Too Many Rules of Trading? Here’s Why You Should Know Them

Online trading requires a robust strategy and a strong psyche. Just like practicing on a demo account helps build a trading plan that meets your trading goals and risk appetite, following the rules of trading helps build a trading psyche that can help you avoid committing the three sins of trading – greed trading, fear trading and over-trading.

The rules of trading are words of the wise, who learned their lessons the hard way. Experienced traders share trading mantras that have helped them succeed. Imbibing these rules can help you make better trading decisions and protect your money – #YMYL.

The rules help traders to:

• Take calculated risks to prevent losses from compounding.
• Size and time your positions appropriately to take advantage of an opportunity.
• Prevent emotions from interfering with your trading plan.
• Use the rules to know when to exit the market.

What is the Number #1 Rule of Trading?

This one is rightly stated by Jack Schwager in his book, Market Wizards:

“The hard work in trading comes in the preparation. The actual process of trading, however, should be effortless.”

Online trading is a series of decisions. Traders need to calculate everything – from what to trade to when to trade and with how much money. Another important decision is when to exit a position. Investing time in research and analysis is critical because it’s #YMYL. Learn about the instrument, the market, factors affecting price movements and how to use technical indicators to help you make informed decisions. Your exit, however, is determined by the loss you can bear or the profit target you have set for yourself.

What is the Risk Rule in Trading?

The risk rule states that traders should not risk more than 1% of their capital on any single trade. This is especially applicable to day trading and helps traders limit losses associated with each trade to 1% of the total capital value, even if they are trading with leverage. Leverage, as they say, is a double-edged sword that enhances potential gains but also amplifies potential losses. This makes it all the more important for traders using leverage to employ risk management techniques such as stop loss. The risk rule ensure that a trader will need to incur losses on 100 consecutive trades before their account gets totally wiped out. However, this is an upper limit and traders with smaller capital may use lower limits (say 0.5%) for each trade.

What is the 80% Rule in Trading?

This rule is derived from the famous Pareto principle and is applicable to multiple aspects of online trading. It proposes that:

• The financial markets move sideways 80% of the time. This means traders must tweak their strategies to take advantage of the volatility in ranging markets.
• 80% of the profits earned by a trader comes from 20% of their trades. This emphasises that even the best trader cannot succeed 100% of the times. The focus should remain on making more winning trades than losing ones, while learning from one’s mistakes.

Broadly, remember that by their very nature, the financial markets are unevenly distributed, and your risk and trading strategies must account for this.

What is the Rule of 3 in Trading?

The Rule of Three states that a trader must consider three timeframes before taking a position. For instance, a scalper may look at 5, 15 and 30-minute charts, while a day trader may use hourly, daily and weekly charts. The Rule of 3 helps traders gauge the primary trend, assess potential entry and exit points, identify support and resistance levels, and look for possible points of inflection.

What is the 1-2-3 Rule in Trading?

This rule is followed by online traders for trend reversals. The rule states that a reversal will have 3 key pivot points. First, when a trend breaks, second when the trend supporters try to push to maintain the trend and third when they finally give up and the trend actually reverses. This helps traders identify that a reversal has actually occurred. Advanced traders use this rule to identify potential reversals with the help of indicators and try to enter the market between the second and third pivot points.

What is the 5-3-1 Rule in Trading?

This rule helps traders build a robust trading strategy. Mostly used in forex trading, the 5 3 1 rule states that:

• A trader should pick 5 instruments to trade (5 forex pairs, in the case of forex trading). Then, they should understand those markets and the factors that move them.
• Next, a trader should perfect 3 trading strategies to trade those 5 instruments. These strategies should involve a balance of technical analysis, sentiment analysis and fundamental analysis, as required by the market they wish to enter.
• Finally, they should pick a time to trade. Forex traders essentially use this to make sure that the liquidity of their chosen pairs is high. The forex market is open 24×7 and maintaining a good trading psyche requires timeout breaks as well.

What is the Rule of 16 in Trading?

Volatility in the financial markets generates trading opportunities. The Rule of 16, also called the VIX Rule, is based on the volatility index (VIX). Although it was initially developed for the S&P 500, many variations of the Rule of 16 are now applicable to diverse markets. It states that the ratio of the volatility index and the average daily moves of a traded index remains around 16:1. For instance, if the volatility index is at 16, the S&P 500 will move up or down by 1%. Similarly, if the VIX is at 32, the index will vary by about 2%.

The above are just a few of the most popular rules of trading that beginners should master remember. Follow this space for more in our #YMYL series.