Chapter 7: Trading with Rules 1 and 2

Art Simpson (ALS): Phantom, your required rules seem pretty simple. Let's use some practical applications in real-time trading.

Phantom of the Pits (POP): In trading, rules are not meant to be broken for your own sake. The rules bring you to a no judgment-type approach. You design your trade program and approach to trading by keeping the major choice of positions within your program while keeping the confirmation to the market. Your only job is to follow your trade program while obeying Rules 1 and 2.

The rules take away the need to decide while the market is open what to do during the trade day. You will have a good idea what you expect of yourself at all times rather than guessing what is actually going to take place with your positions. You will either be proven correct with your positions or you simply get out of the positions. You don't stick around to get hurt with exposure if the market is not proving you correct.

Yes, you will have exceptions when the rules don't corporate with you and what the markets are doing. This will be a minimum problem, as the rules will keep you in the trading game for long-term trading. You must research your trade program well enough to be able to not enter at bad entry levels. Even if you make a simple mistake such as chasing markets, Rule 1 will still keep you from excessive drawdown during your trading career.

ALS: I notice a few questions coming up (on the Talk forum) about excessive commissions when using Rule 1 . . .

POP: Today, as an example, I bought the DJIA after a 30-point rise and expected to see another 5-point increase within 30 seconds. After 30 seconds I bailed. I had a loss of 1 point on the trade. The market continued to drop against me, and my loss would have been 30-40 times my commission, even if I had paid top commission at the low point.

Now you can't tell me that it is better to stay in and wait for the market to come back than it is to get out and re-evaluate the situation. In the end I would have been right, but my mental standing after a simple Rule 1 trade is a lot better and allows me to have sanity about my next move.

Most traders think it is bad for them to be wrong and, when they are, that's it for the day. Well, being wrong is the best chance to put a correct position on with your next trade as you certainly can trade again. If you keep a trade that never proves to be correct within your program of time element, you will never be able to correct a bad situation but only be able to remove that bad situation. Your mental well-being is worth a lot in trading. You can trade well when you are thinking well.

What I am going to say next is something usually learned not by observation but by making the assumption itself. Most of your money from trading is going to come from trades that take off rather quickly from when you put them on. That is the reason Rule 2 is so important. Just look at most starting trends and the good runs you have once a market turns. The chop-chop markets aren't going to give you good income.

While it is true that being in control of your position in the market rather than the market being in control of what you are going to think about your position next simplifies your trading life, it also greatly enhances your ability to make good trades. The main reason is that you know what to expect and have those expectations up front from the entry of your trades.

If you supervise building a house and you have several trades working on the house, you certainly make sure the plumbing that goes in the foundation is being put in correctly before you walk away and let the foundation be completed. Building a position is the same in trading as in most occupations. If the plumbing and foundation on the house are completed correctly, you move to the next step.

Still, at any time the prior work finished could create a problem. Let's say the foundation settles and cracks the sewer pipe. Would you continue on the house? Of course, you wouldn't. Well, no way will you continue with a trade that proved correct but now shows problems.

You can never let your guard down in trading. You must always know what the next step is for you in any situation. You rehearse your criteria of a trade, and it becomes second nature -- just like driving a car becomes a subconscious effort for you when you are proficient at it.

You start out by not knowing what the trade will ever do when you put it on. You can never control what the market will do or how the orders will enter the pits. You cannot tell me when a large fund is going to take a profit or enter a new position. Nor can anyone else tell you for certain.

All you can do is build your criteria or trade plan to take every angle that is important into account. I can give you a plan that will catch every move, but you will catch moves that are the wrong way, too.

Along with that plan to never miss a move, I can give you the big drawdown and the rules that will eat you alive if you can't afford the drawdown. In the end you will have what you think is a very small profit for all your time and patience of going along with the plan. But, yes, you will have a profit.

That is not what the usual trader is about. He is not in this game to earn a few extra bucks for his vacation. He is always after a better return than most would consider fair in any other investment. That is another reason for creating Rule 1. You are expecting a big reward and fail to see the big risk that faces you at first. Somewhere along the way you must face the situation for what it is.

Trading is a loser's game. You must learn how to lose. The biggest loser who loses small will continue in the game.

Obviously, the small trader who loses big will quickly go to the sidelines. Sometimes the sidelines are not even there for a few. Their losses take away their hearts. Believe me, for I have seen them. It is the saddest thing in the world to take away someone's dream -- more so when they never knew the enemy in the first place.

A trader must know and accept what the market can do along the damage side to equity, to mental peace and to self-esteem. Every day is a big surprise in trading. You must plan for the surprise from the time you put your position in place. The big surprise can sometimes be a friend, but you must be prepared for it.

Why do I say the market is going to give you a surprise? Can you tell me exactly how far a market will move and then retrace before continuing? Or if it will continue?

What you can do is to eliminate your reactions to what the market does to you. You do this by not giving the market the power to control your position or emotions with adverse market moves. You start out expecting the adverse market moves and plan your action based on those outcomes.

When you place a trade, don't ever think this is the only trade to make. There are thousands of trades you can make. You aren't going to miss a move for long if you trade correctly. You aren't going to chase markets if you trade correctly. You must have a plan to enter positions based on each market's criteria.

Rule 1 is the rule that keeps you in control at all times when that position is in place.

Behavior modification can take place in many forms, but you need a rule to show you what must be done at all times. One trader suggested the rubber-band method. Each time you took a big loss or did some bad trading, you would snap the rubber-band on your wrist -- that is, if you remembered to do it. I don't like this method, but it is better than a lot of others.

Just because you put on a trade that lost money is no reason to feel bad. If you put a position on and lose big money, that is when you can feel very bad.

With Rule 1 you are freeing yourself from having to feel bad. You put the trade on based on the trade plan. The market either confirms and you now have a good position, or it doesn't confirm and you are not okay with the position and you get out.

Simple! Only a big deal if you don't get out when it isn't confirmed as a good position. No need to ever feel bad. Most of your trades that don't confirm within a logical time frame are usually going to look bad sooner or later. Why not take the sooner?

ALS: It's beginning to look like it takes more thought to put a trade on than the time you're going to be in it if you're wrong . . . or I mean not proven to be in a correct position!

POP: The logical step is to have the plan in place for the next step before you put on the trade. I would guess that 95% of the traders put the trade on and then wait for the market to prove they have a bad position. Even if the position is correct, their next step is wondering when to get out. It's human nature to do it their way. It causes a lot of unsuspecting reactions in their lives.

ALS: Human nature is as you say. I know you did some research on human nature of traders and non-traders. Perhaps we can talk about some of your data.

POP: I'll tell you what I would prefer to do. It would be better to just suggest some of the experiments and let the readers come to their own conclusions. Let's keep that in the behavior modification tips.

ALS: There were some questions on when to get out of a position. I realize this is out of order here, but I know we need to include Rule 2.

POP: That's okay, as a common question is when do you know when to get out of a position. Actually Rule 2 addresses this very well because it says to press your winners correctly without exception. Rather than getting out of a position with the proper criteria, you will be increasing your position. You only do the adding with correctly proven positions.

The time to get out of a position is not when the market is proving your position to be a correct one. You have the opportunity to be wrong as often as correct, but when you are already proven correct, this is certainly the time to step off of first base.

We have two rules to keep us protected from our lack of certainty and enforcement of certainty. Many trading plans have the trader in a position at all times, the thinking being that the market is either going to go up or go down.

Well, this is just absolutely an idiot's plan. Maybe I shouldn't say it so strongly as I should still have an open mind. I have to put this in the category of thinking a statement that says not to do something actually says to do the opposite of that statement.

Too many times I have watched a fund bid the market so they can sell the market. It's a plan to take advantage of the surprise element in the markets. There was the day when you would only see me on both sides only when I was wrong. I am wrong a lot more lately. That's not bad either!

The readers are surely asking by now: How do we use these two rules?

It's easier to use real-time quotes and markets to prove the points, but because we only have hindsight here, we will do it differently. Let's use the old common day-trading technique, on which I am not going to give you judgment at this time.

You say your plan wants you long if you take out the opening range! Okay, let us say we are trading onions and the price is 1000 ($10). The price goes to 1001 and the opening range was 999-1000. Your plan says "buy" so you buy. You get filled at 1002! Why 1002? Well, execution is getting the position filled! You gave up a slip of 1 tick. Not bad. Most of the time it is small.

We can go into the importance of execution now or continue the trade. Let us continue the nature of the trade and cover the importance of execution later.

Now that you are long at 1002, you are using Rule 1. You assume this is a bad trade until the market proves to you that the trade is good. If the market does not prove this a good trade, you are going to exit the trade. Fine so far!

What criteria in your day-trading plan says you are right? Most say what determines you are wrong. Not us! We only want to know the criteria for being right. Okay, for us our program says, "If in the first half hour the market opens lower than yesterday and moves higher, expect a move above the prior day's high within the first half day of trading."

Our program also says the position is only correct if the market stays in the prior day's top half in the first half hour. Our last criteria for the trade is that it must show a 3-point profit by the close. Now, I ask you, what is your next step?

Your criteria for remaining in this position is only when the requirements of your data indicate to you the position is correct. The other data you would need in the program is yesterday's range, yesterday's high and yesterday's close. Your day-trading program says to use the old rule of opening range breakout. Yesterday's data is critical in knowing when you are correct.

For our example we will use yesterday's high as 997 and yesterday's range as 991-997. It gets interesting here because you are going to decide whether you will exit the position. At the end of 30 minutes the market is at 997. What would you do?

The first criterion of our trade program is in conflict with your day-trading strategy, but you still bought the opening range breakout. We don't care if the two are in conflict! We only care what causes our position to be correct.

Okay so far. The market has been open a half hour and our price is 997. As you can see, you must know your trade plan before the market opens and what you are required to do. What makes your position correct? You must be in the top half of yesterday's range after the first half hour of trading.

Are you indeed in the top half of the range from yesterday?

I am going to give you the answer indirectly so you can't slip down to find it. We will go to the next step here. At the end of the first half day of trading the price is 996. Are you still in the position? You did take out the prior day's high but you didn't open lower.

Okay we still did it! Stayed in the first half hour. That's right.

Now the first half day price is down to 996 and we bought at 1002 -- still in the top half of yesterday's range. Okay, we are still in the position. Bad entry, though, as our plans conflicted. Should have only taken the position if it opened lower. It didn't. Well, okay, because we are day-traders, we used the opening range breakout. Our entry wasn't the best but so what!

At the end of the day the market is at 992. Are we still in the position? You have the right answer but why? The market had to be at 1005 to keep the position -- it had to show a 3-point profit on the close.

How would you get out of this position? You would have used a stop close only order after the first half day to sell the position: 1004 stop close only.

The example gives you several interesting situations and perhaps just as many questions about Rule 1. Rule 1 will not protect you from wrong entries! That is your job. You must solve your own conflicts in your trading. Rule 1 did take you out of the trade on the close because you were not proven correct based on the required criteria.

Keep in mind this example is a very different situation than you would expect of your trading program. You can't have a program that says, if the market doesn't go to 980, it looks for the market to go to 1100 sometime. There has to be a time frame on when to expect 1100.

When a market doesn't go up anymore, somewhere it isn't correct to stay in the position, regardless of the expectations. The market must prove and continue to prove. There can be simple or complex strategies in your program, but when the position is not going according to the expectations, it is wrong -- not when it proves your stop price got hit.

Stops? Yes, we did use a stop to get out. We did not use the stop as the criteria for getting out. The stop did not prove us wrong, but the criteria proved us wrong.

I realize that in the example we put conflict, various criteria that was required for the position to be correct and a bad entry. Does this point out more than just Rule 1 to you? Rule 1 will get you out of a position that is not proven correct, but it won't fix a bad entry. Know your plan before the market opens! If you had known your plan in this example prior to opening, you would have never positioned as you did.

ALS: Okay, I see your point. But how can most traders with jobs trade as the example shows?

POP: I can give you other examples, but it all comes down to the criteria for proving a position correct. If you trade by looking in the newspaper each night, your trading plan will be different and your positions must be smaller as you are going to need wider ranges to work with your criteria.

In the example above, you could never have placed the order to buy the opening range breakout; therefore, it would never have been in your plans. You may have had criteria that said to buy yesterday's low plus one tick or two ticks and a time of day order that said, "TOD10:00a.m. sell 993 stop."

The market would have to be in the bottom half after the first half hour to get out as the criteria indicated that, to be correct, the market had to be in in the top half of the range after first half hour.

The other criteria could be met with either OCO (one cancels other) orders or stop limit close only orders. Not all brokers take all orders so your plan must include this possibility of difficulty in trading.

For each tool you lose or don't have in trading, you must reduce your position accordingly to have an effective long-range program. The farther away you are from all the tools you need, the wider road you must have. Reduce the size of your car (position) for the road that isn't wider.

Now that we have your attention, I think it is clear to see how just two simple rules can be exploited. You can't help but understand why trading can be so difficult. You want to be a knowledgeable trader, and you need to take all of the difficulty out of your daily trading when the market is closed.

ALS: I would like to ask you a question that I have wondered over the past couple of decades: When you take a position, do you feel you have taken a good position?

POP: Never! Do you understand my NO? If a trader thinks at any time they have a very good trade, they are going to get removed from trading very quickly. I make the best trade on my trade probabilities program, but who is to say my guess is better than someone else's? Never do I know it is a good trade until it proves to be.

To feel you are making a good trade is signing your death warrant in trading. The majority of traders do certainly feel they have a good handle on a trade and are only putting on good trades.

There is an old saying that the market is never wrong. I don't mean to protest directly, but I think that is not always the case. However, that is what we must trade by in price.

Markets go to extremes, and that is certainly a challenge in always being right. Once we know markets go to extremes, we can put that on our side and exploit the advantage. Very few traders exploit that advantage. You must press your winners with Rule 2.

Oftentimes, you won't understand the importance of pressing the winners, but it makes no difference as to reason when you collect your profits. Who really cares if the market is or isn't always correct? The market price is what we are measuring our equity with and always will.

In trading nothing goes right for most traders unless they take total control of positioning and letting the market only prove when a position is correct. I know I am repeating myself, but there is no better way to impress information of this insight upon the readers.

I don't want to see any small traders wiped off the map when it comes to trading, but that is what happens to most of them. They are small and are stopped by the big traders and funds most of the time. If they can understand the urgency of not letting the big traders ruin their plans and hopes, they will do much better.

The first step is what we are pointing out. I know because I have driven the big cars on the small tracks. It is better to drive the small car on the big track, but it just never comes out the same. With a little understanding we shall change that for them.

ALS: I remember an experiment that proved very successful with a group of traders or would-be traders. Do you foresee that situation again?

POP: I have no idea what you are talking about! I wish them well. No, I think an individual is the best minority of one I have ever hoped to reward. Only one at a time in trading is fine with me. It is their dream and my reality. They have to make it happen. If it doesn't, don't blame the messenger. Look in the mirror.

ALS: You and I are traders, not writers. Doesn't it seem strange to you to bring forward your thoughts on trading for others to read?

POP: You may end up a better writer than you think. It's perfect as the best time to learn about trading is when the market is closed. Most traders only learn when the market is open, and what a mistake that can be! It can be costly and emotional. Both are wrong sides of the coin.

ALS: We need some examples of other questions the traders and readers will have on Rule 2. When do we press a winner, and when do we get out of our winners?

POP: I know they would like me to say this is the plan and it is very simple. I can't say that as it takes work, experience and execution at all times.

Most traders -- I don't mean to group them so severely and handicap them -- but it is true most traders look to remove their positions just as soon as they prove them right. They forget what their true purpose in trading really is. It is not only to make as much money as possible but, most important, to make it in the least amount of time. This keeps them from facing the problem of drawdown because they are not trading to face drawdown but only to trade to make money.

I will never forget my mother's words when I was honest with her on a trade one day. She asked how I did the day she visited the exchange. I said I lost a large sum of money. Well, her remark was, "I wouldn't have done that!"

I didn't attend to my business that day and left a trade on. You don't do that. But that is just what traders do everyday. They leave trades on when their mother visits! Believe me, Your mother will visit you every day when you trade! You have to attend to your job of cutting losses.

Just a couple of days ago, I was asked to go out on a nice boat trip for five days. It is costly if you don't attend to your affairs. There are times you must, above all else, attend to your positions. There are no long-term trades! Only trades that turn into long-term held positions.

Don't ever let anyone tell you they have a long-term position on at any time. How do they know? How does anyone know? Only the market can tell you, and it opens every trading day. Don't ask me what I think. It doesn't matter. I can only give you the best odds. It is up to you to believe what the market is telling you.

ALS: How about Rule 2?

POP: What can I say other than set up an example. Okay, let us say beans opened today at 85-88 and after the first half hour 85 was still the low but 90 was the high. What would you do if it were 15 higher at 88 and you put on your position yesterday? Would you get out and take your profits, take half your profits or add to the position?

I will tell you what most will do: They will take all of their profits. That is when you know your position was proven correct again from yesterday. What do you think the correct answer is?

You must use Rule 2. You certainly don't reverse pyramid by putting the same or bigger positions on because the market could very well take out the lows quickly, and you will have to salvage what you increased if wrong. Do it in smaller numbers. Your plan must tell you when you know that what you did yesterday is confirmed okay and that you must increase your position somewhere along the line.

Sure, the argument is, "But I am not sure it will keep going up." So what? We never really know that anyway. So what is different about going with the current certainty?

As long as you have Rule 1, it makes no difference if you are wrong because you have all the doors covered. Don't ever lose sight of Rule 1 when using Rule 2.

Some traders will say they don't really know where to put the trade on price-wise. Yes, you do! The word E-X-E-C-U-T-I-O-N means make sure you guarantee you have that added position.

There are times when execution is the most important aspect of a trade. If you can't get a position on, you sure can't take one off. I know you have heard that statement in the past, but it is with good foundation. You must say "at the market" in those situations.

Okay, today we pointed out a situation where it was obvious to add. Looking back, it is always obvious. What matters is that after enough lead on your position after you have put some time between the position and an advancing price of a little magnitude, you must be pretty sure it's time to take your profit.

Well, don't take your profit. Add to your position. Then, if it doesn't prove correct, take your remaining profit and expect to re-enter at a different level. So what if you lose a few ticks because you put an added position on and it was wrong! You will get enough lead on adds that you won't ever think twice after you see the runaway markets! It isn't because I say so but because the market catches traders the wrong way. It is seldom that it's not the case.

When a market gaps higher or lower, you are in a position to take the profit-takers position away from them. Do it, but use Rule 1 when you do. That way you will never worry if you are in a correct position or not. Doesn't matter anyway because with your Rule 1, you will do the right thing. It is.never bad to be wrong. Only then can you benefit when you are correct.

Most traders will make a trade and lose a good amount and miss the next trade. Out of step with the market is bad and it gets worse. Don't get out of cadence for long on any one trade. That way you can half step right back in line.

ALS: Phantom, you are acting as if everyone can do what you explained.

POP: Not everyone can do what they must do. Learn what you are capable of doing and stick to those parameters. Use the protection rules in your parameters. Don't modify them or misunderstand them for your own satisfaction. Use them as they were meant to be used. They will hurt you if you don't use them correctly.

ALS: We could use more examples of how to use your rules, but I feel the readers will get a little overwhelmed if we continue to throw examples at them. We could address every situation and eliminate most of the required interpretation by the traders. I don't think we should do that at this time.

POP: Yes, I totally agree, as the integrity of a subject is not always how well it is presented but how well, in this case, it is impressed upon traders. It is up to the trader to fully comprehend their part of what is required of themselves. They can make mistakes but as long as they use the rules properly, they will stay in the game.

It is a fine line when creating a program to trade markets. I have always suggested they establish their own criteria based on the best knowledge they can find. You start with point-and-figure charting to understand the characteristics of your market. Even if it is someone else's chart, you must see what the market is capable of doing to traders.

I am not saying that there aren't good trading programs but only that the trader must fully understand where the criteria in these programs are establishing the entries and exits. These programs will never have Rules 1 and 2 in them so you will have to incorporate them, which could void the program.

So be careful and express your concern to the program vendor on these matters. Your concern is to keep your drawdown within reason to allow you to trade forever.

So, Art, have we covered it yet?

ALS: Never in a thousand books can we cover it completely, but I think we have made our point and you have made your mark on the reader's thinking.

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