Why Rule Based Trading Systems May Be the Best Place for You to Start

In this post you will learn:

  1. The difference between a rule and a guideline
  2. That rules are not just for technical traders; discretionary traders and fundamental investors also use rules
  3. How to find the rules that are worth using

A rule is different than a guideline. Think of it like a road. A rule is like the guardrail that is there to stop you from going off in the complete wrong direction – which could be disastrous. A guideline is the center of the road often marked with nothing more than paint. It is there to provide you a sense of direction. It is there to give you a center. You have the freedom to travel on either side of the line or to even cross the line.

All professional traders and investors use rules. The rule-based trader simply travels on a narrower path than a discretionary trader might.

Discretionary traders have rules about size, risk, and other things that are meant to keep them from flying off the road. Their guidelines may include things like ‘don’t chase’ and to ‘only trade stocks in play’. Long-term fundamental investors use rules as well. These rules have to do with their analysis and selection of companies based on financial data.

It is probably not challenging to convince you that the use of rules is beneficial to you. The challenge probably lies more in whether or not you abide by your rules consistently.

Traders want consistent results. But they rarely do the same thing consistently. The reason for this is likely due to a lack of confidence in the validity of the rules they have selected. It stands to reason that building confidence in your rules may be a very important component to achieving more consistent results.

Here is a quick summary of what I have learned from these tests and through the process of implementing ideas into multiple accounts that I manage for investors.

  1. Yes, there are 100% rule-based systems that can generate “consistent” results. And by consistent I mean positive results most months and most years. And the down months and down years are smaller than the average up year.
  2. I am continually amazed at the following truth about market systems. A good trend following systems is typically 35% to 45% accurate. It does not matter what time frame you use, which market you use, which indicator, or combination of indicators. The difference in the success of the trend following systems has to do with the size of the winners and the size of the losers. The best way to affect these two numbers is to adjust the markets you trade. A market that tends to have large one way moves is more likely to have success with a trend system. This typically does not include volatility instruments or broad-based indexes.
  3. Market neutral options trading allows for the greatest number of 100% rule-based systems that can generate consistent results. While this is true, the challenge lies in the learning curve. I have had the opportunity to watch extremely brilliant people learn the options market. Scientists, surgeons, engineers, attorneys, retired executives, etc. The ones that bring a growth mindset to their learning of the options market tend to do best. This means that they enter the world of options trading with an open mind and a humble attitude; questioning everything that they think they know.
  4. The combination of market neutral options and trend following creates a unique and wonderful strategy for traders. The upside of trend following is the ability to follow the market and not be caught on the wrong side of significant movement. The downside of trend following is that whipsaw creates many small losers when the market does not trend. The upside of market neutral options is that a non-trending market creates the best returns. The downside of market neutral options is that significant movement can create drawdowns.

Many of the strategies that we trade combine the benefits of trend following, the benefits of rules, and the benefit of market neutral options.

Make no mistake, there are still downsides to our style of trading. You should know about these from the very beginning. The first downside is that the learning curve is longer and the concepts are more complex. The other primary downside is that, like many forms of trading and investing, we are still subject to “Black Swan” risk. Most of our strategies have defined risk and enough return on risk that a “Black Swan” event should not be devastating.

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