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6,362 posts
msg #73006
Ignore TheRumpledOne
3/22/2009 4:40:13 PM

10 Unbreakable Rules Perspectives for the week ending March 21, 2009

Trading successfully requires winning the constant battle against your emotions. Normal people have a hard time beating the stock market because their emotional responses to fear and greed get the better of them. To help win these battles, there are some rules that should never be broken. Here are ten rules that I think are important, break them at your own peril:

1. Never Average Down
Averaging down is the practice of increasing your position in a stock when your initial position is losing money. Some misguided traders think that they can trade their way out of a loser by buying more at cheaper prices, allowing their average cost to go down so that their break even point is lower. Admittedly, this practice will work a lot of the time. The problem is that when it does not work, it can completely wipe you out. Without capital, you can not trade.

2. Never Believe in Dreams
Dreams are for Disneyland, they have no place in your trading. The stock market does not serve free lunch, there is no easy money and fast and easy profits in the market are just short term loans. If you do not have a well tested and thought out trading plan then you will lose eventually. I have seen many people make large sums of money because they got lucky but eventually gave it all back.

3. Never Take Trades with a Negative Expected Value
I have seen many traders make money on trades that they should not have. They think they are smart trades but they are really only lucky trades. If you make $1000 on a trade where you risk losing $5000, is that really a good trade? Good trades are those where the upside potential outweighs the downside risk, a trade that will make you money if you do it many times. To understand the expected value of a trade, you have to know the probability of success and the potential profitability if you succeed. A trade that has a 90% chance of making $1 and a 10% chance of losing $10 is not better a trade worth taking. A trade with a 20% chance of making $10 and a 90% chance of losing $1 is worth taking.

4. Never Trade on Public Information
The stock market is efficient most of the time. That means it does a good job of pricing in all available information. A stock that is worth more because they announce a major breakthrough in their business will see its stock price go up to reflect that new information. Once the market has priced in that new information, there is no reason to base a trading decision on it.

5. Don't Listen to Biased Sources
There are a lot of people telling investors what they should do and most of them have a bias. Company insiders, stock promoters, newsletter writers, message board posters, media reporters, financiers, brokers, friends and shareowners all have the potential to be biased. I will never understand why people phone the investor relations department at companies to ask about the business. Do they expect company staff to tell them bad things? The market itself is the only source you can count on to be truthful, listen to what the market says through the stock chart.

6. Don't Ignore Your Portfolio
People don't like pain and when they fear losses in their portfolio they often choose to ignore it. Putting your head in the sand does not make the problem go away, you are better to face the truth and do something about it. If your stocks are going down too much, sell them.

7. Don't Trade to Make Back Losses
Since we don't like pain we will often do whatever we can to make the pain go away. A dangerous time to trade is right after a big loss because we are desperate to make the pain go away. As a result, we take marginal trades, we trade like gamblers. This usually leads to more losses.

8. Don't Be Patient With Losers
No one is right all of the time in the stock market. That means losing trades are part of trading. What is important is to not let your losers grow in to big losers because big losers require many wins to pay them off. When the market tells you that you are wrong, get out of the trade and take the loss.

9. Don't Think You are Smarter than the Market
The stock market is the combined opinion of millions of investors, many of them very smart and very well capitalized. Do you think you are smarter than that? When you look at a stock chart you are looking at the outcome of the many opinions cast by investors. Learn to read a stock chart so you can understand what the market is telling you.

10. Never Stop Learning
I have been trading for 20 years and I am still constantly learning new things about how the markets work. The basic principles and methods that I use have not changed a lot, but how I apply the basics is constantly evolving. Keep your approach simple but always adapt to the changing market.

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