When Should I Break the Rules?

• Posted by Derek
• on July 9th, 2010

“In matters of style, swim with the current; in matters of principle, stand like a rock.”                                                   Thomas Jefferson

That gem of a quote came to my inbox courtesy of Charles Kirk, whose continuous efforts to educate have earned him the respect of traders & investors across the globe.  My first thought was how it applies to my personality…my choices in style show me as a conformist, while my thought process is quite non-conformist.  Not sure why that evolved, but that’s who I am.

But there’s a tremendous relevance to market participants, which I’m sure was Charles’ intended use.  How do we as speculators differentiate between “going with the flow” and “standing our ground”?  It’s funny, most lists of rules offered by successful traders end with “Know when to break the rules.”

I’ve spent years putting into code the conditions under which I identified my best trades.  But the more rules I make, the more I find great trades that wouldn’t have made the cut.  Selective memory?  Sure, we can’t downplay hindsight bias when it comes to remembering events after the fact, but I keep pretty good notes so my reviews are fairly objective.  Bottom line for me…not every aspect of my trading can be modeled.

My instinct is a strength, not a weakness…experience brings unique insight.  I want to take full advantage of it, but without a safety net I face the risk of ruin.  So what is in my safety net that allows me to unshackle instinct at the risk of impulse roaming free?  The following are my defense tactics, all of them clear and all determined OUTSIDE of market hours:

1) Position Sizing- I’m a chicken.  I play very small, risking only 0.5% to 2% of my capital on any one idea.  I love market speculation, and as long as I can provide for my family and experience independence of my time I’m willing to keep making small bets.  My big bet is on myself…I don’t need to jeopardize that on some ticker symbol.

2) Scenario Planning- I plan for (virtually) all scenarios.  Each day, my prep involves determining what I might do if markets trade Way Up, Up, Flat, Down, or Way Down.  I may not have an actionable idea for each scenario, but in the words of Dr. Brett I’ve inoculated myself from being shocked at anything the market throws at me.

3) Opposition Thinking- I do my best to simulate the mirror image of my idea…the Costanza rule.  For example, if I am thinking about selling a position I think “If I were stalking this short, would I feel a need to short it right now?”  This extra step helps me distinguish between actions based on instinct(good) vs. those based on impulse(not so good).

4) Stop Losses- My strategy acts on the fringes, waiting for stocks to show me some type of interim high or low(20-30 days) and then deciding whether we might experience continuation or reversal.  I’m wrong a lot, at least 1/3 of the time. Clearing my inventory of losers is just part of running the business.

5) Daily Journal- I am obsessive about reviewing performance.  What could I have done better? What did I fail to do? How can I get myself to do more of what worked today?  A prompt review is key to both improvement, and moving to the next day with a clean slate.

These are a few things that work for me, but I think they can be applied to most styles and time frames.  To quote Denise Shull, “your brain is going to interpret market data via pattern matching regardless if you want to use that input or not.” Might as well acknowledge that, and get in harmony with it.  To not lose, we need good defense.  But to win, we need to be aggressive when setups appear.  The best rules we can make are the ones that enforce our principles but allow us the freedom to act.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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