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like  growth  stocks  or  investment  real  estate.  The  rest  is  spread  out  be-tween things like start-up business ventures or cutting-edge opportunitieslike  bio-tech  or  alternative  energy  stocks.  Basically,  as  far  as  I  can  tell,they are content to preserve their capital and hope for the best. They don’twant a lot of risk.
All of these various “secure” or “less risky” investments boil down tosomeone else in control. If I buy a stock investment, for example, the po-tential growth to my capital investment is actually going to be determinedby how effective the management team of that particular company is. If itturns  out  that  the  management  team  is  unresponsive  to  the  underlyingbusiness climate, the potential for that company to continue growing mar-ket share (and stock value) diminishes. If I invest in some kind of bond,the  interest  rate  depends  on  how  long  I  leave  that  capital  in  someoneelse’s hands. If a city government wants to build a new highway and raisesthe cash from a bond sale, that city will make more money over time thanit  will  pay  me  in  interest,  and  it  may  require  me  to  keep  the  bond  fordecades.
All  of  this  is  well  understood  by  professional  money  managers,  andthose individuals have mountains of data designed to maximize yield andminimize  risk.  They  have  huge  amounts  of  capital  allocated  across  asmany different market opportunities as possible and they pay the yield toyou, the investor (less any fees). As the investor, you must be content toreceive whatever gain that particular money manager’s skill set is capableof  earning.  The  professional  money  manager  is  not  a  risk  taker.  He  is  arisk avoider.
For us as traders the game is completely different. We are looking toexploit some perceived opportunity when we see the current market priceas too high or too low relative to some other price we are expecting to seetrade down the road. We start from the premise that the risk is certainlyworth taking. But knowing the perfect price/time relationship to assumethat risk is the difﬁcult part. In my view, we have this problem because wedon’t know that asset allocation and money management are for invest-ments, not trading. Trading is about getting paid for a risk someone elsedoesn’t want to take.
If  you  study  wealthy  individuals  who  started  with  nothing,  you  willdiscover there is a common thread behind all of them. They all take con-trol of their ﬁnances and allocate resources differently than the averageperson. They assume risk others will not—and the lion’s share of proﬁtsgoes to them. Most of the self-made wealthy people have discovered thatpeople will pay to avoid risk. This is also where the concept of other peo-ple’s money comes into play. Without question, the proper use of your cap-ital will lead to using someone else’s capital, thereby creating leverage forthe risk taker. In the markets we call that margin. If you are trading crude
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oil, for example, the total contract value is much larger than the cash de-posit needed to control that contract. That crude oil is somewhere in theworld  for  the  time  you  control  it.  Someone  is  willing  to  let  the  pricechange either for or against him, and one of those someones is a hedger.Knowing when hedgers are active in the market leads to knowing how toproperly allocate capital.
A hedger’s goal is to transfer risk to the speculator. You are the specu-lator. When the hedger feels it is time to transfer risk to you, it is time toallocate your capital and take the risk. Properly use of your capital beginswith accepting risk. Individual traders who hope to proﬁt without assum-ing a lot of risk are setting themselves up for a trading disaster. Tradingthe  markets  cannot  be  done  successfully  unless  you  assume  risk.  Whensomeone who does not want the risk is active, you have a time/price rela-tionship that has a very good chance of being a place to assume risk. Thekey is understanding that low rates of return are paid to non–risk takers,and high rates of return are paid to risk takers.
Using our crude oil example, when a hedger sells into the market, thatparticular hedger sells crude oil because he believes a price decline is pos-sible, even likely. By using the markets to hedge he is saying, “I don’t wantto risk a price decline.” Who would be most likely to know if a price de-cline  was  possible?  Wouldn’t  that  be  someone  in  the  business  of  sellingcrude oil for a living? The moment the hedger becomes active, you have avery good clue that it is time to allocate capital and assume the risk thatthe  hedger  does  not  want.  You  now  take  your  capital  and  leverage  hisknowledge.
Now,  I  am  not  saying  that  you  should  sell  into  the  crude  oil  marketjust because the hedgers are selling crude oil today. I am saying that prop-erly allocating your capital begins by knowing who does not want the riskin the market, and accepting that risk. In most cases, simply knowing theprice levels at which the hedgers say, “That’s enough” gives you the bestplace  to  begin  using  your  capital.  Effective  money  management  beginswith assuming the right risk at the right time. The rest is academic.
Why is this point of view the cornerstone to effective money manage-ment? Because the markets are designed for the hedger and not the spec-ulator.  The  speculator  is  attempting  to  proﬁt  from  a  perception  of  pricepotential. The hedger is using actual prices. In most cases the hedger islooking  for  a  change  in  price  when  he  participates.  If  the  price  changedoes not occur he is not harmed. If the price change does occur, he is pro-tected and he provided you the opportunity to beneﬁt from that change. Inmost  cases,  hedging  activity  will  stop  a  price  advance  or  decline,  or  atleast delay it. Knowing when and where hedgers are active provides im-portant clues for when it is time for you to take the actual  risk and thebeneﬁt your account.
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The perception of risk is what most money management concerns it-self with and this perception of risk is what most traders focus on. Theywant  to  play  but  they  don’t  want  to  pay.  There  is  only  one  risk  in  themarket: that you may be on the wrong side of the net order ﬂow. You canperceive that situation immediately by the very next traded price, so per-ception of risk is not really a concern—except for the trader who is igno-rant of or unwilling to accept the actual net order ﬂow. What you want toavoid is executing for your initial position in a place that is of no interestto the person who ultimately receives the best beneﬁt from the markets.You do not want to buy and sell from other speculators. You want to ei-ther  buy  or  sell  with  the  hedger  or  against  the  hedger;  but  you  want  toavoid participating against other speculators for the most part.
Once you are accepting the risk others do not want, and the market ismoving favorably for your initial position, the rest of proper money man-agement comes into play, but this is only valuable because you still haveyour original money to begin with. If you have been trading for a reason-able amount of time and a reasonable number of trades but your equity islower  than  your  starting  balance,  the  only  thing  you  need  to  discover  ishow to get on the right side of the net order ﬂow more often. One valuableclue  is  knowing  when  hedgers  are  active,  because  they  will  execute  toavoid risk only at price areas that are  actually  important. The fact thatmost speculators are losers means that a certain amount of them will beavailable for the hedger to square off with. Who is more likely to win, JohnQ. Public or Cargill, when both are trading in the wheat market?
Once  you  have  a  winning  position  working,  you  must  allocate  moreresources to the winner. The four basic rules for money management atthat point are as follows:
1. Roll protective stops to the break-even point.2. Purchase options to lock proﬁts.3. Add to the winner on pullbacks.4. Scale out when hedgers from the other side become active.
I have found that a 1.5% equity risk on initiation of the position willkeep you in the game until you have found the winner and have a lead onthe  trade.  Using  options  to  lock  proﬁts  will  free  up  equity  to  add  to  thewinner.  When  hedgers  from  the  other  side  are  active,  the  limits  to  theplaying ﬁeld are established and liquidating some or all of the position isadvisable.
Now, I know most traders were expecting this rule to be a discussionof  ratios,  percents,  stop  placement,  and  so  on.  In  the  Introduction  Ipointed  out  that  making  the  rules  work  depends  on  understanding  the
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psychology  behind  the  rules  and  adapting  that  psychology  to  your  per-sonal  trading  approach.  The  psychology  behind  using  effective  moneymanagement  is  ﬁrst  and  foremost  preserving  your  capital  until  you  ﬁndthe winning trade. That’s easy enough; don’t risk more than about 1.5% ofyour starting balance on any one trade. Once you have a lead on the win-ner, you add to it and let it work. You liquidate when the net order ﬂowdries up in that direction. You are looking to initiate when the net orderﬂow  is  set  to  change,  and  you  are  looking  to  liquidate  when  it  changesagain. In between those two points you are looking to add to your winnerand lower your open-trade risk, either by rolling stops or buying optionsagainst your futures.
The best way to effectively manage your equity is to look for the riskno one else wants to begin with. That is usually a price level that is of in-terest to hedgers. The rest is common sense.
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RULE #18
KnowYour Ratios
How  did  I  get  rich?  Well,  I  sold  apples  to  start.  Ibought a dozen apples wholesale for 50¢, polishedthem real nice and sold them for 10¢ a piece. I keptat it until I had well over $3,000 in proﬁts. Thenmy uncle died and left me $1.4 million.
—Henny Youngman, comedian
E very  business  has  ratios.  Every  business  has  expenses  and  in-
comes. Every business has market share, and every business hasproﬁt  and  loss  opportunities.  Trading  is  a  business  just  like  anyother,  and  part  of  your  long-term  success  as  a  trader  will  come  fromknowing exactly what your business balance sheet looks like. You mustknow your expenses and incomes, you must know your market share,and  you  must  know  your  proﬁt  or  loss  relationships.  You  must  knowyour ratios.
Ratios  provide  important  clues  to  the  actual  performance of  yourtrading. When I teach my “Psychology of Trading” seminar, it still amazesme  that  some  traders  have  no  details  or  printed  records  of  their  recenttrade results to show me. They cannot tell me what their performance is.These traders have only one piece of information available: the balance intheir  trading  account.  That  would  be  like  running  a  corner  bakery  withonly one piece of information each day: your checking account balance.No  knowledge  of  your  expenses,  your  utilities,  cost  of  raw  materials,proﬁt margin on a loaf of bread—nothing. Imagine running a business that
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way. Most traders are running their trading business in exactly that man-ner. They have few or no records with which to get the true picture of howwell their business is performing.
Accurate  record  keeping  and  regular  calculation  of  your  ratios  willprovide  you  with  important  information  that  will  give  you  several  solidbeneﬁts. First, by knowing your actual performance from day to day youwill see more clearly how well you are following the rules you have cre-ated for yourself. Next, knowing your performance ratios gives you cluesas to what areas of your daily trade presence need to improve. Last, andprobably the most important information, you will have more data avail-able when you are about to make a serious mistake. Knowing the perfor-mance  you  are  creating  in  real  time  creates  a  sound  understanding  ofwhat you need to do from that point forward. No trader gets to be at thetop of his game without regular and critical review of his moment-to-mo-ment performance.
Every  trader  has  distinct  parts  of  his  trade  approach  that  requiremore focus than others. In my case, I am subject to a tendency to over-trade. I need to critically review my daily execution regularly because ifI  am  not  careful  I  will  easily  break  discipline  in  this  area.  I  have  noproblem holding a winner. So for me, a regular assessment of my execu-tion  records  is  very  helpful  because  overtrading  usually  results  inlosses. My records have provided clues when I am about to start over-trading,  and  more  often  than  not  I  can  head  that  off  at  the  pass.  In  aworst-case scenario, I have a rule that I have learned is a critical part ofmy discipline, and I follow it every day. I developed that rule because Idiscovered my tendency to overtrade by critically examining my traderecords regularly.
Once  you  have  disciplined  yourself  to  keep  accurate  records,  youneed to begin calculating your ratios. Regardless of how you want to sliceit,  because  we  operate  in  an  arena  that  is  subject  to  a  degree  of  uncer-tainty, a portion of our net results is a function of probabilities. We cannotknow in advance with absolute certainty that we will be on the right sideof the net order ﬂow. Once we execute, we are going to have a gain or aloss. A portion of those results will be due to chance, either for or againstour account balance. If we are maintaining a strong market focus and asolid level of discipline we can tip that percentage in our favor. The magicnumbers  are  42%  winning  trades  to  losing  trades  combined,  with  a  2:1proﬁt-to-loss ratio. These numbers are a factor of the probability of ruinmatrix, illustrated in Figure 18.1.
The probability of ruin matrix is a calculation based on several piecesof data. First, it assumes 100 events; in this case that would be 100 trades.Next, it deﬁnes ruin as a 50% drawdown from starting equity. Last, it as-sumes that the methodology used to initiate each event is always the same
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FIGURE 18.1 Probability of Ruin MatrixRuin is deﬁned as a 50 percent drawdown from starting equity.
in every event; in other words, each trade done during the 100 trades inthe sample set is executed for exactly the same reason.
According to this matrix, if you do 100 trades, and have 42% winners,and pull two dollars out for every dollar you give back, your probability ofruin is a little less than 14%. If you calculate the numbers yourself you willﬁnd that (42 (cid:2) 2) – (58 (cid:2) 1) actually yields a proﬁt of $26, but the ruin ma-trix is using the full scope of probability theory. That includes the possibil-ity that all the losing trades will come in the ﬁrst 58 executions, or enoughof  them  that  your  equity  draws  down  50%  before  the  sample  set  of  100trades is complete.
Notice that a high percentage of winning trades is not an indicationthat you will make money net in your account. Someone who has 55%winning trades to losing trades has a worse risk of ruin if he wins aboutthe same amount as he loses every time. It actually is a better probabil-ity  for  your  account  if  you  have  fewer winning  trades  but  hold  thosewinners for a higher proﬁt/loss ratio. Of course, the best of all worlds isto be in the far right side of the matrix. A trader with 60% or more win-ning  trades  and  only  a  slightly  better  proﬁt/loss  ratio  than  1:1  has  nochance of ruin.
Something else that is astounding when you think this through is thatthis calculation is based on only 100 events in a sample set. Flipping a coinand predicting heads versus tails will be a 52% ratio. When the matrix iscalculated for a higher sample set, the percent probability goes down for atrading system but remains the same for ﬂipping coins. That means that if
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you did 1,000 trades with a 42% winning trade ratio and a 2:1 proﬁt/loss ra-tio, the probability drops to less than 8%. The more consistent you are thebetter  you  do,  even  if  your  ability  to  pick  winning  trades  is  less  thanchance. This is where “black box” or systems traders have their successlevels. They really are not in the business of picking winning trades; theyare in the business of holding winners and remaining completely consis-tent in how they select trades.
In  order  to  exploit  the  probability  of  ruin  matrix  for  your  personaltrading you need to know where you fall to begin with. I would suggestyou go back and review the last 100 trades you did and calculate your ra-tios. Once you have that knowledge, you can begin to develop changes toyour  approach  in  order  to  exploit  your  trading  strengths  and  minimizeyour trading weaknesses. If you discover that you have a high ratio of win-ning trades to losing trades, you simply need to develop the skill of hold-ing  your  winners  longer.  Perhaps  that  means  waiting  24  more  hoursbefore liquidating. Maybe you have a low percentage of winners but youare regularly taking two or three dollars out for every one lost. This couldindicate  that  you  need  to  improve  your  entry  timing  a  bit.  Sometimes  itmeans you are running your initial protective stop-loss order too close toyour entry; maybe a wider stop will help you ﬁnd a winner a bit better. Ofcourse, the ﬂip side to that is you will need to trade a smaller position, butyou get the idea.
The information you compile from your record keeping can provideyou  with  all  sorts  of  information  to  improve  these  ratios.  One  trader  Iworked  with  discovered  that  he  had  a  very  high  percentage  of  winningtrades to losing trades on Monday through Wednesday each week but thathis ratio dropped on Thursday and Friday. He made a new rule for himself:If he was not up by a certain amount of proﬁt by Wednesday afternoon, hewould quit for the week. If his equity dropped at all on a Thursday or a Fri-day,  he  would  not  give  back  more  than  a  certain  percent  of  his  Mondaythrough Wednesday proﬁts. He really never improved any other part of hisapproach with that knowledge. He simply discovered that he was great tostart the week but he had a tendency for losses later in the week. Armedwith knowledge of his personal trade performance, he improved his ratiosto the far right of the matrix.
If you think about being in any business there is a correlation betweensuccess  and  the  information  available.  Some  businesses  are  closed  onweekends.  They  have  learned  from  experience  that  Saturdays  and  Sun-days  cost  more  than  they  bring  in.  Other  businesses  don’t  need  a  store-front. Every business has parts that can be improved and things that needto be done more often to increase the success potential.
In the trading environment, there are parts of what we do every daythat will not put money in our trading account. There are things that will
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put money into our account easily and things that increase the potentialthat money will go away. By keeping very detailed and accurate recordsof your actual performance, you can calculate how well you are doingnet. You need to know what you are really doing well and what needs tobe improved. Because trading is what it is and a certain amount of ournet results is not in our control, we need data about our net results tohelp us change what is in our control. Knowing our ratios will keep uson track and show us where we need to develop additional controls onour behavior.
Always remember, the winning numbers are 42% won/loss ratio and a2:1  proﬁt/loss  ratio.  I  also  recommend  including  your  commissions  andfees in your proﬁt/loss ratio. They are part of your expense picture, so youneed to account for them.
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RULE #19
Know Whento Take a Break
When things are at their darkest, pal, it’s a braveman that can kick back and party.
—Dennis Quaid, as Lt. Tuck Pendleton 
in Innerspace
One of the hardest things for new traders to do is to appreciate that
the markets aren’t going anywhere. The worldwide evolution of ﬁ-nancial markets is just like the evolutionary process evident in anygrowth.  Biological  life-forms  mutate  and  change,  weather  patterns  de-velop  and  change,  technology  develops  and  replaces  older  technology;anything  where  you  can  ﬁnd  some  sort  of  a  growth  pattern  will  mostlikely continue to develop and change. I think it is a safe bet that the cur-rent  business  and  economic  climate  will  be  included  in  that  process  ofchange and development. What is almost certain is that ﬁnancial marketswon’t  take  a  step  backward  or  cease  to  exist.  The  markets  aren’t  goinganywhere.
Most traders would agree with this point of view, but that is wherethey stop. It is easy to say that we know the markets will be here tomor-row  and  most  likely  for  as  long  as  humans  live  here,  but  it  is  quite  an-other to remove yourself from the trading environment and simply go dosomething  else  for  a  while.  Many  traders  have  a  hard  time  doing  that.Most traders feel a tremendous sense of loss if they are unable to remainconnected to the market almost continually; they don’t want to miss thatcritical piece of news or that perfect trade. Many traders will literally stayawake for days at a time, trading as close to 24 hours around the clock as
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they can. If the particular market they trade is closed until the next day,these  traders  feel  compelled  to  analyze  their  positions,  select  multipleopportunities for the next trading session, or pore endlessly over marketcommentary.
As a group, traders have an almost manic obsession with their mar-ket and the proﬁt potential they perceive to be available every day. Forthese  individuals  to  stop  trading,  even  for  just  one  day,  is  a  huge  chal-lenge.  Just  look  at  the  proliferation  of  portable,  handheld  trading  inter-faces offering real-time execution. What opportunity could be so grosslyoverwhelming that I can’t afford to ride the bus for 15 minutes because Imight lose a proﬁt?
All  of  this  voluminous  market  data  and  all  of  the  state-of-the-arttrading  vehicles  have  evolved  over  time  as  a  method  of  either  makingsense of the madness or exploiting an ever more esoteric opportunity re-lated  to  the  underlying  fact  that  everything  is  changing  and  it  willnever  stop.  If  you  want  to,  you  can  trade  options  on  options,  you  cantrade pollution futures, you can trade electricity, and you can trade in-dexes  on  indexes;  plus  you  can  get  real-time  data  on  a  palm  computerwhile you are riding in a cab on the way to your daughter’s recital. Don’tforget your cell phone in case you have to call one of your many brokersand  get  your  ﬁlls  on  your  trades  done  in  Asia  or  Europe  last  night  (orwas it this morning?).This is insanity.None of this super-connectivity or mobility will ever help any tradermake better trades or maximize his potential. I want to remind everyonethat the current state of evolution and ﬁnancial specialization has not im-proved the trading environment enough to make more losers into winnersand more winners into bigger winners. Financial evolution is spinning outof control as we start the twenty-ﬁrst century.
We need to remember that trading is not a science—it is an art form.Science does not make good art; that is why it is science. As a trader whowants to develop and maintain his edge for optimal performance and max-imum proﬁts, you would be wise to take a step back and focus on what itis that really creates your proﬁts. Your thinking creates your opportuni-ties, and if your thinking suffers, so does your opportunity.
I am of the opinion that trading is an intensely personal and subjectiveexperience. No two traders will ever see the market in exactly the sameway. No two traders will ever position themselves exactly the same way.No  two  traders  will  focus  on  the  same  information  in  exactly  the  sameway,  and  no  two  traders  will  ever  come  to  the  same  conclusion  aboutprice action. The only thing any two traders have in common is the factthat they buy and sell in the same place. It is because of this personal and
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subjective  nature  of  the  trading  environment  that  the  issue  of  knowingwhen to take a break is so crucial. The moment your thinking stops beingyour best thinking possible, your performance starts to slip.
If you observe any top performer in any ﬁeld, you will probably noticea few things. First, they play their game their way. If they are in business,for example, they do things a certain way and they seldom move too faraway from that baseline activity. If they do change something they are do-ing in a particular way, they will have a very sound, well-thought-out rea-son. Next, they know what is important to make a proﬁt and guard thatpotential  in  as  many  ways  as  possible.  It  really  doesn’t  matter  what  theproﬁt potential is or how it is realized, they know what will work and theyknow that they know. As traders, we do the same things.
But  many  top  performers  in  other  ﬁelds  remember  one  more  thing.They see life as a whole. They are interested in balance. They know thatlife  is  made  up  of  many  different  things  and  that  business  is  just  one  ofthem.  In  fact,  they  will  tell  you  the  reason  they  are  in  business  the  waythey  are  is  to  enjoy  the  various  other  parts  of  life  more  completely,  andthat those things create more energy for them to work better. Business ismore of a means than an end for those top performers. If you look at thelives of top-performing athletes, you will notice that while some things aredifferent,  there  is  a  baseline  that  is  very  similar.  They  train  regularly  tostay in physical condition, they are disciplined about things like what theyeat or drink, they practice their game to stay on edge, and, most impor-tant, they know when to rest.
In  almost  any  other  profession  there  is  a  range  of  performanceacross all participants. Not everyone in a profession is a top performer,but in most professions you can earn a paycheck without being a top per-former. In trading, if you are not a top performer, you most likely will suf-fer  losses.  It  is  wise  to  remember  that  you  are  not  competing  againstother  traders.  You  are  competing  against  yourself.  If  you  are  not  at  thetop of your game when you play, the probability that you will beat your-self increases.
Due to the subjective and personal nature of trading, part of a strong