Trading Rules for the Rule-Less

Originally created in May 2008, Never Posted or Published

Trading Rules for the Rule-Less

By Lucas Tarigal

Read any trading book and somewhere in it the author will mention rules. Everywhere we go we encounter rules, in life, and in trading. Sometimes these rules are enforced by outside forces, such as the day trading capital requirements from your broker. Other rules are self imposed, such as cutting your losses at a certain point, or only allocating a certain amount of capital to each trade. Any way you slice it, rules exist and we must deal with them on a daily basis. This article will delve into rules, why they are important, what their ultimate uses are, and some exercises that will hopefully make you a better trader.

I remember the first day I opened my account with an online brokerage. I had 5000 big ones that I could do anything I wanted with. Dreams of the mounds of cash I would soon be swimming in were going through my head at light speed. Many traders can easily relate to this brief story; we all started out believing that the market was the road to all possibilities. Then of course the losses came, for me it was about 30% of my account within a few months. Over time we realize that we must trade with rules to keep from totally destroying our accounts, and our dreams.

Before rules can really be broken down, we need to know how we work in a basic manner. The way I break this down is a very simple one (I tend to like simple) and while it in no way expresses the complexity of the human mind, it will suffice for this article. In the world of ideas and creativity, our right brain is king. The right brain is what we use to qualify all of the data we receive from the outside world. It tells us whether we like something a lot, or a little; it puts everything in degrees of quality in our mind. Emotions are energy stored in our mind that comes from our past. To put it simply, we experience something, we then experience the outcome of that something, and then our emotions write a code in our consciousness so that when these things happen again, we have a rough direction to follow based on past events. Those are the two parts to remember, our intuition, and our emotions.

A maxim I hear often is that to trade successfully, we must trade without emotion. While I do not agree with this, it shows that most traders know that emotions can wreak havoc on their bottom line if they let their actions be dictated by them. Emotions and the right brain have a very interesting relationship. As a trader gains more and more experience, the right brain gets better and better at qualifying events. Traders are better able to feel where the market may go, or when a potential trading opportunity will present itself (The right brain expands itself in whatever the trader has been studying, so if its scalping, its gets better at finding scalping opportunities, if its asset allocation across many mutual funds…etc). Emotional reactions though are not a learning entity like your right brain, so as time goes on, the same emotional energy will not change if it is not dealt with (more on that later). What happens is the trader gets a great idea from his intuition: “this is a great time to short!” He puts on the trade and sees a loss immediately. The intuition still thinks this trade is a great idea, but the emotions come in and start pumping fear, or whatever programmed emotion associated to loss is, into the trade. If the trader becomes identified with this fear, then it has taken over the trade, and the intuition and objective part of the trader is shouldered to the back side.

So what does this have to do with rules? Rules enable a trader to put a proverbial Chinese Wall between his emotions and his intuition (if those rules are followed). They enable the intuition to work without having to deal with the disruptive emotions that want to come in and make all the big boy decisions! The intuition and creativity is objective, so it will make sound decisions weighing all the facts. The emotions are energy hungry beliefs that need to be identified with to sustain themselves, a bit like parasites at times. So: intuition good, emotions bad, rules good…right?

Well it isn’t as simple as that. Starting out, the trader’s right brain does not have the experience to correctly qualify events, so it is liable to make horrendous calls that are leveraged by the uncontrolled emotions. Rules are put in place so that the little speck of intuition that is developed can grow with minimal losses to the traders’ account balance. Over time, these rules keep the trader (hopefully) from blowing out, and let that person learn in a way that facilitates knowledge and experience without going through too much pain. Rules are a bit of a double edged sword though. While at first, they are great for traders, eventually that trader will begin to see opportunities in trading that are outside of his rules. The problem is that outside of his rules, over the Great Wall, lurk the emotions that are ready to pounce and control that trader’s actions.

Many traders I know are perfectly happy with their systematized trading method. They plug along making trades for themselves and make a good living. What I have found though is that with more experience, comes more accuracy in taking money out of the market. If a trader locks themselves into a system, they are totally dependant on that system and its results. That may work for some, but many others I know wish to achieve greater and greater success in trading, and in life. This process can be put in the following maxim: Success in life and in trading can be found by having the discipline to adhere to rules that facilitate wisdom, and then by systematically breaking those rules down until all that is left is effortless action.

Rules and structure are great, but as success and experience come, adaptation must take place. Take any great achiever in any field and you will see someone who often breaks the “rules.” Garry Kasparov, one of the greatest chess players of all time, does not play by rules. He may have early on, but through massive amounts of experience, he now knows when to break those rules, or completely toss them out. The same can be said of Michael Jordan, Paul Tudor Jones, or anyone of their caliber. At one point in these people’s careers, they did something that redefined their respective fields, and these things were never written down as rules.

Many of us may not think we can be as good as Paul Tudor Jones at trading, nor would want to be, but we can use their process to make ourselves better traders. Getting outside of the box that our rules have defined is not easy; it can be painful, and it can be humbling. I have included in this article a great way to start breaking down that emotional energy, and in so doing, increase the room our intuition has to work with.

Basically the goal is to get ourselves out of our regular trading routines, and into something that is new. First, you will need some trading capital that is totally expendable. It doesn’t need to be a lot, but you should be able to make about 50 short term trades in it without losing it all (in case every trade is a loser). $2500 is a good amount, and it isn’t too much when you consider some of the costs of seminars these days. Consider this amount your continuing education costs. When you have this account, you should look to trade a smaller time frame then what you usually trade (I will describe why this is in a moment). So if you are normally trading hourly charts, move down to 15 minute charts or 5 minute charts. If you normally trade daily charts, move down to hourly charts, or half-hour charts.

Once you identify you timeframe, make 50 trades in this time frame using whatever criteria you like. You are looking to use criteria that are vaguer then what you usually deal with. If you are a very mechanical trader, add in a bit of discretion. If you are very discretionary, get even more discretionary with little to no secondary indicators; just your “hunches.” The breakdown in structure will cause your emotions to get back into the picture. You want to have some vague rules on stops, and not adding to losers so that you can get through the 50 trades, but other then that, go to town.

As you do these trades you want to become a student of yourself, watching how you feel before, during, and after each trade. Write down your thought process for each trade, even if it is only: “felt good.” Try to bring as much of your focus to this endeavor as you can. I can’t tell you what kinds of emotions that may come up; some may encounter mild resistance, while others may have massive torrents of emotion. The goal is to feel each emotion, and to bring your focus into that emotion and feel how it affects you trading. By going through 50 of these, you will hopefully bring some light into these emotions and remove some of the energy that they possessed. This entire process is pretty much a trader choosing to pay for emotional work. It can be fruitful, or give nothing; it all depends on how much you put yourself into the exercise. There are many other exercises that can be done that will break down emotional walls, this isn’t the only one, but it’s a good one for the market. I will touch on other methods in other articles for those not inclined to spend the tuition of this exercise.

The reason you want to move down in timeframe is because the faster the timeframe, the faster the decision making process. If you listen to floor traders and scalpers, they will always talk about their hunches and feelings. They do this because they do not have time to do any kind of quantitative analysis while they trade. They have to make split second decisions on whether to get in or out, and any emotions that get in the way usually spell disaster. By forcing yourself to make decisions faster, you increase the chance emotions will interfere because you are asking your intuition to make your decisions for you without outside aid. If you have long periods of time to make a decision, you can do all kinds of historical back testing and analysis that will give you guidelines on how to trade. Without these guidelines, you are forced to deal with your intuition, and if this decision is outside of your rule boundaries, you can be sure your emotions will have a big say.

One of the best ways I have found of staying focused is to trade 5 minute charts using only my hunches, and either a call or a put contract. I limit my losses to around $50, and trade only the main index ETFs (SPY, QQQQ, DIA, and IWM). By throwing your intuition and emotions on the line, you can shell shock yourself out of your old routine, and expand your edge. If I really want to gain my focus, I do the same but use E-mini Futures. Those can really get away from you though, because of the leverage, and that is definitely not recommended. After these trades, when you go back to your old timeframe, it should feel a bit like slow motion. You will see more opportunities because your intuition has expanded itself, and overtime, you will find yourself becoming a better trader.

The main focus of this article is to get traders to experience and let go of their emotions, and to increase the amount of intuition in their trading. To most, this sounds almost heretical because of the focus on rules you read about everywhere. I am here to tell you though that the best of the best don’t use as much structure as many think. They have cleared their creative field of excess emotional baggage, and are able to tap into their experience and intuition directly. Over the coming decades, more and more traders will become purely discretional and their results will be fantastic and effortless, I hope to see you as one of those leading the pack.