Trading Rule #2: Know Why You’re In A Trade

This is Rule #2, but it may be the most important rule of all.

You have to have a reason to be in every trade. 

That reason can be any one of a plethora of possibilities – it can be something as “silly” as “I think that people like to buy stocks whose tickers contain the letter X on Wednesday afternoon” – but when you know why you’re in a trade, you will be able to evaluate how to make an effective trade exit, which is just as important.

Discipline is a huge factor here too, and is essential:  if you buy $XOM on the “Wednesday afternoon letter X” theory, that’s fine, but then you have to sell it at the end of the day, or on Thursday morning.  Don’t let the “Wednesday afternoon letter X” trade thesis morph into “I’m going to hold this position because it went against me, and maybe I’ll get even some day.”  That’s a recipe for disaster.

I have bought positions in the past due solely to some fanciful multi-level thinking game theory notion I had in my head at the time that other traders would be covering their short positions at the end of the day, not wanting to go home carrying risk.   Without debating the merits of my thesis, my point is that when I buy on that thesis, I do so planning to sell the position into this expected short covering at the end of the day.   If I am wrong, and the short covering doesn’t come, or if the stock doesn’t rally, I still sell the position out – I bought it for a specific reason, and my thesis either came to fruition or it didn’t.   Either way, I have to exit the trade in the same manner.

When you buy a stock because you expect it to bounce off of a support level you are watching, you need to sell it if it violates your level.  When you buy a stock because it’s breaking out of a trading range, you need to sell it if the breakout fails.

If you don’t know why you’re in the trade, you can’t possibly know when to get out of it.   On the other hand, if you have a solid thesis for getting into a trade, you’ll be able to maintain your discipline and exit the trade when the meat behind your thesis falls apart.

related:

Rule #1 – Know What You Don’t Know

-KD

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