Breaking rules and using your judgement for a trading decision

 

I’m a huge fan of rules-based trading strategies.

By having clear rules to trade by, and sticking with them, we can keep ourselves out of a world of trouble.

Rules mean that:

• there’s no dithering in our trading decision -making
• we have clear signals to enter a trade
• we know exactly where to take profits
• we know where to cut losses

Rules-based systems are all about discipline. Our rules are based on past market behaviour, and we have to hold our nerve through the ups and downs of the markets (which are inevitable) – and the rules will win out in the end.

I firmly believe that this is the best way to start out with your trading. And I don’t think we should ever be ‘winging it’ in the markets, just making up trading decisions as we go.

But …

As our skills grow as traders and we get more experience, I believe we should start to introduce discretion into our trading.

By doing this (carefully, and with discipline) we have the opportunity to even out our profit curve.

Break your own trading rules?

Make it up as you go along?

I appreciate, these are the things I’m regularly telling you NOT to do!

But bear with me …

Let’s look at a scenario I was in earlier this week …

My Heikin Ashi Mountain trade came within 4 points of hitting its profit target for a £400 win. At the time I checked it, it was showing about £385 profit.

I left it alone, hopeful that it would soon push through its target and because I didn’t want to fiddle with my rules.

Over the course of the morning, it pulled back further, and I cursed myself for not taking the profits when I could have.

Fortunately, it then went on to win later in the day. But there have been plenty of occasions when this ‘hands off’ technique hasn’t worked out well. 

Let’s say that when I checked my trade that morning, I could see the price was really sticking just below my profit target? Perhaps I should have spotted this resistance when I placed the trade, but it hadn’t seemed significant then. It does now.

Should I use my judgement and close out early, taking what profits I have off the table?

The advantage with taking profits now is that I’ve immediately removed my funds from the risk they face in the market.

The downside is that by not pushing my profits to the maximum, I may have had a negative effect on my risk-reward ratio.

But judgement isn’t only about taking profits early – it can also be about cutting losses faster

I expect you know the feeling … a trade has immediately gone into a loss and all the evidence that got you into that trade seems to have evaporated.

Perhaps a piece of news has come out that that negatively impacts on your position, or perhaps you just don’t like the shape of the candlestick.

Cutting losses early could mean that you’ve turned a potentially winning trade into a loss … or it could mean that you’ve turned a bigger loss into a smaller loss (thereby boosting your risk-reward profile).

What about my rules?

The problem with rules-based trading (and rules in general) is that they are designed as a one-size-fits-all.

Over the long term, the law of averages should see our rules work out for us. But if we can adapt as we go, we should be able to increase our profitability and achieve a smoother profit curve.

So what’s the difference between breaking rules and making it up on the hoof?

This can be a fuzzy area, which is why so many technical traders will tell you to always follow the rules to the letter. The danger is that we start entering trades because we ‘like the look of them’ … taking profits way too soon because we like the feeling of winning … cutting losses before we’ve given trades a chance to come good … or (worse still) not closing out losers at their stop level, because we’re hoping they’ll come good in the end.

The result is a low success rate, a poor risk-reward ratio, and some very ‘emotional’ trading.

So, if you’re going to venture into the ‘judgement’ zone of trading, there are some thoughts on how and when to do it …

As far as is possible, build ‘judgement’ into your rules. This means that your trading strategy rules might give circumstances in which it’s okay to use judgement. Or, if you’ve found a scenario where your rules don’t seem right according to your judgement – you can add a caveat to your rules (this is a good way to test your judgement over future trades).

Markets can throw a subtle warning signs at us, which accumulate into a flashing red light in our heads. Let’s say I get a setup, but it’s on an instrument which is one of my weaker performers … it’s approaching a time of day when I don’t like to trade … the price is a getting a bit close to its daily range … the range of the market has been tighter than usual recently …. There’s no one thing there that negates my signal, but it’s enough to give me a bad feeling about it. This all comes down to experience – and we’d be foolish to ignore it.

Sometimes this kind of gut feeling will tell us to open or close a trade. I believe this is okay if based on judgement and experience, rather than just ‘feeling lucky’ or an emotional response.

Bear in mind that time spent in the market has a price – it adds to your risk, and your trading costs. Closing out early can limit both of these.

Don’t underestimate the ‘feel good’ factor of taking a profit. Ultimately, making money on our trades feels good and encourages us to keep trading. Successful trading is all about sticking with it for the long term – if pocketing the cash, rather than sweating it out, makes you a happier trader, I’m not going to knock it.

Keep tracking results …. the golden rule for judgement calls is that you should record them in your trading journal – what you did, and why you did it. Ideally, you’ll also record what would have happened if you’d stuck with the rules – that way you can measure how good your judgement really is.

So why didn’t I close that Heikin Ashi trade early?

If you follow the results of my trading strategies, you’ll be aware that I never use discretion on these trading decisions, and always follow them to the letter of the rules.

Why? Well, my feeling is that I’ve created a rules-based system for the benefit of clients, and I couldn’t maintain an accurate track record if I was fiddling with parameters as I went. There are few things that annoy me more than system developers who tell you after the event that they didn’t take that trade because of … blah, blah …

So, while I believe that judgement calls based on experience can improve results, that doesn’t mean that rules-based systems can’t be successful in their own right.

If your confidence is growing as a trader, start adding this element to your trading decisions – but record how you go. It’s too easy to lose track of what works and what doesn’t.

Let me know how you get on.

 

 

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