Chapter 5: Rule Number 1

When the subject of why it was so important to write this insight, Phantom's remark was always, "Catch me at the right time for that answer." I remember as a child playing out that situation. It was always better to get my Dad to agree to something when the mood was correct. When gathering Phantom's insight on the reasons for this book, it wasn't clear until I caught him at the right time. It was after a big move in the grains in early October 1997.

Art Simpson (ALS): Phantom, I see you agree on the subject today. I need to know just why is this particular time the right time to give your reasons for this book?

Phantom Of the Pits (POP): This day is an example of the reason for this book. The grain market did a total surprise on most traders. Oh, there were those who were fortunate to be on the right side, but most of them took their positions off too soon. I wanted to discuss the shock most traders get on a day like today.

A great number of traders got what we call "killed" today in the grain market. Most all of the new traders are now wondering what they did wrong today. There isn't anything they did right today because they most likely don't know what the right thing is. I don't mean that all traders are in the dark. I am talking about those who fail to understand what to do and, if they do, don't carry out that requirement.

I am going to express the importance of doing the right thing from the beginning of a trade and at the right time.

Many traders -- and most new traders -- aren't even aware the market can do what it did to them today. I have often said the BIG money is on the surprise side. I should perhaps have said the BIG LOSERS are on the familiar side or the popular side of a trade. I call that the expected side.

Today gave us several reasons for a surprise -- harvest pressure is strong and this is a day you expect there to be more selling by the producer than normal. Expecting prices to be pressured by hedging and seasonal influence is the correct way to trade in most minds. You can't argue with probabilities. It is not what the trader does with his trades until the market starts a big move like today's. That's what separates the big winners and big losers. There were more big losers today than big winners.

There are traders who, because of today, can't make their next month's car payment or their house payment now. It just didn't ever occur to them that what happened today was even a possibility. They were over-positioned, even though they thought they had a good protection plan. They used stops okay, but they forgot to tell the broker to place the order.

Everything they did was based on their thoughts of how much they could take out of the market today. Their trades are designed to lose but not because of the good traders or the way the market works but by their own hand. The worst part is they don't even know it was at their own hands.

It is sad anytime a person's heart gets pulled from their dreams but even worse when they lose money, too. Sometimes they lose a fortune in such a little period of time. It has happened to every trader. It happened to me when I was smarter than the market. Why does it happen? Mostly because a trader's plan doesn't consider, "What if I am wrong?" Their thoughts are always expecting to be right.

Herein is the key to being a successful trader. I have learned this over and over again in my trading career. I haven't found one trader to tell me what I am going to tell you. The reason for our agreement to give something back is that all of these big losers are doomed from the start unless they are given the knowledge of what the market can do to them. The blame is within their own responsibility and not anyone else's fault.

Six months ago we started our journey in presenting one of the most successful sides to a market strategy. On the Futures Talk forum there have been exceptional traders who have read the information I gave and did not understand the simplicity of what I said. We will have a better exposure of presenting the same information in this writing.

I never want to see a homeless person and always wonder how they became homeless. If traders aren't aware of what the market can do against them as well as for them, they will head in that direction. Many homeless people I have talked with have had bad luck. In most of our lives we will experience an evening out of luck.

In trading, if you have bad luck, you will eventually have to stop trading. To be prepared for that bad luck is a requirement in trading. You will not survive if you do not plan for bad luck. My first steps in trading remove the bad luck altogether.

ALS: I know what you are going after here. Should we put this in red letters and double the size of the print here?

POP: Yes, I think that would be appropriate, but traders must discover for themselves what I am telling them. It will save them from an outcome that they never discover until it is upon them. So let us not over-emphasize the most important point of any trading plan here as we will drill it into their plan until they survive at all costs in trading.

There are those who, in a modified way, do exactly as I suggest but may consider it more money management than a plan for trading positions. Every broker tries to limit a customer's exposure and protects them, but the key word is "limit." Putting a limit on something infers that you actually can put a limit on exposure when having a position established. You really only have a ballpark limit in most cases. It seems to be worse than you thought in looking back.

I shall present two main rules in trading. Both are required to be successful. Every trading plan must start with the understanding of these rules. Before I give the first rule, it is important that what we say is understood correctly. Next, it is important to have this rule become second nature in all of your trades. The second rule I shall state and explain after the first is adapted into behavior modification by the traders reading this.

I need to ask you a few questions to better present my Rule Number 1. When the walk light comes on, assume there is traffic that will run the red light at each intersection you cross. What do you do now before you cross the intersection?

ALS: I would double-check and look both ways before crossing.

POP: Of course, that is the correct answer -- you know what I am after. Now, just because you looked both ways before you crossed and each time you cross you looked both ways and each time there wasn't any traffic that ran the stop light, is there any reason to stop looking each time you cross the intersection? Your answer, of course, is no, you won't stop looking.

What kind of limits did I just give you? Are they life-saving limits before you cross the intersection? Yes, they certainly might be, but you will never know that if you follow the restriction each time you cross the intersection. You can't know if it saved your life for you prevented finding out by looking each time.

But what if you don't look and you lost your life. You certainly won't know you should have looked either.

Does the restriction tell you that, if you look, there will never be any traffic running the stop light? No. Does your experience of crossing and looking tell you what the probability of someone running the light will be? You can make an assumption based on your knowledge at this point. What does an assumption do? It actually presents criteria based on proven facts that are a possibility. It in no way gives you a high probability or low probability but the best answer you can present.

I don't want to lose you in this thinking but to point out that it's the same in trading as in crossing an intersection. We need to make our best assumption of what is possible. We must plan for that assumption in trading as long as it is a possibility and not just when it is probable. This is a very important point in understanding Rule Number 1 correctly!

If you were never to look at the intersection until proven wrong for not looking, wouldn't it be too late? It is the same in trading. You must protect yourself from any possibility in trading and not just protect yourself when the probabilities are high.

This will be the surprise side in trading The surprise side is a possible outcome but not a very high or likely probability like today's grain trade. When someone gives you a gift, you are surprised by it. Getting that gift was not a high probability. However, you are prepared for that surprise because you say, "Thank You!"

Most traders plan only for the probability side and that, to them, is always what they consider the winning side. This is the biggest mistake you can make in trading. Instead, you must plan for the losing side.

How you understand your plan is how you will react to a situation. You must learn that, when you are told not to do something in trading, it is not ever the same thing as saying you must do the opposite.

I often get feedback telling me I told someone to do what I never said. As an example, I will tell you not to sell beans today. Would you tell me I told you to buy beans today? It's not funny because most traders would. This is what I mean by "correctly."

We have covered "assumption" and "correctly" in my terms . . . what I expect you to understand in the first rule and second rule. If you don't have those correct, you will not be able to fully understand and accept the two rules for trading required in all plans.

ALS: Let me get this straight! When you say to not do something, you are never telling me I must do the opposite. Seems simple enough. Thanks for making that point by example.

On your meaning when you say "assume," you are telling me there is a possibility or probability based on some fact of the situation that requires me to acknowledge and always have a plan for the possibility or surprise side in trading. Your meaning of the surprise side of trading is the side that presents the possibility but not the highest probability. Am I correct on this?

POP: It really is quite simple. After our dialog, it will be more clear to the traders as to how to interpret our rules. I don't want any misunderstanding. I say with a high probability that the readers will read our dialog again.

We often don't understand how news stories get out of context, but it can be done pretty easily. Lack of proper assumption is routine by lawyers a lot of the time. They'll ask someone something like, "Who is in the picture?" and when they find out it was the defendant, their next question is, "Were you there when the picture was taken?" In their case, it might be proper for information-gathering, but you as a trader must have proper assumptions as you cannot know exactly how a market is going to react each day.

Trading is not a favorable game in most circumstances, and that is what we must use as our assumption in trading. The big mistake made by traders is thinking and expecting trading to be a favorable game.

You have execution costs or slippage when getting in and out of a position as well as commissions as a cost factor to be subtracted from your winnings or added to your losses. The market spends much time in an unpredictable mode. Trends both short- and long-term do exist but not 100% of the time.

The correct way to control positions is to only hold them once they prove to be correct. Let the market tell you your position is proven correct, but never let the market tell you that your position is wrong. You, as a good trader, must always be in command of knowing and telling yourself when your position is bad.

The market will tell you when your position is a good one to hold. Most traders do the opposite of what is correct by removing positions only when proven wrong. Think about that. Your exposure and risk is much higher if you let the market prove you wrong instead of your actions removing positions systematically unless or until the market proves your position correct.

Let me give you an example before we state the first rule. Today let us say you sold beans just like your plan said to do at $6.30 on the open. If that position did not prove you correct, you must remove it to reduce your risk. You decide what is correct according to your plan.

Let us say you expected hedging to come in early and the price to drop from 5 to 8 cents in the first hour. It didn't even drop 3 cents so you remove the position. Say you removed it at $6.29. Just because it showed a profit of 1 cent when you got out did not declare it a good position. However, your exit is a better exit than if you made the market tell you the position was wrong.

When you remove the position because the market proved you wrong, it is always a higher loss, and with stops it also is usually with higher slippage. This is not the same as removing the position because the market proved you wrong -- say, buying back at $6.45 on a $6.42 stop. By making the market prove you correct in order to hold a position is acknowledging that trading is a losers' game and not a winners' game. If you only remove your position because the market proves you wrong, you are acknowledging that trading is a winners' game.

You never want to be in a position that is never proven correct. If you only get out when the market proves you wrong, it is possible to have higher risk due to the longer time period required to prove your position wrong. We will further clarify these thoughts for you further into the book.

So here is 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.

ALS: Phantom, not everyone is going to agree with your first rule. There will be traders who don't feel this is a good rule for them.

POP: Look at it like you would buy a new car. The dealer says you can drive the car you think you want for a month and we will give you credit toward another car if you don't want to keep it. Okay. After a week you decide you don't want this car because it just isn't right for you. You take it back and the dealer says you only owe $80 for rental.

You don't buy the car and keep it until it proves to be the wrong car for you, which could be months from now. If you did, you would lose more of what you would have to pay for the car.

Most traders keep their position until it proves to be wrong for them. I say don't keep any position unless it proves to be correct.

ALS: Yes, but who is to say a position that was not proven correct turns from a bad position to a correct position?

POP: That is the kind of thinking most traders have. They fear being wrong when they get out and that the market will show them they should have stayed with the position. If they don't take early losses, it becomes more difficult to take a loss as it gets larger. However, the market assumption you must make is that big losses will eventually take you out of trading.

My Rule Number 1 is to address the swiftness needed in keeping your losses as small and quick as possible. It won't always prove to be correct, but you will stay in the game this way.

Which would you choose? You have an opportunity of a 10% probability of making money in the long run if you take a position until you have lost 10% of your equity or made 10%. Or take the opportunity to have a 90% probability of making money if you only keep a position for three hours unless it has proven to be correct by that time. It is pretty clear which choice you would make.

Most traders don't know what their choices are when it comes to assumptions about what is possible in trading. Keep in mind that traders are usually unaware that trading is a losers' game. He who loses best will win in the end!

Why not make a time-proven decision to change your behavior to trade the method that gives you the best long-term outlook. Trading is not gambling! Treat it as a business where you only want the best merchandise for the shortest possible time in order to have the maximum profit with the least possible chance of failure. That is what Rule Number 1 does for you.

ALS: I can see the need for much discussion and review of your first rule.

POP: It's critical to have Rule 1 in force by next surprise day. The one thing that teaches most traders to take a small loss is a big loss.

ALS: Yes, but that is expensive behavior modification. My wife, Karen, just gave another parallel example of your Rule Number 1. She points out that you don't go buy clothes, take them home and wear them until they prove to be wrong for you. Instead, you try them on and make sure they have the proper fit and look before you buy them. I like her thoughts along this line.

POP: You can see in ordinary life you try to spend the least amount of money and have the least amount of waste. Why should you do it differently in trading?

ALS: The answer is surely that in trading human elements take over. Everyone knows them and most likely have come face to face with them. They are fear and greed.

POP: We must remove the emotional element as quickly as possible in trading. If you can do it before you put on a position, you have a good start.

Note: To give some insight on Phantom's Rule Number 1, several traders have indicated their experience with it as presented on the Futures Talk traders forum. The following is a copy from one such trader, M T:

I've read Phantom's postings about Rule Number 1. The price action must confirm the position or get out quick. What I have done in trading is to enter a position and have a chart position that is a good spot to exit if the price moves adversely. This would usually either be the previous swing point, which, if violated, would be a signal for a possible new trend and would definitely be the signal for me to exit my position or it would be the first 15-minute high (resistance) and low (support), if it were violated adverse to my position.

So that meant there were times when I entered a position and the price action was flat or slightly adverse but not so adverse as to violate my predetermined chart exit position. I would stay in because there was no violation. I thought this meant I was following Rule Number 1.

I was staying in not because the price action "confirmed" my position but because the price action did not "confirm" my stop-loss chart signal. I was thinking this is what Phantom means. I have to tell you that with this strategy I was keeping my losses small, just by the nature of my plan.

But I was unwittingly violating Phantom's Rule Number 1. I thought I had modified my behavior but, in reality, I was "behaving" incorrectly. It's a very subtle thing, I believe.

Then last night, in a restless sleep thinking about my trading, an inspiration came to me (don't laugh too hard). A lot of my losses had come after I had been in a trade for an hour or longer, where price action was mostly flat but my stop point was never touched. I realized I would have been better off if I had just gotten out in the first 15 minutes. It would have been a loss, but it would not have been as much of a loss as my chart stop point would give me.

Then I realized that is what Phantom means. My position was not confirmed in those first 15 minutes! It wasn't violated according to the nuances of my plan, but it also was NOT confirmed. Get out.

Well, lo and behold, I went back over the last three months of trading and, using the exact entry points (fills) that I used every day, reviewed what would have happened if I had followed this 15-30 minute confirmation rule. Let's just say it made a huge difference. I know back-testing is not completely reliable, but it was significant.

Anyway, thanks Phantom. I'm still learning. I'm still here trading. Started with only a 5K account, day-trading, and I'm still alive without even following your rules. I'm below breakeven. Let's see if I can change that. I'll keep you filled in. Once again, many thanks. You once asked for Rule Number 1 stories. Well, there is mine.

Note: The following is an excerpt from a message in the Futures Talk forum that Phantom presented to help understand Rule Number 1.

Behavior modification is knowing the limits. Let us use basketball shooting as an example. Say you shoot 1,000 times and make an average of less than 50% of your shots. This means you have a better chance of missing than hitting whenever you shoot. After practice, let us say you are able to hit 55% of your shots. You would expect to say that, now when you shoot, you have a better chance the shot will go in than not.

Same in trading. You must know what the limits are! In trading most of you have a greater chance of being wrong than right! Trade accordingly . . . which means expect the limit (being wrong more likely) in your trading.

How can you come out ahead? In the short run, you can only with luck. But in the long run, luck tends to even back the other way. You must trade in the long run!

So what is a trader to do in a losing game? You must trade in the long run! How can you trade in the long run? Only way I know is that you must keep your losses small and take more small losses than small winners to come out ahead. This often means washing a position for the sake of being able to keep in the game.

The theorem now is to assume your position is wrong until the market proves what you positioned is correct. Keep your losses quick and small. Don't ever let the market tell you you're wrong. Always let the market tell you when your position is correct.

It is your job to know you are wrong and not the market's job.

The other side of the coin is that you will get positions that are correct. You must be bigger at that time. This will require a Rule Number 2, which is designed around adding to winners in an unfavorable game to come out ahead in the long run. When you are correct, you must continue to use Rule 1 to keep losses small. It's okay to be wrong small but never okay to be wrong big if you expect to trade in the long run.

Trading is not easy. Most traders just let the market do its thing. The correct way is that you do your thing and control your positioning. You control your positions by using rules that keep you in the game.

Rule 1 is the most important rule in any trade plan. Rule 2 will be the other side of the coin, which must be dealt with if you are expecting to remain in the game in the long run.

Learn to be wrong, fast.

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