Trading Habits - 39 Most powerful stock market rules

This article is the summary of the book “Trading Habits- 39 Most powerful stock market rule” By Steve Burns & Holly Burns. The article is divided into three parts based on its major segments and we will discuss rules 1 to 15 in this part.

Trading Rule 1-15 Part 1

The Foundation

1. A winning trade system must either be designed to have a large winning percentage, or big wins and small losses.

There are two paths to profitable trading, accuracy, and the size of winning trades. A trading system with equal size wins and losses must have more wins than losses. High win rate systems can quickly become unprofitable when losses are allowed to get out of hand. It is crucial to cut losers short, even in high win rate trading systems. Lower winning percentage systems are generally used by long-term trend followers, breakout traders, and options buyers.

The bigger their winning trades, the lower their winning percentage can be to still be profitable. The key is capping the downside risk when you’re wrong, but leaving the upside profit potential open.

2. Your trading system must be built on quantifiable facts and not opinions.

A signal is a quantifiable reason to take a trade based on price action, a technical indicator, or a price pattern. Historical price patterns tend to repeat themselves and create signals for capturing trends and reversals. Other signals can rely on pure price action and buying breakouts of price ranges, trend lines, and chart patterns. Breakout trading is trying to capture the beginning of a new trend. Having a reason for taking a trade is still better than trading off a hunch. I personally prefer using more quantified trading signals, like price support and resistance levels, moving averages, MACD, and RSI.

3. Look for low risk, high reward, and high probability setups. – Richard Weissman

When entering a trade, you want a low probability that your stop loss level will be triggered. Buying 100 shares of Apple at $120 a share with an end-of-day stop loss $1.20 away from your entry is a low-risk setup. Use trailing stops when possible to maximize winning trades.

4. The answer to the question, “What’s the trend?” is the question, “What’s your timeframe? – Richard Weissman

The best way to profit in the stock market, or any financial market, is to capture a trend. Day traders try to capture trends from the time the market opens, until the time it closes. Long-term trend followers filter out the noise and capture trends on daily or weekly charts.

5. Start with the weekly price chart to establish the long-term trend, and then work your way down through the daily and hourly charts to trade in the direction of that trend. The odds are better if you’re trading in the direction of the long-term trend.

Accumulation is when assets are bought as long-term holdings or investments and held. Mutual funds accumulate stock over time because they want to establish it as a major holding. They buy in stages so they don’t push the price up too fast and make it too expensive to accumulate. The distribution of a market is the opposite of accumulation. In a market under distribution, price consistently makes lower highs and lower lows.

Downtrending markets tend to be more volatile than up-trending ones. Try to buy during a downtrend for quick trades, not long-term trends.

6. The more times a support or resistance level is tested, the greater the odds that it will be broken. Old resistance can become the new support, and the old support may become the new resistance.

What causes price resistance and support on charts? Price has memory. If the price makes a new high, then reverses and goes lower, many people will decide that if the stock returns to that price level, they will sell immediately. This creates willing buyers at the new support level, just waiting for the opportunity to get in. There is a pattern of a market moving in one direction, then meeting supply and demand and retracing. If a stock had an old $105 resistance level and it suddenly breaks out to $108, odds are good that it will return at least one more time to $105.

7. Moving averages can quantify trends and create signals for entries, exits, and trailing stops.

Moving averages on charts are 100% quantifiable. Price above the moving average shows an uptrend and price below it shows a downtrend. The easiest way to identify a trend is to look for the uptrend as higher highs and higher lows, and the downtrend as lower highs and lower lows. Moving averages aren’t the Holy Grail of signals, but they can play a very important role in your trading system. They can be used as trailing stops as you let a winning trade run, or to create entry and exit signals when a short-term moving average crosses a long-term one.

8. Bull markets have no long-term resistance, and bear markets have no long-term support.

During a 20% drop in prices into a bear market, key support levels are lost repeatedly. Stop losses are triggered, rallies are sold into, and fear slowly takes hold. A bearish Stock Market is usually short-lived, typically lasting for a year or two. Bull markets are characterized by the ability to repeatedly break out to new highs. Big trends in bull or bear markets are usually followed by a time of price consolidation. Buying dips gives traders and investors the chance to catch the next trip to all-time highs.

9. The larger the market gaps, the greater the odds of continuation and a trend. – Linda Raschke

Price gaps on a chart are generally trend indicators in the direction of the gap. Most gaps are filled, but it can take months or even a year to fill. You can catch a nice trend in the meantime if the gap turns out to be a “gap and go”. A gap and go is a strong signal and is not to be ignored. Gaps late into a long trend can signal the end of a trend. A growth stock gapping down to the 200 days moving average will likely find buyers, as selling has become overdone.

10. The last hour often tells the truth about how strong a trend truly is. “Smart” money shows their hand in the last hour, continuing to mark positions in their favor. As long as a market is having consecutive strong closes, look for an uptrend to continue. The uptrend is most likely to end when there is a morning rally first, followed by a weak close. – Linda Raschke

Traders would be better served by getting into the habit of taking profits in the morning and making entry decisions based on the last 30 minutes of the trading day. End-of-day trading was the primary method that Nicolas Darvas, Ed Seykota, and Tom Basso used to build their wealth.

11. Above the 200 day is where bulls create uptrends. Bad things happen below the 200 day; downtrends, distribution, bear markets, crashes, and bankruptcies.

The 200-day moving average is the line in the sand that separates a bull market from a bear market. A similar line to watch would be the 40-week moving average on the weekly chart. Buy and hold investors can reduce their drawdowns in trading capital if they exit their long positions when the price closes below this line. The 200 day is a way to quantify a long-term uptrend from a long-term downtrend. Bulls look to buy this dip for an initial bounce and a great risk/reward ratio. Traders should get in the habit of going long above the 200 days, and selling short below it.

12. It is much easier to watch a few than many. – Jesse Livermore

Knowing how your stocks move around key moving averages and indicators can give you an edge over others. Develop a robust system for trading price action across multiple markets. Find the entry signals and patterns you’re looking for that will give you more trading options if your watch list dries up.

13. Trends never turn on a dime. Reversals build slowly. The first sharp dip always finds buyers and the first sharp rise always finds sellers. – Alan Farley

Markets and stocks rarely plunge straight down day after day or go straight up in price. The strongest uptrends in stocks and markets tend to pull back to the 5-day exponential moving average repeatedly. Bear markets almost always have strong rallies back to key moving averages before they finally roll over and drop.

14. Successful trading is about consistently doing the difficult thing so often that it becomes second nature. – Richard Weissman

Traders and investors often say they want to buy a key support level or big pullback, but oftentimes the pullback and dip occur due to market fears. The potential dip buyer gets so consumed by fear that they can’t take their desired entry signal because their emotions take over. The two most profitable ways to trade are to buy extreme lows that are caused by unfounded fears, or to buy breakouts or momentum at the beginning of a large trend, riding it to big profits. Trend followers’ best trades are those entered at an initial break out into a new price zone.