Rules Rule

When I was studying in university, I learnt about the game of contract bridge, and played a lot of casual games with other beginners in the university bridge club. After a while, I told other players that I knew something about the game, but a better player disagreed, and instead he asked me:

“Well, if you really know how to play the game, can you describe your playing style to us, then?”

I was left speechless. I simply did not have a style, because I played with random decisions instead of a plan, so it turned out that I did not actually know how to play the game, at all.

This is the same in trading. Although the best traders have different styles, they all have their own rules which they follow religiously to make trades. It is true that some successful traders describe themselves as “discretionary”, but they do not mean they trade on “gut feeling”, instead they just mean they prefer more simple criteria (e.g. patterns, support/resistance) over mathematical indicators.

Missing the Trend.

The importance of following a trading system is best illustrated by the following story. In 1983, two great traders, Rich Dennis and Bill Eckhart, recruited some volunteering protégés (whom were as later referred to as “Turtles”) and taught them how to trade. Although the rules they taught are simple, Dennis and Eckhart urged the students to always follow their rules, despite of the fact that 70% of the trades would be small losses, because the remaining 30% would capture big trends that might account for all the profit, so they should not miss a trend, or else they might kill the whole year.

After that, the students were given real money to trade with, and an opportunity presented itself just a few weeks after the training, when February heating oil rose from about $0.80 to $0.84 a few days into the New Year of 1984. Curtis Faith, the best student of the class, wrote about an unforgettable episode in that trade:

“[As the heating oil rose,] I followed the system and bought three contracts. The trade was immediately profitable, and in just a few days I had bought the maximum 12 contracts [… at the same time,] I noticed something that struck me as very odd; in fact, it still does. I was the only Turtle with a full position. Every other single Turtle had decided for some unfathomable reason not to follow the system Rich and Bill had outlined.”

It turned out that, even though they were reminded to follow the rules just a few weeks ago, many students had already ignored it, because they either thought the trade was too risky as it went up too fast, or the move would not last because there were only a few days to expiration. Faith could not figure out how everyone attended the same training session he did, yet were not buying the February heating oil according to the plan, to which he commented, “We were told over and over not to miss a trend, and here it was only a few weeks later and many of the Turtles had missed the boat on a very significant one.”

Backing Out at the Pullback.

After that, the heating oil move was volatile. Heating oil dropped in price from a high of about $0.98 to $0.94, or about $1,200 per contract. According to their training, the students should hold on during a brief drop and let the profits run. Faith did hold all 12 contracts as the price dropped and saw his profit drop from about from $50,000 to $35,000 in just a couple of days, while the few other students who had significant positions liquidated their contracts.

After the brief pullback, the market woke up and rose again, and soon it passed the previous high of $0.98 and peaked at over $1.05 right before expiration. Since the uptrend was unseen in the March contract, Dennis told Faith to close his positions immediately and his account was up $78,000.

Later, Dennis visited the class and made it clear to everyone that taking the trade was the correct move, and declared that those who stuck with the rules would be awarded with a $ 1 million account to trade with. It was therefore very surprising to Faith when he was given a $2 million trading account, and it was evidently because Dennis liked the way Faith had handled the heating oil move. Faith wrote:

“I was rewarded for holding to the methods we were taught by earning almost three times as much on this trade as any of the other Turtles did. The few who had positions of a reasonable size had all exited near the lows of the previous dip and ended up missing half the move. The Turtles who had not entered the trade made nothing.”

He also added, “The scenario could not have been better for teaching the class a valuable lesson. Slightly more than one month after training, we had witnessed in actual trading the importance of not missing trends and had that lesson reinforced in such a way that none of us would ever forget it.”

The Winners and The Losers.

However, not all of the students learnt from the experience. Although some of them developed into winning traders, up to half of the students were much less profitable, and those who lost money were dropped from the program. The difference between the winners and the losers was that the losers got impatient in an inevitable losing streak, and at some point they simply gave up the rules altogether, yet they did not understand that losing is a part of trading success. As Faith wisely pointed out:

“It turns out that it is much easier to make money when you are wrong most of the time. If your trades are losers most of the time, it shows that you are not trying to predict the future. For this reason, you no longer care about the outcome of any particular trade since you expect that trade to lose money. When you expect a trade to lose money, you also realize that the outcome of a particular trade does not indicate anything about your intelligence. Simply put, to win you need to free yourself and your thinking of outcome bias. It does not matter what happens with any particular trade. If you have 10 losing trades in a row and you are sticking to your plan, you are trading well; you are just having a bit of bad luck.”

Conclusion.

Even Rich Dennis himself expressed a similar opinion, “I always say you could publish rules in a newspaper and no one would follow them. The key is consistency and discipline.” The job of a trader, therefore, is to find a strategy that has a positive expectancy, and execute your plan consistently by keeping your losses small, so that you can live long enough to see that expectancy materializes. The best traders do not predict the outcome of any individual trade, because they know that if they follow the rules, they will make money in the end.