Essential trading rules for success: Avoid common pitfalls and enhance your strategy

An illustration of an open purple book paired with a silver coin and dollar sign, to represent the importance of learning and adhering to essential trading rules

Exploring the crucial rules that lead to trading success.

Much has been written about trading rules, and a quick search online reveals numerous strategies and guidelines for traders to follow. Many of these rules are sound but often oversimplified, explained in isolation, and accompanied by basic examples that may not hold up in real trading conditions. In this post, we’ll unpack some common trading rules, examine their strengths and limitations, and consider how to adapt them effectively in your trading strategy.

Rule 1: Always trade with a stop loss! 

The stop loss rule is perhaps one of the most widely recommended strategies. The concept is simple: if a trade moves against you, a stop loss order automatically closes the position, limiting potential losses. Here’s how it works in a typical example:

A trader buys a stock at $1.00 per share and sets a stop loss at 10%. If the stock falls below $0.90, the trade closes, limiting the loss to 10%. If the trader holds 1,000 shares, this results in a $100 loss – just 1% of a $10,000 capital investment, aligning with the standard risk tolerance for each trade.

While technically correct, this rule overlooks one crucial factor: the stock’s volatility profile. A fixed 10% stop loss might work well for stable stocks, but for stocks with larger price swings, it could lead to premature exits and unnecessary losses. If a stock regularly fluctuates by more than 10%, a stop loss at this level is likely to trigger repeatedly, creating a consistent capital drain.

A more adaptable approach involves adjusting the stop loss to the volatility of the stock, rather than applying a one-size-fits-all rule. Ideally, the stop loss amount should consider both the trader’s risk tolerance and the stock’s volatility, ensuring it’s positioned appropriately to protect capital without leading to early exits.

The key to effective stop loss usage is a reliable stock selection process. The assumption here is that the trader’s strategy – based on paper trading and thorough backtesting – has proven profitable and can select stocks with high potential for price appreciation. When your strategy consistently delivers positive results in testing, it’s ready for real-world trading.

Rule 2: Only trade with money you can afford to lose

This rule sounds practical but can carry a problematic implication: that losing money is an expected outcome of trading. While losses are an unavoidable part of trading, a sound, well-tested strategy should minimise the risk of a complete capital loss. A well-prepared trader shouldn’t expect their trading capital to disappear over time.

A robust strategy, backed by backtesting and paper trading, should have a reasonable win rate and a positive profit-to-loss ratio. A good benchmark is aiming for a 60% win rate and a profit-to-loss ratio of at least 3:1. Achieving this balance means that capital should increase over time, even with some losses.

Instead of preparing to lose their entire capital, traders should focus on risking only a portion of their capital per trade, with each trade informed by a disciplined, tested approach. Ultimately, it’s more accurate to say a trader should be willing to risk a manageable percentage of their capital, rather than expecting the entire amount to be at risk.

Rule 3: Never trade against the trend!

This classic rule suggests that it’s best to follow the market’s direction rather than betting against it. However, contrarian trading – buying during downturns and selling during upswings – can be profitable, particularly when executed with caution. For instance, in a heavily falling market, opportunities often arise as prices reach historical lows. When the market starts to rebound, traders may have the chance to buy stocks at a discount, capitalising on an anticipated recovery.

Contrarian trading requires skill and vigilance, as volatile markets bring high risks. Stock prices may fluctuate widely, triggering premature stop losses, especially if set to a standard percentage, such as 10%. In such cases, a trader might consider adjusting their stop loss to accommodate the stock’s recent price movements.

This doesn’t mean taking on excessive risk; rather, it calls for strategic flexibility. By widening the stop loss percentage and trading with smaller position sizes, a trader can potentially achieve better results than if they adhere rigidly to the textbook 10% rule. While trading against the trend isn’t ideal, buying a stock that is rebounding from a recent low can be worthwhile if the stock has resumed an upward trend.

Applying flexibility to trading rules

Regardless of the approach, every trade should have some form of stop loss or “disaster stop” in place. The goal of trading is to minimise risk while maximising returns, and a rigid, one-size-fits-all approach rarely meets this objective. Successful trading requires flexibility, a willingness to adapt entry and exit points, and an understanding of each stock’s unique behaviour.

One way to gain insight into a stock’s “personality” is by reviewing its chart history, ideally spanning a few years. By examining recent price patterns, the size of chart candles, and the range of peaks and troughs, traders can gauge how volatile a stock tends to be. If a stock shows consistent movement in one direction with small candles and minimal swings, it may offer a stable trade opportunity. Conversely, stocks that frequently change direction without much appreciation may not suit medium-term trading goals.

Adaptability is key to trading success

The rules of trading – like using stop losses, managing capital risk, and following trends – provide essential guidance, but they shouldn’t be treated as inflexible commands. Effective trading relies on a blend of discipline, adaptability, and a solid understanding of each stock’s unique characteristics.

Rather than applying a generic strategy, traders should tailor their rules to fit both their goals and the individual behaviours of the assets they trade. By doing so, they can build a trading strategy that protects capital, capitalises on opportunities, and remains resilient across different market conditions.

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Steve Carlsson, Trade Radar
Written by Steve Carlsson Founder & Director
28 Dec 2024

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