Traders and Mistakes: Rule-based Discretionary Traders - By by Van K. Tharp, Ph.D.

Chances are you’ve never heard of a rule-based discretionary trader. They are rare, but they are among the best traders in the world. I can safely say that anyone who graduates from my Super Trader program has become either a rule-based discretionary trader or a mechanical trader.

Here are some rules that such a trader might have:

• Look at a small universe of stocks that behave well according to my rules. (In other words, not every stock has to behave according to your rules; you just find stocks that do).
• Look for a strong overreaction to the downside. (This would have a very specific description—e.g., market closes down for six straight days).
• Look for moves with a high probability for a continuation in my favor. (This might be one or several rules that are clearly specified).
• Have a likely target in mind based on a prior swing high so that the difference between the entry price and the high is my likely target.
• Place a stop below the most recent low of the last down day so that the difference between that low and the entry price is the risk of the trade.
• Make sure that the reward-to-risk ratio of any trade is at least 3 to 1.  If it’s not, look for another trade.
• Raise the stop when the market makes a new level of support and rises to a new high. Make sure that the ongoing reward to risk in the trade is always above 1 to 1 to allow for profits bigger than 3R.
• Never have more than four active positions at a time so that every trade can be carefully managed.
• Never risk more than 0.5% of equity per position.
• Never have more than 1% open risk in my account at any given time.
• Evaluate my mistakes each evening and work to make my trading efficiency 95% or better.
• Re-evaluate my rules if I’m not up by at least 5R at the end of the month.

Notice how every aspect of trading is covered by these rules. They allow for some discretion (i.e., what constitutes a 3 to 1 reward-to-risk trade and the ability to stay in the trade after it reaches your target), but at the same time there are clear guidelines for the trade. In addition, the trader could add a few other discretionary rules to improve his/her performance:

• I can re-enter the trade once if the reward-to-risk potential is still at least 3 to 1.
• I can add a second position to the trade the first time I raise my stop if the new reward-to-risk ratio is at least 5 to 1.
• If something really bothers me about the trade and I can document it, I don’t take it.

The rules I’ve given are just examples. I’m not even saying that they are profitable rules, although I’ve seen similar rule sets that are exceptionally good.

At the end of the day, this trader can do a daily debriefing and ask, “Did I make any mistakes? Did I follow my rules?” Based on his answers to those questions, he can 1) record any mistakes, 2) assess the impact of the mistakes in terms of R-multiples, and 3) take corrective steps to avoid those mistakes in the future.  These tasks are critical to developing strong, consistent performance. Can you see how these steps are impossible for the no-rules discretionary trader?