Trading Rules to Live By By David Edwards Special to TheStreet.com 6/7/01 1:23 PM ET

In the dawn of my Wall Street career, I took a class in "Risk Management" at the New York Institute of Finance (by the way, I highly recommend these courses to expand your professional expertise; even if you don't live in the New York City area, they have distance learning programs).

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The class was taught at that time by the head of foreign exchange trading at Chase Manhattan, although the risk management strategies applied to any financial product. She recommended that we novices get in the habit of keeping a log of why we entered a trade, conditions that prevailed at the time of the trade and when we closed out the position, as well as whether the trade made a profit or loss. In addition, she told us to jot down notes about strategies and ideas that we learned from more experienced traders or through our own research. She made the point that our memories were more fallible than we knew. The only way to develop a disciplined approach to trading was by revisiting our successes and failures while the markets were closed, modifying our strategies based on a hard record of experience.

To this day, I keep a steno pad on my desk. I don't have to track individual trades anymore -- we have computer systems which do that for me -- but a couple of times a month, I'll recognize a pattern and commit details to my trader's log. For example, I discovered a series of short- term indicators that could reliably tell me when to commit new cash to the stock market. The rules for applying these indicators evolve over time as markets continue to evolve. By referring back to the trader's log, I have the information I need to improve their application.

Here's an example of a rule I developed from last year's Internet fiasco. In 2000, many experienced investors could see that certain dot-coms were woefully overpriced, but their skepticism was brushed aside by soaring stock prices. At a certain point though, I noticed that individual sectors (e.g., business-to-consumer, net infrastructure, etc.) broke down even though the overall Internet indices were still rising.

I had already noted that part of the huge rise was due to demand chasing a relatively small supply of stock, but I couldn't account for the end of the individual rallies. At a certain point, however, I had the revelation that individual stocks broke down about one month before insider lockup expired. As a substantial supply of additional stock reached the markets, demand evaporated and prices cratered just as classic supply/demand theory predicts.

So my new rule is: The next time investors make a mania out of a certain stock sector, keep an eye on the overall stock supply and sell out of anything where the float is about to increase dramatically. You might think this won't happen soon, but investor manias happen fairly frequently (remember the Y2K mania of 1998 or the Iomega (IOM:NYSE - news - boards) mania of 1996? I do because I noted it all down in my log).

Here's a summary of the rules that generally guide my investing (bear in mind that I run a fairly conservative firm with an average five-year holding period for companies in our portfolios). These rules developed out of 15 years of trading logs, additional research and an MBA.

For Companies

Beware the "paradigm shift."

William Eng, a successful trader with 30 years experience and several books under his belt, wrote a terrific primer for short-term traders -- Trading Rules: Strategies for Success. When I first read this book in 1990, I photocopied his 50 rules and taped them to the blotter on my desk. The book is still in print and can be bought on Amazon.

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David Edwards is a portfolio manager and president of Heron Capital Management, Inc., a New York investment management firm, which is consistently ranked among the top 20 in its category by the Nelson's "World's Best Money Managers" survey. At the time of publication, his firm was long Amazon, though positions may change at any time. Edwards appreciates your feedback at DavidEdwards@HeronCapital.com.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.

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