What does a trading rule book mean?
It is a set of rules and discipline points you will not transgress at any cost. You will not deplete more than 20% of your initial capital. As a 50-year old person you will not have more than 40% of your money in equities. You will make it a point to book profits if returns on a stock cross 30% in a quarter. And you will be out of equities at a market p/e of over 25. So on.
RULE BOOK FORMS THE BASIS FOR TRADING…
A rule book forms the basis or the constitution for your trading strategy. It will decipher the boundaries within which your investment plan and trading strategy will work. The more religiously you adhere to your rule book, the more likely that discipline will work in your favour. Let me now dwell on the rule i.e. “The need to create your trading rule book” This rule book will define the frontiers of your trading and, remember, they are only meant for you.
Don’t even enter the market without your rule book in place. It is a recipe for disaster. A trading rule book is, in a way, your constitution for trading. It should ideally be a mix of macro and micro factors. Your rule book has some important functions. You should always fall back upon your rule book whenever you are in doubt.
Given a choice between the temptation of market euphoria and your rule book, do let your rule book prevail. Remember, that your rule book can cause disappointments over lost profits and missed opportunities, but that is part of the game. Don’t fret over it. At the end of the day, it is always better to let go the top layer of whipped cream rather than losing the entire bowl of milk. But how do you do it?
HOW TO GO ABOUT CREATING YOUR TRADING RULE BOOK
Start with the Macro Rules…
Should you be invested in equities when GDP growth is falling and inflation is above 7%? What should be your exposure to rate sensitive sectors like banks, autos and real estate when interest rates are rising? How should you react to global risks like war, tightening, embargoes etc?
Look at the Equity Market-level rules
Should you remain invested when the P/E crosses 25 for the index? What should you do when delivery volumes are at an all-time low? How should you handle low volatility and high volatility as indicated by VIX?
And finally, ground rules for yourself
How much of your allocation can be to equities? How much of your capital are you willing to lose? At what level of profit or loss do you just forget all else and exit? What is the purpose behind your market participation: wealth creation, regular income, contingency planning or just allocation of your surplus cash flows?
“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No.1” – Warren Buffett
FOUR WAYS THE RULE BOOK HELPS YOU:
- Trading rule book prevents over-trading. Between August 2013 and May 2014, an aggressive trader would have made about 30% returns after all the tensions and ulcers. During the same period, had you bought an Index ETF and gone on a holiday, you would have earned a fat 50%. Take a call.
- A rule book keeps you liquid at the top of a rally and fully invested at the bottom. God, is that not a universal problem? I was fully invested at the peak. Then the market crashed and I did not have the heart to book losses. At the bottom, I did not have the liquidity to buy aggressively. That is the same old problem. A simple P/E rule would have overcome this problem.
- A trading rule book helps you to overcome the 2 essential devils of trading viz. Greed and Fear. Well, greed and fear are not bad if these sentiments prop up at the right moment. But in case of most traders and investors, they tend to become greedy when they should be fearful and they become fearful when they should be greedy. In other words; they become bearish at the bottom and bullish at the top. A formula-driven rule book helps enforce a discipline of booking out, stopping out or churning and is the perfect solution to this dilemma.
- And finally, the rule book forces you to look at asset classes beyond equities. When you book your profits as per your rule, you have the liquidity to allocate to debt or gold. You can easily play the waiting game and look to re-enter equities at more attractive levels. Why to lose sleep after buying high? For example: Between 2001 and 2003 when interest rates were falling, debt funds gave 30-35% annualized returns. Between 2007 and 2011, gold ETF was a multi-bagger. Why miss out on these opportunities?
TWO CLASSIC CASES OF THE IMPORTANCE OF A RULE BOOK
In 2000, Wipro was quoting at a P/E of 140 at the peak of the tech boom. Many investors who got out at 40-50 times P/E were cursing their fate. But then Wipro crashed and even today it is below its 2000 peak. Imagine the fate of an over-optimistic investor without a rule book, who had held on. For the boring rule-book types, they surely lived another day to make hay while the sun shone in the next bull market.
Between 2005 and 2008, Unitech saw one of the headiest runs in market history. The stock was appreciating on a daily basis, even when growth was faltering and the P/E was at ridiculous levels. When liquidity dried up, the stock went into a free fall. Even today it is 95% below its peak price. A rule-book approach would have surely made you look silly amongst your bullish friends, but you would have been a lot better off today.
TAKEAWAYS FROM THE TRADING RULE BOOK DEBATE…
Many investors ask me if a rule book approach makes their trading too rigid. I think it does, but still it is essential. The biggest challenge in the market is to ensure that your capital is not imperilled beyond a point. Don’t ever count on the market to repeat trends. As Keynes said, “Markets can be irrational much longer than investors can be solvent.”
A rule book approach to trading can be boring, insipid, irrational and the witness to a million missed opportunities. But it will always ensure that you live to fight another day. As a veteran trader once told me, “Profit is what you book. All else is book profits.” And we all know that it is the booked profits and not the book profits that end up in your bank account.