Rule Number One:
In a losing game such as trading, we shall start against the majority and assume we are wrong until proven correct! (We do not assume we are correct until proven wrong.) Positions established must be reduced and removed until or unless the market proves the position correct! (We allow the market to verify correct positions.)
It is important to understand that we are saying the one criteria for removing a position is because it has not been proven correct. We at no time use as criteria for removing a position the fact that the market proved the position incorrect.
There is a big difference here as to how we treat all positions from what most traders use. If the market does not prove the position correct, it is still possible the market has not proven the position wrong. If you wait until the market proves the position wrong, you are wasting time, money and effort in continuing to hope it is correct when it isn’t.
How many traders ever hoped it wouldn’t be proved wrong instead of hoping it was correct? If you are hoping it is correct, it obviously wasn’t ever proven to be correct. Remove the position early if it doesn’t prove correct.By waiting until a position is proved wrong, you are asking for more slippage as you will be in the same situation as everyone else getting the same message.
What makes this strategy more comfortable is that you must take action without exception if the market does not prove the position correct. Most traders do it the opposite by doing nothing unless they get stopped out, and then it isn’t their decision to get out at all — it is the market’s decision to get you out.
Your thinking should be: When your position is right, you have to do nothing instead of doing nothing when you are wrong!
I don’t mean to repeat and repeat but, in this case, you will better understand the rule the more you read it. It is very critical to your success in trading. Over time it has proven to be the rule which keeps the losses small and keeps a trader swift and fast to take that loss.
A person’s thinking when the market proves a trade to be bad is counter to what is productive. By using the rule properly, you are productive and don’t have to face the demoralizing effect of the market when you have a proven wrong position. This enables you to continue to trade with the proper frame of mind. You are more objective in your trading this way than letting a negative reinforce your thinking. This way you only let good trading reinforce your thinking and actions.–Phantom of the Pits
Rule Number Two:
Press your winners correctly without exception.
Sounds pretty elementary but correctly is the key. What you hear quoted most of the time is cut your losses. Cutting you losses is only one side of the coin. Without Rule 2, you will find that trading still isn’t even a 50/50 game. Without a correct method to press your correct positions, you will never recover much beyond your losses. You need rule two to ensure you have a larger position when you are correct. You always want a larger position when you get a great move or trending market than when your position isn’t correct.
There certainly will be debate on how you know when to add to a correct position and on how a market can turn a correct position into a wrong position. We will cover those debates later. First, let us get the rules and reasons established. By knowing what is expected in Rules 1 and 2, we can prove the theorem based on good assumptions and experience.
Rule 2 does not mean just because you have a position in your favor that you must now add to that position. Correctly in Rule 2 means you must have a qualified plan of adding to your position once a trend has established itself. The proper criteria for adding positions depends on your time frame of expectations in your trade plan.
You might be a day-trader just trading back and forth, a short-term trader, weekly trader, monthly trader or trend trader only . The add criteria will be different for each trade plan. The important point of Rule 2 is to point out the rule is established so you can make the most gain with the least drawdown expectations. You must also use Rule 1 properly.Rule 2 is important for it keeps you in a good position as well as impresses upon your own thinking about having a correct position initially. Most traders are conditioned to want to take a profit to prove to themselves that they are right. Being right does not, in itself, make the most amount of profit. Most traders also want to get out before the market turns and takes away any profit they may have. Ordinarily, they will let losses get larger but only let gain get started before getting out. This is just simple human nature when having a market position. Human nature in trading is not often proper trading technique.Always a good reason for adding to a winner is because traders usually tend to doubt the position unless they reinforce the correctness of that position. Adding to the position correctly best does this.The other good reason is that you must be larger when correct on a position than when your position is wrong.
Correctly adding to a proven position must be done so that a pyramid isn’t established that will hurt the trader in a minor reversal. Each add onto an original position should be done in smaller and smaller steps. As an example,if you put six contracts on as your initial position, you should use four contracts for your first add and two contracts for your next add. This gives you twice the original position when all three positions are in place. This is a 3:2:1 ratio in establishing three levels of positioning.
At all times during the trade it is important that Rule 1 be in your plan.This includes when you are adding to your positions to protect your trade from any major reversals, which often happen.
Your plan for adding positions could be as simple as using each buy signal for longs and each sell signals for shorts. It could be on 45-degree retracements or support lines.
Without exception the rule indicates it is not an arbitrary decision on the trader’s part whether to add. Keep in mind this does not exclude the correct method of adding in respect to variables of different trading plans.What is a correct way of adding in one trade plan may not be in another.Reviewing Rule 2, it states only that you must add to correct (proven) positions and that it must be done correctly. The rule does not tell you how to add, as this is your requirement in the trade plan you develop.The rule makes no exception on adding to correct positions. The intent of Rule 2 is twofold: Reinforce your correct position both mentally in your thinking and your execution and increasing the size of your position. — Phantom of the Pits
The Number Three:
We shall go against the majority and assume the market is not always correct (those times being when liquidity is poor). At those times we shall question all signals and wait for future signals for positioning.
We shall use the converse of poor liquidity and remove our existing positions when extreme liquidity takes place in two steps and within three days of extreme high volume. Half of our position shall be removed immediately the following day after an extreme high-volume day. The other half of our existing position shall be removed within two additional days. We shall wait for further signals in those cases for future positioning.
The first part of the third rule addresses the situation of thin or illiquid markets. It states that we shall question our trade program signals and wait for further clarification of signals in those thin markets. At illiquid times the market is not a valid indicator for taking positions.Because most signals are generated by price, you can see the importance of
the third rule allowing you to have an exception of questioning your signals.Some trade programs address this situation very well. Not many programs use volume and open interest such as moving average indicators in generating signals.
I am not questioning various systems but only saying that with the third rule we must put an illiquid relief valve somewhere in the plan to preserve equity at those times.
The second part of the third rule gives us criteria for taking profits or removing any previously established position. We do know when to take profits. Although we take all the profits and may miss some of the move, we shall await further signals at extreme high-volume days. Additional signals develop quickly after high-volume days, and we want the benefit of that by not being positioned incorrectly prior to additional signals.
Don’t forget that a good plan will continue to give you signals based on market conditions. We are using extreme liquidity to our advantage by knowing that huge volume is the prelude of further correction possibility. Many times huge volume days are the very reversal days in bull markets. At any one time there could be an event that causes extreme volume. It usually takes several days to play out when this happens. We also use that to our advantage in the third rule.
When we say we shall take the last half of our position off within two additional days, it is important to note there will be times when we will do it very quickly and not extend to two additional days. The two additional days gives us the outside limit allowed for our rule.
The third rule is a good rule, and it stresses the acknowledgment of trading in the long run and not the short run.–Phantom of the Pit.
ALS: There were some questions on when to get out of a position. I realize this is out of order here, but I know we need to include Rule 2.
POP: That’s okay, as a common question is when do you know when to get out of a position. Actually Rule 2 addresses this very well because it says to press your winners correctly without exception. Rather than getting out of a position with the proper criteria, you will be increasing your position. You only do the adding with correctly proven positions.
The time to get out of a position is not when the market is proving your position to be a correct one. You have the opportunity to be wrong as often as correct, but when you are already proven correct, this is certainly the time to step off of first base.
We have two rules to keep us protected from our lack of certainty and enforcement of certainty. Many trading plans have the trader in a position at all times, the thinking being that the market is either going to go up or go down.
Well, this is just absolutely an idiot’s plan. Maybe I shouldn’t say it so strongly as I should still have an open mind. I have to put this in the category of thinking a statement that says not to do something actually says to do the opposite of that statement.
Too many times I have watched a fund bid the market so they can sell the market. It’s a plan to take advantage of the surprise element in the markets. There was the day when you would only see me on both sides only when I was wrong. I am wrong a lot more lately. That’s not bad either!
The readers are surely asking by now: How do we use these two rules?
It’s easier to use real-time quotes and markets to prove the points, but because we only have hindsight here, we will do it differently. Let’s use the old common day-trading technique, on which I am not going to give you judgment at this time.
You say your plan wants you long if you take out the opening range! Okay, let us say we are trading onions and the price is 1000 ($10). The price goes to 1001 and the opening range was 999-1000. Your plan says buy so you buy. You get filled at 1002! Why 1002? Well, execution is getting the position filled! You gave up a slip of 1 tick. Not bad. Most of the time it is small.
We can go into the importance of execution now or continue the trade. Let us continue the nature of the trade and cover the importance of execution later.
Now that you are long at 1002, you are using Rule 1. You assume this is a bad trade until the market proves to you that the trade is good. If the market does not prove this a good trade, you are going to exit the trade.Fine so far!
What criteria in your day-trading plan says you are right? Most say what determines you are wrong. Not us! We only want to know the criteria for being right. Okay, for us our program says, If in the first half hour the market opens lower than yesterday and moves higher, expect a move above the prior day’s high within the first half day of trading.
Our program also says the position is only correct if the market stays in the prior day’s top half in the first half hour. Our last criteria for the trade is that it must show a 3-point profit by the close. Now, I ask you,what is your next step?
Your criteria for remaining in this position is only when the requirements of your data indicate to you the position is correct. The other data you would need in the program is yesterday’s range, yesterday’s high and yesterday’s close. Your day-trading program says to use the old rule of opening range breakout. Yesterday’s data is critical in knowing when you are correct.
For our example we will use yesterday’s high as 997 and yesterday’s range as 991-997. It gets interesting here because you are going to decide whether you will exit the position. At the end of 30 minutes the market is at 997. What would you do?
The first criterion of our trade program is in conflict with your day-trading strategy, but you still bought the opening range breakout. We don’t care if the two are in conflict! We only care what causes our position to be correct.
Okay so far. The market has been open a half hour and our price is 997. As you can see, you must know your trade plan before the market opens and what you are required to do. What makes your position correct? You must be in the top half of yesterday’s range after the first half hour of trading.
Are you indeed in the top half of the range from yesterday?
I am going to give you the answer indirectly so you can’t slip down to find it. We will go to the next step here. At the end of the first half day of trading the price is 996. Are you still in the position? You did take out the prior day’s high but you didn’t open lower.
Okay we still did it! Stayed in the first half hour. That’s right.
Now the first half day price is down to 996 and we bought at 1002 — still in the top half of yesterday’s range. Okay, we are still in the position. Bad entry, though, as our plans conflicted. Should have only taken the position if it opened lower. It didn’t. Well, okay, because we are day-traders, we used the opening range breakout. Our entry wasn’t the best but so what!
At the end of the day the market is at 992. Are we still in the position?You have the right answer but why? The market had to be at 1005 to keep the position — it had to show a 3-point profit on the close.
How would you get out of this position? You would have used a stop close only order after the first half day to sell the position: 1004 stop close only.
The example gives you several interesting situations and perhaps just as many questions about Rule 1. Rule 1 will not protect you from wrong entries!That is your job. You must solve your own conflicts in your trading. Rule 1 did take you out of the trade on the close because you were not proven correct based on the required criteria.
Keep in mind this example is a very different situation than you would expect of your trading program. You can’t have a program that says, if the market doesn’t go to 980, it looks for the market to go to 1100 sometime.There has to be a time frame on when to expect 1100.
When a market doesn’t go up anymore, somewhere it isn’t correct to stay in the position, regardless of the expectations. The market must prove and continue to prove. There can be simple or complex strategies in your program,but when the position is not going according to the expectations, it is wrong – not when it proves your stop price got hit.
Stops? Yes, we did use a stop to get out. We did not use the stop as the criteria for getting out. The stop did not prove us wrong, but the criteria proved us wrong.
I realize that in the example we put conflict, various criteria that was required for the position to be correct and a bad entry. Does this point out more than just Rule 1 to you? Rule 1 will get you out of a position that is not proven correct, but it won’t fix a bad entry. Know your plan before the market opens! If you had known your plan in this example prior to opening,you would have never positioned as you did.
ALS: Okay, I see your point. But how can most traders with jobs trade as
the example shows?
POP: I can give you other examples, but it all comes down to the criteria for proving a position correct. If you trade by looking in the newspaper each night, your trading plan will be different and your positions must be smaller as you are going to need wider ranges to work with your criteria.
In the example above, you could never have placed the order to buy the opening range breakout; therefore, it would never have been in your plans.You may have had criteria that said to buy yesterday’s low plus one tick or two ticks and a time of day order that said, TOD10:00a.m. sell 993 stop.
The market would have to be in the bottom half after the first half hour to get out as the criteria indicated that, to be correct, the market had to be in in the top half of the range after first half hour.
The other criteria could be met with either OCO (one cancels other) orders or stop limit close only orders. Not all brokers take all orders so your plan must include this possibility of difficulty in trading.
For each tool you lose or don’t have in trading, you must reduce your position accordingly to have an effective long-range program. The farther away you are from all the tools you need, the wider road you must have. Reduce the size of your car (position) for the road that isn’t wider.
Now that we have your attention, I think it is clear to see how just two simple rules can be exploited. You can’t help but understand why trading can be so difficult. You want to be a knowledgeable trader, and you need to take all of the difficulty out of your daily trading when the market is closed.
ALS: I would like to ask you a question that I have wondered over the past couple of decades: When you take a position, do you feel you have taken a good position?
POP: Never! Do you understand my NO? If a trader thinks at any time they have a very good trade, they are going to get removed from trading very quickly. I make the best trade on my trade probabilities program, but who is to say my guess is better than someone else’s? Never do I know it is a good trade until it proves to be.
To feel you are making a good trade is signing your death warrant in trading. The majority of traders do certainly feel they have a good handle on a trade and are only putting on good trades.
There is an old saying that the market is never wrong. I don’t mean to protest directly, but I think that is not always the case. However, that is what we must trade by in price.
Markets go to extremes, and that is certainly a challenge in always being right. Once we know markets go to extremes, we can put that on our side and exploit the advantage. Very few traders exploit that advantage. You must press your winners with Rule 2.
Oftentimes, you won’t understand the importance of pressing the winners,but it makes no difference as to reason when you collect your profits. Who really cares if the market is or isn’t always correct? The market price is what we are measuring our equity with and always will.
In trading nothing goes right for most traders unless they take total control of positioning and letting the market only prove when a position is correct. I know I am repeating myself, but there is no better way to impress information of this insight upon the readers.
I don’t want to see any small traders wiped off the map when it comes to trading, but that is what happens to most of them. They are small and are stopped by the big traders and funds most of the time. If they can understand the urgency of not letting the big traders ruin their plans and hopes, they will do much better.
The first step is what we are pointing out. I know because I have driven the big cars on the small tracks. It is better to drive the small car on the big track, but it just never comes out the same. With a little understanding we shall change that for them.
–Phantom of the Pit