Saturday, January 20, 2018

The Golden Rule

I would be considered by many to be a loser at trading. This is on the basis that I have far more losing trades than winners. And, if that metric alone determined whether someone is profitable or not, then they would be right.

But fortunately, they are not. Because I use what Van Tharp calls 'The Golden Rule'. It has been around for more than 200 years. Trend followers swear by it. If you can use it, you can make money. What is it?

In his book Super Trader, Van Tharp talked of an experiment that he and Market Wizard Tom Basso did. They took a completely random entry into a number of markets, used an appropriate level of risk, and then applied The Golden Rule. The results showed that simply adopting the principle of cutting losses and letting profits run made money. 

In other words, their entry process had no edge. Yet they could make money, by applying The Golden Rule, which has an 'edge' of its own.

So, by using this 'edge', and adding it to an entry and exit process which also has an edge, it would be difficult not to make money over the long haul.

This is the approach that traders who follow price trends take as a matter of course.

Typically trend followers have a win rate of 30% - 40%. Yet they have been able to stay in the game when they encounter a run of losing trades, and clean up when trends start to appear in the markets they trade.

The thing is, this is a very simple rule. It ain't rocket science. Yet, for a lot of people, it is difficult to accept that a trade isn't working, and that they should take a (small) loss and move on.

Also, a lot of people do find it difficult to let profits run. They are either fearful of losing what profits they have, or try to be 'smart' when price may momentarily stop moving in the intended direction.

Famously, the group of traders known as the Turtles struggled with this in their initial training period, as was shown by the heating oil trade in early 1984 (read more on that here).

Here, is his own words, is how Jesse Livermore used The Golden Rule:

"In the beginning of a trade I watch the stock as closely as possible, because I have hopefully waited to buy it on a breakout. If it does not breakout or in fact goes in the opposite direction, then I will immediately get out of the stock.

Why? It's simple, the stock did not do what I expected it to do, therefore my judgement was wrong, never mind "Why" it was wrong - the fact is that it "Was" wrong so I must get out of the position."

"Stick with the winners - as long as the stock is acting right - do not be in a hurry to take a profit. You must know you are right in your basic judgement, or you would have no profit at all. If there is nothing basically negative - well then - Let it ride!

"Once in the green I was totally relaxed and just observed the stock's movements in total calm and did nothing until it was time to close the trade. The possibility of losing my "paper profits" never bothered me, since it was not my money to begin with."

"If I bought a stock and it went against me I would sell it immediately. You can't stop and try to figure out "WHY" it is going in the wrong direction - the fact that it "IS" going in the wrong direction and that is enough for an experienced speculator to close the trade."

Richard Dennis once said that he made 95% of his profits on only 5% of his trades. Or put another way, 95% of the trades taken made very little money - they basically cancelled each other out. 

So the profits he was able to generate on such a small proportion of trades taken could only have happened by adopting The Golden Rule.

By using this in your own trading, you can get away from the fixation of being 'right' about a trade or idea. 

You can be wrong - a lot - and still make money.

No comments:

Post a Comment