Chapter 16: Rule 3, You Say?

"It's all the traders, you and me, who will be satisfied with Rule 3 at its conclusion." Phantom of the Pits

I've noticed a lot of arrows drawn on pieces of papers, a few triangles and other strange dittos. I thought they might be new flow charts for another one of Phantom's computer programs. It's not unusual to have scribbles that turn into worthless pieces of paper shortly after the markets are closed and are tossed out to the circular file.

These particular scribbles didn't get thrown away, and that made me more interested in them. Because they didn't make any sense to me, I decided to ask Phantom just what they were. He was a bit uneasy about them and didn't want to detail any of them.

I decided to try and figure this out myself. Here is what I saw. In his first set of scribbles, there were arrows and two triangles. The first set contained four arrows. The first arrow pointed to the top of the page, and the second pointed to the right of the first arrow. The last two arrows pointed from the other two arrows down toward the bottom of the paper, and the last pointed to the left side of the paper. In other words, what we had here was your old ordinary "to turn left, make three right turns."

The next set of arrows had but two arrows. One pointed to the top of the page and the other to the left of the first arrow. In other words, we now had the old "turn left directly" symbol.

To the left of both sets of arrows was a triangle, indicating one of two choices. It still looked like a flow chart for a program to me at this point.

But wait, there it is! I see it at the bottom of the page. In very small letters are the words "rule three." Great, I thought, Phantom is going to give us Rule 3 just like everyone had asked.

Traders on the Futures Talk forum had asked Phantom to give them Rule 3 to tell them when they should take their profits. Their feelings were that the circle must be completed. The traders were beginning to understand Rule 1 in getting into a position and whether to keep the position established. They were also beginning to understand Rule 2 better and what the purpose and advantage of adding to correct positions would do for them.

Could it be that Phantom has had a Rule 3 all the time? Did he just not want to share this rule? I wasn't sure about Rule 3 in his trading career as I thought I knew reasonably well how he traded. How had he kept it from me? Why wouldn't he share his Rule 3 with us? So many questions ran through my mind.

I turned the papers over, and I was a little disappointed in what I saw. Nothing other than a big question mark was on the other side. There was nothing written on the pages except the scribbles and "rule three" at the bottom.

Art Simpson (ALS): Phantom, about Rule 3, what can you tell me so I can pass your insight on to our traders as we had agreed upon when we started this project?

Phantom of the Pits (POP): I am afraid I have let them down, Art! I don't have a Rule 3 as such. What the traders are asking of me is more automatic for me than a rule. When to take profits is not an easy and clear-cut rule.

You see, my rules have been set up to address the nature of trading as a losing game and to keep losses small. This is the most important aspect of trading and to add to correct positions when correct. To have a rule on taking profits is to have a rule that is second nature most of the time.

I can understand the point of view that taking profits must be done correctly also. Though it might be second nature for me, I am learning that important insight on that aspect is just as important to our traders.

We will come up with a Rule 3. Did you notice I said "we?" It's all the traders, you and me who will be satisfied with Rule 3 at its conclusion. It is not clear yet at this time, but we shall do what we discover as correct.

If you take a beaker of dirt and water, what do you get when you stir it up?

ALS: The clear water becomes muddy. Is the rule going to be revolutionary?

POP: Okay. Well, that is what taking profits becomes when it is time to take them. Revolutionary, as you say, and I suppose revolutionary Rule 3 will be the most liked rule of all! There are so many variables that we can't just have a simple rule to take profits. Most profit situations should be within the trade program, but I am sure we can come up with the rule that doesn't interfere with a good trading program. We will work on it.

My Rule 1 takes care of removing the position when not proven correct. And Rule 2 takes care of getting larger when proven correct by adding positions. Back again we go to Rule 1 to protect Rule 2 after adding positions. Rule 1 usually addresses removing a position when it no longer continues to prove correct, even though we have also added positions.

Taking profits is never as cut and dry as removing positions that are never correct for me. It's kind of funny, though, as most traders find it pretty cut and dry in taking profits. It is taking losses that seem muddy to most traders.

The traders on the forum have a legitimate request for Rule 3. I take profits within my programs and never gave it much thought that it would be as important a rule as they have pointed out to us.

I can't give my programs, and it is going to be rather difficult to separate Rule 3 from the programs I use to establish and remove positions. I don't want to let them down either. Taking profits is critical to increasing equity in their account. They are right in wanting the rest of the insights into taking profits.

Outside of a trade program, taking profit criteria is going to be a little modified. Because we have to modify when to take profits this way, we will have to have qualifiers as we did in understanding of Rules 1 and 2.

First, it must be stated that any time you take profits, you must be satisfied this is the correct move. If you look back at any time, you will see that you could have made more money -- not that you would have taken the position off at a better price but just the nature of hindsight.

By using Rule 2 to add to positions, our newly found Rule 3 will be much better and agreeable for our traders to use. We need to establish criteria on the rule before we can actually set the rule into words.

Are we going to define taking profits at the point we remove a position and end up with profits? Or are we going to consider a rule to take profits for use only after a success of having added to our total position? Do we consider Rule 3 for taking profits after one add, two adds or additional adds if required? At what point do we consider our trade totally established?

You can see some of the difficulties in coming up with Rule 3 to take profits unless we set the criteria for the rule from the start. Removing positions can, at times, be considered taking profits; yet, at other times, removing positions is keeping loss small. Taking profits must be considered differently than removing positions. We consider removing positions as keeping losses small, even though removing profits at times leaves us with a profit by the nature of the rules working for us.

Art, This is going to be a rule where we must have input from the traders to come up with the wording of Rule 3. This is their rule so we must go back and get their input. It is important that traders understand Rule 3 is with my input also, but it is not a rule I have set into cement over the years. It will include the nature of my profit-taking to the extent of what criteria traders want in the rule. Thought must be given on Rule 3 by all who want the rule to use.

It is not possible to end up with a rule that will cover everyone's input, but we can come up with a rule they will be satisfied with using. We might need to do a lot of computer testing since we are giving a rule they are asking to have. I am not completely comfortable in a Rule 3 if it is different than my way of trading. Because of that feeling, I shall incorporate my own criteria within the rule also.

I must know what the traders want in the rule. Consider all the variables, do your homework and set your criteria so we can work on your rule!

ALS: What about the arrows on your paper on Rule 3?

POP: You see two sets, don't you? We may have three sets after their feedback. Feedback is what we want now before I go into detail on any of my thoughts here.

I can guide some on what we need. Consider both Rules 1 and 2 and do a flow chart of the possibilities of each rule in each step and then point to what Rule 3 is to consider as possibilities for taking profits. Let us know your thoughts by steps if you can. This will help us work the rule criteria better.

ALS: Okay, we will wait for feedback on what criteria our traders need.


Note: Further research and input came from the Futures Talk forum of excellent traders in an attempt to end up with a creditable Rule 3.


ALS: We are beginning to get some ideas from traders on Rule 3 now. Actually, there are some pretty good suggestions. In fact, some of them end up with your arrows.

POP: I'll discuss some of my theory at this point to give some hints, and then we will address the input from the traders.

Consider trading to be nothing but a maze -- by maze, what I mean is a series of rooms to progress through from the entry until you get through all the rooms until you come out the other side. You can go straight ahead or must turn to the left or right. But the object is to get through all the maze and progress from each room until you have ended up through all the rooms and are at the outer side of the maze once again.

In our maze, you must design a system that guarantees you will indeed get to the finish of the maze. You cannot know exactly which way to turn each time, but you know you must make a turn. Trading is the same idea. You don't know which way to turn for sure each time to get to the goal. Your plan can be guess-and-miss, trial-and-error or systematic.

We want a balance of correct procedure each time and a speed that does not create unnecessary moves. Now, the next point is going to make you laugh and question my integrity, but it is an important learning process from observation.

In my younger years at a great university I learned the maze answer by watching a mouse going through a maze. The mouse was released to move around the maze, and we were to learn what the mouse would do. To my surprise, a low-intelligence mouse had a system to get to the other end, and it didn't really take long.

What the mouse did was always turn to the right whenever possible until it had progressed through the entire maze and was out the other end. While this wasn't always the fastest way to get through the maze, it certainly accomplished the object of the study by ending at the other end.

At that time I devised what is a simple method to get to the exit of the maze by just placing my right hand on the right wall and continuing to progress until I could only turn to the right. At that point I would turn to the right. As I continued forward, I would go forward, turn left or turn right (whenever I could), but I would never retrace or reverse my steps. The idea was to guarantee I could get through to the exit of the maze with the least number of steps using a system to prevent repeating my steps.

Isn't that what trading presents to us also? A maze where we never really know which way to turn but must have some kind of system to keep us from retracing our steps and extending the amount of time required to get to our goals.

In trading, you can never really know at each important point what the correct move is until you look backwards. Therefore, you must have a method that is systematic with what your goal is. The goal in trading is to get to the point of the least amount of loss in the journey. In a maze you cannot have the exact path, but you can totally eliminate the unnecessary steps by using a well-devised system. In trading, you cannot make the exact moves each time you trade, but you can devise a system that prevents you from unnecessary steps. The unnecessary steps are usually costly losses in trading.

My Rules 1 and 2 give me part of my system in trading by allowing me to eliminate the unnecessary steps after defining what my goal includes. Let us progress forward with a forward arrow upon entry of a position. My next move is either Rule 1 or Rule 2. I either turn to the right or turn to the left.

When I turn to the left, I am removing my position because it was not proven correct or does not continue to prove correct at that point of the trade. If I can turn to the right, I will do it (my right hand on the wall) because this is my Rule 2, adding to a correct position and the current position has been or continues to prove correct. I want to turn to the right whenever I can to get to my goal systematically without unnecessary steps. You see, this is in my maze system as well in my trading system.

Pretty simple and elementary since it was learned from a lowly intelligent rodent. This in no way lowers the value of the knowledge. I sure don't want anyone calling my system the rodent system so please have mercy on me!

Now you can see some of my dilemma in getting to Rule 3. If I must either go straight ahead (continue status quo) or turn left (get out of my position) or turn right (add to my position), I have no room for turning around 180 degrees and taking profits outside of my Rules 1 and 2. That would interfere with my two rules and cause unnecessary steps in reaching my goal properly.

Two points I want to make here. First, I do not mean to imply that I must either use Rule 1 or Rule 2 when I make a decision. If the decision is to use Rule 1, I know I am either correct or must remove my position based on Rule 1. Just because Rule 1 is used and I now have a proven correct position does not mean I must use Rule 2 until the proper criteria is established. That criterion will not necessarily be to add just because the position was proven correct. We may not add until the next buy or sell signal.

In trying to associate Rules 1 and 2 with the maze, don't forget we turn right only when we are able to do so (add to a position). We turn left (remove our position) when we come to a head-on wall and cannot continue without turning left (removing our position.) A head-on wall in trading is when the position has not proven to be correct. This is not the same as having been proven wrong.

While trying to correlate the maze and our trading rules, don't over-analyze the comparison. I am only presenting it as a background thought in design of your flow charts for trading should you want the simple arrow diagram for your own use.

I am concerned that feedback indicates my insights are a little difficult to understand. Can you imagine if we had 10 or 20 rules? I know I repeat myself often, but it is necessary to continue to reinforce the importance of the rules we have established. I guess I could make a career out of better explaining my thoughts. I think it is better if the traders do more of their own thinking rather than try and imitate my thoughts in coming up with their own plan. Anything can be improved, and I feel each trader has the opportunity to improve their plans by knowing my insights. While mine are not perfect, they work for me. Traders' plans must work for them to be of any use.

I feel like I am leaving something out of my thoughts here, but I am not really holding anything back intentionally. I want to address some of our feedback so far!

ALS: The first one we look at is from M.T. In summary his feedback indicates Rule 3 seems intuitive -- in a sense, that Rule 3 is just an extension of Rules 1 and 2. His thoughts are that taking profit could be at a point of adverse movement back to, say, the last point of adding to the existing position.

POP: I've always liked his thoughts and writings. Because add-on positions are done in smaller parts than the initial position, his thinking can actually be successful if it were considered time to take profits at the adverse movement.

But, for profit-taking sake, all positions would have to be removed to have a profit. Otherwise, it would just be using Rule 1 to assume the last add-on position was not proven correct, but Rule 1 would not be used properly, mainly because using the adverse movement to remove the position was the criteria for removing the position.

I want the last add-on removed if the position's criteria does not prove correct rather than because of an adverse move after entry. Of course, if there is an adverse move, it certainly wasn't proven correct either so it is still right to remove the position. Don't get me wrong, as sometimes the adverse move takes place immediately and you must remove the position because of it. But you are removing because the position didn't prove correct.

ALS: Yes, M.T. does say he questioned whether his thinking was correct in using a price movement to determine what to do instead of controlling the trade. He also indicated he feels he does better if he just has a stream of consciousness type thinking. He also indicated that, at the last add, perhaps you would drop all of your established position, and that is more or less what you said, Phantom.

POP: M.T. is to the point of being more comfortable with his trading and being more subconscious in his actions. Believe me, that is how it eventually plays out when you have your plan in effect and the confidence in what you are doing builds. He is certainly showing a good handle on his future in trading.

ALS: M.T. pointed out that indication of change in trend might be the removal point of positions.

POP: In a trading program, that is what causes us to remove our entire position sometimes. Certainly, when we get an early indication of topping, we remove our positions also. In fact, last week we did get our topping indicator in beans. Now that is a good reason to remove your positions. Also, we sometimes get a very quick reverse position indicator after a topping reversal. We did get that last week.

I see you threw up some questioning to that effect last week on the forum in the proper form so as to not preclude other traders' thinking. Our indicators can be wrong at any time, and it is important we don't inflict our suggestions as advice on trading. Never give the crutch to a trader as long as they can walk on their own two legs. They strengthen their legs by walking on them and not using a crutch -- meaning they must make their own best judgment based on their experience and knowledge.

Let's move on to the next feedback, as M.T. is pretty helpful in helping us drive down the road on our journey.

ALS: David Thomas had a followup to M.T., indicating that perhaps Rule 3 could be quite simple. Rule 3 is simply following Rules 1 and 2. D.T. said that, by using both rules in the last part of your positioning, you will use Rule 1 again and never return to Rule 2 for your position is removed by Rule 1.

POP: Yes, that is basically how I end with most of my positions. But there are times when I get a reverse or topping or bottoming signal where I remove my positions without Rule 1. That is where the traders are correct in thinking there should be a Rule 3. The more I think about it, the more I see this as a qualifier rule to remove positions and take a profit at the time. But it could also be a qualifier to remove a position without a profit also at those times.

It is beginning to look like an interesting story here. The making of Rule 3 or the failure of a rule is this point, I see now!

ALS: Steve Waring has some interesting flow-charting. He did a good job with the format on the forum, as the effort to convey the idea with actual arrows is rather difficult. Steve said he can't see any clear answers to profit-taking, just a lot of tradeoff.

He uses two examples of mechanical profit-taking systems. One system has a target price and one has a retracement of price. As you would expect, each at one time or another has an advantage over the other. They both seem to go against Rules 1 and 2.

He picked up on your "cheapen the price of what you have" trick. As you always indicated, trading is like the ocean when the tide is either coming in or going out. He had good thoughts on how to use Rules 1 and 2. When your program indicates a possible plateau or short-term reversal, offset part of your position, looking to re-enter at a better price and cheapen the price of your position. Steve also indicated his thoughts on positions as being a series of trades. Questions on cheapening your position price arose from some of the holes.

If you re-position in this manner and miss the lower price, do you do it at a higher price? What do you do if the market continues to go against you and it gets to be a cheaper and cheaper place to re-enter (leaving your remaining position losing)? How many attempts do you make to re-enter?

POP: All good questions and the answer to each is along the same lines here. When using Rule 1 to tell you to remove an added position, it is possible you may have held the position for a period of time and you have a good profit. Your trade program may look at the fact that the market is starting to plateau, and you are not seeing your position to continue to prove correct.

By this indicator and using Rule 1, you would remove the position due to the failure to continue to prove correct, even though you have a good profit but have just stalled in the move. In this case you would look to re-enter at a morefavorable price on a reaction and have to prove that re-entry with Rule 1 again.

Of course, if the market continues to go against the proven correct position, you would within your trading program expect to be flagged of that situation and use Rule 1 accordingly. You would not make any new attempts unless your trading program indicated to position further. As far as how many attempts to reposition, that is up to your trade criteria and program.

Rules 1 and 2 are not the criteria to position but only the rules to follow within your indicators from your program to have a mechanical system for doing what is required on both sides of the coin.

In asking questions on different aspects of your rules, I think Steve is actually trying to cover all the bases on proper behavior in all situations of the rules. By asking the questions, he is actually devising a probable and possible scenario that is required in addressing validity of the rules' use. As I have said in the past, it is questions of methods and systems that allow a trader to correctly simplify trading when the market is open by obtaining the answer to the best probability of a method or system.

Does Steve see his points in his research as different than I see them? I don't think so at all as I question every aspect before using my two rules to solve any possible conflict in their incorporation of my trading criteria. I think Steve is going to be able to incorporate his trading program without conflict after satisfying his program criteria to what he expects of it.

ALS: We could debate the use of your rules more!

POP: I don't call it debate. I call it improving trading styles for our traders. They ask the right questions, and they trade the right way after incorporating their knowledge. It gets even better after they incorporate their experience, too.

ALS: Steve indicates his feeling on catching a move as being willing to risk open position profits for the reward of the trend re-asserting itself at plateaus. We still consider a profit-taking rule as a variable.

POP: My trade programs allow me to take profits after three adds upon a third wave of movement. The third wave usually is the strongest, and that is where I get out of the elevator on the 14th floor rather than ride to the 18th floor if it seems to move rather fast. I know it is going to stop eventually. The only question in traders' minds, I think, is do we get out at the 14th floor on the way up or the way down.

The correct answer to that lies in our trading program, using the criteria we have programmed in. Let us say on-balance volume is telling us, above all other indicators, that on our way up we are seeing large volume on any reversal day and more so than on up days, even though our OBV is increasing. This is conflict and perhaps our program will say get out on the 14th floor on the way up and not on the way down. Other times we will have a program that says to stay in as long as the positions continues the move.

ALS: Ronald Adams had another good idea on Rule 3. He felt you should never give back to the market if you can help it -- in other words, keep what you have. He also felt there was really no need for Rule 3.

POP: It has always been easier to make money than to keep it in trading. Ronald has some good points. Giving back is the big problem after having profits. This really leaves us with conflict as to whether there would be a good advantage in having a Rule 3. I know a very famous system of trading over decades never had a Rule 3 until it was proven to them that they must have a way to keep their profits -- at least around 50% of what they had made in their positions. It changed their profits.

ALS: Rob Klatt climbed on board the bus on the Rule 3 thoughts. He is with the other traders on his thoughts, too.

POP: We can let him drive for a while then.

Maybe we need a Rule 3 completely outside of Rules 1 and 2 to keep more of our profits using probabilities based on research. I am 50/50 on this rule now.

As you see, we are still in conflict as to what is the need or purpose of criteria for Rule 3! Go back to the traders and let us listen some more.

ALS: Okay, let us do that! I think this is excellent improvement material on effective profit-taking. I know you have many more ideas, and with that grin on your face, I know, too, that you have the ending answer within your sight. It has been in your computer's program all along.

Where is Alfredo when we need Alfredo? We are at a stalemate. New game?

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