The Greatest Traders All Follow This One Simple Rule

I'm usually a long-term investor. It fits my nature, inclination, and personality. The short-term trades I engage in from time to time are typically arbitrage-related. That does not mean that I don't know anything about trading.

Many years ago, I conversed with one of the greatest traders of the last 100 years. He said that when studying markets, if something can be tested, it must be tested. Since then, I have tested thousands of different ideas, thoughts, concepts, and what I thought initially were grand epiphanies, including dozens of technical indicators.

I have read thousands more tests and studies by traders, professors, and students of the markets. I have had countless conversations with value investors, arbitrage traders, floor traders, quantitative traders, private equity corporate raider types, fundamentalists, technicians, spread traders, scalpers, and everyone in between.

After talking, reading, and number crunching, I can tell you that the secret to trading success is not what you think it is. It is not a magic pattern. It is not the top-secret options strategy of the 1%. It is not the perfect algorithm. It is absolutely not a high win rate. In fact, a high win rate with small average gains is more likely to lead to a job waiting tables at Applebee’s than it is to being featured on Lifestyles of the Rich and Lucky.

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Right-Sizing Your Bets And Learning To Take Small Losses

Everett Klipp was one of the best traders in the history of the Chicago Board of Trade (CBOT). He was often called the Babe Ruth of the CBOT. During his career, he mentored Richard Dennis, William Eckhardt, Mark Spitznagle, and hundreds of CBOT traders. He was emphatic about taking small losses and avoiding the big losses that could wipe out an account or end a career.

Paul Tudor Jones has had spectacular success during his career and has repeatedly said that the key to making big money is not playing offense but playing defense and taking small losses. The wins will take care of themselves if you put defense first.

Charles P. DiFrancesca trained hundreds of successful floor traders at the CBOT. He taught that trading was not about predicting the future. It was about managing the present, cutting losers early, and letting winners run. He believed the only real mistake a trader could make was allowing a small loss to turn into a big one.

Charlie D. died too young, but not only did he get rich, he helped a lot of young traders survive and thrive during his career. If you have never read “Charlie D., The Story of the Legendary Bond Trader” by William Falloon, order it now from Amazon. You will thank me.

If someone claimed that Ed Seykota was the best trader ever, I would find it difficult to argue with them. He made a fortune, and his entire system was built around cutting losses short and letting winners run.

That sounds trite, but it’s a lot like “Buy Low, Sell High.” Really easy to say but very difficult to practice.

Ed is interviewed in the original Trading Wizards by Jack Schwager, as are Paul Tudor Jones and other wildly successful traders. You can get it on Amazon and I would be shocked if your local library did not have a copy.

Stanley Druckenmiller has made billions in the financial markets. He is one of the true greats of trading. He is best known for some of his legendary trades, but he repeatedly emphasized taking losses quickly when a position goes against you.

He did not earn 30% a year for 30 years with no down years because he spent a lot of time hoping a trade would return to its starting point.

William O’Neill’s CANSLIM program worked as well as it did because he never let a stock plunge precipitously and wipe out his account. He used 7% stops on every trade.

While that did not transition well to mutual fund management, O’Neill and CANSLIM made a lot of money for a lot of individual investors. He made billions by hanging on when he was right, allowing powerful fundamentals to send the stock soaring, and getting out quickly when he was wrong.

As individual traders and investors, we do not have the luxury of research staff and trading desks. We do have the luxury of being independent, though, and not having to answer to anyone.

It is not that difficult to set up a system. It does not matter if you want to use trend-based entry points or reversion-based entry.

It matters that you have an approach that is the right mix of probability and payoff and that has rules you can follow.

It matters that you understand the system.

We cannot all be Jim Simons and would go broke if we tried to be.

I am pretty sure you can make money using something as simple as a combination of Williams %R or RSI along with a short-term moving average, unless you hoped and dreamed too much about positions recovering losses and hung on long after you should have closed the trade.

If you want to be profitable as a trader, learn to take small losses quickly and painlessly. If you do not, you will certainly take a large one at some point that puts you out of the game.

Editorial content from our expert contributors is intended to be information for the general public and not individualized investment advice. Editors/contributors are presenting their individual opinions and strategies, which are neither expressly nor impliedly approved or endorsed by Benzinga.

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