Chapter 6: Rule Number 2

Art Simpson (ALS): Phantom, do you want to continue on Rule 1 or is it time to move on to Rule 2?

Phantom of the Pits (POP): There will be lots more on both rules so let's get to Rule 2 and see the other side of the coin. We will need to get to the qualifier of Rule 2, but we will do that later. We'll state Rule 2 right now:

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.

ALS: Phantom, what do you say to the traders who are going to ask you, if they must add without exception, why is there any question as to how to add correctly? Doesn't the fact a proven position is correct indicate it is time to add?

POP: Adding can certainly be done this way, but it is not always good for all trade plans. I oftentimes add immediately when my position has been proven correct because I tend to do it in smaller steps and work more long-term trades.

Let us say you are only a day-trader trying to take a little out of the market each day. You will find your adds at the wrong place by adding as soon as your position is proven correct due to the nature of the markets. They give you back and forth action much of the time, especially looking at it as a day-trade.

One correct way for a day-trader is to see that the position is proven correct and then add at a proper retracement. This will not be the case for a trend trader. A trend trader would most likely have at least one add at a breakout or breakaway gap. It all depends on your trade plan. Your method of adding must be validated by your trade plan.

Day-traders will have a problem with Rule 2 unless they position properly and understand that their adds must only be made correctly. Day-traders are in for the quick profit so it is hard to have a good add plan. Their best trade is to put all positions on at once -- original and adds -- and use Rule 1 to take them off unless or until proven correct. Believe me, this is the proper probability in a loser's game like trading.

Rule 2 says you must add to your winners without exception. As a day-trader, you are only keeping a position if proven correct or until proven correct. In a sense the market is deciding how large your position will be. The variable can be from all to none in this situation.

Trend traders will get larger when they are correct, but day-traders will start larger and get smaller when they are wrong. Day-traders can be large when they are wrong, but trend traders will never be large when they are wrong.

This is due to the nature of a loser's game for day-traders. By reducing your positions when wrong, your exposure is not extreme for a day-trader, provided Rule 1 continues to be followed.

Exposure and risk are also an element of time in a position. That is the edge day-traders expect to work to their advantage. Trend traders are expecting higher probabilities in smoothing out the swings.

ALS: Aren't you changing the rule here for day-traders?

POP: Rule 2 must be used if you expect to make money in the long run. Your validation of how you add is according to your trade plan, and a day-trading plan is certainly going to be geared for the quick profit so why shouldn't you have your biggest position to work with from the start? Right or wrong, you are going to use Rule 1 to protect at all cost.

Criteria will be different for the type of trading you do, and scalping or day-trading has a lower probability of making money than most think. You have to be right when you get in and out and twice the execution cost for each trade. A day-trader takes most positions on a fade of an expected range and on what they consider to be the edge. "Correctly" for day-traders is different than "correctly" for trend traders.

ALS: Wouldn't you say that adding for day-traders isn't always a good rule?

POP: Adding correctly regardless of your time period is useful in making bigger gains in the long run. Day-trading is certainly a shorter run. A day-trader should cheapen the cost of what they have, and to do this you almost certainly have to have your biggest position on first.

I use to watch a very good trader put a big position on and take it off until it proved to be correct. He made good trades and ended up with bigger gains by doing it that way than by adding after being proven right.

What you are missing here is his positions were larger at first, and this really is the Rule 2 in that you still are larger when you are correct than if you had added later this way. The drawback is that you are larger when you are wrong, too, but it's still a protected position if you use Rule 1 properly. It is acceptable but, again, I must remind you that Rule 1 is critical here.

It looks like a modified Rule 2, but as I stated, your trade plan determines your method of adding. It is understood that you want to have a larger position when correct. This is a way to do a trade when you don't have an established trend and the probabilities are lower.

I can't rule out this method. I have used it on short trades. When I feel I am trading an established trend, I have criteria for adding that gives better positioning.

These two rules are to give you the long-term ability to continue to trade with the least amount of drawdown and the best possibility of making the most money in the long run. Huge drawdown is the critical reason some traders go out of the business.

You must start your trade plan with rules created to protect your equity. I am presenting those rules to incorporate into your plan. Experience has proven these rules a necessity in survival and reaching your objective of making the most return with the least amount of risk.

The followup dialog below on Rule 2 took place as a result of feedback from the Futures Talk forum when traders expressed their questions about Rule 2.

Followup to Rule 2

It is clear that the traders are interested in more review of Rule 2. From the posts on the forum, it seems to be a problem of understanding not only why to use Rule 2 but also exactly how they should use the rule.

I asked Phantom to give us more detail on his Rule 2 so it can become more effective for the traders. Phantom feels there are several problems in understanding his Rule 2 from reading the posts of the trader's forum. We will address a few of the problems and also try to explain more on how to use Rule 2..

ALS: Phantom, it looks like your Rule 2 is not a good rule for most of the traders who have given return input on your rule?

POP: By now, you should see why we are spending so much time on just Rules 1 and 2. Rule 1 understanding has been pretty good so far. Rule 2 has been a problem. I could see that coming in the past posts. There is doubt in traders' minds as to the real purpose of Rule 2 and why they should be saddled with a rule that requires them to put a bigger position on than they want to have.

The traders aren't going to like what I am going to tell them here, but I know they want me to be totally honest with them. There are going to be several reasons why a trader does not want to come up with a plan to add to winning positions. I will try to cover some of them.

ALS: Why is it that Rule 2 doesn't seem to work for most of the traders?

POP: One simple fact! That fact is they are putting their entire position on at their entry into a market. This is not Rule 2's intent. A total position is a series of positions until the complete expected position is established. They should only have their entire position established upon getting the move as expected. Rule 2 addresses this expectation.

Keep in mind that I don't blame the traders for their views on my Rule 2. It is not their thinking but their trading situation we must address as a place to start with Rule 2. It is a solid rule and its importance cannot be diminished in trading. Until you see the reward from Rule 2, it is very difficult to understand a bigger position being anything but wrong to you as a trader.

That, of course, is going to be some of your behavior modification (covered in a later chapter). Learning by experience is the only way most traders will be able to accept this rule. It is important to learn this rule by more than just example. It is not a rule you learn by making a mistake. It is a rule you learn by being rewarded for using the rule.

How can we reward the traders for using this rule by example? I don't think we really can. Therefore, we will explain why they are having difficulties and ask them to soul search as to the truth of the problem being within their own situation.

The nature of trading is that more often you see a negative effect from what you have just done. Seldom do you see or remember the good effects from the proper trading as often as the negative. This will leave a plan to add to winners on the back burner when it is time to add unless you fully understand the need for this rule.

The first problem with understanding Rule 2 is that any time a trader cannot or does not incorporate a plan to add to winners, they may be under-funded and unable to margin properly the additional positions in the add. Another aspect of being under-funded may only be that over-trading in the original position is actually a problem from the start.

Any time you plan a trade program, you must consider what size position you are looking to establish. If your position, as mine often is, is that you will have a total of six units upon completion of your position entering, you can have a better idea of what you must fund. You need to be able to fund the position properly from the start.

I believe most traders want to have a certain size position, and that is the position they place from the start. This is not a correct way to allow you to use Rule 1 and definitely Rule 2 properly. When you see an expected move from the start of trading, your thinking is counter to ever adding in the first place.

True, you should be at least twice as big or larger when right than when wrong, but you must work that position into your trading plan. You never risk it all on the initial position being correct or you are defeating the rule. You are trading more like a day-trader if you put it all on at once.

Another reason for problems with Rule 2 is that traders are actually day-trading so they won't have undue risk in their positions. This will cut their odds of making the goals expected in any kind of move. It is more of a hit-and-run type trading.

This type of trading leaves you vulnerable to the flow of orders into the pit. We can never estimate the exact quantity or direction of order flow for more than a very short period of time except in established moves. Sure, we have our three-phase theory, and it does work to an extent but never good enough for us to know without seeing beforehand just where the price turns are going to be. Looking back, we can always pick the price turns and possible support and resistance.

I want the traders to ask themselves two questions:

"Do you put only part of your expected position on from the initial entry?

"Are you planning for adds prior to your initial trade?"

If the answer to either of these questions is no, then you must go back and rethink your trading program. I have said it before. If you can think it, you can do it. Perhaps the traders aren't thinking it to begin with because it certainly is not expected thinking without the proper planning.

I knew we would have problems trying to convey Rule 2, and that is part of the reason we have stepped back to wait and see the blank stares. We have those blank stares as I can tell from reading the posts and resistance to Rule 2.

That is okay for it is what can be expected from such a rule. I don't want to get into telling the traders their game plan for actual trades or their trading programs. What I do want to do is to establish that you must consider the favorable side of adding to positions when they are correct.

More thought must go into Rule 2 as it is not as self-explanatory as Rule 1. It is true that Rule 2 is what makes my money for me. It does it in the long run and not the short run.

There are several good aspects to the rule. We have discussed a couple of them previously. The fact that reinforcing a correct position actually keeps you thinking correctly is one of the important reasons for Rule 2. Another aspect is that, of course, you will be with a larger position when you are correct.

I think one of the of the hidden benefits of using Rule 2 in your trading plan is that it will actually keep you from over-trading from the entry through to the end of the position if used properly.

By incorporating Rule 2 in your game plan from the start, you will be eliminating the desire to be proud when the market moves your way and want to take profits to show that you are right. Traders love to be right.

This is your enemy . . . to love to be right. Your motivation must be to love to do the right thing in trading by either reinforcing correctly your position or removing it should it not prove to be correct.

You see, when you think you are right in the market, this is just the beginning of your trade -- not the time to take your profits to say to the world, "See, I was right!" Let me ask you, "Who really cares if you were right?" So what?

You will become the best trader you can be by being wrong small, not right small! Get that in your mind now. You are going to have to press your winners if you really consider yourself to have the ability to make a living or extra income from trading. Otherwise, face the truth that you are only playing to break even.

Who wants to play for a tie? I sure don't!

I remember a trader asking me how I felt about making money in my early days. She wanted to know how much I made. I indicated to her that if I did not make at least a thousand dollars a day, it wasn't even worth trading to me. She said she would be happy with a hundred a day.

I asked her if she added to winners. She said there was no reason to add to winners. I didn't mean to laugh at her but at what she said. I pointed out to her that, if she had three days a week where she made money and two where she lost, she would be in the hole for it would be a 50/50 game if she was never able to add to winners.

My point was that you must make bigger money on your good days and not just the same amount of money you lose on your bad days. You would be better off working for a living rather than trading if that is the case.

Now, I am not laughing at anyone! I meant what I said about my statements of respect for the small trader! They need to know just why and how important it is to press winners before they will ever be able to approach the idea into their trading plans.

It isn't an obvious thought to think that, even before you trade, you must have a plan to be bigger when the market is going your way. The first thought is always what size position to take to reach your goal.

You must understand that you are not the one who will determine your market position size. It is going to be the market and must always be the market. Rule 2 is going to tell you to put a complete plan into effect before taking the initial position.

The light is starting to come on about Rule 2 now. I can see some raised eyebrows in anticipation of what is possible now. Not only is Rule 2 a saver of your drawdown by its proper use, but it is an enforcer in pointing out that you are looking to have a complete position when your expected move allows you to be totally positioned.

I am a little ashamed I did this, but I purposely held back the best part of the rule to see who would come up with the important aspects of Rule 2. Rule 1 was hit bullseye by at least half of those on the forum who thought it out.

Rule 2 may have had a few who understood it but didn't really make a remark on it. I do know one who did hit the nail on the head: Gerald Mullins. (Perhaps I better get permission to use his name before the book version comes out.) At any rate, there were others, I think, who did not indicate much about Rule 2 who most likely had some good clues.

On adding to winning positions, I could give you my trading plan and my signals and tell you exactly when to add. But that would be doing the same thing as digging out the Mississippi on the west side and changing its course. I would be better off trading for you, and you would be better off giving me your money to trade. I don't want that at all. Don't forget my faith in the small trader. You shall have to see the prospects of Rule 2 more clearly yourself.

I cannot help you with over-trading or being under-margined. You must correct that situation before you can ever expect to be on even ground with the big funds. You must at all times be able to put only a portion of your expected position on at entry and be able to at least double your size somewhere along the route of an expected move.

The protection is Rule 1, but the biggest protection is Rule 2! Now I am going to tell you why Rule 2 is the biggest protection of all. You never suspected what I am going to point out.

You have all heard that you should not add to a loser! Well, Rule 2 takes care of that from the start by keeping you with a smaller entry position in the first place. You never have your entire position until you are getting the move you had expected.

Now, why would I encourage you to have half of your total position at entry? Because it is a losers' game from the start and you knew that from Rule 1. Now, from Rule 2, you find out that, to trade it correctly, you were never really suppose to have your initial position upon your entry of a trade.

Can you tell me that you don't expect the market to fade your trade to a slight point? You really are going to pick a range when you are right, and you are going to be at least half size when you are not proven to be correct. When you take your loss with Rule 1, it is a milder way of slapping your equity from the start.

Are you beginning to see any of the value of Rule 2 yet? We can go into examples but understanding the rule is what we want now. Trading programs will all have different aspects of entry and adding. It is up to you now to understand Rule 2 and try to incorporate it into your plans.

I am giving you a rule that not only makes you larger when you are right but keeps you smaller when you are wrong from the start of a position. I am also giving you a way to not over-trade. It is up to you to make sure you are properly funded to make this step an important one in your favor.

Never over-trading was one of the criteria of my Rule 2. A lot of thought went into Rules 1 and 2, and it must come out the other side for you to understand before it will work well.

Now, you have the background of Rule 2 and can understand it a little better. Whether we go any further trying to impress this rule upon traders depends upon its acceptance by the traders in whom I have complete faith. They shall continue to live up to my expectations, and I shall continue to be proud of the faith I have in them.

I say it again and I know it for sure: Clothes makes the man, in most cases, if that man lets it change his thinking and feeling to a point of betterment. Knowledge is your new suit.

ALS: Okay, you are telling the readers that using Rule 2 properly will keep them from over-trading because their entire position is never in place until they have added the remainder of their initially expected position only after the market has proven the position correct along the journey of the move they are working with in the trade.

What the traders have failed to see is that, to correctly use Rule 2, they never put the entire desired position on until or unless Rule 2 needs to be used along the way. Am I correct so far?

POP: Yes, you are. What other points am I making?

ALS: Your Rule 2 is also protection from adding to losers and keeping the initial position smaller until proven correct. Is that right?

POP: Not exactly. What I want them to understand about that point is that they will only get bigger when their criteria in their trading program tells them it is time to add. They will not add just because the initial position has been proven correct. When they have completed their adding of additional
positions, then and only then should they have their entire expected position
established.

Traders are over-trading most of the time when they say they can't seem to justify adding to an existing position. Most of the time a trader does not think about the reason for adding because they have their initial position on from the start. This is their maximum risk from the start.

That is never what you want in trading. You must take some risk but never your maximum. That is exactly what they are doing if they cannot plan for added positions along the way.

ALS: It is so obvious now! It is just like playing chess and seeing after the stalemate that you could have won so easily if you had just thought there could have been a stalemate.

POP: Yes, the trader is playing for a stalemate if they don't use Rule 2 in some form somewhere along the way in their trading plan. Isn't it simple?

To want to have a correct position from the start is over-trading when you place an entire position. Traders don't add because they have their position. The big drawdown is that when that original initial position is wrong, their losses are as large as their gains seem to be if they were right. We don't want that.

Keep in mind that trading is always a losing game unless you change the odds. With Rule 1 and more so with Rule 2, you are changing what you can in trading to your advantage. If any position is taken without forethought about adding to it later when it has been a proven correct position, you are in a 50/50 game at best.

ALS: You also said the light should start coming on for the traders. Do you think this is enough to digest or should we continue?

POP: It's time to step back and let them get off the elevator. Let us see how many frowns we still have and if we need to review more on Rule 2. My faith in the small trader is that they are the best majority of one I could ever want in my class. I am willing to stoop down and consider the questions of my little Phantoms. I can do it for a day, and I can do it always?

I am trying to make it possible for them to become the best traders they can be. I know they will grow up faster than they realize. Good luck to them as we see what their new plans become.

ALS: Any lights coming on? Do we understand CORRECTLY yet?

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