more likely to exhibit the patience necessary to let a trade evolve.

16. See both sides of every trade.

Someone once said that if you're playing poker and you can't tell who the sucker is, it's likely you. The same can be said for trading; you always want to know what the person on the other side of your trade is thinking, even if-and particularly if-you disagree with it.

17. Trade to win; never trade "not to lose."

If you enter a trade with trepidation or self-doubt, you'll second-guess your decision the moment it moves against you. Don't trade defensively; trade with controlled aggression, and always remember that profitability begins within.

18. Know your own imperfections.

I wrote 12 Cognitive Biases that Endanger Investors earlier this year, which was an adaptation of a similar discussion surrounding rational behavior. I identified with several of the pitfalls discussed and as they say, admitting you have problems is the first step toward conquering them.

19. Trade the market you have not the market you want.

In today's digital world, news travels at the speed of light, trades are executed in nanoseconds, chatter abounds in social media, and central banks seemingly shift their stances in real time. You don't have to like it but you must respect it and incorporate the dynamics into your decision-making process.

20. Take time-outs.

Trading is all-consuming and emotionally draining -- there's a reason you get paid the big bucks! It's essential that you take a break from the flickering ticks and give your mind, body, and spirit a break from the incessant stress. The market will be here when you return; just make sure your head is clear when you do.

For more professional trading and investing tips, check out Minyanville's new MV Education Center.

Twitter: @todd_harrison

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