For any trader in the equity markets or even in the derivative or commodity markets, one of the basic pre-requisites for success is having a proper Trading Rule Book (TRB). What exactly is a TRB? It combines a set of rules and discipline points which you will not transgress at any cost. The TRB is like the written constitutions for your trading and will define the contours of your trading activity. Even when your market view is at cross purposes with the TRB, you must give precedence to your TRB. Let us first look at some classic examples of what a Trading Rule Book could look like
What are some typical Trading Rules enshrined in the TRB?
While there are no hard and fast rules and each trader needs to create a specific trading rule book, here are some possible trading rules that could form part of the TRB
At no point during the trading activity will you deplete more than 20% of the base capital that you started with. This will define your worst case loss. At that point, you will cease to trade and rethink your strategy entirely.
You will not hold more than 15% of your money in cash at any point of time. The beauty of trading is all about putting money to good use and churning it around. Therefore, irrespective of the tepidness or volatility of the market, your TRB stipulates that you need to be as close to fully invested as possible.
You will book profits when the profit on a particular trade exceeds 30% in one quarter. Then it does not matter whether India’s most successful investor is still buying the stock or some of the top mutual funds in the country are still buying that stock. When your TRB stipulates that you exit, you just need to exit at that point of time.
You will not hold a stock where the gap between P/E and growth rate is more than 20. So if a company that is growing at 15% per annum is quoting at 35 times P/E then your TRB will trigger a sell signal on the stock.
Avoid delivery positions in any stock that has an ROE of less than 8%. That does not mean that you cannot buy low-profit companies or loss making companies. The TRB only states that such positions should either be for intraday purposes or a very brief overnight risk only. This is basically meant to avoid the value trap.
Three Steps to creating your Trading Rule Book (TRB)
The first set of rules will be set at a broad macro level. You can set rules based on the gap between GDP growth and inflation or a rule for exposure to rate sensitive stocks when rates are probably headed upwards. The macros here can refer to domestic macros or even to international macros like Fed policy, ECB policy, global liquidity etc.
The second set of rules pertains to the market level rules. These can be rules pertaining to P/E ratios in case of industrials, P/BV ratios in case of banking and financials, Dividend yield in case of high-yield stocks or even in case of the volatility index (VIX). There can also be market level rules pertaining to the delivery volumes and the advance / decline ratios.
The final sets of rules are individual rules and pertain to your trading preferences and affordability. Allocation towards equities, maximum loss limits, rules for profit booking and hedging all fall under this category. They are very specific to your trading strategy and your affordability index.
How does the Trading Rule Book help you in the long run?
The Trading Rule Book (TRB) has a very important role to play in ensuring that you survive to trade and fight another day. Here are four important purposes of the TRB. As a trader, it should form the basis of your trading strategy, which should be built around your TRB
1. The biggest risk in the business of trading is that you over-trade. Trading has a cost and aggressive trading has a steep cost. You need to balance the prospect of profits with the associated costs and that is not possible unless you have a credible TRB.
2. The TRB contains some in-built rules and regulations to ensure that you are not caught on the wrong side of the market. The key to success in trading is that you are liquid when the markets gives buying opportunities and you are fully invested when the market gives you profit booking opportunities. That can be ensured through a rule book.
3. The two of the most feared words in the market is "Greed and Fear". To be a successful trader, you need to be greedy at the bottom and fearful at the top. That is possible only when you follow a strict TRB. Otherwise, you are likely to be left making the wrong trading choices.
4. Above all, the TRB compels you to look at asset classes other than equities. At an equity market top, it makes sense to shift your allocation to gold, debt or even liquid funds. That is not possible without a rule book. In fact, the TRB addresses most of the challenges of asset allocation purely through an inherent discipline.
For any serious trader, the Trading Rule Book (TRB) forms the cornerstone of trading in the markets. It does not matter whether you are trading in equities, futures, options or commodities. The TRB should necessarily form the basic constitution for you!