There are some rules in trading that simply stand the test of time... because they work! Of course, not all traders will agree on every rule but in general, there are some rules that if they are followed with consistency they will help traders stay out of trouble and keep them on the right side of trading.
In this Wiki, we will explore several trading rules to live by that may just help you overcome some trading issues you may have or keep you from developing habits that work against your profitability.
This Wiki is a part of our Essential Forex Trading Guide which is packed full of useful information to help traders achieve better results. Be sure to check that out HERE.
Trading Rules to Live by
There are many ideas and concepts that traders can choose to follow that will help them make effective trading decisions. However, there are very few trading rules that have stood the test of time that have been proven to actually help traders improve their results over the long run.
The rules we will present in this Wiki are simple in concept yet the vast majority of traders fail to follow them with any degree of consistency. This is a major factor in why so many traders fail to make consistent profits over a sustained period of time.
The question becomes this; If there are a few rules that traders can follow that might increase the odds of having a lasting career of profitability in the markets, why wouldn’t they follow these rules? The reason is unfortunate but also simple; lack of discipline, lack of conviction, self-doubt, fear and greed. These are major roadblocks to trading success that traders must be overcome at some point.
Traders will need to master their emotions and control their limiting beliefs about money when they are trading. Without this, most traders will find that following even the simplest of rules is very difficult. The traders who do succeed over the long run are the ones that have totally committed themselves to their trading plans. They are also able to completely focus on each trade without bringing in too much emotion that might otherwise cloud their logical trading decisions and good judgment.
The following are some simple rules that have stood the test of time in the markets and still remain as valid today as they did 50 years ago. You might have heard these rules many times before. But if you have heard about these rules, we have to ask, are you applying them in your trading? If not, you should really ask yourself why not? Be totally honest with yourself. Trading is hard enough and if you are not being completely honest with yourself then the odds are pretty high that you’re not going to achieve your goals.
Let’s now take a look at these trading rules to live by in more detail.
Cut Losses
The most important thing a trader can do is protect their precious trading capital. Without money to trade you will find it rather difficult to make a profit. This sounds pretty obvious but we have seen so many traders ignore basic risk management and wind up with no money to trade because they took on way too much risk. The best way to protect your capital is to never allow a loss to get out of control or become unmanageable.
If a trader allows a loss to get out of control it can potentially be emotionally devastating and cripple their ability to have rational thoughts about their trade in the moment. This is not the best thing to do because you absolutely need to be in the right frame of mind when you are trading.
In the Wiki on psychology, we discuss being in your ideal state for peak performance. Letting losses get out of control will take away your ability to trade in your ideal state which is not something we want to happen.
There are many traders who just can’t bring themselves to close a position that is showing a loss. They sit and stare at the profit and loss blotter watching as the damage continues to get worse and worse. Eventually, this trade turns from a day trade into a buy and hold for life position. In the worst-case scenario, the trade will be liquidated by the broker because there is not enough money left in their account to support the margin requirements.
Most of these bad trades never come back in the time that the trader needs them to. This can leave a trader emotionally defeated and worse, leave them with no money left to trade. If the trade was closed at a small loss it would have been much easier to recover from using some of the psychological techniques that you will learn in the Wiki on psychology.
Not wanting to close a position at a loss is what sends traders down the path of trying to find a trading system that never loses money. This will pretty much take forever because there is no such system that will work over the long run without infinite capital to back it up. All traders would be better served by taking the time to learn a proper trading method and then implementing it until they find success.
A major key to having a long-term successful career as a trader is getting rid of losses as quickly as possible so that you can put your hard-earned capital to work someplace better.
Professional traders would consider the trade a win if they cut a trade at a loss of 1% and then watched it move another 10% against the trade after they got out. If you were to ask any successful trader what they attributed their success to, cutting losses quickly would be one of the most common reasons and it is highly suggested that you do the same thing.
Let Profits Run
Letting your profits is the exact opposite of cutting your losses quickly but is still something that takes some time to learn. All traders should have a plan that produces profits at least 40-50% of the time. In fact, many of the best traders will tell you that they only make a profit around 50% of the time. This is the exact reason why all traders need to make sure that the winning trades will be bigger than the losing trades. Your winners need to be larger than your losses in order to pay for those losses and then generate an overall net profit in your trading account.
All traders will need to try and take the most amount of pips out of a move as possible. Having conviction in your trading abilities will help you hold for larger gains. As we have mentioned before conviction only comes from doing something consistently over a sustained period of time. So you need to make sure you can hold through moves against a profitable position so that you can get those larger wins. Sure there will be times when a nice profit might turn into a break-even or even a losing trade but the key is that you are consistent with how you manage your trades. If you are in a trade for the right reasons then you will win more often than you lose.
All traders are going to have losing trades because that‘s just part of the nature of trading. If you think that you will find a system that produces profits 100% of the time you’re really kidding yourself. That kind of thinking can lead a trader down the path to failure very fast because in reality a 100% perfect profitable trading systems do not exist. The profits that you make must outweigh the losses that you will inevitably have.
The Trend is Your Friend
Trading can be a harsh environment to try and make a living in. There are literally millions of people trading with the hopes of making money and they are all competing directly against you. Some of these people work for money management firms that have virtually unlimited resources and are the brightest trading minds in the business. Because of this, the trend may be the only friend that you find in the Forex market.
One of the major mistakes that traders make is to try and call tops and bottoms. They see a currency pair have an extended move in one direction and they start to think that it can't go any further. This is a huge mistake that will put you on the wrong side of the current market sentiment.
Never try to predict a top before the market has fundamentally proven a top has formed. It’s even harder to call a bottom because markets tend to fall harder and faster than they go up. If you do this you are trading against the established momentum created by the long-term fundamentals or the sentiment of the day. We only want to trade with the market sentiment because we want to trade the actual reasons the market is moving. In other words, we only want to trade with the power of the move.
You always want to trade with the fundamentals because the power of the trend will be with you which will make it more likely that you will have a winning trade. Trying to call a top or bottom without confirmation is nothing more than gambling. Sure, the rewards may be high but the risk is almost always much higher than the reward. You are sure to have way more losing trades if you attempt to pick tops and bottoms without confirmation.
An example of a terrible habit that many traders suffer from is when a trader buys something that is falling and the market continues to fall hard against their position. The trader sits there paralyzed with no ability to react. If the market ever does come back to where the trader entered the trade he will probably sell immediately to get rid of the pain. Trading like this leads to the habit of taking small profits and huge losses. This is a road to disaster so please don't let this be you. If it is you, head over to our Trading psychology Wiki.
Don't Buy because it Looks Cheap
If a Forex pair looks cheap, there is probably a very good reason for it. You need to know what the actual reason is that the currency is cheap. You do this by being in tune with the markets and what is currently driving prices today. You do this by watching the news feeds, listening to the audio squawk, and surfing industry websites that other professionals are using to help them with their trading decisions. This is basically how you gather all the current fundamental and sentiment data that is currently driving the market.
A trend is a trend, it’s really that simple! If the market is in a downtrend and looks cheap the odds of success will be to follow the trend and go short. A body in motion tends to stay in motion until it encounters an unbalanced force comes to mind when talking about trends in the markets. This makes total sense when talking about trends because a trend will continue along until a real fundamental reason hits the markets to change the direction of the trend.
What looks cheap almost always gets cheaper. We believe your focus should be on buying high quality up trending currencies with strong fundamentals and sticking to shorting fundamentally weak currencies. We want to buy a strong currency against a weak currency. Doing this will put you on the right side of the fundamentals and sentiment trend most of the time.
Don't Sell because it looks Expensive
This is the exact opposite of not buying something just because it looks cheap. If you are thinking about shorting something that looks too expensive, be careful. Bull trends can last for years. If we are talking about an intrady trend then bull trends could last well through the entire session and into the next if the sentiment is strong enough. Of course, there will be pullbacks along the way but those are the best times to buy because there is an obvious fundamental reason that the currency is going up. This is not the time to think about going short.
In theory, when you short something your risk is unlimited because it’s possible for a market to continue moving higher infinitely. It’s unlikely that a market will move higher forever but there are many examples of currencies going up and not slowing down for a much longer period of time than most traders’ account balances can handle holding a short position.
When a currency is really strong greed can really move prices for extended periods of time. Your job is to look for the best spots to join the other market participants and make some pips on the back of their greed.
Don't Overtrade
It can be very easy to convince yourself that if you don’t trade every day then you’re missing out on all the good trades. How many trades you make per day, per week, or per month will depend on the type of trader that you are. You might be a scalp, day, swing, or position trader, all of which have different holding periods and frequency of trades.
If you are a long-term trader looking to hold positions for months, then it wouldn’t make much sense to buy and sell 30 times a week. Also, it’s very easy for day traders to get caught up in the thinking that they always have to be in a position. This is simply not true. You should only be looking for the best setups that match your trading plan. If you miss the one good opportunity of the day then move on and come back tomorrow. The key is that you only get into your best 10 out of 10 trade setups rather than settling for less than the best.
If a trader must always be in a position at all times the chances are high that they have chosen to take many poor-quality trade setups which will lead to many unnecessary losses. This violates our risk management policies of only taking the best trade setups. The trader who can learn to only take the best setups will be lightyears ahead of the rest of the retail traders.
Never trade just for the sake of trading or because you need to be in the action. It’s okay if you miss a trade or two here and there. There are dozens of currency pairs, commodities, and indices worldwide to choose from. You can even trade individual stocks should you choose. Your time would be better spent searching through the markets looking for the best trade setups rather than regretting taking a poor-quality trade setup that winds up costing you money.
Don't Trade Tips
Trading on tips is a very dangerous proposition. This is because you will be acting on the opinions or beliefs of other people without seeing any proof to warrant the validity of this information. What you have done is basically removed yourself from the analysis of why a particular currency or market should do this something. This makes the analysis completely subjective and more like gambling which is never a good thing in the trading world.
Most people have probably acted on a tip before and the major problem with this is that if the market starts to go against your position you will be more likely to not use smart risk management because you may not have your own stop loss rules. Even worse, you may not even have a trade plan because the hot tip wasn’t your idea.
It’s also worth mentioning that if the trade does go wrong then you have someone else to blame other than yourself. This can cause a whole host of poor psychological issues and habits that can be debilitating to your trading. It's easy to rationalize why the loss was not your fault but the fact is you are the only one that can pull the trigger on a trade. If you choose to get into a trade on a hot tip then you are the only one who owns that trade and whatever the result is you have to live with it.
You need to focus on your own trading plan and not tips, regardless of who the tips are from. Sure, trading a tip might work from time to time but in the long run, tips fail more often than not because they are typically coming from a source that has no business offering that kind of information in the first place.
Trading is about putting the odds in your favour to create reliable and consistent profits, not about hitting home runs. If you consistently execute your trade plan and hit singles, every once in a while you will hit a home run just because you are doing something so consistent that the market will reward this good behaviour. Always trying to hit home runs is for gamblers and you definitely don’t want to join that camp.
Trade Liquid Markets
You should always trade currencies or markets that have good liquidity and a lot of open interest. It’s a terrible feeling to have a trade that goes against you and when it comes time to take your stop loss there is no one to sell your inventory to. This can wind up costing you more than you may have planned for in the form of slippage.
On the flip side, it can be very disheartening to get a nice profit and not be able to take it off the table because there is no liquidity to sell your inventory to. Currencies that lack liquidity will typically have a wide spread which is why it’s also important to pick a good broker with strong access to the interbank market. The better the access a broker has to the interbank market the tighter the spreads and the more liquid the currency pairs will be.
A good rule of thumb is to only trade currencies that have tight spreads. This is more important for day trading than it is for longer-term trading. Having wide spreads will eat into your trading profits so having tight spreads is important. Most traders like to stick with the G8 currencies because they are the most liquid.
Keep Position Size Manageable
Managing and controlling risk is one of the most important aspects of long-term profitability in any market you can think of. All traders must learn to manage their money in a professional manner if they want to survive in the long run.
The size of any one position should be based on how much you are willing to lose on that particular trade. For example, if you are willing to risk $500 on a trade and the stop loss is 50 pips away then the maximum amount of currency that can be purchased is $10 per pip ($500 / 50 pips = $10 per pip) or a trade size of roughly 100,000 units. This should also be based on the size of your trading account. It obviously wouldn’t make much sense to risk $500 on a position if you only have $1000 in your trading account.
Trading is not a role of the dice. Smart traders play the odds and the odds will always be better with intelligent risk management principles. There have actually been studies that show random trades perform better with a consistent risk management approach than without. So if you have an edge in your trading and you are using intelligent risk management then you are putting yourself far ahead of the competition.
Never Average Losing Positions
One of the worst things that a trader can do is throw good money after bad money. Losses that are not being managed well are bad money. Your hard-earned trading capital is good money. Why would you want to throw more money into a trade that is causing you pain and losses? Averaging a losing position is the trading equivalent of drinking too much alcohol and then driving a car, it's just plain stupid!
If a trader averages a losing position to lower their cost basis all they are doing is increasing their position size and therefore increasing their total risk in the market. If the market continues to move against their position the losses will add up much faster and destroy capital much quicker.
This is not to say that you can never average a losing position. If your trade plan allows for you to scale into your full position size then that is completely fine. There are lots of good entry methods that can be used around scaling into a position but adding more size just because the position is losing money is a road to ruin over the long haul. Don't let this be you.
Related Wikis
Readers of Trading Rules to Live By also viewed: