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TradingRulesthat Work
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TradingRulesthat Work
The 28 EssentialLessons EveryTrader Must Master
JASON ALAN JANKOVSKY
John Wiley & Sons, Inc.
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Copyright © 2007 by Jason Alan Jankovsky. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmittedin any form or by any means, electronic, mechanical, photocopying, recording, scanning, orotherwise, except as permitted under Section 107 or 108 of the 1976 United States CopyrightAct, without either the prior written permission of the Publisher, or authorization throughpayment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the webat www.copyright.com. Requests to the Publisher for permission should be addressed to thePermissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030,(201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions.
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Library of Congress Cataloging-in-Publication Data:
Jankovsky, Jason Alan, 1961–
Trading rules that work : the 28 essential lessons every trader must master / 
Jason Alan Jankovsky.
p.
cm. — (Wiley trading series)
Includes bibliographical references and index.ISBN-13 978-0-471-79216-1 (cloth)ISBN-10 0-471-79216-0 (cloth)1. Speculation.
2. Investment analysis.
3. Futures.
I. Title.HG6015.J36332.64—dc22
I. Series.2007
Printed in the United States of America.
10
9
8
7
6
5
4
3
2
1
4. Foreign exchange.
2006014076
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The fault, dear Brutus, is not in our stars,but in ourselves, that we are underlings.
—William Shakespeare
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Contents
Acknowledgments
Introduction
PART I
Getting in the Game
RULE #1
Know Your Game
RULE #2
Have a Trading Plan
RULE #3
Think in Terms of Probabilities
RULE #4
Know Your Time Frame
PART II
Cutting Losses
RULE #5
Deﬁne Your Risk
RULE #6
Always Place a Protective Stop
RULE #7
Your First Loss Is Your Best Loss
RULE #8
Never Add to a Loser
RULE #9
Don’t Overtrade
PART III
Letting Proﬁts Run
RULE #10
Keep Good Records and Review Them
RULE #11
Add to Your Winners
ix
xi
3
9
15
23
31
37
43
47
51
59
65
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CONTENTS
RULE #12
Use Multiple Time Frames
RULE #13
Know Your Proﬁt Objective
RULE #14
Don’t Second-Guess Your Winners
Part IV
Trader Maxims
RULE #15
Know the Limits of Your Analysis
RULE #16
Trade with the Trend
RULE #17
Use Effective Money Management
RULE #18
Know Your Ratios
RULE #19
Know When to Take a Break
RULE #20
Don’t Trade the News
RULE #21
Don’t Take Tips
RULE #22
Withdraw Equity Regularly
RULE #23
Be a Contrarian
RULE #24
All Markets Are Bearish
RULE #25
Buy/Sell 50% Retracements
RULE #26
The Only Indicator You Need
RULE #27
Study Winning Traders
RULE #28
Be a Student of Yourself
Conclusion
Recommended Reading
About the Author
Index
71
77
83
91
97
105
111
117
123
129
133
137
143
149
155
161
167
173
179
183
185
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Acknowledgments
Special  thanks  to  those  helped  me  stay  focused  on  completing  this
manuscript  on  time:  my  editor,  Kevin  Cummins,  who  just  let  mework but reminded me that deadlines are part of the business; EmilieHerman at Wiley for being so patient with my lack of computer skills andendless questions; the staff at Inﬁnity Brokerage and ProEdgeFX, who al-lowed me to work after hours with company equipment to ﬁnish the manu-script; Jim Cagnina and Jim Mooney at Inﬁnity, who encouraged Wiley tosign  with  me  even  though  this  was  my  ﬁrst  real  publishing  opportunity;and my family, who encouraged me to stay with it when the work seemedoverwhelming. Thank you all.
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Introduction
My  editor,  Kevin  Commins,  and  I  were  in  the  company  conference
room  having  a  discussion  about  new  book  ideas.  He  wanted  topublish a quality book on trading rules and had seen the 50 rulesmy company had published on its web site as a great starting point. Couldwe expand those basic ideas and produce a book on trading rules?
The owners were interested but really didn’t have the time to commit.I told Kevin that the reason so few good books on trading rules were outthere is because trading rules are more like guidelines and completely sub-jective; in my opinion most of the rules don’t work anyway because mosttraders don’t know how to use them. He was surprised to hear that pointof view, but he was open to seeing something different. We discussed theconcept  a  bit,  and  that  became  the  basis  for  this  book—answering  thequestion, “Why don’t the rules work?”
I discovered that is not an easy question to answer. For the ﬁrst fewmonths I had notes all over my home and ofﬁce but nothing you could calla manuscript. After giving it substantial thought, I decided on a pathway ofsorts to offer the reader a fair answer to “Why don’t the rules work?”
At the core level, all the trading rules, guidelines, trader maxims, or in-sights are a factor of trader psychology and market psychology. The mar-kets provide the illusion of unlimited opportunity and complete freedomto pursue it; “rules” and behavior controls seem to be in opposition to thatidea. It is only after we as traders get beaten up by the markets for a periodof time do we begin to have the light go on. “Cut your losses” is not a rule,it is a point of view that leads to protecting yourself. But what exactly doesthat mean for me personally, and why do I need protection from myself?Why don’t I follow the rules?
In  Edgar  Allan  Poe’s  short  story  “The  Purloined  Letter,”  he  tells  of  athief who has outwitted the best efforts of the police to recover a stolendocument. As the story unfolds it becomes apparent to one of the outside
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INTRODUCTION
observers that the letter must be hidden in plain sight; otherwise the po-lice would have found it by that time seeing as no effort was spared in ran-sacking the home of the thief, nor was it ever found by his direct arrestand  search.  Working  from  this  hypothesis,  this  observer  was  able  to  re-trieve the stolen letter on his second visit to interview the thief; the letterwas indeed “hidden in plain sight.”
The  rules  of  trading  are  much  like  that  stolen  letter.  We  often  ac-cept  the  various  rules  that  have  been  taught  to  us  as  traders,  but  thepsychology  behind  those  rules  is  so  inherently  assumed  that  we  over-look it. The psychology that really makes those rules work is often hid-den in plain sight. As traders, we all would agree that properly applyingthe rules will help us better achieve consistent trading success, and weall know from personal experience that breaking the rules has cost usmoney  in  the  markets.  None  of  us  want  to  admit  we  break  the  rules(and some of us don’t even want to admit we need rules). So why don’twe follow the rules?
The purpose of this book is to outline the deeper psychology behindmost of the accepted trading rules and provide you, the individual trader,a better understanding of how to make your rules work. The rules are ac-tually  guidelines  grouped  into  four  separate  parts;  the  underlying,  basicpsychology  of  each  individual  part  is  explored  as  each  rule  guideline  isshown in proper context. As most traders know, there are literally unlim-ited ways of interpreting price action, choosing execution points, or for-mulating  a  hypothesis  of  general  market  conditions  or  potential  priceaction. The intention is not to provide you with another trading system—God knows there are enough of those—but rather provide you a way ofshowing you two things to improve your trade approach: how you thinkand how the market thinks.
When you stop and realize that most traders have net losses, yet weall know the rules, what could possibly be the deﬁning factor that sepa-rates the winning trader from the losing trader? I believe that there is noclear and deﬁnitive answer to that, other than one trader consistently fol-lows the rules he has adopted for himself and the other trader doesn’t; orworse yet has no rules. Because there is an unlimited number of ways toparticipate, I think the crucial issue is to ﬁnd a way to personally applythe rules in a unique way that will work for you, and then do it all thetime. It’s easy to say “Cut your losses,” but every trader will have a dif-ferent way of deﬁning that for themselves. The purpose of this book is tohelp you better deﬁne your personal trade approach by helping you in-terpret and apply the rules in a way that will work for your trading style.The rules are not the problem; it is making the rules work for you that isthe problem.
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Introduction
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HOW THIS BOOK IS ORGANIZED
The  ﬁrst  step  is  getting  a  ﬁrm  grip  on  exactly  what  you  are  doing  whenyou participate. Part I, “Getting in the Game,” outlines the psychology ofmarket price action, what that can only mean as far as your trade selec-tion  is  concerned,  and  how  to  begin  from  the  point  of  a  strong  marketpresence. Trading is not as simple as “buy low–sell high” it is learning tounderstand the how and why behind price movement and how to partici-pate  proactively  without  letting  prices  make  your  decision  for  you.  Youmust buy weakness and sell strength to successfully trade, even if anothertrader would call that “picking tops or bottoms.” Your trade plan is a criti-cal part of developing a mind-set that uses prices rather than reacting tothem. Part of this process is learning to think in terms of probabilities, be-cause no trading approach can be 100% accurate 100% of the time; that isnot realistic for anyone. So Part I details what the game really is and howyou can better participate from a more unbiased point of view.
Part  II  is  “Cutting  Losses.”  Every  trader  has  had  losses,  and  everytrader  still  participating  every  day  will  tell  you  how  important  cuttinglosses is for the long-term health of a trading account. In this section weexplore the underlying psychology of the rules of self-protection and whyit is so hard to enforce this much-needed protection for ourselves. Manytraders have a subconscious need to be “right” and will not liquidate a los-ing trade quickly. Even if you are not one of those traders, you will havesomething in your personal trade approach that makes it difﬁcult to cutlosses  quickly  under  certain  conditions.  Developing  a  set  of  personaltrade rules uniquely designed for your trading style will help you protectyourself—even when it is emotionally difﬁcult to do so. Sooner or later,you  will  meet  your  Waterloo  if  you  have  failed  to  develop  and  enforcerules designed for your protection. Knowing when you are setting yourselfup for a loss, and what to do if you are already in the market when you dis-cover that fact, is a huge part of cutting losses. Sometimes your protectionstrategy will dictate that it is simply better not to trade. Having all theseoptions clear in your trade approach is half the battle.
Part  III  explores  the  opposite  dynamic:  “Letting  Proﬁts  Run.”  Everytrader at one time or another has liquidated a winning trade, only to seethat trade continue farther and farther in his favor. By applying a simplerule or two to remain in a winning trade, that trader might have taken ahuge win from the market. Letting a proﬁt run involves different things foreach  trader,  but  the  underlying  psychology  is  the  same  for  everyone.Learning  to  develop  an  ever-expanding  rule  structure  can  help  you  holdyour winners until the market has run out of potential in your favor; andthat is rarely a function of price. Rather, it is related to the net order ﬂow
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INTRODUCTION
behind the price. Knowing when order ﬂows are running out of potentialfor a winning trade is more important than the price at which it happens.Tracking this will involve multiple time frames, so a solid understandingof  how  those  time  frames  are  interrelated  will  help  you  write  personalrules to maximize a winning trade.
Part  IV  is  “Trading  Maxims.”  In  Part  IV  we  look  at  the  some  of  themost common trading rules and how they have both negative and positivepsychological implications. Some of these rules will simply not work foryou  personally,  but  because  they  make  sense  initially  you  might  betempted to adopt them into your trade approach. This is frustrating at bestand self-destructive at worst. Some of these trade rules work best only un-der certain market conditions and should be used only under those condi-tions or not at all. The underlying problem with most of these rules is thatwhile they all sound good at ﬁrst, they are often misunderstood in relationto time frames or the psychology of your personal trade approach. Some-times they are simply in conﬂict with your overall style.
For example, the trading rule “Buy the strongest member of the com-plex”  is  not  a  rule  that  would  work  well  for  a  day  trader.  This  rule  wasoriginally used by position traders attempting to diversify across the un-derlying strength of something like the grain complex. Not knowing whichof  the  grains  may  advance  farthest  for  the  underlying  bullish  scenario,traders would buy all of them and leverage a little farther in the strongestpotential performer. In this case, anticipating a drought, they would buycorn, soybeans, and wheat but buy a bit more soybeans because soybeanstraditionally  will  move  several  dollars  a  bushel  more  during  a  droughtthan corn or wheat might. If you are not trading for the pull in the grainsunder  those  conditions,  a  modest  correction  in  the  soybeans  will  mostlikely take you out or cause a loss on the buy side, because soybeans havetraditionally  been  subject  to  extreme  volatility,  more  so  than  corn  orwheat. Buying the break for a day trade (in the strongest performer) couldeasily be the worst move possible for a day trader if that market went of-fer shortly after your entry. In that illustration, the trade rule doesn’t work.I’m  not  suggesting  that  you  refrain  from  using  a  rule  that  you  ﬁndvaluable, but I think a solid understanding of what the rule was developedfor, how successful traders use it, and whether your time frame could useit as well is a great way to determine if you could make that rule work foryou personally.
In  the  ﬁnal  analysis,  making  the  rules  work  is  really  about  knowingyour personal psychology and your market’s psychology well enough thatyou  do  two  things  every  day:  Limit  your  potential  to  hurt  yourself,  andmaximize your market’s potential to pay you. Knowing the underlying psy-chology behind the rules will help, as well as personal study to apply themproperly. During the time of your trader development you will most likely
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come to the same conclusion most successful traders have: The rules areunique to each trader, but every trader follows the same guidelines. All ofthe various rules, insights, guidelines, and trader maxims work together todo  two  things:  prevent  the  trader  from  hurting  himself,  and  allow  thetrader to get paid the most for his approach.
BEFORE YOU BEGIN
Before  we  get  started,  I  would  like  to  illustrate  how  this  understandinghelped  me  improve  my  personal  trade  approach.  As  a  young  trader,  Iwould often shoot from the hip—I would make a snap judgment based onmy point of view and execute instantly. Because I had no real rules for ex-ecution, I did my share of jumping the gun on trades that eventually wouldhave worked from that side, had I waited. Once I learned to follow Rule#10, “Keep good records and review them,” I discovered that I was oftencorrect on my initial observation about net price action, but being a day ortwo early (breaking Rule #4, “Know your time frame”) I was often stoppedout for a loss just before the market would turn. After this happened sev-eral times, I would simply execute again immediately at my stop price fora reentry, resulting in another small loss as my tighter but deeper stop waselected (breaking Rule #7, “Your ﬁrst loss is your best loss”). This wouldhappen  six  or  seven  times  (breaking  Rule  #9,  “Don’t  overtrade”)  as  themarket went a signiﬁcant distance against my original execution; then themarket would turn. I would hold the winner but I would need to overcomea major loss to my equity before the trade had a net gain. On a 200-pointmove in Japanese yen, for example, I would net only 30 to 40 points be-cause I had a 150-point deﬁcit to overcome ﬁrst.
After reviewing my notes, my observations, and my execution history,I decided that my skill at observing a trade was not the issue. My timingwas  usually  a  day  or  two  early.  I  made  a  new  rule  for  myself:  “If  I  havethree  losses  in  a  row,  I  cannot  trade  for  24  hours.”  If  my  ﬁrst  three  at-tempts to buy what I felt was a sell-off were losers, usually I would get an-other  chance  right  in  the  same  area  or  better  within  a  day  or  so.  Bydisciplining  my  execution  in  this  manner,  I  would  save  myself  three  orfour more losers, ﬁnally obeying the rules in Part II, and then I was oftenable to use the rules in Part III. Nothing really changed in my trade selec-tion or my analysis, but following the rules better allowed me to get intoposition better and stay there better. I learned to make the rules work forme personally. The money to be made was always there.
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PART I
Getting in the Game
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RULE #1
KnowYour Game
The longest journey begins with the ﬁrst step.
—Lao Tzu, in the Tao te Ching
A key to making the rules work is an understanding of the psychol-
ogy behind the rules, knowing where they work best, and know-ing  if  that  is  congruent  with  our  personal  trading  style.  Thepsychology behind the rule is what it is, in part, because the psychologyof  the  market  itself  is  what  it  is.  I  don’t  think  we  can  make  our  ruleswork at their best without a solid understanding of this underlying mar-ket psychology.
Critical to that assessment is understanding our own personal psy-chology. No matter where you personally are on the scale of trader evo-lution or your application of your developing skills, you will eventuallydiscover that your own personal psychology is by far the single most im-portant variable to your lasting success as a trader. Indeed, only a traderwho accepts this point of view about his own psychology will be able tosuccessfully  make  his  trading  rules  work—because  the  rules  are  self-created, self-enforced, and self-defeating. Without a solid grasp of bothmarket  psychology  and  personal  psychology,  your  results  will  mostlikely be net losses, even if you have a winning systematic approach andgood rules.
Regardless  of  your  current  level  of  sophistication  or  trading  back-ground,  there  is  one  indisputable  fact  about  the  underlying  structure  oftrading markets that you need to thoroughly understand before you placeyourself  at  risk.  Futures,  options  on  futures,  and  cash  foreign  exchange
3
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4
GETTING IN THE GAME
(FOREX), the markets most readers will be trading are all zero-sum mar-kets. The price action and cash management take place in an environmentwhere  no  money  is  ever  made  or  lost;  gains  or  losses  accrue  as  a  cashdebit  or  credit  between  accounts  on  deposit  after  trades  are  cleared.  Inother words, a winning trade is paid its cash credit from the exact oppo-site losing trade. The clearing corporation of the exchange simply assignsa  cash  credit  to  the  account  with  the  winning  trade  and  assigns  a  cashdebit to the account with the losing trade.
In the ﬁnal analysis, it is the losers who pay the winners. You cannotaccrue a cash credit increase in your trading account unless some othertrader  (or  group  of  traders)  somewhere,  trading  through  the  same  ex-change with you in the same market, has lost the exact same amount. Inorder  for  you  to  make  $10,000  from  your  trading,  someone  else  (or  agroup of someone elses) had to lose $10,000. You can’t participate in zero-sum trading without accepting that risk.
It is the very nature of zero-sum transaction trading that makes usingand  applying  trade  rules  so  critical  to  lasting  success.  If  you  personallydon’t know enough about what you are doing, or the risk you are reallytaking,  you  will  be  the  loser  who  pays  some  other  winning  trader.  Themarket does not function any other way.
Let’s take a look at the psychology behind price action. I believe this ismuch deeper than the simple fact that for every winning trade there is aloser. Zero-sum trading presents some fascinating insights into crowd be-havior and what is really needed or required to exploit price action prof-itably. Let’s start with the basics:
Buyer→ $2.33 ←Seller
You enter a buy order to open a position in corn at $2.33/BU. In orderfor you to receive a ﬁll on your buy order, it must be matched against a sellorder at that price. For the sake of illustration, let’s assume there is also asell  order  to  open  a  position.  Therefore,  two  separate  traders  have  putthemselves at risk, and a new long position and a new short position arenow active. What happens next?
Another set of orders comes in, and those are matched, but if at thatmoment there is an imbalance in the order ﬂow, the market is requoted toreﬂect  the  imbalance.  In  other  words,  if  there  are  more  buy  orders  leftover  after  the  sell  orders  are  matched,  the  market  ticks  higher  and  ismatched with sell orders at higher prices, if they are there. The remainingbuy orders are then matched at that new higher price. If there are morebuy orders left over again, another tick higher results.
Of course, this illustration is conceptual. As most traders know, thosebuy and sell orders are constantly coming in and are combinations of stop
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Know Your Game
5
orders, limit orders, and market orders from both sides; the mix is alwayschanging. What we are concerned with is the pressure on the price as thenet order ﬂow is processed from one moment to the next. If the order im-balance remains on the buy side, the market will continue to tick higheruntil the imbalance is corrected and the buy/sell orders are about evenlymatched again. If, at that point, the sell orders overwhelm the buy orders,the market will begin to tick lower and will continue to do so until the buyand sell orders again become about evenly balanced with the sell orders.The ebb and ﬂow of price action comes from these order imbalances, andwhat we call an uptrend or downtrend is in reality a net imbalance lastingfor some period of time.
So let’s assume after a period of time, the net order imbalance for that
period of time has resulted in a new price for corn at that point:
→ $2.38/BU ←
Your open-trade long now has a proﬁt of $0.05 per bushel. The openshort from  your  executed  order  (the  other  trader  speculating)  has  anopen-trade loss of exactly the same $0.05 per bushel. If, at that exact mo-ment, both of you choose to liquidate your positions, and your orders off-set each other at that point, your account will be credited and his accountwill be debited the exact same dollar amount (less any fees, of course).
This is all easily understandable, but there is a completely other worldat work in that process. That other world is the psychology of the tradersinvolved and how that creates their urge to action resulting in them plac-ing the orders in the ﬁrst place.
What is not immediately apparent in price action is perception—howthat net credit or debit is affecting the account holder, what that accountholder  is  thinking,  and  what  he  must  do  next.  What  is  certain  is  that  atsome point, both traders must liquidate; no one can stay in the market for-ever.  When  the  losing  position  is  liquidated  at  some  point,  the  losingtrader  must  do  an  equal  but  opposite  trade  against  himself.  In  otherwords, if I have bought the market