Friday, December 27, 2019

Don't think you know better than your rules

"If you take emotion - would be, could be, should be - out of it, and look at what is, and quantify it, I think you have a big advantage over most human beings." - John W Henry

In trading, hindsight can be a not-so wonderful thing. Your stop gets hit, kicking you out of a trade for a small profit. All of a sudden, price takes off in the direction you were looking to profit from, leaving you on the sidelines.

Take it from me. If it's happened once, it will happen a thousand times.

Is this type of event frustrating? Sure.

But think back to when you were last in that situation, and what you were thinking at the time. Price had initially moved in your favour, only to fall back and threaten to trigger an exit. Yes, it may subsequently move back in your favour. But you don't know. No-one knows. Price could just as easily continue moving against you. As a consequence, you can only act upon what price is doing in the moment of now.

If this means price hitting your stop, so be it.

It's easy to be a Hindsight Harry after the event, and wonder whether you should have relaxed your trailing stop, giving your position a bit more wiggle room, or worse still, remove the stop altogether!

However, at the time the stop was triggered you wouldn't have known which direction price would have moved in. As a trader, all you can do is keep taking the exit signals when they are presented to you, bank your profits (or losses) and move on.

While manually overriding your rules could have led to a monetary benefit on that one trade, it creates a dangerous precedent. This can open up the potential for a catastrophic event in the future, where you again think you know better than your rules, resulting in a significant drawdown, or even an equity blow up in extreme circumstances.

The market seems to have a sixth sense for this type of thing, and you want to ensure you do not fall into that trap.

Where you have clearly defined rules for your entries and exits, you NEED to let the rules take the strain of your buying and selling decisions. The last thing you want to think about doing is trying to be 'smart', by thinking you are cleverer than the rules you spent time and effort creating, only to override them when the pressure is on and real money is at stake.

To me, that has never made sense - why go to all the trouble of developing a clear, objective methodology only to go and ignore it?

It is a recipe for disaster.

You can go through the Market Wizards books and come across numerous stories of traders who ignored their rules - the interview with Larry Hite has some stark examples, both in terms of entries and exits, but also from a risk perspective.

If there's one thing I've learned from studying the great trend followers is that adherence to their method and rules has been critical to their long-term success. They focus on sticking to the process, and are indifferent to the monetary outcome on any one trade, or any small group of trades.

They have demonstrated that, over the long-haul, and a big sample of trades, sticking to the rules will pay you far more than trying to think you know better.

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