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The Five Golden Rules of Profitable Trading

InvestorEducation / Learn to Trade Apr 24, 2008 - 10:26 AM GMT

By: Money_and_Markets

InvestorEducation

Best Financial Markets Analysis ArticleLarry Edelson writes: The topic I'm writing about today has nothing to do with the current state of the markets, but everything to do with making money in them.

The reality is that there are certain core competencies you must implement if you want to trade profitably.


Unfortunately, most investors either don't get it, or worse, simply choose to ignore these fundamentals. Still others understand these rules. And yet, when push comes to shove, they let their emotions get the better of them, which often leads to disastrous results.

I call the following concepts “Larry's five golden rules of profitable trading.” Follow these time-tested precepts each and every time you trade and invest, and I think you'll have the essential framework to make money in any market.

Larry's Golden Rule #1: Making money in the markets has almost nothing to do with how often you win — but everything to do with how you manage your risk.

Repeat this to yourself every time you invest in the market until it becomes ingrained in your thought process.

Why? Have I lost my marbles? How can you make money in a market if you're wrong more than you're right?

The answer is simple, and the proof is mathematically certain. Let me show you ...

The Nature of Risk Equilibrium: The stock market is a dynamic structure that ebbs and flows pursuant to the forces exerted upon it by investors.
The Nature of Risk Equilibrium: The stock market is a dynamic structure that ebbs and flows pursuant to the forces exerted upon it by investors.

Trader A makes 10 trades. Nine are losers — dead wrong each and every time. Only one trade is a winner. Sounds like a pretty lousy track record, right? After all, Trader A was wrong 90% of the time!

If that's how you see it, change your thinking right now. Because making money in the markets has almost nothing to do with winning all the time.

Rather, it's the magnitude of the winnings when you are right that counts.

Trader A lost $200 on each of those nine trades (including all costs and commissions). Net loss on the nine losers: $1,800.

But Trader A let his one winning trade run, ultimately netting a huge profit of $3,000.

So how much did Trader A make on those 10 trades? Nine losers for a net loss of $1,800, plus one winner worth $3,000. Total net profit: $1,200!

Imagine that: Trader A was wrong on 90% of the trades — taking losses on nine out of 10 trades — yet still netted a profit of $1,200!

Now, let's compare that to Trader B who claims that nine out of his 10 trades are winners — a 90% win rate. Trader B makes $200 on each of the nine winning trades, for a net gain of $1,800.

But on the 10th trade, Trader B fails to control his risk and loses $3,000!

Result for Trader B: Nine winning trades for a net gain of $1,800. One losing trade for a loss of $3,000. Net result: A $1,200 LOSS!

So while Trader B was right 90% of the time and produced nine winners, he lost $1,200! Get the picture?

To sum up ...

— By strictly and consistently controlling your risk and hence your losses, you avoid the “risk of ruin” on any one trade or investment.

— You can withstand losing streaks and stay in the game till the big winner comes along.

— You can be wrong 90% of the time and still make money!

— And then, as more of your investments become winners, as long as you consistently and rigidly control risk, you'll make even more money!

So how do you control risk so tightly? Simple ...

Larry's Golden Rule #2: Never risk more than 2% of your account equity on any one investment, trade, or recommendation.

This is for any trading you do on your own. The only exceptions: Long-term core positions where you are not using any kind of leverage or margin.

But for short-term investing — day-trading and position trading — you should never risk more than 2% of your account equity on any one trade.

Why? Let's say you have $100,000 to trade with. If you risk 10% of your equity on every trade and you experience 10 losers in a row, you're wiped out. You are out of capital, and out of the game.

Even if you lose nine in a row, you've lost 90% of your equity ... you then have only one chance left to be right. And just to make back all the losses and breakeven, you have to hit one heck of a windfall profit on that 10th trade.

On the other hand, if you risk only 2% on each trade, you have twice as many opportunities to be right.

You have 20 opportunities instead of 10. And with 20 opportunities, the probability of you being right on any one trade goes up exponentially. And so does the probability of a winner that will run to full profit potential, helping to not only wipe out any losses you incurred, but to also push your account firmly into positive territory.

How do you control your risk so consistently? This one is really a no-brainer ...

Larry's Golden Rule #3: Always use protective stops!

This is an absolutely imperative measure you must implement, and it works hand-in-hand with rule #2 above. Once you've defined your 2% risk in terms of your account equity, always place a protective sell stop to get out of that trade at a maximum 2% loss, no matter what .

You can always get back in. You can always trade another market. There is always another opportunity. But if you don't religiously use stops to limit your risk to 2% — I can say with absolute certainty that you will never make any money on a consistent basis.

You might get lucky once in a while by not using stops. But I assure you, without a hard and fast rule of using stops, you will give back any “lucky” profits you make in no time, guaranteed.

Of course, if you are trading options, using stops — and the 2% rule — it's not practical. But as long as you are only purchasing calls or puts, you can implement similar risk-controlling measures by never buying an option position that equates to more than 2% of your account's total equity.

It's also important to remember ...

Larry's Golden Rule #4: How you exit a trade is as important, if not more important, than how you enter it.

Another peculiar sounding rule, right? Not really when you think about it. If controlling your risk to small, predetermined amounts is the key to successful trading and investing, then that, by definition, tells you how important the exit is.

When properly aligned with natural market forces, your trading strategy might well turn an initial stream of profits into a flood of wealth for generations to come.
When properly aligned with natural market forces, your trading strategy might well turn an initial stream of profits into a flood of wealth for generations to come.

Exiting with a small loss — the 2% rule —is critical. But knowing how and when to exit with profits is equally as critical.

After all, what good is it if you give back a majority of your profits before getting out?

Or, what good is it if you get out of a winning trade prematurely, when a big trend is about to emerge, and you caught it early on?

So how do you exit a trade with locked-in profits? By always using a trailing stop to reduce both the risk and the odds — as well as the amount — of profits that you can potentially give back.

And no matter what, when that trailing stop is hit, get out of the trade.

Discipline makes money — discipline in predetermining your risk and putting as much emphasis on when to exit a trade as you do on when to enter a trade.

There are myriad types of exit strategies designed to maximize profits, and I'll go into them in future issues. Suffice it to say for the purpose of today's article and my Golden Rule #4, that ...

— Knowing how and when to exit a market is as important, and often, more important, than knowing when to enter. Always remember that.

— For a good, general exit strategy, always use a protective sell stop that starts at a 2% loss level, and always move the stop in favor of your position to reduce risk of loss, or risk of a setback in profits.

As a corollary, never move the stop in a way that increases your risk of loss, or gives back a greater portion of your open profits!

And by all means ...

Larry's Golden Rule #5: Ignore the News.

I don't know one single successful trader or investor who watches any news shows during the day. I myself turn the TV and radio off during the day.

Watch these shows in the evening — unless you have a special analyst you want to see or listen to during the day.

But other than that, when the markets are open, the commentary you find on these shows will more often than not just confuse you, frighten you, or mislead you.

And always keep in mind: News does NOT dictate the major trends in any market or security. To the contrary, news flows FROM the trends!

Think about it: How often has a stock reported better-than-expected earnings, and its share price tanks? Or it announces worse-than-expected earnings, like Citibank did just the other day, and the share price soars?

The same holds true when economic stats are released by Washington like unemployment numbers, CPI, trade deficit numbers, you name it — they are all backward-looking statistics and do not create or change trends.

Rather, the statistics are the result of trends already in motion, and if you follow them, or rely on them to trade, you are virtually guaranteed to lose money.

So what can you rely on? Your own homework on the markets, whether it's based on fundamental or technical analysis. Or on an analyst you trust, and who has proven that he or she not only understands the major trends at work in the markets, but also knows the importance of sound money management concepts.

Best wishes,

Larry

This investment news is brought to you by Money and Markets . Money and Markets is a free daily investment newsletter from Martin D. Weiss and Weiss Research analysts offering the latest investing news and financial insights for the stock market, including tips and advice on investing in gold, energy and oil. Dr. Weiss is a leader in the fields of investing, interest rates, financial safety and economic forecasting. To view archives or subscribe, visit http://www.moneyandmarkets.com .

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6 Critical Money Making Rules