<s> RULESOF THE TRADE
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RULESOF THE TRADEIndispensable Insightsfor Online ProfitsDavid S. Nassar
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Copyright © 2001 by The McGraw-Hill Companies. All rights reserved. Manufactured in the UnitedStates of America. Except as permitted under the United States Copyright Act of 1976, no part of thispublication may be reproduced or distributed in any form or by any means, or stored in a database orretrieval system, without the prior written permission of the publisher.0-07-138120-1The material in this eBook also appears in the print version of this title: 0-07-135463-8.
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Dedicated to:My sister, Rebecca:You had a tough year,but you handled it like the champion you are!
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CONTENTS
Foreword: Bill Lupien
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Acknowledgments
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Introduction
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Chapter 1Preparing to Trade
1
Chapter 2Rules for Trading
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Chapter 3Rules for the Active Trader
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Chapter 4Rules for Stock Selection
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Chapter 5Rules for Entering Trades
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Chapter 6Rules for Exiting Trades
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Chapter 7Rules for Hedging Risk
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CONTENTS
Chapter 8Rules for the Technician
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Chapter 9Rules for Evaluating Performance
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Chapter 10Rules for Technology and the Internet
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Chapter 11Rules for Money and Mind Management
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Chapter 12Interviews and Insights from the “One Percenters”
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Afterword
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Appendix A. Tax Laws Specific to Traders and Securities
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Appendix B. Types of Orders
239
Appendix C. Web Resources
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Index
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FOREWORD
Many books have been written on the subject of trading stocksand securities, and most focus on the mechanical side of the market such as chart reading, mathematical indicators, electronictrading systems, and other methods that would fall under thecognitive thought process of trading. Fortunately, there is anabundance of information available for understanding themechanical nature of the market. But because the market is sodynamic, mechanical techniques and trading styles such as“scalping” are the most prone to change. With the explosion ofelectronic trading, recognizing this now is vitally important.The most recent phenomenon to help make the point couldbe traced back just a few years ago to the “SOES bandits,” as theyhave been called. Trading opportunities often were found byexamining the depth of buyers and sellers at the inside marketand determining how strong a market maker’s propensity was tobuy or sell a given stock by witnessing how long he stayed at thebid or offer and by how much he traded at a given price level. Atthat time, market makers would show size on average of 1000shares, and the spreads were much wider between the bid andask at the inside market shown horizontally on a Level II screen.Note: Horizontal simply means the difference between the pricesat which market participants would buy and sell a security, theoretically the most favorable price at any given time. Vertical isthe spread in price on the same side of the market (buyers or sellers). For example, if Morgan Stanley (MSCO) is the best buyer of
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BRCM at the inside bid of $112 and the next buyer on the LevelII is not indicating until $111, it would suggest a wide verticalspread among buyers of BRCM and therefore a thin or illiquidperiod of time for BRCM stock.SOES traders traded these opportunities created by widespreads, attempting to make money on market inefficiency, andmany did! But much of that has changed due to changes in rules,much tighter spreads, lower size being shown to the market bymarket makers, and other events that have limited the opportunity for this mechanical trading style. Trading today forspreads alone is a mistake. While the opportunity still exists to alesser degree, the spreads are so tight that success is not as attainable with this narrowly focused trading style. Therefore, tradersmust recognize changes in strategy and mechanical systems overtime and adapt with the market.Over the 30 plus years I have traded, including the time Ispent on the floor of the Pacific Stock Exchange as a specialist, asa market maker, and currently as an EDAT trader, I have formedthe opinion that enduring factors like personal and marketpsychology need much more attention. Cognitive, mechanicalknowledge of the market is important, but what plays on atrader’s emotions and how he or she reacts to events is of muchgreater importance and much less prone to change. That is whatis so unique about this book and why I have agreed to contributeto and endorse it.David concentrates on methods and insights that have beenused by traders for many many years. Although there are fewcommon denominators that are present in all markets, the fewthat do apply are the focus of this book. This book is a rulebookfor trading, focusing more on the intangible assets that tradersneed over time than on the mechanical methods that will changeand leave those that don’t vulnerable.The rules covered in this book are written from a trader’sperspective. Few rules are new and original; most have been discovered over many years from many traders. These rules havegrown and survived because they are not prone to change. Muchis gained by “checking your ego at the door” and opening yourmind to what could be taught only from many years of experience—experience that has been passed on through generations ofgreat traders and multiplied exponentially over trading floors,
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hedge funds, institutions, and brokerage houses around theworld and that cannot be duplicated by any one person in a single lifetime.Those that understand this have already acquired the firstand most important rule down: The market has little room forarrogance and ego. You must have the humility to admit whenyou don’t know or understand something. To admit failure earlywhen you are wrong and to cut your losses, and to learn fromeveryone, new or experienced, is the attitude the market rewards.David makes the point that you need to be driven to buildknowledge through your passion. I would add that if you thinkyou already have the answers or possess the magic mechanicalmethods and techniques to trade, this book is not for you. Egomay have lead you to believe such “self-actualization” has beenachieved in your trading, but time will correct that—just give it achance. Many of us have gone through this stage of our trading,including me. Once you humble yourself and put your ego incheck, your trading will improve directly with your wisdom.And wisdom is not as much mechanical cognitive knowledge asit is emotional intelligence. Both will be covered, with anemphasis on the latter.Most books start with a wonderful promise of excitementand mystery and give you the feeling that if you only begin reading, you will find the destination you are looking for. This book’smessage is the opposite: You must learn the cold hard facts aboutthe market and the rules that must be employed to engage it. Ibelieve this lesson must be learned early, while keeping earlyexcitement at bay. This book does an excellent job of introducingyou to it. David approaches the subject of trading with the samehonesty and humbleness you must approach it with. Thisapproach centers on the fact that the market is not a destination;it is a journey. If you are expecting a book that will lead you tosome destination at which you will find the financial rewardsyou hope to achieve, your expectations will not be met. Neitherthis book nor I support such illusions.This book is a beginning of a journey. It relays the obviousas well as the more subtle nuances between successful tradersand unsuccessful traders. Rules are an interesting institution.They are almost destined to fail on one hand because humanityhas spent its existence testing them, stretching them, and cer-
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tainly breaking them. On the other hand, where would we bewithout them? In the end, we all profit by following them tosome degree and by breaking them to another.Wall Street has had unwritten and written rules for too long.Thankfully day traders have had the courage to test them, stretchthem, and even break them in order to create a brand new industry that now properly includes the average person. In this sense,we certainly have all profited from the breaking of the “oldguard” and rules that have unfairly punished (financially) thosewho were not market insiders.With the emergence of this new industry and pioneers ofchange, you will on the other hand find abuses of the rules thatare put in place to protect us. Manipulations through chat rooms,margin requirements, lending practices, and hype certainly havefound their way into this exciting new genre of electronic tradingas well.What David brings out in this book is a balance of rules thatleads the electronic trader through the quandary of informationthat sends conflicting messages to what all market participantshope to achieve: clarity. I define clarity in the world of trading asa clear plan of action that leads to a statistical edge large enoughto justify the implementation of an idea as to where stock pricesare heading, called a trade. In the absence of such a plan, claritywill never be found consistently enough to yield sustainableresults. Although the rules covered in this book focus on some ofthe mechanical practices required to find clarity, the psychological rules and attributes that have stood the test of time are rightfully covered in much more detail.The question I ask others and myself is, Why do peopletrade?I think the answer is in part that the market is a seductiveinstitution. Experts from all walks of life have engaged it with alltheir expert skills, trying to find the perfect fit with the marketbased on what they know—mathematicians, psychologists, psychiatrists, floor traders, engineers, rocket scientists, softwareprogrammers, athletes, and on and on. Many have applied theirdeep understanding of their respective fields to trading, trying topigeonhole their specialized skill and understanding into someliteral solution to trading. Because many industries make uppublicly traded markets, the market is a huge melting pot of ser-
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vices and industries. The irony is that, just as no one industry ordiscipline makes up the market, no one style or market mechanicwill provide the trader with what he needs to trade. Hence, trading is more an art than it is a science.Drawing from many fields of thought, many psychological,some mechanical, will be the melting pot of ideas that will giveyou the greatest chance for success. Diving too deeply into anyone idea or any one mechanical system through software, technical studies, or mathematical formulas is too narrowly focused.Only by constantly reading and enriching yourself through exposure to the market can you gain the well-rounded base of knowledge you need.I have read psychology books that make sense and havegreat application to trading, and I have read other books on mathematics and technical study that also do the same with explanations of how the math can quantify the psychology. But thelesson to take from this book, in my opinion, is to apply a combination of many views to ultimately form your own recipe forsuccess. This recipe will be a living recipe that will continuallychange with your experience.Among the tools and attributes most would choose to createthe ideal recipe, magical software and technology seem to top thelist. I have developed and contributed to some highly sophisticated trading systems. I was involved in the world’s first electronic trading system on the Pacific Stock Exchange, andcontinued as the chairman and CEO of Instinet from 1983through 1988. More recently as the cofounder and chairman ofOptiMark Technologies, I can tell you that while technology hassignificantly enhanced the markets, it has yet to replace theessential characteristics that only the human mind possesses.Unfortunately, in most cases, knowledge, research, and thepsychological characteristics of traders often take a back seat totechnology through excitement and greed. Technology and software unfortunately have been sold to the public as the solutionor “holy grail” to finding the trading rewards that so many aspireto, but this ideology is no more effective than chasing leaves inthe wind. Software has yet to replace the need for thinking,research, discipline, passion, commitment, and certainly theadherence to the critical rules of trading. These critical rules, asstated, have evolved over time through the mistakes, experience,
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and pain of many traders who have unknowingly written themby making the mistakes that you undoubtedly already have madeor have yet to make.David has done an excellent job assembling the key characteristics and attributes traders need that are often ignored. Thisbook builds on the backs of many market pioneers who have, likethe trail blazers of the old wild west, carved a pathway that, iftrusted, will prove to make your journey toward your tradinggoals less painful and more profitable in much less time.Software has certainly impacted electronic trading in a verydramatic and positive way, but software will come and go andchange. The critical rules to trading are timeless, and they maychange to some slight degree, but they will remain steady beacons of light for all to follow who engage the markets.Because critical rules are never based on the opinion of justa few but rather on the experience of many, the rules stated arenot all original. Some may even sound like clichés because theyhave been heard around trading pits for decades, but rememberclichés become clichés because they are worth repeating andhold value. This book gives these time-tested rules a new coat ofrhetorical paint and has added new rules based on the beliefsand attitudes of some of the best traders in the world. Regardlessof their origins, if you put the axioms you find in this book intopractice, it will make a real difference in whether you succeed orfail as a trader.Because rules are more often broken than followed by newmarket participants, let me highlight an example that relates to thepsychological demons that every trader has to deal with on a regular basis. When day trading, fighting demons becomes exaggerated because you have less time to rationally deal with them. Yousee a position run uncontrollably lower, knowing it must find support soon; but greed rears its ugly head and causes you to hold on,and before you know it, you are licking your wounds eating amajor loss. Or perhaps you are in a trade going into the close andit moves against you, and you decide to hold the positionovernight because you hope it will recover. “It’s a good, solidstock” speaks the two-headed monster of greed and fear, whorepays your misguided trust by taking a bite out of your net worth.Greed and fear are just two of the many adversaries to themind of a trader that will prevent many from reaching their
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potential. Fear of failing. Fear of succeeding. Fear of pulling thetrigger. Fear steals confidence and paralyzes traders. Greed, onthe other hand, creates exuberance at the expense of doing valuable research, which, in most cases, gives you exactly the opposite of what this useless emotion elicits, the desire for money.Unfortunately, in trading, the more you chase it, the harder it isto catch up to. Ultimately, you will recognize that doing the workborn through your passion for the markets will build confidencethrough knowledge that replaces greed and fear.Adopt the critical rules highlighted in this book and massage them to fit your own trading style and personality, and theenigma of the market will quickly dissipate.Another example and component of this book David coversrelates to technology. Technology has not just impacted tradeexecution. Imagine trying to conduct research today without thesea of information available through the Internet. In the last fiveyears, the technology needed for the average person to trade fastand efficiently has come into its own, and if you are not takingadvantage of it yet, the most likely reason is that you lack passionto trade or you are afraid of it. The first reason is a good reasonnot to trade; the second is not, and it is the result of ignorance.The point is, technology is here and will continue to impactmany facets of our lives, and to remain ignorant and fearful of itwill only spell regret in the long run. By reading now, I suspectthat you have the passion to trade. As we say in the business,“Don’t fight the tape!” Embrace your passion for the market; it isan advantage. For two centuries, the securities industryattempted to convince the typical investor that he or she was notcapable of understanding the complexities of the stock market.The industry maintained that the market was so esoteric thatonly a highly trained, extremely experienced stockbroker couldcomprehend its intricacies. Today, you have the power to controlyour own investing destiny. Along with that power and controlcomes added responsibility in making your own stock selections. To push the envelope of responsibility, once in a trade, youmust also decide when to exit—and that’s often the most troublesome question for the amateur trader.Remember that the word amateur is better defined as a stateof mind than defined as a level of experience. I know many newtraders who are true professionals because of their approach to
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the market, and I know even more amateurs who have been inthe market for years. Their survival kit is made up of five partsluck, three parts hope, and two parts knowledge. This group hasyet to face the music and in the meantime is being ground downby poor trading and blaming its dismal results on factors that itcan’t change, like interest rates, market volatility, bad brokers,commissions, and any other external factors it can think of. Thetruth is, these individuals will constantly blame others or eventsoutside their control for what they don’t have. They are usuallyvery vocal, and they talk the most and accomplish the least,which earns them the title of “amateur.” Professionals takeresponsibility, admit when they are wrong, learn from their mistakes, and move on down the road toward results. Results are theonly true measure in the market, which is why the market is notpolitical, but pure. Professionals believe that in most cases, likelife, you get out of trading what you put into it. Professionals takeresponsibility for these results and often feel proud of wherethey are in their journey of learning, and they continually learn,while the amateurs are justifying and rationalizing to anyonewho will listen and join their plight. The amateur stays in constant pursuit of the holy grail of market mechanics and technology that alleviates the responsibility to do the work. You decidewhich category you fall into, but if your past suggests some ofthese amateur characteristics, I strongly suggest avoiding electronic trading. It rarely works out for this type of individual.While these words are tough and hard to hear, I told Davidwhen he asked me to write the foreword, “Don’t expect me to‘run for mayor’ and hold anything back.” These are the facts Iwould tell a good friend or family member who aspired to be anelectronic trader. This way, you can quietly and privately categorize yourself now, which may save you many thousands of dollars later. The fact is, trading is not easy and not for everyone,and only you can decide.I share the same beliefs as David, and commend him on hiscandid and honest approach, which is the reason I have agreed toendorse this excellent book.Warmest regards,William (Bill) Lupien
ACKNOWLEDGMENTS
Thank you again to Stephen Isaacs and Jeffrey (Player) Kramesfor the opportunity.Thank you to all our traders for your support.A special thanks to Tom McCafferty for the contributions tothis book and the hard work you provide each day.A special thanks to my friend Bill Lupien. Your insightshave helped me grow as a trader. I look forward to working withyou on our new book!To Stan Yan for the great illustrations. To Dr. Peter Berndtfor your contributions. Paul Mann, CPA, for your appendix ontaxation. To all members of Market Wise Securities, Inc., for thesuperb effort you give every single day.To Jack Whitehouse for the insightful advice, daily support,and friendship. I couldn’t ask for a better partner!To my family:Glenna A. Nassar and Gabriel E. Nassar, Sr., my parents whohave always been there for me.To my sister Rebecca who reminds me what strength really is.To my wife, Tracy, and sons, Zachary and Weston, whoremind me what is most important.
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Disclaimer
Everyone who enters the stock market assumes the risk of losing money. Thisrisk is amplified for those who make their own decisions and execute their owntrades. It is further amplified if one day trades large positions on margin. In thiscase, the trader can lose even more money than is in his or her trading account.This book and the rules it contains will not protect you from losses. We have noway of predicting market action once you are in a trade or your reaction to anadverse market move. You must realize this before you actually trade and beprepared to assume responsibility for your actions. Always keep in mind, youare never under any obligation to trade—it is solely your decision.This book is intended for educational purposes only. It is expresslyunderstood that this material is not in any way intended to give investmentadvice or recommendations to buy stock or any other security or investment.The author and publisher assume no responsibility for the investment resultsobtained by the reader from relying on the information contained in this book.Investing and day trading is inherently risky and the results obtained by someinvestors may not be obtained or obtainable by other investors in similar or dissimilar conditions. The reader assumes the entire risk of investing, trading, orbuying and selling securities. The author or publisher shall have no liability forany loss or expense whatsoever relating to investment decisions made by thereader.The reader should understand that most people lose money day tradingand that technology can substantially slow down during times of heavy marketactivity.
INTRODUCTION
Few disciplines are as pure as trading stocks. It is neither political nor does it discriminate, and the dichotomy is that there doesnot exist a more potentially rewarding or unforgiving financialendeavor. The only separation between amateurs and professionals are the critical rules that the market demands be followed. Obey them or become yet another victim of the dynamicenigma called the stock market.Over the years that I have traded and trained people to tradestocks, I have come to the conclusion that some have had passion, but most do not. As cold and direct as that may sound, it isreality. I have been asked many times what the success rate is ofstudents who come through our courses, as if to suggest thecourse is the sole solution to what traders need to know to tradesuccessfully. I would love to tell you that our course and the education we provide is the “Shangri-La” of your trading needs, butI would be lying to both of us. The reality is, trading success canbe found only within your own personal psychology and the passion you have for the market. Sure, education is critical. Soundunderstanding of the market and tools of the trade are imperative, but without the right attitude or willingness to form theright perspective and discipline, success will be elusive if notimpossible.At the risk of starting off on a negative note, we must beginby recognizing that many self-defeating mechanisms are presentfor the trader that constantly work against you. Chief amongthese self-defeating mechanisms are greed, hope, and fear. There
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are many others as well—not quite as vicious but just as expensive to harbor, such as laziness, revenge, and boredom. And theconclusion that I have come to is that successful trading is morea state of mind than a state of mechanical or cognitive understanding of the market.The opportunity is simple. The growth of electronic tradinghas been and continues to be phenomenal. There were zeroonline accounts in 1994, and there are estimated to be 15 milliononline accounts by the year-end 2001.1 This incredible acceptance of the concept of trading without the assistance of a brokeris the result of several totally unrelated trends converging. One,of course, is technology. The Internet and the personal computerare not exactly recent inventions. Both have become very traderfriendly. Other events, such as rule changes within theexchanges, and, more recently, increased market accessibility,including pre- and post-market trading, have also contributed tothis growth. With the explosive growth ahead of us, I believethose that have the passion to embrace and learn to trade willhave the advantage. After all, how many people would be tradingtoday without a user-friendly user interface and a browser?Therefore, the number of traders and investors in the markettoday and the growth rate of more to come will provide tremendous opportunity and liquidity for a smaller crowd (smartmoney) at the expense of a much larger crowd (amateur money).The “smart money” crowd of traders are who I refer to as the“one percenters”—a small, esoteric group of active traders whocontinually write the rules of professional and semiprofessionaltrading.The rules I outline throughout the book provide the rationale to avoid common pitfalls that traders before you and I havemade. While trading nirvana is not realistic even after you master all the rules, you will become much more aware of commonmistakes traders make, and if you learn from them and how toavoid them in the future, you will take years off your learningcurve.While creating this book, I interviewed many professionaltraders in order to assemble ideas and strategies that could beconsidered “rules of trading.” What I have come away with in1
“Brokers and the Web,” The Forrester Report, September 1999.
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the process is that the truly enduring rules are small in numberbut enormous in value. Therefore, it is not my focus to highlightcomplicated technical formulas or chart formations that areprone to change. This information is already in vast supply, andI chose not to contribute to the “imbalance.” Instead, I focus on arelatively small list of rules that, if followed, will provide farmore value than the almost infinite amount of literal and tangible formulas now available to those who demand them. Unfortunately, it is this very information that defines trading as a sciencewhen, in fact, it is an art. Following the rules of trading that support the art is the primary focus of my work and of my personaltrading methodology.Whether it is day trading, swing trading, or longer-termtrading you aspire to, there is no one right way to trade. Only thetrading style that meets your personality, time horizons, risk tolerance, and personal goals married to the right mindset willbring the results you desire. Incorporating the right rules and discipline to that style will complement all trading styles.Throughout the book, the rules are printed in a bold typeface and listed at the beginning of each chapter. As you developyour trading style and find your own way, alter the list, addinginsights that only you can articulate based on your unique experience and trading style. Be patient on your journey, and allowyourself to continually develop as you define your naturalpropensity and style of trading.I wish you success. Trade wise, and trade with passion!
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PREPARING TO TRADERules of the TradeThe rules are ever changing.Get a mentor.There are no silver bullets in this business.Develop conviction.Create a written plan.Avoid holding positions over weekends.Scared money never wins.Get the knowledge.
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ith the emerging gateway to electronic trading openingwide due to revolutionary changes in the securitiesindustry, a volatile stock market, and technologicaladvancements, the first rule in preparing to trade is to understandthat The rules are ever changing. With these changes and advancements has come an unprecedented explosion in demands totrade equities and securities. As a result, the markets have literallychanged shape and form overnight when compared to the pace ofchange experienced in the markets since the New York StockExchange (NYSE) was first organized in 1792.New methods of trading have created new paradigms andtrading techniques that have fueled this growth. The “new economy” is rewriting the rules of trading in terms of price-earnings(P/E) ratios, technical analyses, and market opinions. Many professionals, analysts, and market participants have been predicting a great bear market at epidemic proportions, but they haveyet to happen. Corrections (defined as 20 percent retracements inan established index) and even a crash have occurred during thisbull market, but they have been shallow and short lived by comparison to its growth.Another major change that is redefining trading strategiesand paradigms is a shift of money flow, from institutional tradingthat historically dominated our markets to a more balanced trading pattern that includes individual traders and investors. Thesemajor changes, and others, have sparked an inferno that is sweeping across our country and enabling more individuals to take control of their own financial destiny. Many have rushed in and havebeen burned, while others are reaping great rewards. All contribute to changes that are continually rewriting the widely heldrules of trading that relate to strategy and market mechanics.Before we dive into what the more enduring critical rules oftrading are, I raise the following question