May 22, 2006

Playing By The Rules

The movie "Apollo 13" shows the ingenuity of humans at their best. Due to a design flaw, three astronauts were stuck in space with no clear way to get home. Rather than panic, though, a team of engineers and scientists on the ground and the team of astronauts in space methodically devised a strategy to return the crew safely to earth. The laws of nature can be rigid and you have to play strictly by the rules. On the other hand, there are clear and specific rules to follow, and when you devise a plan according to the laws of nature, and execute it perfectly, you can be absolutely certain that it will work. Trading doesn't always operate that way, however. Rules are tenuous. Indeed, when it comes to trading the markets, it is better to look at so-called rules as merely practical guidelines.

Sometimes the markets seem to behave as if they work according to human nature, but other times they don't. I remember one trader explaining to me that Elliott Wave Theory works because neurons in the human brain respond instinctively to the ups and downs of buying and selling sprees. It would be nice if the brains of the masses were wired that way, but any neuroscientist will tell you that the human brain, and the mind for that matter, does not always work as precisely as navigational computers on a space shuttle. There is an element of uncertainty every time you make a trade. No one knows for sure what will happen next.

Take the market action last Thursday, for example. The major indexes went down on Wednesday. If the masses followed the rules (or one version of them), they would have seller's regret and re-buy on Thursday. They didn't. Sometimes the rules work, but sometimes they don't. That's the nature of the trading game. History only repeats itself when it does, and the masses only behave as they should when they do. In the end, you have to make your best guess and live with the consequences. (But as long as you use proper risk management, the consequences are never so bad.)

So why pay attention to rules? Well, people do act consistently at times, and it's worth developing conventional rules of thumb to capture these consistencies. You should view them as guidelines, however, rather than rules or natural laws. When developing a new trading idea, it's valuable to consider conventional wisdom. Maybe the past will forecast the future, and if you are fortunate enough to find a strong possibility of the masses following a past pattern of behavior, it's wise to follow it. But also consider the infallible nature of the rules. Sometimes the masses have a different idea. If there are no rules, then why commit to a specific course of action? Some traders make the mistake of thinking that they can waver when they are about to execute a trading plan, or as they monitor a trade. Just because your trading plan is not foolproof does not mean that you should not be strongly committed to your plan. When you are devising your plan, and exploring your options, it is useful to play with ideas and concepts. Maybe the masses will follow the "rules" of conventional wisdom, but perhaps they won't. It's useful to be carefree and playful during the planning stages. But once you are about to execute your plan, it is wise to pretend that your trading plan is your best chance of success. Don't waver. Don't doubt your plan. Stick to it and see it through. You may not be right. You may lose money. But you have to trade your plan once you have devised it, and believe that it is your best shot.

If you abandon your plan, or show indecision, you will not only end up with a losing trade but you will not cultivate a sense of discipline. Disciplined trading requires you to trade your plan with zeal. The markets may not always play by the rules, but a disciplined trader devises a trading plan and follows it.


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