the actual dol-lar risk you take when you establish a new position.
How does your spouse or signiﬁcant other feel about your desire totrade?  If  your  spouse  thinks  you  are  nuts  for  trading  soybean  futures,maybe you don’t plan to tell your spouse you are losing until it is tax timeand you have a brand-new deduction to discuss. Imagine the pressure onyour relationship at that time. Maybe it would be a good idea for you toconsider the input your spouse may have. Many traders have discoveredthat the critical component to their trading has been a sense of conﬁdencethat  they  are  supported  by  their  spouse.  Some  traders  ﬁnd  sharing  thewealth  they  have  earned  from  the  markets  with  their  families  has  given
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them a better sense of achievement. But the essential element that is oftenoverlooked by many traders is that their day-to-day relationship with theirspouse can be both positively and negatively affected when the family ﬁ-nances are in question one way or the other. Having your spouse’s full sup-port will help you deﬁne your risk better if you are one of those traderswho might have your focus broken by conﬂict in the home.
One thing you can count on: Certain times in a person’s life make oneless available for the strong emotional and personal focus required to suc-cessfully speculate. Be sensitive to the personal side of your trading andconsider that there might be times when you will just not be at your best;those are the times to either stand aside or reduce your trade size for a pe-riod of time.
Once we have done enough of the right homework for the market wewant  to  trade,  and  we  have  assessed  our  personal  pressures  enough  toknow we won’t be negatively affected by them, we are ready to address theissue of the ﬁnancial risks inherent in every market. The fact is, we couldbe wrong on our next trade and we might have to accept a cash dollar loss.No successful net winning trader has 100% winning trades. There is a ten-dency for some traders to subconsciously expect each individual trade tobe the home run; otherwise, why are we in? Often it is this very expecta-tion that causes us to make the mistake of not deﬁning what dollar loss weare prepared to take in the event the trade is a loser. After all, why place astop or select a getting-out point if this trade is the home run?
Many  traders  who  have  suffered  larger-than-intended  losses  havelooked back on how that happened and said, “Yes, I could have gotten outsooner but . . . (enter stupid reason here).” The unwillingness to deﬁne therisk ahead of time put them in a position where they had no plan in placeto protect themselves; they lost control of their execution and now wereat the mercy of the market. Instead of ruthlessly cutting the loss at a pre-deﬁned point, they did something else. They hoped, prayed, waited, etc.and the end result is that the market kept marking their account lower un-til they had no choice.
In  the  ﬁnal  analysis,  deﬁning  our  risk  is  a  method  to  cut  our  losses,simply because we refrain from putting ourselves at risk until we have ad-dressed all the potential ways we could lose money to begin with. We arenot going to let anything take money away from us if we can avoid it. Wehave put things in place to protect ourselves. Sometimes that is an orderplaced in the market; sometimes it means going back to school to learn amissing skill; sometimes it means admitting we are not emotionally readyto trade, for reasons that we have to get straight ﬁrst.
Lastly, your actual cash balance on deposit with your broker needs tobe money that is completely unencumbered for you personally. This needsto be an amount you can emotionally walk away from. Again, this is not as
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Define Your Risk
35
simple as “Only trade with money you can afford to lose.” In fact, the ex-act  opposite  is  a  factor  that  most  traders  miss  until  it  is  too  late.  If  youneed those funds for any reason under any potential time frame, you run arisk of cutting your proﬁts short. If you need your starting balance safelyback home in, say, six months, suppose you enter a strong position withreal potential at the ﬁve-month mark? Perhaps that trade might need an-other  four  months  to  develop  its  full  upside  potential,  and  maybe  thattrade is the big mover in the market this year. Nothing will break a trader’sheart faster than having to liquidate a small winner that would have be-come a huge winner, for the sole reason that those funds are needed for adifferent purpose and he knew that going in.
Whatever funds you choose to work with, make certain that your riskon those funds includes not needing them later if you can avoid it. If, for in-stance, you know you will need a certain amount of cash for home repairsin the spring, ask yourself if the money you are depositing in the fall withyour broker is intended to be that home repair money. Not only do you risknot getting the repairs done if you have some losses, but if you are on theright side of the big trade for this year, you risk not getting your full beneﬁtif you have to liquidate early for the sake of that pending obligation.
Because  there  are  unlimited  ways  to  lose  money  once  you  haveplaced yourself at risk in a trade, deﬁning your risk incorporates as manyof those variables as possible and involves creating as many safety nets asyou can. Make this rule work for you by considering the possibility thatyour  personal  risk  involves  something  in  your  life  other  than  your  cashtrading balance.
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RULE #6
Always Place aProtective Stop
I  shall  tell  you  a  great  secret,  my  friend.  Do  notwait  for  the  last  judgment,  it  takes  place  everyday.
—Albert Camus
Probably the single most misunderstood rule in the trading game is
the rule regarding the use of predetermined exit points, or, as it iscommonly stated in the industry, “placing a stop-loss order.” Mosttraders use stop-loss orders ineffectively at best. The most often heardcomplaint  is  that  liquidating  stops  are  elected  right  before  the  marketcontinues farther in the intended direction of the original working tradeafter only a small correction. Many traders have experienced frustration,anger, or just plain disappointment when a trade that had real potentialfor gains was stopped out early. However, the issue appears to be morecentered  on  the  proper  use of  stop-loss  orders,  not  the  question  ofwhether  they  should be  used.  It  only  takes  one  unexpected  adverseprice  move  to  teach  any  trader  the  value  of  stop-loss  orders.  It  seemseveryone  wants  the  protection  of  stops  but  genuinely  hopes  they  arenever elected.
Without  a  doubt,  there  is  a  tremendous  amount  of  argument  andopinion as to what exactly is the best use of stop-loss orders and whentrades  should  be  protected.  The  only  part  of  this  debate  on  which  allsuccessful traders agree is that this is the one rule that simply cannotbe  ignored.  Consistently  placing  and  using  stop-loss  orders  on  your
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open positions is your ﬁrst and best defense against an excessive or un-intended loss.
When  we  ﬁrst  started  our  discussion  of  trading  rules  that  work,  Imade the observation that you cannot consistently trade for proﬁts unlessyou  are  on  the  proper  side  of  the  eventual  order  ﬂow.  If  you  have  doneyour homework and your trade hypothesis turns out to be the correct onefor the time in question, the order ﬂow will show up on that side, and untilit changes, you are accumulating an open-trade proﬁt. We are concernedwith the net order ﬂow, not the temporary imbalances that create the ebband ﬂow of price action on the tick-by-tick basis.
Understanding the net order ﬂow and the potential that the trade maydevelop is a factor of understanding multiple time frames. I discuss multipletime frames in detail later (see Rule #12), but for the sake of understand-ing  the  psychology  of  using  stop-loss  orders  let’s  make  an  assumption:Order  ﬂow  is  never perfectly  balanced  on  any  one  price  tick,  no  matterhow many time frames are involved. There will always be at least one left-over  buy  or  sell  order  at  every  traded  price  tick.  Therefore,  the  marketwill always be subject to a temporary imbalance on some time frame thatwill cause prices to ﬂow back and forth many times as that leftover orderﬂow creates the need for the bid or offer to be adjusted.
This knowledge instills the conﬁdence that as long as prices are mov-ing in a general direction over time, we can hold that open position untilthe full potential develops as we see it. The market might ebb and ﬂow be-tween two price levels for a period of time until it breaks out and reachesour  objective,  but  we  can  recognize  this  as  “consolidating”  or  “conges-tion.” The basic price action is not signiﬁcant enough for us to liquidatethe open trade yet; that price action is normal on the way to the eventualobjective.  We  know  that  markets  don’t  go  straight  up  or  straight  down;they  zigzag  back  and  forth  on  the  way  to  a  particular  level—so  sittingthrough that zigzagging action is our goal—except when that supposedlynormal  zigzag  in  prices  is  a  full-blown  61.8%  retracement  covering  fourweeks of time and 7% of contract price value.
Now  we  have  the  issue  of  placing  stops  and  what  to  do  with  them.How do we muster the conﬁdence to hold a position through normal, ex-pected, and healthy price action on the way to our eventual goal? How dowe maintain the winning position without getting stopped out on a typicalretracement?  I  think  the  answer  lies  in  how  you  deﬁne  the  purpose  ofstop-loss orders and in understanding what it means to experience the un-expected—which will happen to every trader sooner or later anyway.
I take the point of view that stop-loss orders are not used to protectan open-trade proﬁt. They are not a risk control tool. Stop-loss orders areproﬁt  management  tools  and  should  not  be  used  to  liquidate  winningtrades. They should be used to liquidate a position—any position—when
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something has changed with the underlying structure of the market, andnot before.
If you follow this thinking to its logical conclusion, that your winningtrade is happening only because you are on the right side of the net orderﬂow at that moment, then the best time to liquidate that winning trade willbe only at the point when the net order ﬂow in that direction is about over.In other words, you have bought low and sold high for the maximum po-tential before the net order ﬂow reverses. If you have called it right thenthe fact is that your protective stop-loss order was never in question—themarket had no potential in the direction against you, and you were prop-erly positioned for that order ﬂow. Therefore, the stop was not elected. Infact, you could almost go so far as to say that if the stop order was neverplaced, the result would have been exactly the same because the fact ofthe order ﬂow was what it was. This is why some people are tempted totrade without stops—but that is a different issue.
MOVABLE STOPS
Why then would you move your stop?
I think that is the critical issue of properly using stop-loss orders. Ifyou have properly identiﬁed the net order ﬂow, the stop is not needed andmight as well not be there. All the little price ticks in all those tiny littleswitchbacks or corrections are not the issue; the issue is whether the netorder ﬂow has changed. You would only move your stop-loss order if youare not certain that you have identiﬁed where the order ﬂow has run outof potential. You place your original stop-loss order only to protect your-self  in  the  event  that  you  have  not  properly  identiﬁed  the  initial  placewhere the order ﬂow will change; if you are incorrect in your entry, youhave limited your loss to a predetermined amount according to your sys-tem methodology and trade plan.
If you are correct in your assessment, then there is nothing to do butwait until the net order ﬂow runs out of potential in that direction. If youare uncertain of that point, then the movement of the stop closer to thetraded prices is your only option. And that brings us to the point of subse-quent stop-loss order placement after the market has begun to show youan  open-trade  proﬁt.  It  is  the  psychology  of  moving  this  stop-loss  orderthat  is  the  central  issue  of  properly  using  stops,  because  they  are  notneeded  if  your  ﬁrst  hypothesis  is  the  correct  one,  unless  something  haschanged and you missed it.
Your only question as it regards moving a stop-loss order closer to themarket prices after your winning trade begins working is “What if something
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changes before I see it change?” There is no other reason to move a stop. Atthe very least, your trade plan should have some kind of rule that allows youto  roll  your  stop-loss  order  up  to  your  entry  price  on  open-trade  winners,thereby assuming a no-risk trade.
If you intend to use stop-loss orders effectively, you need to use themas a worst-case exit order only. Your ﬁrst worst-case scenario is being inthe market on the wrong side of the order ﬂow at the moment of initial en-try. The next-worst case is that the order ﬂow runs out before you have areasonable  lead  on  the  market.  The  third-worst  case  is  if  somethingchanges and you didn’t see it coming fast enough to liquidate with whatthe trade had in it at that point. Otherwise, the only thing to do is wait foryour objective.
In  my  view,  rolling  stops  aggressively  to  lock  in  proﬁts  is  the  surestway  to  cut  proﬁts  short.  Regular  ebb  and  ﬂow  in  the  small  order  imbal-ance,  regular  retracements  from  signiﬁcant  highs  or  lows,  and  randomnoise between highs and lows are part of the game. It is unlikely that youor any trader will be keen enough on your observation that you will accu-rately call the near-term price points for such price action. Placing yourstops too close to the market is an expression of uncertainty and fear, ofattachment to a particular price instead of waiting patiently for the net or-der ﬂow to run out in that direction. By rolling your stops aggressively yourun the risk of having your stops elected by the minor tick-by-tick orderimbalance. To avoid this potential, you need to see stops as the method ofliquidating only if something has changed. If nothing has changed with thestructure  of  the  market,  why  would  you  increase  your  risk  by  moving  astop-loss order?
One way to make the issue of placing stop-loss orders work for yourparticular trade approach is to move the stops for only two reasons. Theﬁrst  reason  is  to  take  you  out  at  a  predetermined  dollar  loss  or  gainamount as deﬁned by your risk management rules. In other words, if thetrade  is  working  up  to  a  certain  amount  of  open-trade  proﬁt,  you  moveyour order to secure either a smaller loss/break-even amount or a smallproﬁt. After that point, the stop should not be moved until your objectiveis reached.
The  second  reason  to  move  a  stop  would  be  if  you  are  pyramidingopen trade positions. It would be advisable to always have a break-evenexit stop on your entire position in case something changes and the pyra-mid begins working against you, and the open trade position falls belowyour starting equity on the trade.
In all other cases, moving your stops aggressively is a dangerous andunnecessary method of increasing your risk of cutting a proﬁt short. Oncea trade has given you a reasonable lead, you can make the near-term as-sessment that your hypothesis is the correct one. And once that trade is
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protected  for  little  or  no  risk,  moving  a  stop-loss  order  closer  to  themarket  on  a  regular  basis  will  only  put  you  in  the  position  of  gettingcaught in the random minor tick-by-tick action that you have no need tobe concerned with anyway. If something has changed, and you don’t seeit fast enough to keep most of the open-trade proﬁt from evaporating,why  would  you  want  to  be  in  a  market  that  you  don’t  see  right  in  theﬁrst place?
Always remember that stops are not risk management tools. They areproﬁt management tools. They can only be considered risk managementtools if something has changed and you are on the wrong side of the orderﬂow by accident; in which case you would act in your best interest by liq-uidating  anyway—except  it  happened  faster  than  you  could  see  at  yourcurrent skill level.
In any case, your equity is protected and you can now look for the nexttrade with a clear head. Judgment day is every day, so place stops properly.
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RULE #7
Your First LossIs Your Best Loss
Great opportunities come to all, but many do notknow they have met them. The only preparation totake advantage of them is simple ﬁdelity to watchwhat each day brings.
—Albert Dunning
T raders who have a strong personality or high intellectual capacity
are often found to be breaking this rule consistently. These tradersare  often  able  to  call  tops  and  bottoms  ahead  of  major  marketmoves for very concise and accurate reasons. They also tend to executeearly on those potential trades and suffer losses before eventually get-ting on the right side. Their belief in and commitment to their hypothe-sis is so strong that they continually execute from the side they feel isgoing to be the big move. Some of these traders have been right in theirhypothesis so early and continued to trade from the wrong side for solong that their account has lost signiﬁcant equity getting to that point.Then when the big move comes, it is really only an opportunity to getback to even.
A bull market can stop being a bull market long before prices top; abear market can stop being a bear market long before prices bottom. Inreality, this is what these traders are usually seeing. They are looking farenough  ahead  to  see  a  greater  potential  in  the  other  direction  and  theyknow that the turn is coming. They may even spend long hours in analysislooking  for  that  time/price  relationship  and  take  quality  positions  that
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have  an  initial  small  gain;  but  then  the  market  continues  sharply  in  theoriginal direction and they are taken out. This type of trade situation givesrise  to  the  outdated  rule,  “Don’t  pick  tops  and  bottoms,”  but  the  fact  isthat  sooner  or  later  a  market  must top  or  bottom;  the  lowest  risk  andhighest proﬁt potential are always at the turns.
Identifying those turns is a completely separate issue, and I don’t evenaddress it in this book. It is my belief that in today’s market climate thetools  and  knowledge  needed  to  ﬁnd  major  turning  points  are  availableeverywhere. The problem is not in identifying the turns; the problem is be-ing early.
The psychology behind this rule is the issue of nonattachment. Manytraders  have  not  developed  the  underlying  ability  to  adequately  detachfrom price action emotionally. If we have a strong understanding of themarket we trade, and we feel very certain in our approach, and we can-not proﬁt unless we buy low and sell high, at some point all of our knowl-edge and preparation pressures us into an urge for action. We concludethat  “the  time  is  now,”  and  we  execute.  Because  we  have  invested  somuch  of  ourselves  in  forming  that  conclusion,  we  have  a  subconsciousattachment to that trade. What we really have is an attachment to that ex-ecuted price.
When we have formed some kind of attachment to a particular price itis a small step in our thinking that something is “wrong” if prices do notadvance favorably in a reasonable amount of time. Having an attachmentto pricing is the problem, because prices do not move unless there is or-der ﬂow on that side. If the price you personally select is not reasonablyclose to where the order ﬂow is, that trade will simply not work from thatparticular  price  at  that  particular  time.  It  might  eventually,  and  the  timefor that might be sooner rather than later, but in the meantime nothing iswrong. The market hypothesis that you currently hold might be the exactfuture that market has in store, but at this particular price/time relation-ship, you are on the losing side and you simply must stand aside. How youfeel about that trade, your knowledge, and your commitment to being inthe market have nothing to do with what is actually happening.
By  accepting  the  ﬁrst  loss,  you  remove  yourself  from  the  equation.Notice that I said “accepting the loss.” The problem at this moment is notwithin the market. The problem is with the trader and the attachment tothe trade hypothesis. The more educated, experienced, or successful anytrader becomes, the more susceptible that trader is to trade attachment,especially if he has previously taken a lot of money from that particularmarket previously.
Developing  the  ability  to  remain  unattached  to  your  trade  results  isthe issue behind making this rule work for you. No one trader will mostlikely call a turn in the market at the exact day and time it actually occurs.
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Most likely you will be near the price and time that a turn in the markethas happened for your time frame and your method. Most likely you willalways have slightly more losing trades than winning trades over time. Be-ing emotionally attached or strongly committed to any one price area, anyone trade, or one particular side creates an inability to reconsider your hy-pothesis. Perhaps you are 100% correct about the eventual path that mar-ket will take but at this particular moment you are on the losing side ofthe order ﬂow. Don’t argue with it; take a new look at it.
Making this rule work for you is a function of both self-awareness andyour methodology. When we create a methodology for trade selection weare attempting to ﬁnd and exploit an edge in the market. Self-awareness isa completely different part of the trading process, but it is also part of ouredge.  Only  we  as  individual  traders  can  make  the  assessment  that  “thetime is now” for our trade approach to be reasonably accurate, and onlywe as traders can admit it isn’t working. The less attachment we have toany one executed trade, the better our net performance will be; our trad-ing methodology will never have 100% winning trades in any case.
Our ﬁrst loss is our best loss because a loss tells us something veryimportant. A loss tells us that we are on the losing side of the order ﬂow atthis moment. That doesn’t mean our trade hypothesis is not going to bethe correct one at some point; it doesn’t mean we as a trader have donesomething “wrong”; and it doesn’t mean we won’t be able to make anothertrade from the same side and have it work at some later time. The onlything you need to accept from a loss is the education it brings. If you as atrader  ignore  that  knowledge,  refuse  to  admit  your  hypothesis  is  not  anaccurate  accounting  of  the  market  structure,  or  justify  executing  againfrom the same side again without thinking it through, you run the risk ofmaking another loss for the same reason—not knowing the order ﬂow.
Your ﬁrst loss is your best loss because it opens your information ﬂowto the only two real issues of participating: (1) Get on the right side; (2) ifyou  are  on  the  wrong  side,  get  out.  Ignoring,  blaming,  justifying,  gettingangry, whatever you feel or do with your ﬁrst loss does nothing to preventanother loss. The only thing that prevents another loss is ﬁnding out whatcaused this ﬁrst loss and discovering whether your attachment to your in-tended result is part of the problem. If you have done a masterful job ofpre-trade  research  and  come  to  a  reasonable  conclusion  that  is  strongenough  for  you  to  commit  yourself,  you  need  also  to  have  a  reasonableamount of willingness to admit that your hypothesis may be early or in-correct  completely.  Suppose  you  are  100%  correct  but  six  months  early.You could burn through a lot of your trading capital by ignoring the lessonthat your ﬁrst loss could teach you. If your trade hypothesis is completelyinaccurate, then you are facing the prospect of a total loss if you ignorethe lesson revealed by that ﬁrst loss.
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If you can honestly say to yourself, “I don’t care what happens on anyone trade,” you are a lot closer to getting the real answer to the question“What created the loss?” because the only thing that creates a loss is beingon  the  losing  side  of  the  order  ﬂow.  If  you  can  lay  aside  all  your  study,analysis,  pain  of  a  cash  debit  in  your  account,  or  emotional  frustration,then you most likely can look objectively at the market and ﬁnd the cluesto its actual current structure at that point. Getting on the winning side ofthe order ﬂow might mean opening another trade from the same side atthe same price, or it might not. You might be fairly close to the turn for thenext big move, but maybe you won’t see it at all if you won’t accept thelesson that the ﬁrst loss is teaching you: “Not yet.”
This rule can be a powerful tool for your long-term success. Having aloss for all the right reasons may sound like an oxymoron, but the under-lying psychology of this rule carries real beneﬁt to you. A loss simply tellsyou that you might be early. That is a good problem to have. In the ﬁnalanalysis, you must exercise some kind of foresight to be able to exploit atrue inequality in the markets. Having that foresight is something that canbe  developed.  Once  you  have  developed  that  foresight  to  some  degree,you will also need to develop the ability to time your trades close enoughto where the actual change in the order ﬂow is developing. Regardless ofhow well you personally develop that skill or how you personally createand maintain your edge, you will often be early sometimes. Assume youwill have that problem, and take the point of view that your ﬁrst loss is amegaphone.
Remain completely unattached to the results, seek to understand theorder ﬂow, and let your ﬁrst loss tell you something about how you pickedthat spot. Don’t argue with the market. Listen to what it is saying. Be will-ing to accept the possibility that your hypothesis is completely inaccuratefor the moment.
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RULE #8
Never Addto a Loser
If you don’t know who you are, the markets are anexpensive place to ﬁnd out.
—George Goodman (paraphrased)
F or the most part, almost all losses can be traced back to the same
root  problem.  By  losses,  I  don’t  mean  the  usual  and  reasonablewinners-versus-losers results that successful traders have; I don’tmean “a particular losing trade.” In this case I am talking about a con-sistent and net losing result that occurs over time. The inability to cutlosses is the symptom; the actual problem is nearly always a variationof the same basic theme. Most signiﬁcant or consistent losses are a re-sult of some form of attachment to results on behalf of the trader. Notplacing initial stop-loss orders, holding losing trades past a reasonabletime, overtrading, and so on are all symptoms of an emotional attach-ment of some sort. In those cases, the trader simply cannot let go andexit the market. Nothing announces that you have this problem louderthan adding to a loser.
This rule, “Never add to a loser,” is ﬁrst cousin to Rule #7. In the casewhere a trader feels compelled to add to a losing position, the problem isactually a more severe manifestation of attachment. In the case of a lossgetting larger than originally intended or several small losses all adding upto a large cash debit, the problem is probably a lack of discipline or a de-nial of the actual net order ﬂow. In the case of adding to a losing trade the
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