Having a set of day trading rules is a crucial first step for anyone looking to get into day trading. These rules will be your guidelines to follow as you build your account and learn the intricacies of the markets.
Rules to always follow:
- Use limit orders
- Have hard stops in
- Trade with a proven strategy
- Have max losses set for each trade and each day
Always Use Limit Orders
Using a market order is like writing a “blank check” to the market makers, according to Dennis Dick of the CFA Institute. You don’t know where your trade will get filled, which makes it difficult to play out your strategy with precision.
Using limit orders means you’ll miss out on some trades, but knowing the price of something you’re buying or selling it vitally important.
Of course, there are rules in place like regulation NMS, which prevent market makers from filling your order at a less favorable price than the National Best Bid and Offer (NBBO), but this is your money at play.
In the time between you hitting your order button in your trading platform and when an exchange or wholesaler receives your order, many things may have changed. The stock could have ticked up or down several cents, making the risk-to-reward profile of the trade completely different.
For those of you who don’t want to miss out on trades because of limit orders, there is the marketable limit order. This is basically just taking liquidity from the market with a limit order. Here’s an example.
Limit Order Example
You want to buy XYZ stock and its bid-ask spread is $10.50 by $10.51. A marketable limit order would be placing a limit order to buy at $10.52. This ensures that you jump in front of the line and get filled first, and it also protects you from the “blank check” risk that a market order carries.
Depending on the stock price, liquidity, and volatility, you may want to adjust how wide you make your marketable limit orders, as sometimes a penny over the ask isn’t enough.
On the other side of the token, there’s evidence that using “passive” limit orders in favor of “aggressive” limit orders results in better results for retail traders. The idea here is that instead of taking liquidity, you provide liquidity.
Not only does this often result in ECN rebates rather than debits, but the data shows a better expectation. This, of course, will not apply to all trading strategies, though.
Placing Stops
One of the biggest traits that set apart winning and losing traders is discipline. The discipline to cut losses, the discipline to commit to the same daily routine every day, and especially, the discipline to stick their stop losses.
Many traders go into trades with good intentions. They see a setup forming and they come up with an entry price, a stop loss, and maybe even a profit target. But once they’re in the trade, their mind starts playing tricks on them and they move their orders around.
They watch the stock move with a bias now and can no longer view the price action objectively. Whether it’s a scared trader who closes trades way before they hit his stop loss at the first sight of a red candle, or the masochist trader who rationalizes his way into moving his stop loss to stay in the trade.
You should be entering a stop loss at the same time as you place your entry order. Psychologically, it’s more difficult to cancel your stop loss, because you know it’s wrong. When you have a mental stop, it’s easier for you to come up with excuses to let the market trade past it.
Having a stop order in place will also save you from catastrophic events where the stock trades quickly against you.
Have a Strategy
Only the world’s best traders can get by on their pattern recognition skills alone. You can’t simply find a chart that ‘looks good,’ and start trading it. Too many cognitive biases are at play in trading.
Without a strategy and a plan on how to execute that strategy for each trade, it becomes very easy to mentally move the goalposts.
In other words, on a trade that you should only be risking $0.25, without a plan, it becomes easy to let that become $0.35 with the intention of “letting the market breath,” or an equally ridiculous rationalization made to keep you in the trade.
A strategy should set parameters that make it clear when you should buy or sell a stock, and when you should stay flat. A simple example of this would be “buy when the 20-day moving average crosses above the 50-day moving average, and sell when the opposite happens.”
The risk parameters might be to not risk more than 2 daily ATRs (average true ranges).
These quantitative criteria make it very simple for you to determine when to open and close trades, and if you’re adhering to your system correctly. Further, if this system has good backtest and live trading results, you have the confidence that you’re trading a sound strategy when you go through a sustained drawdown period.
Diversify Your Wealth
Once you cross that hurdle of becoming a consistently profitable trader, it can be alluring to let your trading account keep growing.
But, most trading strategies are cyclical, meaning there will be some sustained drawdown periods. In order to weather these inevitable storms, it’s a good idea to use some of the proceeds of your trading to produce other income streams.
Whether that’s real estate, dividend stocks, or even a small business, establishing a security blanket around your life that doesn’t revolve trading can actually make you a better trader.
Trading with the mindset of “I need to make money today to pay for my son’s hockey league,” is suboptimal at best and catastrophic at worst.
A trader who has an interesting approach to diversifying his wealth is Phil, also known as @OzarkTrades on Twitter. As Aaron from Chat With Traders put it, he is “short hype stocks, long farmland.”
Phil described in his interview with Aaron that his farmland tenants are stable unlike those of multi-family buildings, and farmland has historically appreciated at around 5% annually.
Learn Proper Position Sizing
The biggest risk of ruin for traders is sizing their trades too big. In fact, a Journal of Finance study of 82 pension fund managers found that 91% of portfolio performance could be attributed to position sizing and asset allocation, not their market timing or individual security selection.
Ideal position size will vary by strategy and portfolio size, but a good rule of thumb is you shouldn’t risk much more or less than 1% of your portfolio on each trade.
Have Another Income Source to Start
Most traders blow up a few times before they become consistently profitable. Unprofitability and losses are a part of learning the markets, so consider your losses tuition and learn from them.
With that said, reloading your account with more funds will probably be necessary at one point, so you’re going to need some income coming in, not only to fight off the net worth losses you’ll be experiencing due to your trading losses but also when you inevitably blow up your account. If you have no income, that’s game over.
For those of you who are students, get a part-time job. And definitely don’t blow all of your part-time income on beer or eating out. Put aside money every week before you start spending.
There’s an interesting behavioral finance phenomenon at play when you automatically save, where you adjust to your new weekly balance without noticing a difference.
Further, try to think critically about your spending. When paying $12 for lunch, think about how that might set your trading back. How this saving could compound in a profitable trading account, and how as a beginner, you’re likely to blow up your account at some point, so it’s best to set aside as much as possible for such events.
You can do so by cutting your spending wherever it’s possible.
Final Thoughts – Day Trading Rules
Most of trading is simple, but not easy. Conceptually, it’s simple to take a course on technical analysis, risk management, and trading principles. Conceptually, it’s simple to find a simple technical trading strategy that has a positive expectation.
However, none of this is easy. Hurdles like a bad mindset, overriding your trading plan, sizing your positions too big, and overconfidence almost always get in the way of new traders. And that’s okay.
The difference between the traders who remain losing traders and those that cross into profitability is simply acknowledging their drawbacks and working on them.
It took a long time before I developed the self awareness to realize what was causing those actions. My hope is that by reading this you will avoid the years of trial and error it took me to learn these important lessons.