The full title of this book is The Four Cardinal Principles of Trading: How the World’s Top Traders Identify Trends, Cut Losses, Maximize Profits & Manage Risk by Bruce Babcock (1996).
This is a pretty unique book which focuses on trading techniques, specifically techniques to identify the trend, cut losses, let winners run, and manage risk. Babcock interviewed a number of professional traders on how they implement the four cardinal principles as Babcock calls them. Aside from this book, the only other book I can think of that focuses on techniques is probably Alexander Elder’s Entries & Exits: Visit to 16 Trading Rooms book.
The style of this book is in the same style as Jack Schwager’s Market Wizards book, but I find that Schwager’s book gives more insight because Schwager would probe deeper in his interviews, while Babcock did not probe deeper to clarify certain points which are unclear. Understandably, most people would not want to share their hard-earned ‘secrets’, so Babcock was likely treading a thin line to avoid making his interviewees uncomfortable. Nonetheless, if the whole point of the book is to go into the techniques, his interviewees need to be prepared to share else it defeats the point of the book.
All in all, I like the book and have picked up a few things from it. It is also great to see so many different methods that people have adopted for doing the same things. I wish that there are more books in the market where successful traders disclose their profitable systems in detail. Eventually it is highly unlikely that you can take someone’s system wholesale, but there are usually good things that you can learn from a successful system. I find it interesting that in the IT industry, there are so many people writing great open-source code that they freely share but in the trading industry, people are asking for thousands of dollars to share their system which either can’t be used wholesale or doesn’t work in the first place.
THE FOUR PRINCIPLES
- Trade with the trend
- Cut losses short
- Let profits run
- Manage risk
TRADE WITH THE TREND
Trading with the Trend is an Edge
- It is the trend component that allows a trader to achieve a long-term statistical edge that translates into profits.
- If there were no trend component, everyone would eventually lose because the costs of trading would overcome any random short-term profits.
- In order to exploit the trend component, however, you must trade with the trend.
Countertrend Traders Anticipate Rather Than Wait for Confirmation
- Countertrend traders are really trend traders in a shorter time frame.
- They also tend to anticipate rather than wait for a confirmation of trend change.
Countertrend Traders Are Not Trend Traders with a Shorter-Term Trend
- Countertrend traders look for moves to be exhausted or showing signs of being exhausted anticipating that the rubber band will snap back the other way. Of course, by implication they’re trading with the short-term trend back, but they’re really trading the turning points.
- If the methodology is using prior movement and trading in the same direction as the prior movement, you can call it a trend methodology.
- If the methodology is looking at the prior movement and trying to define when that prior movement has run its course, when it’s time to go the other way, then you’re dealing with a countertrend methodology.
Always-In-The-Market Trend Following is Difficult to Follow
- Markets have become choppier, the trends are still there, but they have become much more volatile and difficult to follow.
- It’s impossible to develop a single always-in-the-market, trend-following system that will not leave one vulnerable to some very severe periodic retracements (i.e. drawdowns being the same % as your annual return).
- The trick will become to extract the profits from trends and yet have other strategies to protect against that increased volatility.
Stick to Your Time Frame
- The critical factor is identifying which trend you intend to trade. If you’re trading an hourly trend, you don’t take your entry points or stop-loss points from monthly charts. Determining that length of trend is inextricably tied to the other three principles: cutting losses, letting profits run, and managing risk. If you don’t identify which trend you’re trading, you can’t accomplish any of those.
The Stop Determines the Entry, Let the Market Come to You [Steve Briese]
- You determine your stop based on where you know the trend will have turned against you. You can’t change the stop. If the projected potential loss is too large a percentage of your account, there are only two things you can do: (1) pass the trade entirely or (2) wait for a better entry. So you must adjust your entry or pass the trade.
- I’m not willing to risk more than $500 per contract on a trade regardless of my account size. In order to respect that limit, I set the stop point first. Then my entry can be no more than $500 above the stop point (for longs).
- I’m buying as the market is coming to me. The short-term trend has not fully established itself. I count on other factors to make that trend turn up. One of those other factors is the next longer-term trend. The longer-term trend should have an effect on a market. When the short-term trend becomes oversold, the longer-term trend will move the shorter trend back up. You can use different length oscillators to measure the longer-term trend.
- Another indicator I favor is the Commitments of Traders data. In a sustained uptrend, a reaction will often run its course when prices react back to a point where commercials start aggressive accumulation. When I see this accumulation, it is confirmation that the major trend is about to reassert itself.
Research Your Market’s Cycle
- Some of the research [Jake Bernstein] have done has shown a distinct tendency for markets to change direction about every 14 days. There’s a tendency to move higher for about 14 trading days in an uptrend — not higher every single day, of course — and then have a correction that usually lasts about 4 to 6 days… Psychologically, if you set yourself up to trade within those time frames, you’re much better off.
Simple System to Trade at the Open and Close
- In uptrending markets the closes tend to be higher than the opens. In downtrending markets the closes tend to be lower than the opens.
- If you’re a very short-term trader, buy lower opens in an uptrend and sell higher opens in a downtrend. You can exit those positions on the close.
CUT LOSSES SHORT
Have a Maximum Time Stop of One Week
- If by the end of a week (at the very longest) after you put on a trade, the market hasn’t moved in your favor, get out.
Let the Market Come to You
- I don’t like to buy a market at any price. I’d rather have it come back to me, so I can get in at a price where I can manage the trade.
- Let’s assume we’re going to take a long position. Most people can figure out pretty where the stop-loss should be. Their account size dictates that they must buy somewhere between that point and the optimal entry point. They must wait for additional weakness where price approaches their stop point. But where do you buy on weakness? There is no good way to determine how much weakness to wait for. Using the stop-loss point as the entry point is a pretty good short-cut method.
LET PROFITS RUN
Use a More Relaxed Stop With a Profitable Position
- When a position becomes profitable, it’s often best to use longer-term indicators with a profitable position than you do with a losing position. We use much longer-term and more stringent requirements to get out of a profitable position than we do a losing position.
- If new participants come in to feed the trend, that is a sign you should stop being aggressive in tightening your stop. If a trade continues to be profitable, I gradually move the stop away from the market. That gives me the potential to hold the trade through some subsequent noise that will always occur over the life of a one- to five-week trade.
Lock in Some Profits in Quick Rallies
- If a market rallies for a $1,000 profit in a day and a half, a person should be very aggressive in moving their exit stop at least to breakeven if not higher.
- Occasionally, we have markets that stretch out so far they don’t give you a reaction. All of a sudden your trade is four or five limits into the money. I call those extraordinary markets, and I take extraordinary means to protect my profits. When I’m trading for myself, I’ll usually reduce my position size.
Tighten Stop When a Risk / Reward is Poor
- The only time I narrow my trailing stop back to a $500 risk is when the seasonals are going against me or the chart is showing some sign of topping out.
- If I were up $10,000 and had been looking for $12,000 at the most, I might tighten my stop to risk $1,000 because I see only $2,000 more in potential reward.
Taking a Short-term Profit May Not Penalize You as Much as You Might Think
- When you look at the open profit generated in most long-term approaches and compare that to how much they actually closed out, the percentage is quite low.
- People would be staggered to see what the total maximum open profit generated by a long-term system is. It’s generally huge, and even great systems actually take out only about 1/5 of that total potential.
Place Stops Below an Even (Whole) Number
- If I’m going below 19.00, I don’t place the stop at 18.90. I’ll go down to 18.80 or 18.75. When I talk to floor traders, they say there are so many stops at 18.90 that when the market goes below 19.00, it is going to go at least down to 18.90 just to get those stops.
- That means I usually go 20 ticks over or under the even numbers. This applies to trailing stops on profitable positions, not initial stops where I’m more concerned about limiting the loss.
Position Size Limits
- Trade risk limit
- Never risk more than 2%-5% of your equity on any individual trade.
- Simultaneous open positions risk limit
- The risk on all the open positions together should never exceed 10% of the account.
- The total risk exposure (to their stops) for all positions should never be more than 50% of your total capital.
- Consider correlated markets a single position
- For applying the 2-5% risk per position, consider all the correlated markets as a single position.
- Gradually build up positions
- You need to take a decent-sized (up to 1/3 of equity) position to capitalize on markets that are moving for you. Take a small position initially, and if it starts working, build up to a full weighting.
- Margin limit
- Total initial margin requirements for the contract size you trade should be no more than 15-50% of your account size. 20-30% to be more conservative. 40-50% to be more aggressive.
Time Out Stops
- Monthly money management stop
- If during 1 month, you lose more than 10% of your equity as of any Friday close, you shut your system down until the next month
- Define simpler rules
- Even when you establish your rules, if you can’t follow them, it isn’t going to work. Most people should define simpler rules rather than complex rules because we’re more likely to follow a simple rule than a complex one. That’s the key to managing risk and managing the entire trading process.
- Trade what you tested
- If when you test your system, you did not include overnight sessions and major reports, then trade the exact same way you tested.
- Safeguard against overoptimization
- If a concept works the first time you test it (without optimization), that’s the best safeguard against overoptimization.
- Average profit / Average loss ratio needed depends on time frame
- For very short-term systems where the transaction costs are huge, you would need a much higher ratio of profit to loss.
- With a longer-term system, the transaction costs are small, if you have three to one, you’re okay.
- If you have a reasonable system of an intermediate-term nature that trades maybe a couple of times a month, then three to one is a reasonable number.
- Don’t modify your trading plan because of an opinion on a market
- Do it because testing shows your new model is better than the old one.
- Accept the reality that having opinions independent of your plan is the most destructive thing you can do. That is the way to cultivate the patience and discipline needed to follow our proven, tested trading plan. Absent any opinions, you are free to follow your rules. That is the way to be a successful trader.
Markets to Trade
- Market diversification
- Pick one market from each sector of commodity futures to smooth out the equity curve.
- Don’t diversify too much
- Every time you put on a trade you take a risk. Too many different opportunities will bankrupt an account, especially a small one.
- Trade markets when they are most active
- Add commodities to a portfolio when the profit potential increases (seasonal effects of each commodity increases volatility).
Psychological Risk Management
- If you’re out of balance, you’re going to make bad decisions, and trading the market is a decision game
- If you’re overtrading, you’re out of balance
- If you’re overcommited, you’re out of balance.
- If your dollar risk is too high, you’re out of balance.
- If you’re hung over, you’re out of balance.
- If you’re sick, you’re out of balance.
- If you need the money, you’re out of balance.
- If you make too much money, you’re out of balance.
- You’ve got to take time off. You can’t trade every day.
- Pay more attention when you account size gets bigger
- I’ve noticed over the years that when my account has been small for whatever reason, I have been really careful with it. I watch it like a hawk. When my account gets rich, I tend to fall into a habit of neglect. I’m making money. I have profits, and I’m more comfortable. I don’t keep as close an eye on it. That’s very foolish.
- Take profits out of your account
- You should spend some profits rather than letting the money stay in your account indefinitely. That’s been important to me over the years. I withdraw money from time to time and take a vacation or buy a new car. From a behaviorist’s standpoint, it gives a sense of reward. It provides conscious and subconscious motivation.
- Avoid market moving events
- Avoid staying with positions through major reports unless there’s a profit cushion or unless the technicals are very strong.
- Note however that many of the interviewed traders simply trade through the reports as usual.
- Use options to hedge against limit moves
- The risk with options is absolutely limited, and it can be converted to futures positions.
Have Precise Definitions to Identify the Market Trend
- Trend is only relevant in a particular time frame. To trade with the trend, you must know what your time frame is. No matter what method you use to identify the trend in that time frame, you should have a very precise definition of when the trend is up, down, or sideways (indeterminate).
Keeping Losses Small Is the Most Important Ingredient
- The method you choose will relate to your trading personality and the method you use for entering trades.
- Having the discipline to keep losses small was perhaps the most important ingredient to trading success. If a trader could do only that, he or she might stumble on enough winning trades to make some money.
Essence of Successful Futures Trading
- It is wrong to conclude that any trading style that matches your personality will work. You must have both: a trading style that works and one that matches your personality. The former is clearly more important than the latter.
- The two are almost always mutually exclusive. The methods that work are not those that make sense, feel comfortable, and are easy to implement. If they were, a lot more people would be successful.
- There are four things you should do: Develop a proven trading model. The emphasis is on proven. That’s your trading plan. Raise enough capital to trade it. Overcome your fear of losses. Finally, forget about having opinions on the markets. Just follow your model.