Chapter 17: The Third Rule

"Find the positive in taking small losses rather than getting wiped out. Find the positive in the simple rules we have given you to use. Decide what you want to do with the guidance you have been given!" Phantom of the Pits

Art Simpson (ALS): Phantom, you have indicated you used Rule 1 and Rule 2 in your trading career to allow you to change your thinking and your behavior. Why do you now state a third rule?

Phantom of the Pits (POP): The third rule has not been a written rule for me but has been a second-nature type of rule over the years. You know I strongly disagree that the market is always correct. From experience I have concluded that to be the case. I use this assumption on my part to protect profits and eliminate new positions in illiquid markets.

I'd like to point out that the third rule is not my rule, and the credit goes to the traders who have convinced me there certainly is a third rule to be used after Rules 1 and 2. I was very reluctant at first, but I see they are correct in this request. Let us look at everyone's rule here and not my rule.

Almost every trader who read my Rule 1 and 2 felt there is a third rule. They really are sharp and more observant than I am. Even though I have used a third rule more as a rule of thumb, it is indeed a third rule. Our traders thought it should be a rule on when to take profits. It extends beyond that point because our true focal point is to keep loss possibilities as small as possible and retain as much profit as we can. That implies taking profits at the correct time and properly outside of Rules 1 and 2.

Although Rule 1 does address taking the quick loss when the position has not been proven to be correct, we do need Rule 3 to tell us something about our trading plan that is very valuable in trading. That rule tells us when we must question the liquidity in the market and the place that indicator has in our trading plan. I feel it is better to have that in a rule outside of the original trading plan to give us our criteria in illiquid market times for not losing much money.

I also feel the time to take profits is clear within market conditions when we have our extreme volume days. This is usually a turnaround indicator in most cases. But let us get out on those indicators. Why? Because we can re-enter any market as soon as we get another signal from our trading plan. Even if we were to miss part of the move at the expense of being early, we still will be better off in the long run. It is the long run we plan to trade in our careers.

ALS: Do we need to qualify the third rule?

POP: No, we do not. We will state it now!

The Third Rule

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 postion 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.

ALS: Many experts are going to argue with your Rule 3, as it will surely interfere with their professional trade programs. Most systems say to trust them over a valid time to allow them to work properly in the long term.

POP: My trading experience has told me to have enough integrity to bail out when I see that everyone starts putting on their parachutes. Why stick around to see who leaves their seat belts on? Trading is a run-run game. There are times you have to run before they run. That way there is less chance the market will out-run you.

Do you think the experts ever buy insurance for their homes, cars and health? Surely the experts have a plan to protect positions at critical times. The third rule just places another double-check in a good trading plan.

Traders must never be complacent when the market is at extreme volume, whether high or low. These times are to be flagged, and I don't know a better way to flag them than to remove existing positions. How much can you lose after removing a position after a market volume extreme? Why not make your plan give you another signal before you re-enter the market?

ALS: Do most traders have the same kind of thinking on this liquidity situation?

POP: We are either at the first floor (bottom) or approaching the 18th floor (top) of the elevator. Few traders watch the floor indicator. They wait to get off. I say just don't wait long! Liquidity is giving us our floor information so we know where to get off the elevator.

I've seen what waiting can do to people. It was back when the Hunt Brothers had too many bean positions in place. They were told they would have to get out. I had just put a position on and within seconds the market was practically all sellers. I lost money that day within 10 seconds and I got out. The volume was extreme, and the market went limit down very quickly. Sure, this was a short time frame and few knew to get out until it was too late, but many situations do flag you that you are looking at a special price level.

We have all heard "when in doubt, get out!" I think a poet made that statement, and it took hold. It makes sense to this day and always will. You don't ever lose when you are out. There are times to be out.

ALS: It looks like the third rule is more of a rule to keep from losing money and to keep from losing profits previously made in the market. How often do you foresee a situation in which market conditions present these criteria of either high or low liquidity? Or should I call it volume?

POP: Yes, you could associate liquidity with volume in most cases. We are talking normal and abnormal market conditions of liquidity, and we measure liquidity by using average daily volume as our reference. But don't forget, we are only talking about extreme conditions of liquidity that are abnormal.

Traders will see the validity of watching for extreme volume days. Their use of the third rule will become second nature. They will see the thin markets better and know what not to do in those situations. The third rule is a good rule!

We would normally expect the conditions to be a possibility at trend-reversal times and at certain events that cause lack of interest in trading a particular market. At times in front of critical reports you could see the situation develop.

ALS: In front of reports what do you usually do with your positions?

POP: From experience I have learned that, if you make a mistake, you pay heavily with being wrong after the report. You have to have a big lead and then it takes it back sometimes. I must consider always cutting back in front of a report unless I am given a big edge. There are times you cannot control your position the next day so why not cut back? Most traders should remove their positions to allow longer views of their trading careers.

I just recently had a new trader ask me about a sugar position, and my guidance was to look at what the market had done the prior four days -- we had three higher lows in a row. The opinion was that sugar would go down. That day it made a contract high. Rule 1 and Rule 2, with the help of the third rule, allows all traders a long-term outlook in trading.

First, behavior modification must be adapted to the rules to have any expectation of trading long term in a trader's career. Many shall have to face the aspect of human nature to oppose any change. Change is required, and you are the only one who can do it. Your trading career depends on it. Don't take it lightly.

If you must, rehearse your behavior daily until you have it down correctly. Behavior modification requires positive reinforcement, and trading often is not positive. Find the positive in taking small losses rather than getting wiped out. Find the positive in the simple rules we have given you to use. Decide what you want to do with the guidance you have been given!

Unless you go down the defeat road, you will never have to endure the hardship of knowing you didn't make a good attempt to change your behavior in trading.

I would like to leave you with one last thought: Trading is not as we had all thought. The sooner you learn that what you imagined about trading is far from reality and that you must change your thoughts on that reality, the better trader you shall become.

Good trading to all of you! I shall watch you trade and shall always be your shadow.

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