These 2 rules can improve your trading

Equal Traders Trade Equally: No Memory Trading

Consider the example of two traders. They each have:

  • The same amount of capital.
  • The same tolerance for risk.
  • The same trend following system.

What must they do? They must both trade exactly the same. What do I mean? If two traders are essentially equal then there is neither room nor reason to act differently. Successful trading requires precision and discipline. There is no room for ego, personal opinion, subjective interpretations or emotion.

What are some example of violating the idea of “no memory trading”?

1. Do not try to recoup your money. Trade for today, not yesterday. Trade what you have now. Since you can’t change the past and you can’t change the market, don’t let your past trades determine what you trade today. Take Cisco. Many people rode Cisco straight up and they made a fortune. Many of those same people rode Cisco right back down and lost most of it. Were there sure signs to sell Cisco after it peaked? Yes. There was the falling share price. However, once people became fixated on Cisco with fond memories of how much they made originally and how good winning felt, they could not stomach accepting a loss, any loss. Instead of following a system and selling Cisco after it peaked, they elected to keep holding on in the hopes that it would come back. As Cisco continued on its death spiral their focus was still on the past as they asked themselves, how do I get my money back in this one stock?

2. Do not try to take revenge.
Why do you have to get even with the market on this one stock? No one cares that you lost money but you. Trying to recoup in the one stock that sank you is not a strategy. It’s an emotional attempt at revenge that is doomed to fail. You can’t get revenge on the market. You can only do the right thing, the right way. Trade for today, without regret, without wishful thinking, without anger. Trade by following a system.

William Eckhardt, the great trend trader, has spoken forcefully about the idea of not having a memory in your trading:

Suppose two traders, A and B, who are alike in most respects except the amount of money they have. Suppose A has 10% less money but he initiates a trade first. He gets in earlier than B. By the time B puts the trade on, the two traders have exactly the same equity. The best course of action has to be the same for both of these traders now. Mind you, these traders have very different entry prices. What this means is that once an initiation is made, it does not matter at all for subsequent decisions what the entry price was. It does not matter. Once you have made an initiation, what your initiation price was has no relevance. The trader must literally trade as though he doesn’t know what his initiation price is.

Curve Fitting: Putting It Into Practice

Putting “no memory trading” into practice requires testing your system or your set of rules that you will use for trading.

When evaluating any trading system, hold it to these standards:

  • Is it profitable in a wide variety of market groups?
  • Is it over optimized?
  • Is it profitable across a range of parameters?
  • Are the trading rules fully disclosed with no black box “secrets”?

Those questions are just the start of the curve fit process. Consider also:

  • Curve-fit systems customize the trading rules differently for each market you trade, producing unrealistic results. Trend Following rules are the same for each market.
  • Computer technology can be easily used to over-optimize a trading system and produce something that looks good. By testing thousands of possibilities, you could create a system that works. However, trying to produce a magical or perfect system falls apart in the real world.
  • Trend Following parameters or rules work across a range of values. System parameters that work over a range of values are robust. If the parameters of a system are slightly changed and the performance adjusts drastically, beware. For example, if a system works great at 20, but does not work at 19 or 21 you have a system with poor robustness. On the other hand, if your system parameter is 50 and it also works at 40 or 60, your system is much more robust (and reliable).
  • Traders often only focus on future profits when looking at a system. The key, however, is risk control (or money management). If you control your risk and let your profits run, you position yourself to make bigger money throughout the long term.

Human beings want patterns and or connections to the past. They want to answer the questions of “why?” No memory thinking forces you to break away from constantly searching for patterns and forces you to test vigorously your trading ideas. There are no free lunches.

Michael W. Covel is the founder and President of Trend Following. A researcher of the most successful Trend Following investment managers, he has been in the alternative investments industry consulting on Trend Following to individual traders, hedge funds and banks for ten years. His best selling book, Trend Following: How Great Traders Make Millions in Up or Down Markets (Prentice Hall, May, 2004) is a complete and concise guide to trend following. It includes interviews with great trend followers who have won millions if not billions in the market. The trading world has embraced the book with endorsements from Van K. Tharp, John Mauldin, Ed Seykota and many more. Trend Following is now in its fifth printing, and is currently available in a Japanese translation with Chinese, German, French, Korean and Russian translations soon to follow. Teaching and sharing unique insights about Trend Following trading and alternative investments has earned Mr. Covel respect as a rational and logical voice in uncertain times. Mr. Covel also writes for numerous industry publications including Your Trading Edge, Stocks, Futures and Options Magazine and International Petroleum Finance and is consistently quoted and interviewed by a variety of financial publications.

Mr. Covel is also Managing Editor at
TurtleTrader.com, the leading Trend Following news and commentary resource since 1996. Thousands of visitors from more than 70 countries as well as hundreds of trading professionals engaged in years of debate and interchange making the site the rich archive of trading information, data and opinion that it continues to be today. TurtleTrader, one of the largest & strongest trading community on the web with over 7.5 million unique visitors since its inception, also functions as a resource center for the Trend Following Educational Course.