I wrote recently about the microbubble created around stocks like KRTX, and how irregular traders and would-be traders were being pulled into the market by the apparent ease with which money can be made. I speculated that a lot of money would be lost by those with little experience. This led to some questions from readers of this blog asking about what rules I would use to trade explosive stocks like KRTX.
The simple answer, and the one I suggested in that post, is that I use the exact same rules as I use to trade any other stock. Just because something is moving faster, doesn’t mean we should change the way we manage it. I used the example of driving a car in the previous post. The rules of the road are generally the same whether we are driving on the highway or a country lane; everyone sticks to their side of the road, those joining a road give way to those already on it, and so on. Changing rules for different situations would probably create chaos. Plenty of drivers seem to have enough trouble remembering one set of rules as it is!
Not Rules
The thing is though, I don’t actually trade by a set of rules. They might look like rules, and in my books I teach them as rules (I even have a section called Golden Rules). But really they are guidelines. The difference is subtle. Rules are supposed to be abided by all the time (though as Morpheus would say, some can be bent, others can be broken). Guidelines are there to provide direction whilst leaving flexibility. It is this very flexibility that gives traders their advantage. If we were simple rule-following machines, we might as well be replaced by, well, machines.
Back To The Car
In reality, Morpheus is right. Many rules in life can be broken under certain circumstances. Going back to driving as an example, I said earlier that everyone knows they have to stick to their side of the road. But what happens it that side of the road is blocked? What happens if a storm has blown down a tree in a suburban street? A rule-following machine would be stuck behind the blockage, waiting for someone to come and move it. A human driver knows that provided the other side of the road is clear, it’s perfectly reasonable to use it to get around the obstacle. Everyone understands that the rule about driving on one side of the road is there to keep us safe but that under certain circumstances, when necessary, breaking it is not going to cause harm. The traffic cops are unlikely to revoke anyone’s licence in such a situation.
Does this mean we should program a driverless car to always steer around fallen trees? What about if the tree is on the freeway? What if there’s a central reservation in the way of the other lane? What if the tree is on a quiet suburban road but there are some helpful residents in the process of dragging it out of the way? In that case it might be safer to wait and let them move it.
Clearly the decision as to when it’s okay to break the rule of the road depends on the circumstances of a given situation at a given time. We can’t come up with a set of rules that would govern every possible scenario, it would be unworkable (and it’s why self-driving cars are so hard to do). We compromise and use rules that keep everyone safe, and trust that as drivers gain experience they understand when it’s okay to bend them.
The Benefit of Experience
Knowing when it is safe and appropriate to bend or break a rule is a benefit of experience in any domain. That’s why most people who teach trading, including me, start out with a set of ‘rules’ rather than calling them guidelines. A driver who sticks rigidly to the rules is unlikely to come to any harm. If they sit and wait for the tree blocking the road to be moved, there is little risk of a head-on collision with a car coming the other way. It might take them longer to get to their destination, but they are more likely to get there in one piece. And a trader who rigidly follows a set of trading rules might miss out on extra profits or take a few small but avoidable losses. But crucially, they are unlikely to suffer a major trading accident that wipes out their account.
By starting beginning traders out with a set of rules, those of us who teach are trying to ensure that they will survive in the markets long enough to gain sufficient experience to know when it’s okay to break those rules. When a trader has been around the block a few times, they soon learn which rules are really guidelines, and when it’s appropriate to treat them as such.