The Importance of Following a Rules-based Trading Framework | Trade Risk Core Values

The Importance of Following a Rules-based Trading Framework | Trade Risk Core Values

Show Video

(upbeat music) - Hello everyone, it's Evan here from the Trade Risk and in today's video, we're going to be discussing the importance of a rules-based trading framework. Now, this was a post in an article that I had written that I was going to just publish to the blog, but because this is such an important topic, because it's something that I personally believe is very important to lots of traders to hear, to think about and to maybe implement in their own trading, I wanted to at least fire up a video where we cover some of what's discussed in this blog post. So what I'm going to essentially do is kind of skim down through this article. We're going to bring up some different examples.

I'm going to go through a few different tabs here and I'm sort of going to explain some of the main takeaways from this blog post and the importance of having a rules-based trading framework. Now, if you prefer to read the blog, you can do that. There's a link in the description.

You can just read the article if you want to skip through and skim through at your own pace. Now, the reason this topic came up is because I believe more and more that rules-based trading can solve lots of a traders problems. It's not going to solve everything and there are some cons against it, we're going to discuss that later in this video as well, but as I reflect on my own trading, my own sort of arc as a trader, being more rules-based, me being more streamlined has helped me tremendously. It has streamlined my trading. It has made it more profitable.

It has made it more robust, and I feel more confident in the decisions that are being made on a day-to-day basis and I've had the privilege at this point to talk with at this point, I mean, thousands of traders through meetups and conferences and our website and support and all these different places and there is a common couple of buckets, couple of areas where lots of traders seem to have difficulty or get hung up or run into issues and when I work with these traders or I talk with these traders, having a more rules-based foundation is almost always, if not the solution, at least part of the solution or at least something that can help them get through to the other side. That's why I really wanted to put up this article and I think before we get into it, one thing as we are discussing throughout here in today's video, I want you to think about maybe how rules-based are you or do you need to be. Not everybody needs to be a 100, not everybody needs to be a quant or a systems trader. That is nice if you want to, that is personally where I like to operate, but you might not want to be that hands-off.

You may want to make some decisions on the fly, some discretion, and that might be very valuable. You might have insights or skills that you've developed over the years that are worthwhile to hang onto and to make yourself, but for everything else, you want to cut that out, or you want to streamline it, or you want to automate it, or you want to turn it into a more if then type of scenario. So let's jump into it.

The first real big issue that I see traders fall into and I full on was in this camp is betting too large, not cutting losers, having too much size on, being too aggressive. These are all different problems that essentially fall into the bucket of risk management. Risk management, position sizing, they go hand in hand and this is where, first off, I think a lot of traders struggle. How many shares should you be putting on, right? How big can you size up and how many different positions should you have on? How correlated are these positions, right? These all stem and really boil up to risk management, understanding your strategy, your decisions, and how they have performed historically can be extremely beneficial. So let me give you a concrete example. A few months back, we published a Beyond the Charts trading series.

So it's this episode here in particular. So I can also bring up this blog post, so you can find it. Is buying stocks trading at 52-week highs a profitable trading strategy? This is part of our Beyond the Charts series where we simulated a strategy.

I wrote the code, I backtested a strategy that bought stocks, breaking, closing at new 52-week highs and we simulated out if you bought the stocks at highs and you put a 10% stop loss, we did some different stop losses, basically simulated out the results. We ran a backtest. We simulated a 100% fully rules-based trading system. So I encourage you to check out the blog or the video on our YouTube channel here if you didn't catch that.

And so the cool thing is, is when you have a fully rules-based trading system and you've got all this market data that you can run it on, you now have a long history of how this performed, how this objectively performed in the market. And so when you have all of your wins, your losses, your entries, your exits and your different position sizes and you have all of this tallied up, you can start to compute some pretty cool stats and in this case, this is a simple example I like to give that we talked about in this blog post is when we think about how does a rules-based approach help with risk management? Let's say you're a trader that doesn't like to lose more than 10% of their account value, right? So this would be considered like a max drawdown. Let's say you never want to see your account fall more than 10%, that's your risk limit. That's your volatility limit. You get a little nervous when you start losing more than 10% of your account value.

Okay, so how can that, how do you then size your trades if that's the case, right? If you're a fully discretionary trader that maybe varies position sizes and varies the way they make decisions, this can be a difficult thing to know. But if you're a fully rules-based trader, well, this is a simple sort of equation. Let's take the concrete example of the 52-week high trading system that we built. So in this example, in this trading system, this system experienced 14 consecutive losing trades in a row. That was it's over 20 years of testing, so we tested basically from, I think, it was the year 2000 to 2020. We ran this trading system on 20 years of historical data and we looked at the results, they were profitable, but we saw that there were periods where the max period was a 14 losing trades in a row.

So if you are someone that only wants to risk or having max drawdown of about 10%, so we talk about, we use this example exactly in the blog post, then you could at most risk 0.71% per trade. With your 14 losers, would get you about a 10% drawdown, right? We are using the, we are being informed by our rules-based trading system results to determine, to dictate how we can then position size looking ahead. Now, a couple of things, first off, this tells us nothing about what the future holds.

So just because, right? In the past 20 years, the largest losing streak was 14 trades, it doesn't, it's not suggesting that next year we couldn't get into a 20 consecutive losing streak, right? It's absolutely possible, so we're not talking about forecasting, but we're at least informing our decision. We know, we already know that 14 losing trades have happened, that's a fact. So the only thing that can happen is that number can go up. So if you are really afraid of a 10% drawdown, then you probably want to be probably sizing 0.5% risk per trade because that's going to give you some wiggle room when a bigger drawdown ultimately happens in the future.

This is one, very small example of how being data-driven by being objective with having rules can inform your decision on risk management and it can help you to deal with volatility, to deal with uncertainty, to not bet too big and to know just a little bit more about position sizing. We have some other, we've got other literature on the website about position sizing. We think it's extremely important we have a fairly in-depth position size calculator on the website for sale. It's in Microsoft Excel. You can watch this video about it. There's multiple ways to sort of manage risk and do all kinds of fun stuff, so I encourage you to check that out.

I'll put the link in the description of this video as well, but you can find it at our position size calculator on the website. So this is the first sort of helpful example here on how rules can help. If you are a full-on discretionary trader, it can be really hard to pin down these types of stats.

That is sort of the first helpful way. Number two, on the biggest reason why I think traders run into issues is this one comes down now to emotions and psychology and everything that's in between your two ears and this is something where you hear me talk a lot about on the podcast, for instance, on Smarter Trading, right? A lot of the guests are trying to optimize on the mental side of the game and they talk about how important it is and it is. It is so important because I know as coming up as a discretionary trader, I know the toll of the market takes on an individual that has to go out there and make decisions every day, every hour as one is day trading, every minute you right, is a new opportunity.

You're either managing a trade, looking at other trades on that market open and it's extremely taxing. It can be extremely taxing on a human being. I know I had many difficulties just really tying my self-worth and how I thought I was doing into the performance of the day and that was very difficult. Well, the clear winner here on having a rules-based trading system is that it helps reduce all of that anxiety, all of the decision fatigue, all of those decisions into your day, or even if you're a swing trader, it doesn't really matter, all of the decisions when you're staring at markets moving and the VIX is climbing and the fear is pushing out through CNBC and Twitter and everywhere else and it's panic, panic, panic, growth, inflation, all this stuff, it's hard to objectively make those decisions.

So again, if you do your research away from the market and you get a rules-based trading framework that can execute without emotion and you can follow that system, that is a key asterisk here which we're going to talk about a little bit later in this video as well, then you're in a much better spot. Now, having a rules-based framework and automating that rules-based framework, these things start to come hand in hand, right? Because if you suddenly have all of the rules planned out, then the question becomes, well, how can I automate this system as much as possible? Because if it doesn't require you, then why are you there still clicking the buttons? Can you use GTC orders with your broker? Or could you do bracket orders with your broker? Or could you write some simple code to maybe execute some orders when certain conditions happen, right? These are all potentially possible once you become and once you go down this road of sort of rules-based trading. We published the article last year on how to maximize your screen time adjusted returns. This was all about being efficient, using tools and different ways to essentially automate or streamline a lot of your trading and so I would encourage you to check out this article on the blog here because it starts to fit in to today's lesson of being rules-based. So, again, back to what I said at the beginning too, the one thing I will sort of bring up here is that rules-based needs to be figured out for everyone watching this.

So if you are someone that has the ability or has the value, the skills that you've built up to maybe get in at good entry prices, right? You are really good at picking entries, but you aren't so good at trade management. That's where things go wrong for you or they get difficult for you, or they get mentally draining for you. That's where you should automate your trade management side and if you can be the one to maybe come in in the morning, you get your 20 minute window to put on a couple of trades and then they get managed by your broker, your brackets, some scripts, whatever, then that is the system for you, right? If you're in that type of shoe.

So everyone needs to sort of think about that, but there is obviously some discretion that is allowed in all of this depending on where your skills are and what your strategy is. Now, this next one is kind of the third core bucket. So we had risk management being the first and emotions being the second. I mean, honestly, 99% of traders, 98% of traders, are running into major difficulties in those two areas, risk management and then the psychology, the emotional control. The third one, which is if you once you get through those first two hurdles, basically, then it's really sort of honing in on your edge, finding an edge in the market, the trading strategy.

That is what becomes the last missing piece. By having the ability to write code, right? to do something like what we do in the 52-week highs trading strategy in the Beyond the Charts series where we open up a backtesting engine, write some code, test our assumptions and then analyze those results, that is very powerful. If you're not a coder, there's other solutions.

So first you can open up a charting platform, right? And you can take out your notepad, you can open up Excel and you can look back over this historic data as long as you're honest and if you can mark down the entries and exits based on a set of rules, you can see how you would have performed doing it by hand and just going back in time and saying, yep, here's the conditions I would have bought right here and oh, yep, there's my stop loss and then you log that as a trade and then you go back in time, oh, there's another entry, here's another exit. This one made money and you can compile that and then you can start to build, you can start to essentially backtest by hand, little bit slower, but worthwhile and gives you lots of valuable information. You can also hire a programmer and a developer to assist you. I've had a number of guests on the podcast that do it.

If you're a TC2000 user, I can do some lightweight scripting for you, but I don't do any full on backtesting for anyone just because it takes a lot of work and effort. So those are some other ways you can think about rules-based trading frameworks as really helping you find that edge really fast and because you can just, again, test assumptions on 20 years, 30 years, 40 years of data instantly which would take a real-time discretionary trader years to accumulate that type of market knowledge, market feedback so to speak, okay? So those are the core three buckets. There's more details in this blog post, but those are the three things that I believe rules-based trading frameworks can really help solve and now let's talk about maybe some of the cons to it, right? Let's talk about, well, the last one is one I've sort of blended in altogether is saving yourself time, decision fatigue and stress. This is something we already sort of talked about, but that's kind of the fourth one I threw in there in the blog post and these are the two big cons here.

They're not necessarily cons, but there are things you need to be aware of, right? So the first is just you have rules, right? Doesn't mean you're done. You have to actually follow those rules. This is going to be a post that I'm going to do in the future. So I'm going to write this out 'cause this deserves its own post, but essentially, we can all say and you can listen to this and you can say, "Yeah, Evan, I agree. "I should be more rules-based, let's do it."

But when you then turn on the market on the next trading session and you take three, four, five, six losers in a row, does your brain short circuit? Do you start to revenge trade? Do you start to slip on your size? Do you start to get a little sloppy with your rules? And again, I'm going to raise my hand because I know I did. When I was starting out, I wanted to be rules-based and I remember day trading and I'd start the day off good and if I made three, four good winning trades in a row, it was a good day. But if I came in the next day and I had a couple of losers in a row and then maybe a third loser and a fourth loser, that was it. My brain was just like, oh, I got to get back the money and I'm going to force this trade here and, oh, let's see what this trader is talking about. Oh yeah, let's open up this ticker 'cause they're talking about it, maybe I can get back my money. That is a horrible place to be mentally and again, it just goes back to wanting to streamline and have those rules, have the structure in place.

So you have to actually follow the rules. It's very hard, right? Easier said than done. Again, I would suggest maybe looking at this post here to help automate your trading as much as possible.

Lastly, not all rules are good rules, right? You may have some rules, but they might be lousy rules. They might not be rules that actually make money. I have tested lots of things that I thought were going to be very profitable, right? When I was discretionary trading, I had some things I was doing and I had some market insights that I thought were really valuable and then when I wrote the code and put them in and tested them on data, I was like, wow, these aren't profitable at all.

These are break even at best or maybe they even lose money, right? So just because you have rules, doesn't mean they're good rules and doesn't mean you should follow them. So you actually have to find that edge, kind of goes back to point number two earlier about finding an edge using backtesting or going back on charts and proving that you actually have something unique. So those are sort of the considerations that you have to be realistic with yourself when you're sort of going down this approach. I have lots of other content on the site. So how to develop simple swing trading strategies.

This can help you find an edge. We've got lots of different patterns in TC2000 scans and indicators that we've seen success with. Backtesting, looking at historical patterns, looking at how markets work, so there's lots of different ideas here. These are not full trading strategies.

They're not going to tell you when to exit or how to position size by themselves, they're just starting patterns, but they can at least get you potentially started down a reasonable path on sort of finding an edge or finding good rules. So that is pretty much it. I think everyone can stand to benefit from being more rules-based.

It really does come down to kind of that scale of maybe one to 10 and we all need to decide where we fit on that scale. How much, what percentage are we of being fully rules-based streamlined, automated versus discretion and so what part of our system is going to be handled by us in our decision-making and what part is going to be left to foundation? Is really what I consider it. Rules-based foundation to keep you sane, to keep you disciplined, to keep you managing risk appropriately and to keep those edges intact. I believe that being more rules-based will help you in all of those sort of problematic areas or areas we all need to solve for as traders. So that's it for me. Let me know what you think about it.

Are you rules-based? Are you fully rules-based? Please leave a comment, let me know your feedback and maybe what's holding you back or what you find challenging about this type of trading approach or being more rules-based. Comment, love to read them. Always respond to anyone that's leaving thoughtful comments, questions and so on. So with that, thanks so much as always and we hope to see you back here in another video.

(upbeat music)

2021-10-30 02:11

Show Video

Other news