 I  have  since  lostthe book and I couldn’t ﬁnd it again searching the Web. I probably threw itout, now that I have a better grasp on what I am doing every day. Aboutthe only thing I remember about the book was how intoxicating it felt toread something for the ﬁrst time that provided me with such a simple so-lution  to  my  goal  of  getting  rich  in  the  markets.  I  was  too  uneducated(some would say naive) to understand that it wasn’t going to be that sim-ple. There were numerous books and services available for people inter-ested  in  trading  equities,  but  there  was  very  little  data  availablespeciﬁcally for traders interested in futures or options. The cash FOREXmarkets were the exclusive domain of banks and private investors, so thatmarket wasn’t even available. For me as a new trader, the best course ofaction was to actually go to work in the industry and learn the businessfrom the inside out. So I did.
After  I  began  trading—and  accumulating  losses—I  continued  toravenously devour anything I could ﬁnd on market analysis. At the time,the alleged science of technical analysis was still in its infancy. Most ofthe  technical  indicators  that  are  used  by  traders  today  were  just  con-cepts. Commonly used indicators such as Williams %R, MACD, and the
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commodity  channel  index  (CCI)  had  not  been  developed  or  were  not licensed  to  all  the  available  charting  services.  Many  indicators  were formulas  you  had  to  compute  manually  and  then  physically  mark  the results  on  a  paper  chart.  At  the  time,  having  a  real-time  data  feed from  the  exchanges  was  very  costly  and  required  dedicated  computerhardware.  There  was  no  online  access  to  information  like  there  is  to-day, and you needed an actual broker available to place trades and re-port ﬁlls. All of what we take for granted today as a professional-level,online market presence literally had not been invented yet; and this wasonly 20 years ago. (As a side note, I actually met George Lane, the de-veloper of stochastics, at the Chicago Board of Trade just after I beganworking  full-time  in  the  markets  in  1987.  He  was  considered  a  god  atthe time.)
I continued to read, study, chart, and trade for years, spending hugesums  of  money  on  real-time  data  feeds,  books,  audio  courses,  chartingservices, live seminars, and so on. During this educational experience, atno time did any of these self-created gurus ever mention that the futuresand options markets were zero-sum transactions. The only exposure I ini-tially had to the concept of zero-sum transactions was when I passed mySeries III brokers exam. I didn’t know how critical that information wouldbe until after I had my ﬁrst blowout. In fact, when I teach my “Psychologyof Trading” seminar today, there is always at least one person in the audi-ence who has been trading for years but has never even heard the termand has no clue what it means. The inherent nature of zero-sum transac-tions  makes  analysis  of  the  markets  a  very  different  thing  than  the  ana-lysts and chartists would have you believe.
During this part of my development as a trader I continued to havenet losses. I searched and searched for the cause of my losses, believing,like most novices do, that the problem must be at least in part due to howI was doing my analysis. What made this period so frustrating for me wasthat  the  root  problem  was  exactly  that—how  I  was  doing  my  marketanalysis—but real analysis of the markets has very little to do with tech-nical  analysis  or  technical  indicators.  Knowing  that  difference  is  whatmade all the education come together for me. You need to know that dif-ference as well, or your results will remain net losses, because zero-sumtransactions cannot be mathematically analyzed nor predicted with anycertainty. Proponents of technical analysis methods will have a ﬁeld daywith that statement, but I am going to show you something that will helpyou  understand  that  the  limits  of  technical  analysis,  when  properlyviewed  in  the  context  of  zero-sum  transactions,  are  the  very  thing  thatmakes it valuable.
The very nature of zero-sum transactions means that exactly 50% ofexecuted  contracts  have  proﬁt  potential.  Once  the  net  order  ﬂow  has
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moved the traded price away from the executed entry, it is impossible forboth of the open positions to show a proﬁt. Without advance knowledgeof the net order ﬂow, your actual mathematical probability for a winningtrade once you have executed for your entry is 50%. Bear in mind, I am notusing any trading hypothesis, analysis, or previous support/resistance in-formation. I am merely stating the fact that once the market moves, youwill have either an open-trade proﬁt or a loss at that point. We are not dis-cussing  the  market  “coming  back,”  the  potential  to  make  a  new  yearlyhigh/low, chart formations that have probabilities, or anything else. I amsaying that from a mathematical point of view, it is impossible for every-body to be right.
The idea behind technical analysis is that by somehow combining ordividing previously traded prices, overlaying a type of constant algorithmto previously traded prices, comparing previously traded prices to someformula, and so on, you can thereby arrive at a number that the markethas a potential to reach, predict the market will change direction, or beconﬁdent that it will continue in the same direction. The seduction of yourwill is now complete and you place yourself at risk.
But the market continues to move for the only reason that it will evermove—because of the net order ﬂow. Most traders now believe that if youhave an open-trade loss after this mental dance of technical analysis hasbeen  done,  somehow  the  analysis  was  not  done  correctly—otherwise,they  would  have  been  on  the  other  side  or  waited.  This  illusion  is  whatmost traders operate under for the entire life of their trading career. Themore ﬁrmly entrenched a trader is in this illusion, the greater amount ofstudy or analysis he will do or the greater amount of money he will spendtrying to develop a better technical approach.
The  important  bedrock  understanding  you  as  a  trader  need  to  haveabout technical analysis is that it is not predictive; it is historical. Techni-cal analysis cannot predict price action because it is mathematically im-possible for everybody to be right in the ﬁrst place, and everyone has thesame technical analysis available to them.
A  price  chart  with  a  21-bar  moving  average  and  stochastics  on  mydesk is identical to your price chart with a 21-bar moving average and sto-chastics on your desk. If we both conclude the same thing—that this datapredicts a price rise, for example—and every other trader in the world us-ing that same technical analysis sees the same thing we have been taughtto glean from it, and we all decide to buy because we trust the analysis,the only way we can get into that market is if someone sells to us. What isthe seller using to conclude that the time to get in is also now but that themarket is poised to move lower? What is his analysis based on?
The  really  seductive  part  of  this  whole  process  is  that  if  the  trademakes a proﬁt, the trader assumes the analysis works. That is the conclu-
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sion most traders will come to. The only reason the trade worked is be-cause the net order ﬂow was from that side, but the trader concludes itwas the analysis that found the trade. Once the analysis works one time,the trader extrapolates that to mean it will work all the time. If using theexact  same  analysis  again  results  in  a  loss,  the  trader  assumes  the  faultwas in how the analysis was done. In other words, the crystal ball wasn’tplugged in this time. But the trader is still convinced that he owns a crys-tal ball.
If you do your homework you will discover that any form of technicalanalysis has some level of probability of ﬁnding a winning trade. For themost  part,  all  technical  analysis  or  mathematical  models  developed  forsystemized use have a success rate between 38% and 52% winning tradesbased on the predictive hypothesis used by the developer. That is no bet-ter  than  chance.  If  you  ﬂip  a  coin  100  times  you  will  have  52%  heads  ortails, or some random bell curve distribution based on probability theory.In  fact,  the  entire  industry  based  on  this  predictive  illusion  of  technicalanalysis  is  very  proud  to  document  to  you  the  winning  trade  to  losingtrade ratio of the system in question. If you want a real eye-opener, justcount how many of these high-tech, systemized approaches have win/lossratios lower than the 35% range, which is actually less than ﬂipping a coin.What are these people thinking?
Since  technical  analysis  will  only  help  you  52%  of  the  time  at  best,
why would you trust it 100% of the time?
Answering that question and really thinking about what you are do-ing  is  the  key  to  following  this  rule.  You  must  know  the  limits  of  youranalysis and what the analysis is really saying in order to use it success-fully. In my opinion, the simplest way to effectively use technical analysisis to look at it from the loser’s point of view.
Proper analysis of your market starts with the understanding that notall of the participants are going to be winners. The loser is in there some-where and he must liquidate at some point. Looking at the market priceaction from the point of view that the loser is in there, thinking and trust-ing something that allows him to place himself at risk, puts you in a posi-tion  to  anticipate potential  net  order  ﬂow  when  it  is  about  time  for  theloser to quit. Your best analysis is done by asking the question, “Where isthe loser?”
The last thing you want your analysis to do is attempt to predict priceaction.  You  want  your  analysis  to  disclose  historical information.  Youwant information that discloses where the loser is, what he is most likelythinking,  and  where  he  will  most  likely  be  forced  to  liquidate  the  losingtrade. You already know that the loser has trusted some form of analysis,he is using it to predict price action, and he can’t be right. Armed with thatpoint of view, you need to assess at what point a loser would come into
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the market and where he would most likely liquidate. All of your technicalanalysis  is  best  used  to  help  uncover  where  the  loser  is  and  what  he  ismost likely thinking in order to continually keep placing himself at risk.Your analysis is best used to help you understand what has already hap-pened and then help you deduce what must happen next.
This is a different process than predicting price action. The process ofcritical deduction, intuition, and knowledge combined with the question“Where is the loser?” is not predictive. You really don’t need to answer thequestion, “Which price is coming next?” You need to answer the question“Where and when will the loser quit?”
Before  we  conclude  this  discussion  on  the  limits  and  usefulness  oftechnical analysis, I think it is best to make a few things clear so no one getsthe wrong impression. I am not saying that technical analysis is bad or thatit is without value. There are many parts of technical analysis that are veryuseful  and  should  be  part  of  a  well-rounded  trading  methodology.  I  thinkyou would be best served in your use of technical analysis if you would nottrust it implicitly to ﬁnd winning trades. I believe that it is best used in con-junction with sound knowledge of what ultimately drives prices.
Net order ﬂow can only change if someone is certain enough that hewill make a winning trade and he is willing to initiate a position to ﬁnd out.Regardless of all the little nuances that happen around the net order ﬂowor  the  degree  of  probability  one  kind  of  analysis  has  versus  another,  thebottom  line  is  that  only  a  fraction  of  open  contracts  will  be  on  the  rightside of the price action long enough to have a proﬁt. Technical analysis isdesigned  to  uncover  this  inequality,  but  charts  cannot  tell  you  what  willhappen. Charts and analysis can only provide a detailed history of what hasalready happened. It is up to the trader doing the analysis to deduce whatis most likely to happen next from that historical information.
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RULE #16
Trade withthe Trend
The trend is your friend.
—Edwin Lefèvre, Reminiscences
of a Stock Operator
A nyone who has traded for more than one day in his life knows this
rule. As a factor in managing risk/reward ratio and playing it smart,most traders attempt to trade with the trend currently in progress.Identifying a trend in progress is rather easy. If we set aside all the otherparts  of  a  trading  approach,  things  like  how  to  get  positioned  properly,limiting losses, adding to a winner, and so on, and focus on just this onerule for a moment, we have only one thing we need to be concerned with:the direction, or trend, of the market.
WHAT IS A TREND?
A  trend  is  usually  deﬁned  in  the  markets  as  a  general  direction  that  netprices are moving. There are three kinds of trends, and all of them can behighly proﬁtable when traded properly. All three kinds of trends have a be-ginning and an end. Additionally, the end of one trend usually signals thestart  of  the  next  trend.  I  personally  believe  that  identifying  the  end  of  atrend is the single most proﬁtable trading tool you can develop. The end ofthe  current  trend  is  the  best  place  to  liquidate  an  open-trade  winner
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and/or initiate a new position at the beginning of the new trend, when therisk is lowest and the proﬁt potential is greatest.
The three types of trends are uptrend, downtrend, and range. Obvi-ously, an uptrend, as shown in Figure 16.1, is a series of prices where thehigh prices keep getting higher and the low prices are marked higher, too.Figure 16.2 clearly shows a downtrend, while a range is illustrated in Fig-ure 16.3.
Making this rule work for you requires a willingness to identify whatis already happening and simply assume that it will continue for at leastthe  time  you  are  in  at  least  one  trade.  You  also  need  to  decide  whetheryour trading methodology will work for each kind of trend. Some system-ized approaches or technical methods are  trend  followers and some arebreakout or momentum identiﬁers. Breakout or momentum approachesare  not  good  for  initiating  positions  with  an  existing  up  or  downtrend;they are not designed to remain in a market long enough for the trend toresume and create a proﬁt. Breakout or momentum approaches are bestused when a market has been in a range for a period of time. When therange is over, that is usually signaled by a large move in one direction orthe other.
If you intend to trade with the prevailing trend as part of your trade
FIGURE 16.1 Typical Uptrend Chart
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FIGURE 16.2 Typical Downtrend Chart
FIGURE 16.3 Typical Range Chart
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method,  make  sure  you  know  which  trend  your  method  is  designed  for.Systems designed for range trading will lose money on any other kind oftrend, because trading a range assumes a shorter time frame and often as-sumes you will use a close and reverse methodology. If you are not willingto be long from the bottom of the range and then short back down fromthe top, then a range trading system may not work as well for you.
No matter which trend you choose to trade, the common-sense psy-chology  behind  this  rule  is  “Don’t  argue  with  the  market.”  Figures  16.1through  16.3  all  clearly  indicate  which  prevailing  trend  is  evident,  andyou  should  be  able  to  determine  the  right  side  for  initiating  a  positionwithout a lot of argument. As a trader looking for long-term success, oneof  the  important  disciplines  to  learn  is  that  the  market  is  always  right.The  market  very  clearly  says  what  the  prevailing  trend  is,  and  takingmoney from a market no matter which trend is evident does not require alot of effort, study, or work. It requires discipline. Once you are in posi-tion along with the prevailing trend, there is nothing to do but add to theposition  as  the  trend  continues.  Regardless  of  your  initial  objective  forliquidation,  if  the  trend  remains  in  place  and  a  further  price  advance  isdeveloping, there is nothing to do but add to the winning position untilthe trend is over.
Before we discuss clues to discovering the end of a trend, I would liketo discuss each trend individually. Each kind of trend has some unique un-derlying  behavior  that  needs  to  be  understood  in  order  to  take  less  riskwhen trading it.
UPTREND
An uptrend is the most difﬁcult to trade successfully. Finding a market ata critical or signiﬁcant low price does not insure that a bull market willever develop. But if it does, bull markets are actually aberrations and ex-ploited  by  professional  traders  as  a  short-term  situation  that  provides  ashort-selling opportunity. The more convinced the typical trader is that abull market is under way, the better the short-selling potential for the pro-fessional. It is no accident that most fortunes in futures and options havebeen made by short-selling.
When discussing bull markets in futures and options, it is important tonote that equities are not included in this discussion. Equities are invest-ments,  not  speculation.  The  underlying  reasons  for  a  bull  market  instocks  are  almost  never  the  reasons  for  a  bull  market  in  other  markets.Equities are not zero-sum markets, so the forces that create price actionare different. Unlike the 50/50 relationship between long and short posi-
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tions  in  zero-sum  markets,  short  interest  in  equities  typically  is  nevermore than 5 to 8%, even in raging bear markets.
There are no bull and bear markets in FOREX, either. True, you maybe long or short one currency from the point of view of the other, but thatis a function of relative value, not bullish or bearish. Currencies are notmoney in the truest sense of the word. The currency markets have alwaysbeen  subject  to  some  stable  store  of  value  throughout  history  (such  asgold), and only in the last 50 years or so has the stable store of value rela-tionship changed. All currencies devalue over time, regardless of whetherthey rise or fall faster against one another for a period of time. A bull mar-ket in currencies is not possible, even though one currency may gain valuebrieﬂy against another.
If you intend to be long a market for a developing uptrend, you mustbe prepared to consider that a shorter-term trade. Bull markets attract alot of noise and people who normally would never be in that market. Forexample, in 1988 I traded the grain complex during the Midwest drought.At the height of the price advance, over half my customers buying grainshad  never  traded  in  any  market  before.  Many  had  bought  only  becausethey saw it on the news every day and simply couldn’t pass up a suppos-edly sure thing. The entire bull market was over in four months, and thegrains  haven’t  traded  those  prices  again  since.  Bull  markets  are  exhaus-tive in nature and are often subject to manias, panics, and nonprofessionalparticipation, much more so than other trends.
As a developing trader, part of your best approach for trading an up-trend is the point of view that “All of this could be over tomorrow. There isno such thing as a bull market.” Always be hyper-vigilant on a long posi-tion when trading an uptrend. Bull markets make me nervous.
DOWNTREND
Trading in a downtrend is the most secure and proﬁtable way to increaseyour account balance. Once the pressure comes on, that market could goa long way and be under downtrend for years and years. Contrary to up-trends,  bear  markets  need  very  little  to  keep  them  going;  hence  the  oldtrader’s phrase, “A bull has to eat every day but a bear only needs to eatonce in a while” (referring to news and additional new traders coming in).I say more about bear markets in Rule #24.
A downtrend always follows an uptrend. It is the nature of zero-sumtransaction markets that any bull market will be followed by an equal orgreater bear market. If your trading approach is to include short-selling,then  any  bull  market  needs  to  be  closely  monitored  for  the  inevitable
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change in trend that will occur. It is only a matter of time, and if you areprepared properly you will make an absolute fortune on the short side ifyou are willing to remain disciplined and add to that short over time. As Imentioned  earlier,  the  grains  have  never  traded  back  to  the  highs  seenduring the bull market in the spring of 1988. A properly positioned shortwould still be making money years after the highs in June of that year. Ifyou  want  to  really  get  serious  about  trading  and  you  want  to  make  thisrule work for you, look for an equal or greater number of downtrends inyour regular analysis and trade selection.
RANGE
Trading in a range is the easiest money available to you. There is a lowerrisk  of  being  early  on  the  buy  or  sell  side,  which  could  occur  when  themarket  is  in  an  uptrend  or  downtrend.  No  matter  how  you  slice  it,  youcould buy a low market a little too early or sell a high market a little toosoon. In a range trade, the buying and selling points are already predeter-mined  for  you.  Your  only  real  question  is  whether  the  range  is  over  themoment you execute one way or the other for the ﬁrst time.
I have found that range is the most proﬁtable trading opportunity forshort-term  trading.  A  market  typically  will  trade  in  an  established  rangethrough at least three or four attempts to seek a new higher or lower equi-librium. In other words, once the range is established, there is a very lowrisk of a breakout in either direction for usually two solid attempts fromthe buy side or the sell side of the range. You simply buy the lower 5% ofthe established range and sell the upper 5% of the established range. If youare  aggressive  you  can  close  your  longs  and  reverse,  attempting  to  cap-ture both sides.
Range  trades  are  more  common  in  shorter  time  frames  such  as  the120-minute or less. Almost all uptrends or downtrends experience periodsof range lasting from several hours to several weeks while continuing theoverall advance or decline. Some traders establish base positions on theuptrend or downtrend and then, when range is apparent, trade short-termfrom the same side until the overall trend resumes. Then they add to theopen trend-following position.
BENEFITS OF CLEARLY APPRAISING TREND
Uptrends, downtrends, and ranges occur with regular frequency, and eachoffers better money-making potential when it ends. Once an uptrend ends,
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it will be followed by a downtrend very quickly. A range at the end of anuptrend is less common than before the end of a downtrend. A range willend in a continuation of an uptrend or downtrend more often than not. Inother words, the prevailing bull or bear market usually continues a bit fur-ther once a range has been evident for a short time. When a downtrendends, it is usually followed by a range for some time. Very rarely does adowntrend end and an uptrend immediately begin, forming a “V” bottomat a signiﬁcant low price. In most middle-priced markets, the process oftrend  identiﬁcation  goes  like  this:  range,  resumption  of  uptrend/down-trend, range.
The  end  of  an  uptrend  or  downtrend  is  the  most  proﬁtable  time  be-cause the risk is low and proﬁt potential high just before prices reverseinto the change in trend. Identifying a change in trend from up to down (orvice versa) is easy in hindsight because the price chart will clearly showyou the directional change. But in most cases, if the event is about to hap-pen in a middle-priced market—a market that is not at a signiﬁcant highor low, (such as a 10-year price level)—then there will be some period ofrange just before the turn. If volume and open interest have declined dur-ing this period of range at the end of an uptrend or downtrend, there is ahigh probability a reversal is in the works. See Figure 16.4.
FIGURE 16.4 Change in Trend: Uptrend Followed by Range prior to Downtrend.USD/CHF  Cash  Spot  FOREX,  April  17,  2005,  to  April  17,  2006.  Courtesy  of G.T.S. Charting.
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The important thing to remember about this rule is that each of thethree potential trends available has unique characteristics. Developing asolid  trading  method  is  all  about  ﬁtting  your  personal  trading  approachinto the most comfortable kind of trend for you. I personally have workedwith traders who, after learning enough about the market psychology andtheir  personal  psychology,  have  decided  to  only  trade  one  kind  of  trendrather than try to trade all potential price action. As a matter of fact, thehighest performers have always been short-sellers working in downtrendsor the sell-side of ranges.
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RULE #17
Use EffectiveMoneyManagement
Success does not depend upon having enough capi-tal but in deploying it properly.
—Frank A. Taucher
Every  trader  at  one  time  or  another  has  made  the  mistake  of  im-
proper  equity  allocation.  By  that  I  mean  trading  too  large  or  toosmall,  adding  to  a  losing  trade,  cutting  a  proﬁt  short,  or  failing  toadd  to  a  winning  trade.  In  reality,  equity  allocation  is  not  a  function  oftrade management. It is a function of understanding who is taking risk andwho is using the market for what purpose. Very few traders have fully un-derstood  the  relationship  between  real  risk and  perceived  risk.  Evenfewer know that properly assuming risk to begin with is the key to build-ing a healthy balance.
Many books have been written on proper money management. Mostof  them  start  with  the  premise  that  taking  an  unreasonable  risk  iswhere  all  the  woe  in  your  portfolio  comes  from.  Many  successful  in-vestors have well-diversiﬁed portfolios and have various percentages inlow-risk,  medium-risk,  and  high-risk  investments.  The  underlying  as-sumption is that the more risk you take, the worse your potential gainswill be. If you look deeper at the issue of money management, you dis-cover  that  the  real  problem  is  who  is  managing  the  wealth  and  whatthey are thinking.
I know many people who have what they consider to be well-diversiﬁedportfolios. They have 40% or so of their money in low-yield places like mu-nicipal bonds or U.S. debt. They have 30% or so of their money in places
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