Hey Ya’all!

What did you think of last weeks gift?  Is it something that you can get behind or at least wrap your mind around?  I hope so because that is the good side of trading.  When we have the ability and opportunity to turn the bad into the good with a few clicks of the mouse button that is a tonne of fun.  What happens when things go the other way and no such avenues present themselves to salvage our positions?  What happens when Mr. Market says it’s your turn to get bit regardless of what you try?  Does this happen in trading?  You bet it does!  So what do we do about it?  Let’s take the recent market action as an example.  We had the G20 summit on the weekend and this brought some furious market action and had the Bulls dancing in the streets like Mick Jagger and David Bowie!  And then came Tuesday…….  The markets reversed and looked very heavy and had a lot of folks spinning not knowing how to proceed and this brings us to this weeks blog topic.  Rules vs Reaction!  A no-holds-barred look at what every trader asks themselves on a very regular basis.

One of the most common things from newer traders and in general human being alike is the need to try and see the future.  If you need evidence of this just go to your local fair or circus and see that there is almost always a fortune teller booth or something to that effect.  I even remember seeing television ads regarding people who can supposedly see into the future and for $20 bucks per min they will tell you all about it, anyone remembers Ms. Cleo?

Now, I am not here to debate the merits of these services and there are proponents on both sides of this debate, I am just making a point that it is very natural to want to see into the future and that this affects traders possibly more than anyone else.  If you have been following this blog or been a member of Tackle Trading for any length of time then you know that we preach that trying to predict the future of a stock is a fruitless effort and that this endeavor usually just ends up costing a trader alot of money.  This is why we say that we REACT to the stock market versus trying to PREDICT the moves of the stock market.  We talk a lot about how we must be patient and let the market tells us what is next and what we need to do in reaction to the moves of the markets.  We say this because this is really the only logical way to excel in this game.  As I mentioned earlier that trying to guess where the market is going is an exercise in futility.  That being said then the topic of today’s blog should have a cut and dried answer, yes?  That would be REACTION over RULES, right?

Not so fast, what happens when you are reacting to certain changes in market conditions and this counteracts the rules you have for a particular type of trade?  What do you do, hotshot?!

Ok, you have two choices here, do you follow your rules and let the market turn on you and do nothing or do you say rules be damned I am reacting to what the market gives me?  This question comes up more often than one can imagine and unfortunately there is no one right answer.  The real answer is it depends.  I know that is the most wishy-washy answer of all time, right?  Yes, but please let me explain the position and it may become more useful.

Here is the picture, let’s say you have a bull-put credit spread on and your rules tell you to close the short strike if it is hit.  Sure enough, the market turns down and you close the short strike and take your small loss on the trade with the opportunity to cash in on the long strike if the market continues in the same direction.  This is relatively simple to follow this rule, however, what happens when the market turns back in the direction you expected it to go, do you react and put on the same original trade or do you follow the rules of the trade and close the long strike and move onto the next trade?  This is where the debate between REACTION and RULES gets a little blurry.  You know as a trader you must have a rules-based approach to be successful but you also want to flow with the currents of the markets?  Hmmm, what to do?

From experience I would say sticking to your tried and tested rules is the way to go, this will bring long-term success even if you take it on the chin in the short-term from a trading perspective.  Now, trade management is important to learn and will bring success as well but there is one thing that I think brings this debate to an end?  That is creating rules for all the eventualities of any trade and then backtesting those rules to see if they are effective and then using these RULES to REACT to the many situations that the markets can present.  We can never be 100% prepared for what the market can throw at us and losing trades are part of the business but spending more time planning out the different scenarios can only help us in the long run for two reasons.  One, it can help us adjust our trades better and two, it can help us gain a deeper understanding of the trades we are putting on.

So in closing, we need to REACT to what the market gives us by putting solid RULES in place for whatever scenarios we can think of that may affect our trade until it is closed.

So go forth and trade on!

Happy Trading Everyone!