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Investing Commodities: The 9 Rules of Trading | SterlingTerrell.net

Investing Commodities: The 9 Rules of Trading



By: Sterling Terrell

Want to be a trader?  Or, more importantly - a profitable trader.

Here are the 9 Rules of Trading:

1. Don't fight the trend.
Don't bet against the market - it will crush you.

2. Avoid big losses.
If a trade is going against you - you get out.

3. Take small losses.
Do not be afraid to take a loss though. Just keep your losses small.

4. Be diversified.
The only people trading in only one asset should be those that are hedging.

5. Do not listen to your gut.
Repeat after me. Emotional trading is bad. Your gut is not a system.

6. Hold on to winners.
Do not let go of winning trades too soon.

7. Let go of losers.
Let go of losing trades at your defined loss point.

8. Do not go in under-capitalized.
Know how much equity you need to trade is a specific market. Over-leveraging is to be avoided.

9. Understand expected value.
This is the key to a rational trading system. Make gains bigger than losses and keep an eye on your winning percentage.

Now go trade.

But first, read on in a little more detail.

One: Don't Fight The Trend

Rule #1 on being a profitable trader: Stop fighting the trend.

You realize you can't make money when prices are constant, right?

So whether you are buying low - and selling high, or selling high - and buying low, every trade will involve a trend of some sort.

Now that trend may be long-term - and you may hold a position for weeks, or that trend may be extremely short-term - and you may hold a position for mere minutes or even seconds, but every profitable trade will involve some movement, or trend, in prices.


The quickest way I have seen traders get hurt is trying to fight the direction prices are moving.

When I hear people say:  "I only trade reversion on Bollinger bands," I just want to shake my head.

Or when I hear, "Prices will always revert to the mean," I always think: "Yeah, until they don't."

The sad truth is - at some point - the market can, and will, go against you more than you can afford for it to.

When prices are going against you, it is not a time to buy more!

"Fundamentally, I think the price of commodity X should be trading above price Y. Therefore, below price Y, I will be long commodity X." is a quick way to be put out of business.

On this, I think I read it best in Sebastian Mallaby's book, More Money than God.

He quotes George Soros saying:

"Just because the market is overvalued does not mean it is not sustainable."

Exactly.

If prices are moving with you - hang on.

If prices start going against you - get out.

The mark of an immature trader is getting out of winning trades too quickly and being too scared to cut loose bad trades.

Be a professional about your trading - and stop trying to fight the trend.

Two: Avoid Big Losses

Rule # 2 on being a profitable trader: Avoid Big Losses.

The old line that goes:

"There are two rules to trading. The first is: Don't lose money. That's also the second rule." seems to apply again here.

The fundamental point of this is: If you are going to trade, you have to have the equity to be in business.

And how are you going to be in business for very long if you are risking it all on one single trade?

If you are willing to take a 5% - 10% loss on each position, your trading life may be short-lived..

Starting with $10,000 and risking 10% equity, 5 losing trades in a row will leave you with less than $6,000 - and that is if you scale your percent loss to your dwindling equity roll.

The answer to this issue is common sense:

Never, ever - ever - let a trading loss get too big for you handle.

Always live to trade another day.

As a good rule, I believe that no trade should risk more than 1% - 3% of your total trade equity.

Maybe use .5% - 1% to be more conservative. And 2% - 4% to be more aggressive.

Take for example, someone who starts with $20,000 and is willing to risk $400 per trade - or 2%.

In that case, 10 losing trades in a row would be a 20% draw-down ($4,000).

The point is to play with it and find a ratio that works for you and your trading.

Be a professional.

And - never - ever - let a single loss wipe you out.

Three: Take Small Losses

Rule # 3 on being a profitable trader: Take Small Losses.

This is the corollary of Rule # 2, which is to: Avoid Big Losses.

While you should be mindful in your trading of taking losses that are too big, at the very same time, you need to be completely comfortable with taking small losses.

If you are like most traders, while you are seeking to maximize your average losing trade, and minimize your average winning trade, you are still only entering into profitable trades 50 - 60 percent of the time. This why expected value is so essential to your trading.

You have got to get comfortable with being wrong!

Good-grief. If you are going to be a trader, you are going to be wrong - and be in a losing trade about 40 - 50 percent of the time.

I mean, how many other careers are like that?  Imagine in whatever other jobs you have done in the past going into work and making a decision. You decide to pursue - or not pursue some project, and in doing so, you make a decision that looses your company money 50 - 60 percent of the time.

Trading, venture capital, and film production are some of the only roles that come close to this.

But here it is.  And it is simple. The key to being comfortable with losses in trading is this: Use stops in your trading - and only risk what you are comfortable losing.

A good rule to start is to limit your loss on a trade to 1% of your equity.

Have a $50,000 equity roll starting out?

Only be willing to lose $500 on a given trade.

That way the coin of the trade can come up tails 10 times in a row - and you would only be down 10%.

This is mostly psychological.

Most people care more about avoiding losses than finding gains (loss aversion), and large infrequent losses are easier to take than smaller frequent ones.

But - if you are going to be a trader, losses are something you are going to have to mentally overcome.

Take small ones - and never, ever, let one loss take you down.

There is always another trade.

Four: Be Diversified

Rule # 4 on being a profitable trader: Be Diversified.

I cannot for the life of me understand traders that only want to trade one thing.

"I just feel like currencies are my thing."

"Gold just feels like where the action is."

Or:  "I grew up around cotton, so I just feel like I understand it better."

That all sounds like a novice talking.

Who cares what the market is.

I mean, if you are trading completely by fundamentals - then I suppose specialization is best. One would have to really "understand" a market before you can fundamentally say where it "should" be.

All I know is that trading 100% on fundamentals is essentially saying:  "Based on my expertise the market should be trading at X.  The market is actually trading at Y.  I bet I am 'right' and the market is 'wrong.'"

Here is a new flash. The market can be "sustainably wrong" for a lot longer than you can.

In short, the market is always right.  Good luck betting against it.

That is why trading by Expected Value is best.  It can allow you to "predict" the price of anything.

The great line on systematic trading is:  "Don't tell me: 'You have no experience trading that.' It's a data point. I will trade anything."

Exactly.

When one market is lackluster it is not a big deal because that one market is .5% to 1% of your portfolio.

With diversification, markets that are moving (i.e. profitable) can compensate for markets that are not.

No diversification in your trading implies that you are going to try to outsmart the market.

Diversification in your trading implies you are trying to take what the market gives you.

Don't be an amateur about it. Take what the market gives you.

If you are going to trade, you have got to be diversified.

Five: Do Not Listen To Your Gut

Rule # 5 on being a profitable trader: Do Not Listen To Your Gut.

I am not even sure anymore what 100% discretionary trading means.

Does it mean just "listening to your gut?"

Trading based on "how the market feels?"

Or, is discretionary trading simply a reference to trading the market using fundamentals?

Who knows for sure.

All that can be certain is that the first two examples above come across as total nonsense.

I mean, can you imagine being interviewed by a trading firm for a trading position with that kind of thinking:

"Thanks for joining us Mr. Smith. Let's just jump right in. Can you tell us what your trading philosophy is."

"I don't really have one - exactly."

"You don't have a way in which you trade?"

"Not really. I mean, whatever feels right. I like to get a feel for the market and just go with my instincts."

"So given certain market conditions, Mr. Smith, there is no telling what you may, or may-not, do? You will simply act as you see fit?"

"That is correct."

Can you imagine what a joke an interview like that would be? They would laugh you out of the building.

Discretionary trading using fundamentals even seems dubious.

I mean, couldn't a trading formula still be used in a systematic way using fundamentals?

For example: "We are only interested in investing in companies with, a Price/Earnings ratio below X, a Price/Earnings-Growth ratio below Y, a Debt/Equity ratio below Z, etc."

A trading rule like that seems to take most of the discretion out of a fundamental investing decision.

Most of the problem "trading your gut" is not, however, a function of the type of trading rules or trading system you follow.

Most problems arise when people simply abandon their trading systems under stressful draw-downs.  A few losses pile up and suddenly you have entered a few buy and sell orders based in emotion.

The only way you should ever abandon your trading system is to sit on the sidelines.

If the markets are killing you for some reason, get out! Take a breath and re-evaluate everything. And live to trade another day.

The point is:  Back test your system. And trade your system.

Trading based on your emotions - or gut - is a quick ticket out of the trading business.

Six: Hold on to Winning Trades

Rule # 6 on being a profitable trader: Hold on to Winning Trades.
The decision to holding onto, or get out of, winning (and losing) trades is an issue that should define a large part of your trading philosophy.

How do I deal with winning trades? And exit winning trades?
How do I deal with losing trades? And exit losing trades?
This issue is especially important when you are trading by using Expected Value.

If in trading by Expected Value, the goal is to maximize the gain per trade and minimize the loss per trade (as well as your winning trade %), over a large number of trades, then the act of holding onto winning trades is simply maximizing the gains of a particular trade.

Maximizing winning trades is crucial because, even at a 50% chance of loss and a 50% chance of gain on a trade, you can be a profitable trader by having larger gains and smaller losses:

Expected Value = (50%)(-$100)+(50%)($120) = $10

A $120 average gain, and $100 average loss can even make for a trading career!  A $10 profit per trade may not look like much - but importantly, it is scalable.

What if you are averaging 100 trades per day?

So, if you sell sugar and make $2,500 on the trade, do you need to exit the short when you give back $600 in profits? Or, do you stick with the trade and give up $1,500 in profits before sugar goes down another $2,000 worth of gain in your favor?

If the question of when to enter a trade is answered by a signal or some sort of system - this should also be the case for exiting a trade.

The answer of when to get out of, or when to hold onto a winning trade should be the same answer for when you should enter or exit any trade.

With a system, a trade should be entered when a signal is hit- and a trade should be exited when a signal is reversed, or when a stop is hit.

Obviously, emotional trading is to be avoided - no matter the trade.

This is not rocket science.  Have a system, and trade your system.

Don't let selling winners too early ruin your long-run returns.

Use your common sense and your trading system to follow the old adage:  Let your winners ride!

Seven: Let Go Of Losing Trades

Rule # 7 on being a profitable trader: Let Go Of Losing Trades.

This is obviously the corollary to Rule #6: Hold on to Winning Trades.

As I have said before, this is all part of trading with Expected Value.

So if the goal is to maximize the gain per trade and minimize the loss per trade (as well as your winning trade %), over a large number of trades, then the act of letting go of losing trades is simply minimizing the potential loss of a particular trade.

Minimizing the loss of losing trades (and maximizing gains of winning trades) is so important because, even at a 50% chance of loss and a 50% chance of gain on a trade, you can be a profitable trader by having larger gains and smaller losses:

Expected Value = (50%)(-$100)+(50%)($120) = $10

A $120 average gain, and $100 average loss can even make for a profitable, and scale-able trading system.

It is a little bit like profit maximization from economics.

Maximizing revenue - AND - minimizing costs is required for profit maximization.

In the same way:

Maximizing trade gains - AND - minimizing trade loses is required for maximizing a particular trading system.

In my experience: Having a trading rule set in advance can comfortably take the guesswork out of when to hold on to winning trades, and when to let go of losing trades.

As always, emotional trading should be avoided.

Buy strength.
Sell weakness.

And never let a loss get too big to handle.

There is always another trade.

Eight: Don't Go In Under-capitalised

Rule # 8 on being a profitable trader: Don't Go In Under-capitalised.
This rule is common sense - really - but important nevertheless.
And it boils down to this: To trade a particular asset, or asset class, you have to have enough capital to make it work.

For example, if it costs $990 to trade a cocoa contract you are not going to fund your account with $1,000 and just start trading.

You will not last two minutes.

This is especially true if you are going to trade by Expected Value.

Before each trade is begun, you must determine what you are willing to lose on a particular trade.

This is where volatility comes into play - because you are not going to look at the cocoa contract above and say: I am only willing to loose 10 points on a cocoa trade.

That is because on a daily basis, cocoa can easily move up and down 30 to 40 points.

How can you look at the volatility so you don't get stopped out in the first 30 seconds of a trade?

I use the Average True Range over the last so many days.

So, if the Average True Range for cocoa over the last ____ days is 50 points, your stops are going to be 50 points - and you are going to be risking $500 per cocoa trade.

And then, to keep the amount you are willing to lose per trade to 1% of your equity, you are going to need $50,000 to begin this trading.

See how we worked back into that?

The point is that volatility should determine your stops. And your stop size should determine your equity.

In short:  Don't start with less equity that you can handle.

If you do - I promise - your trading won't last long.

Nine: Understand Expected Value

Rule # 9 on being a profitable trader: Understand Expected Value.

Question:  "How do you become a (profitable) trader?"

Answer:  "Predict the future."

Since we know that predicting the future is impossible, maybe the question should be more general:

"How can anyone become a profitable trader - when nobody has the ability to systematically predict prices?"

The answer is actually simple. 

It is encapsulated in an equation they made me work through in grad school.

The answer is understanding Expected Value.

Technically:

Expected Value = (P1)*(EV1)+(P2)*(EV2)

For the purpose of trading, we modify this to be: 

EV = (Probability of Losing Trade)(Expected Loss on Losing Trade)+(Probability of Winning Trade)(Expected Profit on Winning Trade)

What if to start a trade, you just flipped a coin to decide if you should buy or sell?

You have no idea where prices are going and you are flipping a coin to trade.

I would expect you would be correct about 50% or the time. Right? Prices can only go up and down - and you are just guessing at it.

But you don't do that do you?

You use a signal (please do not use your gut, never use your gut) - some sort of signal - and with that signal you enter into a trade with a buy or sell order.

In most cases, a signal will get your profitable trade percentage to somewhere between 50% and 60%. Let's say 55%, just to pick a number.

Now you are using a signal to trade and you have profitable trades 55% of the time.

This means that you have unprofitable trades 45% of the time - and this is where Expected Value comes into play.

If your average loosing trade is -$100, and your average winning trade is $100, over many trades you will average $10 profit per trade:

Expected Value = (45%)(-$100)+(55%)($100) = $10

(And you are a profitable trader!)

If your average loosing trade is -$122.22, and your average winning trade is $100, over many trades you will average $0 profit per trade (as this is your break-even point):

Expected Value = (45%)(-$122.22)+(55%)($100) = $0

Even at 50% chance of loss and 50% chance of profit on a trade - the answer is simple: To be a profitable trader, your average loss must be smaller that your average profit:

Expected Value = (50%)(-$100)+(50%)($120) = $10

So, look at you own trading.

What is your chance of loss or gain on a trade? What is your expected loss or gain?

Play with it. 

In short, we could say that the best advice - the only advice - to becoming a trader is to have your gains be larger than your losses.

I guess that is why some say there are two rules to trading, the first rule is "Don't lose money. That's also the second rule."