The banner image above sums up how I like to trade. There’s periods of boredom (doing nothing) followed by being highly engaged in a trade for a short period of time. To describe my style of trading, I like to use an anatomy analogy. Skeletal muscles are made up of two kinds of muscle fibers: slow-twitch and fast-twitch. Let’s consider slow-twitch fibers the ones that support long distance, endurance activities. From an investment perspective, slow-twitch fibers are akin to the fibers needed to become successful long-term investors. Fast-twitch fibers, however, support short bursts of energy and require frequent rest periods to recharge energy. Fast-twitch fibers are those required by active traders. Trading is like mountain biking because it’s a game of intervals, short bursts followed by steady pedaling until the next short-burst is required. This brings me to the next rule, dealing with trading frequency. Rule #2: the best traders do not over-trade or trade just to have something to do. Here’s a great quote from one of the best books on trading that’s ever been written (Reminiscences of a Stock Operator), “if you have no decisive move or confidence in your next move, stay still.”
Great traders have a set of rules and guidelines and they adhere to them consistently which helps them execute their game plan with precision. Notice I said, “the best traders…”. Most people who trade do it with a wild wild west mentality and are just flying by the seat of their pants hoping to find an endless number of horses to quickly jump on. The cowboy approach can work for a while but trust me, it tends to end in tears and it’s definitely an exhausting way to operate as a trader. Trading is to be taken seriously even if you don’t do it for your living. Rule #3: when you’re trading, you have to be on the job all the time or you will eventually be forced to find a new job. Trading can offer a significant way of life or be a great side hustle if treated seriously. I remember a trip to St. Barths with my wife when she was pregnant with our daughter. I focused on finding attractive trades each morning with the intent of closing them out the same day or 1 day later. My trading gains paid for our entire trip to paradise but I didn’t try and force trades. If there was no action to take advantage of we just spent the day having fun. That’s the great thing about markets, when they are open there’s always some trades to consider if you’re looking in the right places.
When you’re in the trading room, distractions or arrogance can lead to unnecessary losses. Do your chart work, identify a target and entry point, size the trade correctly, have a stop loss set, be unemotional about taking losses, be patient and wait for the price to move to your sell levels. I traded for my supper from 2004 to 2011 and some of my best trades where times when I set a buy and sell price that was executed when I wasn’t even in front of the computer. Rule #4: every trade is different but the odds favor your success when you buy right and sit tight while waiting for your levels to be hit.
Rule #5: check your ego at the door, the market doesn’t care about your opinion or what your cost basis is. The market is never wrong. Adapt or perish. Peoples ego’s are so often their downfall. Many in the trading community always say, “you want to make money or you want to be right in your thesis?” We prepare so well for our trading and investing but sometime the market has other ideas. Fighting the market for too long can be detrimental to your wealth. When your bank account is full, you were right, when you have tax losses, you were wrong. It’s just that simple in trading.
Rule #6: the best learning experiences happen when you learn what NOT to do. Unfortunately, there’s no better learning experience than losing some of your hard earned money. It’s impossible to be right 100% of the time, if you do not have the stomach for losses, trading might not be for you. If you know what NOT to do, you will begin to learn what to do to make money at trading. On the job training is by far the best way to learn the art of trading. Rule #7: when you’re quick trade turns into a multi-month hold, it’s usually because you are losing capital and on the “hope train.” Ignore the hope train at all costs, its mentally draining. If you’re on the hope train with a trade-gone-wrong, you need to make a decision - take the loss and get mentally in “re-build my capital mode” or convert to being a long-term investor, assuming your losses are from something worthy of a longer-term hold. It takes time to get comfortable accepting you goofed and lost money but it’s also important to remember that if you see a more obvious trade, taking a loss to jump on a new train that goes uptown is the same thing as staying in your bad trade at the moment it begins turning in the right direction. If you’re trading in a taxable account, trust me, you need to take some losses sometimes if you’re pretty good at capturing gains. I had a massive cap gain in one year and got clobbered the following year at tax time because I chose not to harvest some losses along the way.
I can’t stress this enough, many traders trade things they have no faith in simply because the chart or momentum is attractive. That’s fine for some people but it doesn’t work for me. Sometimes those positive conditions change without warning and there’s nothing more mentally draining than being stuck in a trade gone bad and in an investment you don’t even believe in. Everyone has their own philosophy and none of them are wrong but I prefer to trade stocks that I have high confidence in as a long-term investor. If I see an opportunity to swing trade Nike or Amazon or Costco or Home Depot, I will likely get bailed out over time even if my trading entries were poorly timed. Trade a crap company like AMC and get the timing wrong and now you’re stuck holding a bag of doo-doo that may or not survive as a business. Rule #8: it’s normal to get a trade wrong, it’s catastrophic to stay in a bad. It’s much better to take your lumps, step away for a few days to get your head right and step back into the arena when you see a high probability set-up.
Too much leverage and an unwillingness to take a small loss that turns into a massive and catastrophic loss is a career ending mistake. Rule #9: sizing a trade is very very important. Every trader has their own strategy for building a full position in a trade, I prefer to enter small and test the water while observing how my entry is treated. When I feel more confident, I like to build my full position and walk away so I don’t let the small squiggles shake me out. Some traders only buy strength, I like to add more aggressively when my high confidence trade pulls back a bit. I may still have some PTSD from the Internet bubble chasing moving trains so I rarely chase and prefer to buy shallow dips. Perhaps it’s my way of being a value guy even when I’m chasing a momentum stock. Rule #10: be completely clear on what kind of trade you are entering. What do I mean? Is it a trend-trade or a counter-trend trade? This is very important. If you are getting long a stock or ETF in a downtrend and trying to catch a knife, be very strategic about your entry points and use a tranche system in case the target keeps falling precipitously. Counter-trend trades can be very quick from a hold-time perspective and be fantastically lucrative in a fast market but your exit price and timing is critical since you’re rowing into the wind. Counter-trend traders need to be much more nimble and quick-fingered until the target gets above a downtrend where new buyers will emerge. If you’re entering a trade in a current uptrend, poor timing is much less stressful when you have positive momentum in your favor. Rule #11: when an asset goes parabolic in either direction, that’s a warning sign of an imminent major trend change opportunity. I call these rubber-band trades because the rubber-band only stretches so far until some energy in the opposite direction needs to be expended. As in physics, often times the opposite reaction is just as fierce so these pivot trades can be highly attractive on a multi-day basis. If you get these entries right, they can offer some of the most robust gains in very short periods. Capitulation in both directions has a very definable foot-print: huge volume of 5-10+ times the normal 10 day average, stretched RSI & MACD, VIX term structure inversions, breadth washouts, or a very elevated put/call ratio. I rarely try and short upside capitulation until I see clear evidence of a trend change but as the “knife-catcher”, I absolutely love building positions in downside capitulation conditions and am willing to look stupid for being a bit early. Getting to the party early and having a great seat with a full box of popcorn makes me very happy when I feel like I’ve seen the movie before. Rule #12: be very mindful of which style factors are leading and lagging. Knowing this helps you understand whether you are trend-trading or counter-trend trading. Example: if I have some cash available and looking for a trade opportunity, first I’ll look to see which styles have strong momentum. As of June 2021, growth stocks are mostly still in downtrends so those are counter-trend opportunities. Value is still the place to be and energy, financials and REIT’s have strong momentum. I’ll search these 3 sectors and the top stocks inside the sectors to see if there’s a 3 day pullback in a name I believe in. I’ll shorten up my charts to 3 days and 5 minutes for the right timing while understanding the 6 month picture as a frame of reference. Multiple time periods in charting is a very helpful tool, it helps you find the most attractive set-ups versus just being focused on a 3, 5 or 10 day chart.
Summary
Everyone has their trading rules and trading process, doing what works for you is the most important. We all have strengths and weaknesses, biases and preferences. If you know what works for you and you stick to that strategy, you can make great income as a trader. If you’re new to trading, you still need to figure out what works for you and only through placing trades will you begin to build your own process. For newer traders, I recommend starting with small amounts of money to hone your craft. Bonus Rule #1: keep a trading diary. Write down what you do, how you do it and what the results where for your trades. Write down any patterns you see so you can profit from them when you see them again. Bonus Rule #2: when the VIX rises >40% in less than a week, most of the time these tend to be terminal events, meaning they offer great entry-points for your favorite stocks or ETF’s. Usually we know what’s happening that’s causing VOL to rise so be mindful that rising VOL isn’t the beginning of a larger decline but generally these short-term VOL explosions are short-term spasms that traders can take advantage of being long into price rises of greater than 40% in a week. Bonus Rule #3: If VIX is over 30, bad things tend to happen so shorting rallies might be a better idea than counter-trend long trades. Always be on the look out for a parabolic rise in VIX as a potential warning sign the sell-off is getting overdone. Active traders tend to see robust opportunities between VIX 20-30. The volatility around earnings reports also offers wonderful “reactive trading opportunities.” I say reactive because it’s very hard to know how the reaction to an earnings report will be and you can get clobbered expecting a move versus waiting for the reaction to a report and then deciding if it needs to be faded or embraced. Lastly, be more careful with long-trades with VIX over 30. Obviously these are generalities, just some of my rules.
Starting a trading diary & continuously summing up the current environment on a regular basis can be a wonderful resource over time. Being in tune with the current rhythm of the market is vital to your success. I cannot tell you how many times I have referred to my diary over the last 28 years. Nothing is fool proof and no two markets are exactly alike. Over time, markets do rhyme and patterns tend to repeat. Time in the trading room is your best ally. Over time, we all tend to have certain set-ups that are most familiar to us and personally, I look for those first versus trying to force a quick trade. I like W patterns, cup-and-handle breakouts, capitulation trades, head-and-shoulder breakouts, adding on downtrend breaks, and buying confirmed uptrends on shallow, low volume pull-backs. And yes, those that know me best know I like to catch falling knives in high quality businesses showing signs of capitulation. Why? Because sooner or later, there’s always demand for a great business on sale so even if I get the timing wrong, the best brands on sale tend to pay investors and traders well because demand for their shares always returns.
These are just a handful of my trading rules. You likely have your own. Stick with what works and follow those who show acumen for this craft. Be focused, prepared, nimble, and humble. Happy Trading!
