Two rules every trader should follow

Fancy a go at trading? Adel Merheb, managing partner at www.tradeyourmarket.com, offers his insights into how to make the right decisions and not the wrong ones:

In my career as a financial market analyst and a trader, I have come across many people who attempted to make money from trading the markets. They were skilled people with daytime jobs and some money lying around and they were looking to make additional income on the side. Funnily enough, most of them eventually gave up on the idea after losing part or all of their investments.

While there could be different reasons as to why most non-professional traders end up losing money or simply fail to succeed, the one most common is that very few people, if any, actually approach trading the same way they do their businesses or jobs.

Being a trader is just like being a business owner. You do not go about setting up your business without a very well-thought out business plan and definitely not before you properly understand the risks that your business could face in the short-term and the long.

I have seen business owners do countless hours of research before spending a penny on their existing businesses and I have seen the same people take decisions to buy and sell stocks worth hundreds of thousands of dollars, if not millions, over rumours or a gut feeling they had.

As the great business magnate George Soros puts it: “It’s not whether you’re right or wrong that’s important, but how much money you make when you you’re right and how much you lose when you’re wrong.”

In my view, there are two essential rules that every trader should follow religiously to even have a remote chance at being successful:

RULE 1 – Preserve your capital:

To become a successful trader, you need to be able to stay in the game long enough and preserving your capital guarantees that you do.

Different people may use different measures for defining capital preservation but in my book, any loss beyond 25 per cent of your capital will put you at risk of ultimate failure.

See, the more of your capital you lose, the harder it becomes for you to recover let alone generate positive returns.

A loss of 5 per cent on your capital will mean that you will only need to make 5.26 per cent to make up your loss but a loss of 25 per cent on your capital will mean you need to make a return of 33.33 per cent to recover. Now, imagine a scenario when the loss exceeds 25 per cent.

Traders have to have a threshold for the loss they are willing to take and the unfortunate reality is that most of them don’t.

When faced with losses, traders get too emotional and retreat to what I call a “hopeful strategy" as they simply wait for the market to recover so they can exit at a better price. They forget the importance of capital preservation and the crucial need not to let the losses drag beyond a certain point.

How many of the people you know who had invested money in the UAE stock market prior to the 2008 crash actually pulled out after the initial losses? Most of those I know are still holding positions from before the 2008 crash.

RULE 2 – Have a trading plan:

Like any business, you have to have a plan for trading and you have to constantly re-evaluate your plan. Many people trade on tips, rumours or even gut feelings and rarely have a solid plan in place.

I am not saying you will never make money trading on tips or instinct but I seriously question anyone’s ability to consistently gain trading that way.

In fact, it’s last thing traders should hope for because operating in that manner will get them addicted to a form of trading that is bound to fail in the long run.

Having a plan enables traders to have a clear understanding of the real reasons behind their activities and, more importantly, allows them to quickly determine whether or not these reasons are valid.

I know a trader who has made every mistake in the book but because he had those two rules covered, he managed to become very successful at one of the most challenging forms of trading – intraday trading.