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In This Issue:
Don't throw successful trading rules out the window when the market turns volatile. Read these time-tested tips from Chad Butler of RJOFutures.

March 26, 2007
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Trading Rules to Live By

With some volatile swings across the futures markets over the last few weeks, it is probably a good time to revisit some of “The Golden Rules of Trading.”

During this time of market gyration, there has been plenty of opportunity to throw the rules of successful trading out the window and trade by emotion. But it is important to not only have a set of rules to follow, but to also make sure you are following them in times of uncertainty. This is what keeps you alive as a trader and allows you to trade another day.

I have put together some considerations based on my 13 “Golden Rules” and I have indicated which rules these concepts are associated with.

(continued below...)

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Avoid Arbitrary Goals and Rules

(Rule #1 – Have a Trading Plan)

Setting specific rules and goals ahead of time is critical in helping you when the going gets rough. If you don’t have a set of rules or a well thought out plan, then you have no roadmap. However, make sure you have sound reasons for every rule you set. A flawed approach that is too common is setting arbitrary rules.

Plan for the Downside.

(Rule #2 – Know Your Risk, Rule #12 – Accept Responsibility for Your Money)

Don’t just plan for how you will handle profits. Make sure you have planned for how you will react when markets make moves you didn’t expect. Have a well constructed and logical money management plan. Account size is going to determine what you can and cannot do with your money management. But you will also need to consider some other factors. These will vary from person to person, but the general concept will be the same:

• What markets will be traded?
• Will any markets be traded simultaneously?
• For each market, what is the average drawdown for each trade?
• For each market, what is the maximum drawdown for each trade?
• What is the average profit achieved?
• What is the win/loss ratio?
• What is the average range of the market for the time period being traded?


(Rule #2 – Know Your Risk, Rule #7 – Be Aware of Margin)

In the last few years, I have seen it become quite popular to daytrade the E-mini S&P and other similar contracts with as little as $500 intraday margin per contract. Think of it this way. In a $2000 account (quite common, unfortunately), that is 4 contracts that can be traded. Each full handle in the E-mini S&P is $200, or 10% of the account. Each tick is 2.5%. In my experience, the most common amount of risk for these people is 2 handles - $400 in our scenario. If you are wrong on your first two trades, you are down 40% and you are probably out of business.

Over-leverage can kill your trading business. Don’t be lured in by the potential for fast money. Have patience (Rule #11) with what you are doing and build on a solid foundation. Get appropriate risk capital to work with or get out of the casino!

A Word About Stops

(Rule #2 – Know Your Risk, Rule # 8 – Know How to Place Orders)

Conventional wisdom says that you do not trade without stops. I tend to agree. Stop placement, just like all other things, cannot be arbitrary. Setting your stops at a set dollar amount because you are comfortable with the risk is not a wise approach. You must consider the potential swings in the market. If the dollar amount of that risk is too great for your account size, then you need to remove that market from your trading plan.

Once that is determined, you can approach stops as part of your overall money management plan. Essentially, you are factoring the amount of the account that will be risked on a given trade. Trend followers tend to use a percentage of the overall account size to determine how much is risked on each trade.

I tend to use that approach in combination with the average market swings. For example, if my plan has rules to risk no more than 2% on any given trade, then the trade has to fit within those parameters. I consider the range of the market in combination with other technical analysis. My stop is placed a percentage outside of that range. If that amount is more than the account percentage my money management rules state, then the trade must be passed on until all parameters fit the rules.

Be Aware of Your Emotions

(Rule #3 – Be Aware of Your Emotions)

OK, I know this section has the same heading as the rule, but this is paramount to trading. Emotions are the reason that we must have a trading plan established in advance. The plan is what prevents us from allowing our emotions to get in the way of our trading. The two key emotions that every trader must deal with are fear and greed.

I like to think of these two emotions as the checks and balances of trading. We must have both – greed to make us want to take a trade in the first place, and fear to keep our greed from getting us into bad situations. Too much greed and not enough fear results in things like over-trading or holding on to a losing position hoping it will come back. Too much fear and not enough greed will keep you from ever pulling the trigger on a trade and missing opportunity.

You need to have both of these emotions, but they need be balanced. Constructing your trading plan ahead of time allows you to plan on how will balance fear and greed, and you will do it at a time when they are not out of balance.

Putting it all Together

These are some basic and fundamental considerations that, from my experience in this business, too many traders brush over. Many traders want to get to the “real meat” of trading, searching for that one special indicator or trade setup that will make them rich beyond belief. Blinded by this, they have taken the most fundamental rules and broken them.

When fear and uncertainty grip the market, these are the traders that tend to be hardest hit. They have no real plan, they are trading on hope – hope that the market will go their way. But if you focus on following some simple rules, you may just possibly avoid disaster.

Some of the rules that I follow were the basis of this discussion. If you would like to receive the full list and discussion of the 13 golden rules, request our offer this week of “The Golden Rules of Trading.”


About Today's Author:

Chad Butler is a Senior Market Strategist with RJOFutures, a division of R.J. O'Brien. His 16 years of market experience includes option spread trading, diversified trend following, and development of a number of index arbitrage programs.

Chad’s published work appears in McGraw-Hill's Complete Guide to Single Stock Futures, Futures Magazine, and other trade publications. He currently writes for various commodities newsletters, including RJOFutures MarketNews and has been a featured seminar speaker teaching his various trading techniques to audiences large and small.