crop I plan to grow, I would sell my entire projected crop at the cur-rent price of corn futures. If the price of corn goes higher, I can’t partici-pate in that additional proﬁt, because I locked up my crop before then, butmy beneﬁt is certain: I will have a proﬁt this year. If the opposite happens,such as a big drop in corn prices, I will still have a nice proﬁt this year be-cause I own the right to sell my crop to someone at a higher price—andthat contract is guaranteed by the exchange. The buyer of my crop is ob-ligated to pay that price.
The speculator, on the other hand, is looking to exploit price action tomake a personal proﬁt due to changes in the price of corn. He probablyhas never seen an ear of corn except at a barbeque. He has no idea how itis grown or what it is used for besides eating at a barbeque; he spends lit-tle time speaking with farmers who produce the corn. He simply compilesthe data he ﬁnds valuable and decides when it is time for the price to riseor fall. He places himself at risk, and once that happens he will either havea proﬁt or a loss; that is all the speculator cares about. As far as the specu-lator is concerned, the corn market is nothing more than a potential checkin the mailbox.
You are probably saying, “Yeah, I know that—I have been trading for
years. What does this have to do with a bear market?”
The point is—in this case—the hedger’s selling pressure is never an-swered  with  a  corresponding  buy  order.  The  market  has  more  net  sell
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orders as long as the hedger participates. The hedger sells the market. Hedoesn’t  have  to  buy the  market.  He  may  deliver  against  his  position.Therefore the speculator who buys and sells is the net force on the mar-ket. Sooner or later that will create a permanent net selling market. To seehow, look at Figure 24.1.
Now, suppose the market has apparently become bullish. Speculatorsare  buying  the  market,  and  the  sellers  that  are  letting  them  in  are  otherspeculators. The losing speculators on the sell side continue to buy backtheir losing shorts, creating a price advance due to the net order ﬂow im-balance from the buy side. Prices advance to a point that is considered toohigh for everybody.
Enter the hedger. The hedger sells, the speculative seller opens a newshort, and the open trade longs decide to liquidate and they also sell. Atthis point, that market is under three times the selling pressure it normallyhad been under up to that point. This is why markets always break fasterthan they rally. Once the winning shorts from above the market decide tocover,  that  is  the  only  buying  pressure  left.  When  those  winning  shortscover,  the  game  is  over.  The  losing  longs  have  to  sell  at  a  loss  and  thehedger doesn’t have to let them out. The hedgers from above the marketdon’t have to do anything. In fact, a bona ﬁde hedger is not subject to mar-gin  requirements  or  forced  liquidation  to  begin  with;  once  they  sell  intothe market, they really are under no further obligation the way the specu-lator is. The bull market was a temporary aberration that was exploited bythe hedger or professional short-seller. The longs had no chance net, even
FIGURE 24.1 Forced Liquidation Matrix
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though the price advance may have been several months long and manyshrewd traders may have pulled some money out.
Obviously, the relationship between the hedger and the speculator ismore complex. Hedgers will scale positions into a price rise; they will buyback  on  breaks  in  price  to  confuse  participants  as  well  as  draw  morelongs in. Speculators will be long from one area and then short at anotherarea; fundamentals will develop that change the way participants are see-ing new price potential. All sorts of things will play out during a temporarybull  market.  The  essential  thing  to  remember  is  that  sooner  or  later  thehedger will have exploited the market from the net sell side and will sim-ply wait for the speculators to exhaust their potential. Once that happens,the  remaining  net  short  potential  will  crush  the  remaining  longs  untilprices return to a lower equilibrium.
If you want to see historically how bull markets are exploited by pro-fessional selling, try looking up the data for the grain bull market in 1988.If you look at the highest prices paid when the rally had become exhaus-tive,  compare  that  to  the  Commodity  Futures  Trading  Commission(CFTC) “Commitment of Traders” report. Note the net short position heldby  hedgers  for  the  two  or  three  weeks  leading  up  to  the  highs  in  thegrains. The record high open long positions by speculators were all placedinto the market during that time as well. There was nowhere for the priceto go but lower as those losing longs liquidated and added to the sellingmomentum. By September of that year prices had fallen back to within ashort distance of the ones traded in the spring. The hedgers simply sat ontheir hands for the most part as prices hit the highs and then declined. Bythe  end  of  the  year,  the  open  trade  gains  and  losses  had  all  been  liqui-dated;  delivery  notices  were  not  any  bigger  than  usual.  Most  of  thehedgers  had  covered  their  shorts,  too,  probably  because  the  distance  ingain  was  enormous  and  there  was  no  need  to  actually  deliver  the  grainagainst  the  short  contract.  The  grains  have  never  traded  to  those  highsagain since that time, as of this writing in 2006. In fact, due to grain in stor-age and the import/export situation at the time, there was no real shortageof grain at all, even though some of the crop was lost to the drought thatyear. There was no bull market. There was a selling opportunity.
I am not trying to oversimplify. I realize that fundamental changes areoccurring in the breadth and scope of the marketplace. I know that priceaction is not as simple as described here, but the important thing is to un-derstand  is  simply  this:  Markets  exist  for  the  hedger’s  beneﬁt.  In  mostcases, the higher the price goes in any market, the more the hedgers willexploit that from the sell side. Very few markets are used by hedgers fromthe buy side, and when they do use them, they don’t want higher prices ei-ther. In both cases, the hedgers really want the buyer to come to the tableand play—to assume the risk they don’t want. A selling hedger needs the
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bull market to sell into; he only needs one bull market every few years tohedge several years out. The buying hedger will liquidate his buy hedge atthe drop of a hat because it is in his best interests for the price to decline.Think of it this way: No matter what happens to the fundamental pic-ture, once a bull market develops, the selling hedger will cap that marketsooner or later and the buying hedger will sell off his longs once the bullmarket is over. Both kinds of hedgers need the blood of the speculativebull to return prices to equilibrium after they have protected themselves.By the time the dust settles, in almost all cases, the number of sell ordersthat have been executed is greater than the number of buy orders; the re-maining numbers of open shorts are delivered against. This doesn’t haveto be a large number of open contracts, only enough to tip the balance tocreate a no-win situation for the speculative bull who must add pressurefrom the sell side to take his loss. All three eventual sellers execute, andonce prices are lower, the sellers who choose to cover by executing fromthe  buy  side  will  always  be  fewer  than  the  open  shorts  who  will  holdthrough delivery.
If you are going to trade under bullish conditions, learn to be hyper-vigilant  on  the  activities  of  hedgers  and  professional  large  sellers.  Theyare  going  to  use  that  bull  market  to  sell  into,  and  when  the  stage  is  set,that market is going south in a hurry. Always remember that bull marketsare temporary.
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RULE #25
Buy/Sell 50%Retracements
You  can  make  a  fortune  following  this  one  rulealone.
—W.D. Gann, The Tunnel Through the Air
M ost  successful  traders  will  tell  you  that  their  systemized  ap-
proach  to  executing  trades  is  “very  simple”  for  them.  Theymight appear to be analyzing the market differently than losingtraders do, but in reality they are not doing anything different—they arejust  simplifying  the  bedrock  issue  of  identifying  the  net  order  ﬂow.What they have learned from experience is that certain types of marketbehavior  look  like the  same  thing  to  them  every  time.  From  their  per-sonal trade results, they know that what looks like the same thing hap-pening  is  usually  followed  by  a  certain  higher  percentage  of  priceaction in a certain direction. In other words, once something happens,and it looks like it is time to buy, since their historical results indicatethat they are correct about 67% of the time, they buy. Obviously, the keyis in how they are deﬁning what the market “looks like” to them. Mostwinning  traders  have  a  systemized  approach  that  includes  a  certainamount of basic analysis and discipline, but this “looks like” thing is anintuitive issue.
Developing a winning approach takes time and discipline. You needto  keep  it  simple  whenever  possible,  and  you  will  always  do  betterwhen  you  boil  down  whatever  you  are  learning  to  the  essential  teach-ings contained inside the theory. That is what this rule is about, creatinga very simple tool to use successfully. One of the best ways to develop a
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winning approach, to add that “looks like” component to your personalresults, is to enter positions on 50% retracements.
I  want  to  make  one  thing  abundantly  clear:  50%  retracements  arenot Fibonacci study, projections, or retracements. Fibonacci was a Re-naissance  mathematician.  He  was  interested  in  uncovering  the  grandharmony and design of the universe. He wanted to ﬁnd the all-pervad-ing, bedrock component to the nature of physical reality—what you andI  would  call  the  essence  of  the  physical  universe.  He  lived  in  a  timewhen money was a very unsophisticated concept. The general level ofignorance in which people existed at the time just before he lived wasprofound.  Fibonacci’s  discoveries  would  have  been  seen  as  dramaticleaps forward, so much so that they looked like magic and bordered onheresy.
Still,  Fibonacci  believed  things  about  the  nature  of  reality  that  youand I know today are completely erroneous. For example, Fibonacci wasan  alchemist.  He  believed  with  all  his  heart  that  he  would  discover,through mathematical design and prayer, the very nature of reality. Whenhe  did,  he  would  exploit  this  knowledge  to  turn  lead  into  gold,  therebyending  his  money  problems.  If  I  told  you  that  as  a  trained  trader  I  willtrade  for  you,  and  that  I  will  execute  for  your  account  by  studying  theﬂights of bees, you would be no worse off than if you followed Fibonaccithrough his day as he tried to turn lead into gold.
Fibonacci  never  applied  the  golden  ratio  or  the  Fibonacci  Progres-sion  to  markets  or  trading.  None  of  that  existed  yet.  Fibonacci  discov-ered a part of nature that is accurate for the study of nature, nothing else.He didn’t know that at the time. He himself lived under a cultural illusionand  wasted  his  knowledge  pursuing  something  that  couldn’t  physicallybe done.
Why am I telling you this? Because Fibonacci retracement study is anaccepted  method  of  simple  technical  analysis.  All  successful  traders  usesome  form  of  retracement  analysis  in  their  simple  methodology.  But  Fi-bonacci never intended his discoveries to be developed or applied to trading.That was W. D. Gann’s idea, so your best bet in understanding retracementsis to study W. D. Gann, not Fibonacci.
Gann discovered a unique relationship between time and price that isstill  considered  accurate  today.  That  relationship  is  apparent  across  allmarkets in all time frames; no successful trader should ignore it. The rela-tionship is very simple and actually was initially discovered by Fibonacci,except  Fibonacci  had  no  use  for  this  knowledge—he  was  busy  goingbroke trying to turn lead into gold.
The  time/price  relationship  follows  the  rule  of  72  and  50%  ratios.Some of this is also covered in Elliot Wave analysis but I want to make thissimple. Any time pundits of Elliot Wave, W. D. Gann, or Fibonacci start
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talking they complicate this whole retracement issue so dramatically thatyou would think the sun rotated around the earth just prior to the mooneating it. People need to just relax and focus on the main issues.
Fifty  percent  retracements  are  important  because  they  balance  thenet inequality between the competing net order ﬂows. That’s it. Retrace-ments do not predict price action or portend new highs or lows. Retrace-ments are not predictive. They are historical. The reason Gann, Elliot, andFibonacci are all included in this discussion is because they happened tonotice the relationships ﬁrst—though they didn’t necessarily understandwhat it might be saying. Fibonacci noticed that a mathematical ratio ex-isted in nature. He assumed that lead and gold would also be subject tothis natural ratio but, as we know now, this is not true. This ratio is appar-ent in nature and in the way things grow; it is not apparent in crowd be-haviors, and markets are about crowd behaviors.
Gann asked the question, “What if the market has a ratio and rhythmin and of itself?” Gann thought he had found an answer to that questionwhen he and Elliot noticed that markets appear to have waves that occurwith  regular  frequency  and  repetition.  By  combining  these  two  assump-tions into a larger assumption, we now have a supposedly “veriﬁed” math-ematical model to follow in pursuing our trading success.
But the apparent relationship is not the same thing as the real rela-
tionship. The real relationship is what we want to discuss.
Fifty  percent  retracements  happen  because  once  enough  buyerssquare off against enough sellers, only half of those contracts will be prof-itable. At the 50% number, exactly half the bulls have a proﬁt and half thebears have a proﬁt. When I say this, it is important to note that this is a netperspective. The actual result to any one trading account isn’t the issue. Ifyou  could  ﬁnd  a  way  to  look  into  the  total  number  of  open  trades,  youwould see that of the sum total of the open longs, about half of that totalnumber of open contracts will have an open-trade proﬁt—the others willhave losses. In other words, if there were 10,000 open longs, around 5,000of them will have some open-trade gain and the other 5,000 will have someopen-trade loss. The exact same situation will be accurate for the shorts.The market is now temporarily balanced from the net perspective.
This  situation  won’t  last  long;  it  will  only  take  a  short  time  for  newbuying or selling pressure to come in. Whoever has the net advantage atthat point will tip the balance. Most of the time it is in the original direc-tion back toward the previous high or low because from the net perspec-tive the late loser entered from the short-term trend—that is, the few daysor so just before the 50% level is reached.
This is a factor of the rule of 72. Most market participants operate on atime frame of 72 hours or less. That means that in all the various ways ofcreating a market timing signal that now is the time to initiate a position,
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most traders have gotten at least one signal in a 72-hour period and haveexecuted, creating net order-ﬂow. Once they have initiated, they must liqui-date to accept their open-trade proﬁt or loss. Most methodologies will havegiven the exit signal within that time frame as well, with the net result thatalmost everybody has gotten in and out at least once within a 72-hour pe-riod. If this process happens at a 50% balance point, the net result is usuallya resumption of he previous trend. See Figure 25.1.
HOW TO USE THE RULE
First you must select a signiﬁcant high or low price previous to the pricethe  market  is  currently  retreating  from.  When  I  say  signiﬁcant  price Imean  a  price  that  is  around  72  bars  back  in  time;  also  they  are  usuallyweekly, monthly, or daily price points. If we use a bullish scenario, you arelooking  for  a  previous  important  low  price  and the  market  is  retreatingfrom the most recent high. If you use a daily chart, as used in Figure 25.1,your previous low price must be about 72 days/bars back or so, I ﬁnd thaton longer time frames anything substantially less is not as accurate, andanything signiﬁcantly more is usually ignored by traders as “old data.”
Place  a  50%  retracement  study  between  the  old  low  and  the  new
FIGURE 25.1 Buying  and  Selling  50%  Retracements—Cash  Euro/USD.  FOREX,April 2005 to April 2006.
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high—that would be your best buy point. That point will be some time inthe future that approximately reﬂects the 72-bar ratio. This is why a pricecould trade to a high and Gann would say, “By this time next week, themarket will trade at _____ (price).” He would be merely projecting his ra-tios and computations forward some amount of that ratio as a price/timerelationship.  Of  course,  the  opposite  would  be  a  sell  point  if  you  weretracking  a  rally  in  a  bear  market.  But  the  underlying  psychology  behindthe  50%  retracement  is  not  about  resumption  of  a  previous  trend  or  afailed reversal; it is about the late trader who entered in the last 72 hours.Most  people  who  initiate  a  position—about  80%  of  the  total  warmbodies sitting in front of a trading screen—are going to do at least one fullround turn in the market just prior to the market reaching the 50% pricearea. The vast majority of those traders are looking to make money rightnow.  If  they  follow  standard  technical  analysis  or  use  any  of  the  mostcommon methodologies, because the market was trending lower for morethan 30 bars from the rejected high to the 50% point, they are looking tosell  into  the  market  and  join  the  apparent  downtrend  currently  inprogress, from their point of view. Their focus is to get positioned on theshort side because “the trend is your friend.”
But  the  market  has  just  become  balanced  momentarily.  That  meansonly one thing. The shorts from above the market will cover; they have themost recent 72-hour open-trade proﬁt. The late shorts cover, adding to thebuy  order  imbalance  as  they  take  their  loss.  Last,  the  old  longs  on  thegreater-than-72-bar  time  frame  (the  20%  of  long-term  traders,  the  oneswho know how to follow this rule—the professionals who know you needmore than 72 hours to beat the loser) add to net winning open positions,many  of  which  they  have  owned  since  the  turn  under  the  market.  Theyknow  that  the  retracement  is  coming  and  it  will  draw  in  late  blood.  Sothey gladly sit through the 50% retracement with at least part of their orig-inal position. Of course, the exact opposite scenario develops when a de-clining market rallies 50%.
Now  obviously,  markets  don’t  always  turn  on  a  dime  once  they  re-trace 50%. Sometimes they take more time to balance temporarily; some-times they need several more or fewer bars than 72; sometimes they sit atthe 50% level for a bit and then retrace farther before moving back in theoriginal trend. None of that is the point. The point is, if you want to make alot of winning trades and keep it simple, enter your position at the 50 per-cent retracement point and wait. More often than not you will get at leastsomething you can work with.
When  you  combine  this  rule  with  Rules  #11,  #14,  #16,  and  #17,  youhave a huge potential to take a lot of money when a market still has moreto go and you are willing to wait for it. In fact, you only need a handful oftrades a year if you are willing to think ahead more than 72 bars when you
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are  developing  a  trade  hypothesis.  Traders  who  have  hit  the  home  run,traders  who  have  been  long  a  bull  market  when  an  honest-to-goodnessshortage  is  developing  or  short  an  hysterical  bull  market  when  thehedgers ﬁnally cap the rally, will tell you that when the 50% retracementhappened, it was truly a thing of beauty and the money rolled in.
One last thing before we close out this rule: In fairness to all the peo-ple out there who are legitimate experts on the theories of Gann, Elliot,and Fibonacci (which I am not), I really don’t intend to discredit anyoneor their theories. I just think that the essential part of what these men canteach us is best found when we use some simple common sense. No onehas  a  secret  method,  and  there  is  no  perfect  technical  approach.  Thesegreat men of history and of the markets found pieces of the deeper truthand expressed it the best they could. Only they could know how to use thesum total of their knowledge in today’s markets; the rest is conjecture andopinion by people who never knew them personally.
I think it is important to remember that the essential part of marketknowledge  is  simplicity.  Remember,  Livermore  was  a  contemporary  ofGann and Elliot and made more winnings then they did combined. Liver-more never used these kinds of analysis. He understood people and howthey behave, so well that he could read a market better than others couldanalyze a market. I think the best traders are those who read the marketsﬁrst; I don’t think the analysts are thinking along the same lines. StudyingGann, Elliot, or Fibonacci by reading their books is similar to saying youunderstand Beethoven well because you can read his music scores.
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RULE #26
The OnlyIndicatorYou Need
You should try to buy weakness and sell strength.That’s  the  crowd  panicking.  The  problem  is,  howdo you know they are getting in or getting out?
—Mark Twain, Discussions with Nikola Tesla
Many people are unaware that Samuel Clemens (Mark Twain) was a
trader. During his time, traders were referred to as “Speculators”and they had a somewhat unsavory reputation. Speculators wereseen as exploiters, making money from other people’s suffering or need.The  worst  form  of  speculator  was  the  carpetbagger  who  helped  rebuildthe South with Northern money after the U.S. Civil War. Clemens himselftraded in cotton and grains but with little success, according to some bi-ographies of his life.
At the time, the development of futures contracts was in its infancy.The  Chicago  Board  of  Trade  was  only  founded  in  1848  and  probablywouldn’t have survived if futures contracts hadn’t caught the eye of the vi-sionary industrialists and large farmers. Most of the attention that was fo-cused on market opportunities revolved around the Industrial Revolutionsomehow. Speculators were often involved in buying land that they hopedto sell to the railroads or lease for the right of way, buying steel to sell toship  builders,  and  so  on.  Only  occasionally  did  speculators  trade  in  fu-tures  for  consumable  commodities;  it  was  still  a  new  concept.  But  eventhen,  during  the  late  19th  century,  people  saw  ahead  to  the  explosivepotential in ﬁnancial markets, and a new class of ﬁnance evolved. In to-day’s world, ﬁnancial brokers are the gateway between market opportuni-
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ties and capital—even now when electronic trading typically bypasses thetraditional brokerage relationship.
One  thing  that  remains  constant  in  the  process  of  ﬁnancial  evolu-tion is the concept of inside information. To this day, part of what peo-ple view as a trading edge is knowing something ahead of time that ispotentially market moving. This is not quite the same thing as a tip. Get-ting  a  tip  means  being  advised  what  to  do  by  someone  who  allegedlyknows  something.  Market  information  or  trading  edge  is  more  aboutﬁnding a better way to do something that is already known to work. Inthe opening quote for this rule, it is apparent that Clemens understoodthe basic nature of the market and knew it could be exploited; his prob-lem  was  getting  the  information  required  to  know  whether  he  was  inthe  right  place  at  the  right  time.  This  is  where  the  whole  business  ofanalysis  and  indicators  came  from—an  attempt  to  quantify  market  in-formation  to  exploit  what  already  works.  The  basics  of  trading  havenever really changed.
Remember,  some  of  the  biggest  fortunes  ever  made  from  tradingcame at a time when the only tools available to traders were their guts, in-tuition, and knowledge of the crowd. I say this because, as you will haveguessed by now, I put only a small part of my trade study into technicalanalysis. I know many will stop there and form some sort of value judg-ment. They might assume that because I don’t use what they have used,and they are making money with it, I must not know what they know; per-haps I don’t know the experts they know, or maybe I just have an axe togrind. They might say I am not qualiﬁed to discuss technical analysis be-cause I don’t use technical analysis the way they do. The proof is in thepudding, they would argue.
I say this about big-money traders and historical ﬁnance because suc-cess without analysis is factual history—not because I feel that analysishas no place in trading. Quite the opposite. Successful technical analysiscan be a very important part of lasting trading success but, as discussedin Rule #15, like it or not, it can only go so far. The fact is that using tech-nical  analysis  is  like  an  unskilled  carpenter  using  power  tools.  Withoutthe  basic  knowledge  of  carpentry,  an  unskilled  carpenter  will  make  awreck of house building when he is turned loose with better tools than heknows  how  to  use.  That  brings  us  to  this  maxim  of  “the  only  indicatoryou need.”
But ﬁrst we should clarify the thinking behind most of the indicatorscurrently  used.  Most  indicators  and  oscillators  attempt  to  quantify  theconcept of overbought or oversold. The psychology behind this thinking isactually  very  sound,  in  my  opinion.  The  idea  that  the  market  can  getoverextended in one direction or the other is not a new idea. It is one ofthe  cornerstones  of  successful  trading.  That  is  one  of  the  concepts  that
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