My Strategic Trading Rules
I would not set out on a hike in unmarked and unfamiliar territory without a compass and a map because without those tools I might become lost. Neither do I trade without strategic trading rules–because without them I AM lost.
The rules I will outline below are strategic because they answer the big questions: Should I be long, short or neutral? What segment of stocks should I trade? Relative-strength leaders or RS laggards? Once these big questions are answered, I am ready to look for stocks that offer the best entry.
These are my map and compass: a chart of The Spread and a chart of the average RS leader and the average RS laggard (review Basic Training, Chapter Five and Chapter Seven).
There are two sorts of rules, mandatory and optional. Mandatory rules require that I take the prescribed action. Optional rules, on the other hand, merely allow me to take certain actions–they do not compel. I might or might not trade within the scope of an optional rule, but I may not trade outside the limits imposed by that rule.
Here are my Strategic Rules:
The Only Mandatory Rule. When the Spread is rising and the average RS leader is also rising, I must go long stocks chosen from among the strongest 20% of RS leaders (those stronger than the benchmark).
Discussion of The Only Mandatory Rule (TOMR)
TOMR trades are the market’s low-hanging fruit and offer the highest probability of success I know of. Trades made with the rising trend of the Spread and with the rising price-trend of the strongest stocks produce an outcome that is as close to certain as you will find in the equity markets. Under TOMR, I double down by using leverage. You may or may not wish to use leverage, but if you do, this is the time for it.
I find that it is best to purchase a handful of the strongest issues. If one should fall from grace, and lose its premier relative-strength position, discard the stock and draw another from the current strongest 20%.
Strong stocks routinely become overbought. An overbought condition in a strong stock during strength-following markets is not terminal, but sticking to relatively oversold issues substantially enhances the odds for superior returns. Moving down the list of the strongest 20%, from the strongest through weaker issues, circle those which are more oversold than the average stock in your universe. Your universe should be large enough to produce five or more relatively strong, relatively oversold stocks. These are your best purchase candidates. Avoiding overbought stocks also adds a measure of safety. During contrarian markets, when RS leaders fall from favor, strong, overbought stocks are hit the hardest.
I prefer to purchase marketable issues–stocks with plenty of liquidity. It is unnecessary to chase after thin issues during strength-following markets. I generally exclude thin stocks from consideration as candidates, regardless of relative strength.
I also remove low-priced stocks from the deck. These stocks tend to be dominated by the public; big-money sponsors often will not pick up a stock until it is over $15 or $20.
Optional Rule 1. When the Spread is falling and both RS leaders and laggards are rising, I am permitted to go long. I may not short.
Discussion of Optional Rule 1 (OR1)
Under OR1 I am also permitted to do very little or nothing. A falling Spread drastically reduces the chances of trading success. Market leaders–RS leaders–are underperforming, and traders are skittish and risk-averse. Under these conditions, trends have difficulty developing and whipsaws are commonplace. A falling Spread often produces a range-bound trading market suitable for scalpers and short-swing traders only.
Returns during these “contrarian” markets are lower, risk is higher and I have to work harder monitoring my trades in order to protect capital. My ratio of profitable to unprofitable trades sinks, along with average profit per trade. Often there is no profit. I find that it is best, both psychologically and financially, for me to trade small or to sit out the market when the Spread is falling, although that is very difficult, indeed. Trading is more than a little bit addictive, and the idea that I might be missing out on an important move is a strong draw. Nevertheless, if there is a time to be out of the market, it is when the Spread is falling.
Optional Rule 2. When leaders and laggards are both trending lower, I am permitted to sell short, but I may not go long.
Discussion of Optional Rule 2 (OR2)
OR2 defines necessary, but not sufficient, conditions for selling short. Because there is much more to determining a severe correction or a bear market than lower prices, I must look to other factors before deciding to sell short. The strength of this rule is that it prohibits me from going long when leaders and laggards are both trending lower. For a fuller discussion of short selling, see: Chapter 3-Distribution and The Turkey Shoot.
You may object that these rules are not definitive enough. The two optional rules allow too much discretion–they do not tell me what to DO! They do, however, tell me what NOT to do: OR1 precludes selling short, while OR 2 prohibits long positions.
You may object further that the definition of “rising”, “falling”, and “trend” are not well-defined. Intentionally so. What constitutes a rising or a falling trend, or a trend at all, is left to the judgment of the trader. Trading well is not, after all, a mechanical process, but an art that requires the good judgment that comes with study and experience.
Finally, the good trader knows when to bend the rules. I have found that straying too far from these three rules gets me into trouble more often than not, but from time to time I am able to anticipate a convergence of conditions which will trigger one of these rules. But not by much. Usually it is best to wait until conditions are in place. In either case, these rules throw a bright light on the market–one that guides me to the market’s sweet spot while keeping me out of trouble.
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