and long-term marketplayers looking for an opportunity is such that so far the net order ﬂow re-mains  offers.  Since  in  most  cases  the  majority  of  traders  will  not  see  achange in conditions far enough in advance to buy into a declining mar-ket, nor will they hold a position for the time required to earn the largestgain from a change in trend, we can assume that the majority of tradersare either still short the falling market, on the sidelines waiting to make amove on the short side, or executing regularly from both sides with vari-ous results to their accounts. But as far as you are concerned, buying into
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a declining market has a degree of risk; hence the old favorite rule, “Don’tpick tops or bottoms.”
The absolute best place at the lowest risk for a trade is at the top orbottom, but ﬁnding that point is where the issue of probabilities comes in.If you knew the market had bottomed, and you were willing to assume therisk  that  conditions  were  turning  bullish,  you  would  want  to  execute  atyour price right now. It is absolutely certain that sooner or later that mar-ket  will bottom,  but  is  the  current  bottom  a bottom  or  the bottom?  Nomatter your research or analysis, you cannot know that for certain untilsometime later, so you must think in terms of probabilities. Let’s look atan example, shown in Figure 3.1.
In  this  ﬁgure,  prices  are  moving  in  a  general  sideways  trend.  Thismeans that buying and selling pressure is about equally balanced, becausea market cannot steadily advance or decline unless there are more ordersnet  from  one  side  or  the  other.  At  this  point  in  time,  both  the  proﬁtableshorts  and  the  potential  longs  are  seeing  two  opposing  things.  For  theproﬁtable short, his risk is increasing because no further net price action
FIGURE 3.1 Nearest  Futures  Contract,  CBOT  Corn  for  July  Delivery,  as  of  De-cember 2005
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is favorable for additional proﬁt; he must either cover or wait for the trendto resume. For the potential long, the lower the price goes the better theopportunity  if  the  change  in  trend  is  coming  eventually.  The  longer  themarket does not go down, the better the potential that the actual bottomis ﬁnally in place.
In  both  cases,  a  choice  to  enter  a  buy  order  is  the  only  result,  nomatter when either side decides to do it. How those buy orders are nowbeing absorbed by early long liquidating with a sell order is a great clue.If the buy orders are mostly late (old) shorts liquidating, a drop in openinterest will result. The traders with the selling point of view are chang-ing their minds. Figure 3.2 shows this well. Note the steady advance incorn prices after high volume and a drop in open interest from that pointforward.
The study of volume and open interest (V/OI) is an entirely separateissue  from  the  psychology  of  thinking  in  terms  of  probabilities.  If  youwere looking at a potential bullish scenario developing and you knew thatmost traders were bearish or prices were still declining, at some point you
FIGURE 3.2 Nearest  Futures  Contract,  CBOT  Corn  for  July  Delivery,  as  of April 2006
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knew that would change sooner or later because it is not reasonable toexpect corn prices to drop to zero; somewhere between zero and wherethey are now, there will be a bottom price. It is more likely that a bottomis forming when no one wants to sell the market anymore; it is too riskyfor an additional price decline as far as the shorts are concerned. The po-tential  bulls  see  their  risk  dropping  the  farther  the  market  goes  lower,and at some point they will simply say “Wow! That market is on sale!” andbuy.  If  that  scenario  develops  to  the  point  where  the  buy  orders  (bothnew longs getting in and the old shorts getting out) compete with the sellorders (late shorts getting in and early longs getting out), and a drop inopen interest results, the probabilities are rising that a bottom is formingbecause the only trade group who is most at risk for a price rise would bethe open-trade winning shorts. The late short is dead meat anyway so hedoesn’t count.
When these two opposing points of view actually do something, youhave the potential of a bottom forming at that price area. The V/OI ratio isonly  one  clue.  As  a  trader  thinking  in  terms  of  probabilities,  your  onlyquestion is what is more likely to develop as time goes on. Sooner or laterthe market would have bottomed anyway. If you want to be on the rightside for the pull when the trend changes, you have to ask yourself whenand where it is most likely to happen, and that is not at any one price; it isa factor of the psychology behind the price.
The same psychology is behind every form of trade selection you do.You are looking for what is most likely, given your understanding of thebullish  and  bearish  pressures  that  are  playing  out,  as  you  understandthem.  If  your  time  frame  is  shorter  or  longer,  there  will  still  be  a  morelikely  scenario  that  needs  to  be  considered  when  you  make  your  tradeanalysis.  It  needs  to  be  considered  as  part  of  your  trade  plan  because  aﬂexible trade plan accounts for the possibility that something is changing.Your goal as a trader is to go with the path of least resistance, and that is afactor of probabilities, not analysis.
I have found that the best thing to do when I am looking for the truepotential of a trade is to argue the case from both sides. I ask open-endedquestions: Who is winning? Who is losing? What could make either sidequit?  What  will  cause  the  bulls  or  bears  to  liquidate?  What  will  causethem to commit themselves more fully? Then the big question: Which ismore likely?
By  asking  several  kinds  of  questions  designed  not  to  form  a  certainabsolute conclusion but to uncover the market’s best probability forward,you as a trader have more options open to your trade selection process.As that trade selection process gets better and better deﬁned over time,you will see that some trades are better for you personally than others. By
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thinking in probabilities you reduce the potential to have a loss by not tak-ing low-probability trades, and you increase the potential to let proﬁts runwhen you are in a high-probability trade. You can’t know for certain aheadof time, but you can see the likelihood of one situation developing betterthan another.
At that point, you take your position and wait.
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RULE #4
Know YourTime Frame
There is no right way to do something wrong.
—Anonymous
No discussion  of  trading  would  be  complete  without  some  dia-
logue regarding the issue of a trading time frame. There is a rela-tionship between you as a trader, your trading plan, your tradingmethodology, and the amount of time all of these variables need to ei-ther  conﬁrm  or  deny  that  an  opportunity  for  a  proﬁt  exists.  Not  allmethods  will  work  under  all  time  frames  and  if  you  personally  don’tknow  your  own  decision-making  process  very  well,  you  might  betempted to work with a system that is not compatible with your naturaltime frame.
Everyone has a natural time frame in which they function best. By“natural time frame” I mean the amount of time required for you person-ally to reach a conclusion and then act on it. You cannot participate inthe  markets  without  reaching  some  sort  of  conclusion  that  prices  aretoo  high  or  too  low  relative  to  some  other  price  that  the  market  willeventually  reach,  assuming  that  your  hypothesis  is  the  right  one.  Afteryou  reach  that  conclusion,  you  then  act  on  it.  Depending  on  your  per-sonal  temperament,  your  tolerance  for  risk,  your  previous  success  orfailure, your education, and so on, the amount of time you need person-ally might vary, and this is what gives rise to the multitude of differenttrading approaches.
What is not immediately apparent to most traders is that what soundsgood  or  makes  sense  initially  when  trying  to  create  a  market  presence
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may not be compatible with their natural time frame. If this kind of con-ﬂict  develops,  then  following  the  rules  of  the  system  will  be  difﬁcult,  aswill  trying  to  create  a  trading  plan,  because  those  things  are  not  in  har-mony with the unique person of the individual trader.
The ﬁrst step in selecting a methodology that will be best for you andin learning to best apply the rules is to select a trading time frame compat-ible  with  your  character.  If  you  are  someone  who  likes  to  think  thingsthrough from many different angles and then sleep on it before making adecision,  a  longer  time  frame  for  trading  might  work  better—perhapsweeks or months. If you are someone who can make fast decisions andthink on your feet, then a shorter time frame might be best for you. Mosttraders go through many different approaches and systems, not becausethey  haven’t  found  the  right  system,  but  because  they  haven’t  found  theright system for them. In many cases, it is the issue of a compatible timeframe that is a major factor.
Most traders start out trading in shorter time frames and then gradu-ally expand to longer time frames. This is partly due to general inexperi-ence  and  partly  due  to  fear.  Because  gains  or  losses  can  occur  quicklyand  sometimes  appear  to  be  random  to  new  traders,  a  shorter  timeframe  is  attractive  because  it  limits  the  amount  of  initial  stress  a  newtrader  feels  when  he  is  learning  to  maintain  or  develop  a  market  pres-ence. Some traders conclude that trading is a completely random eventand  therefore  they  must  trade  a  smaller  time  frame,  such  as  minutes.Others feel that the markets must reﬂect actual supply and demand fun-damentals sooner or later, and they view day-to-day or intraday ﬂuctua-tions  as  random  noise;  they  focus  on  remaining  on  one  side  of  themarket for months at a time.
If a trader selects a time frame too short to begin with, that trader typ-ically feels that things are moving too fast and they tend to have a lot ofhesitation at entry points, looking for conﬁrmation before entering a posi-tion. Even a small correction can be frustrating because that was a lossthat happened too fast, and often the market will return to the entry pricequickly. If a trader selects a time frame too long for his temperament, theboredom of waiting for a trade to work over days or weeks will cause adesire to overtrade or try to force the market to pay him. The frustrationof watching equity inhale and exhale daily by several thousand dollars willcreate a fear of loss and typically liquidation before the best objective isreached, because it is just taking too long to get there.
If you personally are experiencing a high degree of emotional conﬂictwhen you trade at this point, you can do a lot to eliminate that pressure byconsidering whether you are trying to trade a time frame that you person-ally are not compatible with. Additionally, if you have a high degree of ex-
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pectation that a trade should work by a certain amount of time, you mightbe using the wrong time frame for you. Both of these inner experiencesare good clues that you are not trading under your natural time frame.
FINDING CONGRUENCY IN YOUR TIME FRAME
Why do a natural time frame and a trading time frame need to be congru-ent? The simple answer is because that is how the market itself is struc-tured. Every individual trader is operating under a unique world of bias,assumption, expectation, and emotion. Not one of those traders enteredthe market expecting to lose; they all (including you) are expecting theirtrade  to  make  money  “right  now”  when  they  put  themselves  into  themarket.
In order for that particular trade to either make money or lose money,a certain amount of time must pass—and every one of those traders canonly give that trade so much time. The time between the execution to getinto  the  market  and  the  execution  to  exit  the  market  is  the  actual timeframe  the  individual  trader  is  operating  under;  but  that  is  often  not  thetime frame he had planned on for himself.
Since most traders are experiencing losses, most traders feel a senseof attachment to their trades, and most traders are disappointed when anyone trade is a loss; most traders are exerting force on the market in a timeframe  that  is  not  what  they  intended.  They  all  expected  their  trade  towork  “right  now,”  but  if  the  concept  of  “right  now”  is  not  exactly  clear,then the amount of time required for the trade to develop its true potentialis not clear. If the price action that is happening “right now” is not whatthe individual trader expected or intended, he loses control of his execu-tion because the price action in the market is inﬂuencing his willingnessto act. That trader is not choosing to make use of prices; the prices are us-ing him.
A simple illustration of this potential is a successful long-term traderholding a position for weeks against him. If, for example, this trader is ex-pecting a rise in prices, and he is willing to wait months for the potentialto develop, he might buy that market on a weekly time frame. He knowsthat it is usually impossible to pick the actual day or hour the market willmake the actual turn in price, but he also knows that when it does, he willbe positioned near the best area for a price advance. He might buy part ofhis position at that time and plan on buying more over a six-week periodof time. He may even buy part of his position at an actual lower price thanhis ﬁrst execution because he is conﬁdent enough in his analysis and his
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trade plan to trust himself with that particular use of his capital. He mighthave  committed  himself  to  holding  the  position,  no  matter  what,  until  aparticular date forward because if it isn’t happening by then, the potentialin  the  trade  is  dropping.  For  this  particular  trader,  on  this  time  frame,what happens the day after his initial purchase is unimportant; he mightsee  that  as  random  noise.  That  particular  trader’s  concept  of  the  tradeworking “right now” is six weeks long.
Now consider a bearish trader in the exact same market. He might belooking at a weekly high as a selling opportunity, but he is using an hourlytime frame and has no intention of holding any trade over a weekend. Af-ter that market trades to a weekly high, he might wait six hours for a con-ﬁrmation  that  the  high  is  in  for  the  week.  He  then  executes  on  the  sellside, and if that trade is not working by the end of the day he will liqui-date. This trader’s time frame for “right now” is two hours. Additionally, ifthe  trade  is  proﬁtable  he  will  exit  the  market  within  a  very  short  timeframe—by the weekend.
In both cases, no matter what time frame each trader is executing un-der,  sooner  or  later  the  net  order  ﬂow  will  affect  their  positions.  In  onecase,  weeks are  needed  for  the  corresponding  pressure  on  the  trader’sthinking  to  develop;  in  the  other  case,  only  a  few  hours.  The  eventualprice that market ends up at during the next three months probably won’tmatter to the hourly time frame trader; he will have had many opportuni-ties  as  he  would  deﬁne  them  during  that  time.  The  weekly  time  frametrader might see things entirely different. Yet both traders are executing inthe same market, and both traders exert pressure on price action by theirexecution.
WHICH TRADER ARE YOU?
Knowing your personal time frame is a necessary part of your trade ap-proach because the only thing that will pay you a proﬁt is getting on theright  side  of  the  order  ﬂow  for  that  time  frame.  If  you  are  an  hourlytrader,  it  is  not  wise  to  position  yourself  on  the  opposite  side  of  theweekly trader. His order ﬂow takes longer to develop, and he will not exe-cute on the other side of the market until a much larger price swing hasoccurred. If you are selling against a weekly trader who is buying, he iswilling to hold that trade much longer, whether the market moves for himor against him. He won’t be there to sell off his unproﬁtable longs in thetime frame you are looking to buy back a proﬁtable short. Your $200-per-contract  open-trade  short  is  random  noise  to  him.  Consequently,  if  yourtrade is not working in a few hours and you want to liquidate your loser,
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he also won’t be there to liquidate his open-trade proﬁtable long—he in-tends to hold it for months.
Of  course,  this  is  an  over-simpliﬁcation  of  price  action,  and  in  anyliquid market there will be plenty of orders available on either side. Butthe point is this: Different time frames are competing, and the intentionof  one  time  frame  is  not  always  the  intention  of  another.  Your  besttrades occur when your own time frame is the same as the time framecurrently in control of the market at that point. When that changes, yourtrade is over.
Part  of  developing  a  sound  trading  plan  and  a  strong  market  pres-ence  depends  in  part  on  knowing  how  to  get  positioned  on  the  orderﬂow  as  it  develops  for  a  particular  time  frame.  To  do  this,  you  mustknow what your time frame is before you begin trading. If you are notwilling to hold positions past a certain amount of time, your system ormethodology must be compatible for that time frame. Don’t buy a trend-following approach if you aren’t going to stay in the market long enoughto get paid from that trend; instead, maybe you should consider a volatil-ity  approach,  one  that  will  give  a  signal  for  liquidation  in  a  shorter  pe-riod of time.
A good rule of thumb is that your time frame should reﬂect your will-ingness to hold a winner, not your tolerance for risk. All systemized ap-proaches or methodology must have an effective way to cut a loss quickly,but the ability to hold the winner is a factor of your time frame. If yourtime frame is daily, how many days could that trade have potential? Onceyou understand your personal time frame you can better hold your posi-tions because all time frames have a period of time that they need to fullyexpress their potential. Quite possibly that amount of time might be verysimilar to your natural tendency to allow things to develop for you, underyour personal natural time frame.
To help determine that ideal amount of time, I have found that a factorof three seems to work best. If you execute on a weekly time frame, youcould expect your trade’s full potential to take around three weeks to de-velop,  assuming  you  are  seeing  it  right  to  begin  with.  If  you  are  a  15-minute trader, expect your trade to need 45 minutes or so to develop. Ofcourse,  any  one  trade  could  have  signiﬁcantly  more  potential  than  yourparticular time frame will uncover, but that isn’t really the issue. No mat-ter what your time frame is, in every trade those probabilities drop aftersome period; how far that trade goes beyond your objective is an issue ofusing multiple time frames (see Rule #12).
But  in  all  cases,  whichever  time  frame  you  choose  to  use  for  yourmethod, ask yourself if that method and time frame are something youare naturally comfortable with. If you don’t like making snap decisions,then a short-time-frame approach offering several potential trades every
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day  will  probably  not  work  well  for  you.  If  you  can’t  stand  waitingaround for things to happen, then a methodology that requires months(such  as  a  system  heavily  biased  to  the  underlying  fundamentals)  maynot be a good ﬁt.
The important thing to remember when you select your time frame isthat  cutting  losses  is  only  part  of  it.  Sooner  or  later  you  will  get  on  theright side of the order ﬂow, and when you are you need to know that it isokay to give that trade the full amount of time it needs to develop the ac-tual potential it has. Your time frame is a signiﬁcant part of that.
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PART II
Cutting Losses
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RULE #5
DeﬁneYour Risk
Not risking is the surest way of losing. If you donot  risk,  risk  eventually  comes  to  you.  There  issimply no way to avoid taking a risk. If a personpostpones  taking  risks,  the  time  eventuallycomes  when  he  will  either  be  forced  to  accept  asituation  that  he  does  not  like  or  to  take  a  riskunprepared.
—David Viscott, M.D., 
Commodity Trader’s Almanac, 1989
It  is  my  opinion  that  the  single  most  important  skill  to  develop  as  a
trader  is  the  dispassionate  ability  to  cut  losses.  How  you  conclude  isthe best way for you personally is less important than having a way todo  it  and  doing  it  all  the  time.  Of  all  the  trading  traps  that  have  to  beavoided, the one trap that will cripple any trader the quickest is the inabil-ity to know and admit when the trade hypothesis is simply not workingnor may it ever work. This goes much farther and deeper than “admitting Iwas wrong,” believing “I can afford to wait a little before I decide what todo,”  “taking  necessary  heat  until  this  turns  around,”  or  any  number  ofways of doing the same thing: justifying your inaction in the face of yourequity evaporating.
The only reason a losing trade happens is because at that precise mo-ment you are on the wrong side of the order ﬂow. It really doesn’t matterhow that happened or what you told yourself in order to execute at that
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point; the fact is you are losing money. As long as you continue to remainon the wrong side of the order ﬂow your loss will continue to grow, untileither you are forced to liquidate (margin call or worse) or you choose toliquidate when the pain of the loss affects you so greatly you can’t bear itanymore. In all cases of a loss being large and unbearable, the simple actof  liquidating  is  done  when  the  trader  has  lost  control  of  his  execution.Someone or something else—either the exchange, the broker, the marginclerk, or your personal need to avoid pain (emotion)—controls the net re-sult now sitting in the trading account. The worst losses will always occurwhen you lose control of your liquidating execution.
This loss of control over your own money is not a trading issue. It is asymptom  of  a  deeper  problem  that  at  its  root  cause  is  a  factor  of  thetrader’s personal psychology. No matter what the root issue is, the poten-tial for that root issue to take away your money must be adequately ad-dressed and prepared for. Sooner or later you as a trader will break theone rule you simply cannot trade successfully without: Deﬁne your risk.If you trade without deﬁning your risk of loss, it is only a matter of timebefore you ﬁnd  yourself in a trading situation you were unprepared forand  money  is  leaving  your  account  at  a  hypersonic  pace.  To  avoid  thatpotential  you  must  master  this  most  important  rule  of  trading:  Deﬁneyour risk.
What does it mean to deﬁne your risk? In my view, it is not as simple asmerely entering a protective stop order, although that goes without saying(I address stops in Rule #6). Deﬁning your risk is a factor of your personal-ity and your personal skill set. Deﬁning your risk should include not justthe cash dollar risk on each and every trade but should also be consideredas part of your overall market presence and willingness to participate.
Not  every  trader  is  a  good  ﬁt  for  all  market  conditions  or  even  allmarket opportunities. As an example, just because you own a gas stationand are intimately involved with the purchase and sale of gasoline everyday does not mean that you would instantly understand all the importantrequirements  for  successfully  trading  in  Harbor  Unleaded  Gasoline  Fu-tures (HU) at the New York Mercantile Exchange (NYMEX). Nor wouldyou immediately comprehend HU’s unique relationship to crude oil sim-ply because you have read a brief discussion of the “crack spread” or at-tended a one-day seminar on “Using Candlestick Analysis in the EnergyComplex.” Many traders make the mistake of assuming that a general un-derstanding of their personal business can provide them an adequate be-ginning edge to exploiting price action. Nothing could be further from thetruth.  In  fact,  the  exact  opposite  is  often  the  case,  usually  because  thetrader makes the assumption that his business knowledge is transferableto trading and therefore does not understand why his knowledge is nothelping his trading.
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One question you should ask when deﬁning your risk is “How muchdo I really know about the _____ market?” If your honest answer is “Noth-ing, really,” then it would be a very good idea to commit to learning a basicunderstanding of what traders in that particular market focus on and whattends to cause a reaction in prices. As an example, many traders are sur-prised to learn that the Producer Price Index (PPI) and Consumer PriceIndex  (CPI)  reports  are  often  largely  ignored  by  professional  FOREXtraders but are closely watched by interest rate traders, even though thetwo  markets  are  intimately  related  on  many  levels.  Without  that  knowl-edge, a novice trader might be tempted to execute a FOREX trade basinghis  choice  on  something  the  FOREX  market  hasn’t  considered  tremen-dously  valuable  at  this  time,  thereby  assuming  a  potential  risk  that  hewouldn’t have had otherwise.
As a trader looking for the best market presence you can master, it iswise to consider your actual education process as part of your risk-reduc-ing strategy. Can you honestly say that you are an expert on the marketyou trade? If not, part of knowing your risk might be to take a regular re-fresher  course  on  market  basics  for  the  markets  you  trade.  All  marketsevolve  and  change  over  time.  What  worked  last  year  may  not  work  thisyear. Be prepared to regularly review and supplement your market knowl-edge, because often the best way to deﬁne your risk is to know in advancewhere the potential pitfalls might be.
Additionally, deﬁning risk can include an assessment of your personalﬁnancial condition and where that adds pressure to your life. This is dif-ferent than the maxim, “Only trade with money you can afford to lose.” Ifyou are recovering from a divorce, for example, and have a strong need torecover ﬁnancially, those non-market-related emotional pressures or con-ﬂicts  might  easily  spill  over  into  your  trade  execution  for  reasons  thathave  nothing  to  do  with  actual  trade  potential.  Someone  who  thinks  hecan  make  his  house  payment  from  trading  and  expects  to  make  thatmoney from the market in a short period of time may be placing himself ina worse position should he have even a small loss. Those types of risk canbe very real and should be carefully considered along with