Rules to Trade Stocks

Rules to trade stocks are essential for success.  In the October 1989 issue of Futures, Dennis Gartman published 15 simple rules for trading.  Dennis is a successful trader having experienced the gamut of trading from winning big to almost losing everything.  Currently, he publishes The Gartman Letter, a daily publication for experienced investors and institutions.  For the most part I have taken these rules as they were published with some minor adjustments and additions of my own based on experience. 

1. In a bull market only be long.  In a bear market only be short.

Approximately 60% of a stock's move is based on the overall move of the market.  So go with the trend when investing or trading.  That is why Trends is one of the primary pages on this site, so everyone begins with a the market trend in mind.

2. Buy what is showing the most strength; sell what is showing the most weakness.

Basically, the idea is not to buy low and sell high, but to buy high and sell higher.  We never know what is the low price, nor what is the high price.  By buying strength we greatly improve our probability of success.  Shorting on weakness works the same way.

3. Do not trade until the fundamentals and the technicals agree.

For fundamentals I focus on Return on Capital and Earnings Yield as defined by The Little Book That Beats the Market that is further discussed on the How to Beat the Market page.  The technical review focuses on the chart pattern and the growing strength of volume.  

4. Do not enter a trade until it has been thought out, including your target price and your stop loss price.

Before entering a trade, I identify the entry price, 1st and 2nd target prices, the stop loss, the Risk-reward ratio, current volume as a percent of the 50 day average, the technical pattern, the market trend, the sector, the Return on Capital, the Earnings Yield, the capital to put at risk, why make the trade and the risks that may be encountered while the trade is open.  This incorporates all the important aspects of a stock before I make the trade decision.

5. Only add to trades on minor corrections to support or resistance levels that go against the major trend.

Use the technical chart to identify these support and resistance levels in different time frames.  Monitor volume expansion and contraction during these pull backs.  Generally, you should see pull backs occurring on lower volume and then a pick up in volume as the price rebounds off these levels, indicating greater strength.

6. Be Patient with good positions.  If you miss an entry trade, wait until a correction occurs before entering.

Often the price will return to its breakout point, so you do not have to chase the price.  Also, your technical charts show support and resistance levels to help identify good entry points.  Volume expansion and contraction also provides a good indication.

7. Be patient with good positions.  Once a trade is entered, give it time to develop.

Set your targets and stops and then it perform.  As the price moves up toward your first target, move the stop up to the next clear support level.  When your first target is hit sell according to your plan and the market (1/2 of your position in a bull market, 3/4 of your position in a flat market).   This creates capital for further investments and trades.  Adjust your stops up to new support levels.  Review your 2nd target and adjust if strength continues.  The real money is made by letting your best positions to continue to perform.  Taking small profits unnecessarily will not create wealth and most likely will lead to ultimate loss.

8. Be impatient with losing positions.  Small losses are the best losses. 

Use your stops to minimize losses.  You use up too much time, money and mental capital sitting on a losing trade.  Holding on to losing positions cost measurable sums of actual capital, but it cost immeasurable sums of mental capital.  Of the two types of capital, mental is the most important.  Besides there are always new opportunities to focus your valuable time and capital.

9. Never add to a losing position, ever.

While it goes counter to an often followed belief of traders and investors it is critical to your ongoing trading success.  Many investment advisors recommend averaging down to get a better average price on a stock.  Adding to a losing position or averaging down on a bad trade will take you out of the trading business very quickly. 

Let's look at what happens when you "average down" on a losing stock.  When you add to a stock that is declining, your net worth declines as well.  Also, if you increase your short position in a stock that is rising you will experience the same decline in net worth.  Sure, it may prove fortunate if the stock returns to its previous levels, but in the mean time you have spent your precious capital (financial and mental) waiting and watching for it to turn around.

10. Do more of what is working and do less of what isn't.

Each day look at your positions and try to add to those that that exhibit the most strength while subtracting or eliminating those that are showing weakness.  While "letting your profits run" is an interesting concept, you really want to try to maximize your profits with your strongest positions.

11. When trading well, trade somewhat larger positions.  When trading poorly, take time off for a few days, closing all positions.

Align the size of your positions with your performance, making the most of when things are going well and minimizing your losses when things are going badly.  When times are good even trades based on bad analysis will work.  When times are bad even the best analyzed trades will go wrong.  This is the nature of the market.  Embrace it.

12. Act like a mercenary fighter who invests and trades on the winning side.

Fight on the winning side and be willing to change sides readily when the other side has gained the upper hand.  Invest and trade on the winning side.  If no side is winning then you do not need to trade.  The facts of the situation can and do change, so you must be willing to change as well.

13. When investing and trading in the markets, an understanding of mass psychology is often more important than an understanding of economics.

Markets are made up of all the insight and ignorance of the people who participate.  Mass psychology often rules the day, week and month.  Markets can remain illogical longer than you can remain solvent according to Dr. A. Gary Shilling.  Look at all the bubbles that have occurred.  They each grew to extremely high levels before economics finally took over. 

14. Keep your technical systems simple.

Complexity breeds confusion.  Simplicity breeds elegance.  Decisions need to be made with a clear understand of the factors.  Simplicity also makes errors stand out so they can be easily corrected.

15. There is never one cockroach.

When you encounter a problem due to management malfeasance then expect many more will follow.  Bad news begets bad news.  Should you encounter any hint of this kind of problem, then avoid the stock and sell any you currently own.