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. (more…)