, and prices are moving lower, I mustsell to liquidate my loss, adding power to the dominant force in control ofthe market at that point. My mental and emotional state is in direct con-ﬂict with my desire for a proﬁt, and my only choice really is to liquidatenow  or  risk  a  bigger  loss.  If  I  “wait  it  out”  I  am  trying  to  anticipate  themarket  will  reverse  and  eventually  show  a  proﬁt  on  the  trade  for  me(thereby  making  a  loser  out  of  the  original  short  who  initially  had  theopen-trade proﬁt).
But all of this thinking or emotion is going on inside my mind and hasnothing to do with what is driving the market. In order for prices to ad-vance or decline, there must be more orders on that side of the market.
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Prices can advance only if there are more buy orders than sell orders atthat  moment.  Prices  can  decline  only  if  there  are  more  sell  orders  thanbuy  orders  at  that  moment.  How  that  order  ﬂow  personally  affects  myaccount balance or my emotional state does not concern the net order-processing function of the market. In any attempt to proﬁt from any per-ceived opportunity in a zero-sum transaction market, you simply must beon the right side of the eventual net order ﬂow from that moment forwarduntil you liquidate. If you are on the wrong side of the net order ﬂow, youwill have an open trade loss until you liquidate.
None of what happens inside the mind of the trader during that timecan affect the market in any way; it can only affect the net balance con-trolled in some way by the trader in some way. This is why you must haverules  and  know  how  to  follow  them.  You  cannot  know  for  certain  untillater, after you enter your position, whether you are on the right side ofthe net order ﬂow.
The important thing to remember is that there is an emotional pres-sure at work in most traders that will inﬂuence their perception of priceaction. They all entered their trades expecting to win, but in most casesthey will have to consider liquidating at a loss. All of the emotional or psy-chological stress involved in trading boils down to “When do I get out?”Because the owner of the winning position has a lead on the market, he isunder  less  of  this  stress  than  the  loser.  In  most  cases,  when  the  pain  ofholding the losing hand gets too big for the losing trader, he will liquidatein the same direction as the winning position. A simple example is a mar-ket  slowly  advancing  higher  as  more  buy  orders  overwhelm  the  sell  or-ders,  until  the  market  hits  the  liquidating  buy  stops  above  the  marketplaced by the sellers who are holding a losing position. The market nowadvances further on that buying pressure.
None of the above-described background to price action has anythingto do with market study, risk control, trading systems, or technical analy-sis. It has to do only with the fact that if you are going to be in the market,you run the risk that you will be on the wrong side of the order ﬂow. Whatdoes that do to the trader’s emotions? What will he do? What will you do?Because  you  cannot  proﬁt  consistently  in  a  zero-sum  market  unlessyou  are  on  the  correct  side  of  the  order  ﬂow,  your  entire  analysis  andtrade plan must take into consideration some way to identify where theorder ﬂow is and what to do if you are on the wrong side of it. The issue ofcutting  losses  is  essentially  to  have  some  method  of  negating  any  emo-tional conﬂict created by a losing trade, in such a way that you will nothesitate  to  get  out  of  the  way  of  the  actual  order  ﬂow  if  you  are  on  thewrong side of it. Part of how you participate on your trade, regardless ofyour unique approach to ﬁnding a trade opportunity, must always answerthe question: “Where is the order ﬂow?”
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7
Most of the studies done on net trader performance come to the in-escapable conclusion that around 90% of traders will close their accountsat a net loss. None of those traders expected to lose, and yet they did. Partof  their  losses  came  from  the  emotional  conﬂict  created  in  their  mindswhen the market moved against them, creating pressure on their execu-tion. Every trader has had the frustration of ﬁnally throwing in the toweland liquidating his position, only to see the market reverse shortly there-after  and  prices  move  favorably,  if  only  he  had  stayed  in.  All  that  reallyhappened is that the order ﬂow dried up in one direction and then turnedthe other way. For that particular trader it resulted in a net loss to his ac-count. That particular trader will now be tempted to “just ride it out” onthe next trade until prices eventually return. Of course, the one time thisdoesn’t happen will result in a total loss in the account. It only takes one“just ride it out” to ruin that particular trader.
To avoid being that trader, and to master the game of successful spec-ulation, you must know what you are really capitalizing on when you iden-tify a trade opportunity. You must accept and trade from the point of view:“Where is the order ﬂow?” and you must have a method of getting out ofthe way when you are not on the right side of the order ﬂow. All the analy-sis or study you could ever do must answer these two central questions.
One  assumption  you  can  make  to  know  your  game  is  that  mosttraders do not know the game they are playing. About 80 to 90% of priceaction is simply the losers liquidating their losing trades. When you begineach day, and before you place a trade, ask yourself this question: “Whereis the loser?”
In the ﬁnal analysis, the game you are playing is “Beat the Loser.” Thegreat trader J. P. Morgan said it best: “Anyone who is unaware of the foolin the market probably is the fool.”
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RULE #2
Have aTrading Plan
If you fail to plan, you plan to fail.
—Old wisdom
I have had the privilege of seeing almost everything there is to see in the
business  of  trading.  I  have  met  some  very  well-known  traders,  bignames in business or ﬁnance; I’ve been on several trading ﬂoors, vis-ited  the  trading  pits  numerous  times,  worked  side-by-side  with  sometremendously  successful  market  participants,  and  seen  all  the  catastro-phes,  mayhem,  blowouts,  and  ﬁnancial  blunders  capable  of  novicetraders. I have asked all the right questions and all the wrong questions. Inmy experience, I have to say that there was very little critical differencebetween the net winning traders and the net losing traders in most areas.All of them had good understanding of basic market fundamentals, used asolid technical analysis or research of some kind, and exercised a lot ofpersonal discipline.
The one thing that stood out, the one thing that separated the net win-ner from the net loser, all things being equal, was that the net winner had atrading plan in addition to his other skills. The net winner knew he was upagainst  not  just  the  market  and  his  competitors,  but  he  was  up  againsthimself,  too.  To  guard  against  the  possibility  that  he  (the  trader)  couldblow himself out of the water at any time if he wasn’t careful, that traderhad a plan.
A trading plan is different from a trading system. A trading system isdesigned to ﬁnd an inequality in the market and offer a better buy or sellentry  than  at  some  other  time.  A  trading  plan  takes  into  account  what
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happens after that. Once we have identiﬁed what we think is an opportu-nity, it is how we participate from that point forward that makes all thedifference. A trading plan will address and complement a systemized ap-proach much better if it is seen as an equally important part of a strongmarket presence.
A  trading  plan  addresses  the  parts  of  trading  that  are  most  fully  inyour control. For example, when and where you do your market study oranalysis; when and where you place or move a stop-loss order; when youtake a trading break—basically anything that involves you taking action ornot taking action, independent of the actual market itself, is spelled out ina trading plan.
A trading system is only designed to exploit perceived inequalities inthe market, but it can never be 100% accurate or ﬁnd exactly where everypotential “top” or “bottom” is in the time frame you are working with. If asystem could do that, no other discussion of rules would be needed. Onceyou have executed and placed yourself at risk, you have moved into thearea  of  your  system’s  probabilities  and  limitations.  You  as  an  individualcannot  extend  control  over  price  action;  you  can  only  control  how  youuse price action or how you participate in price action. Once the trade istaken, the “die is cast” so to speak. Whether you win or lose at that pointis completely out of your control.
Because  your  system  is  not  capable  of  ﬁnding  each  and  every  turnthere is to proﬁt from in real time, a trading plan is needed to prevent youas a trader from getting reckless or from placing yourself in lower-proba-bility trades, and what to do when the unexpected happens. A trading planneeds to address your particular trading strengths and weaknesses; it inno  way  diminishes  the  need  for  a  systemized  methodology,  nor  is  it  de-signed to replace one.
Your trading plan can be followed 100% of the time because it is an ex-pression of the sum total of what your rules are designed to create; it con-trols  your  behavior,  which  is  a  function  of  discipline  and  willingness  tofollow those rules. Your trading system may never be more than around55% predictive in ﬁnding winning trades, but you can follow your tradingplan’s  rules  100%  of  the  time.  When  your  trading  system  is  wrong,  yourtrading plan will help you minimize the loss. When your trading system isright, your trading plan will help you maximize the gains.
A qualiﬁed trading plan is both concise and ﬂexible. It adapts to mar-ket  conditions  as  needed  and  is  concerned  with  protecting  the  trader.You can think of a trading system as strategic and a trading plan as tacti-cal. To use a military illustration, “winning the war” is the goal, strategyinvolves ﬁnding the enemy’s weakness, and tactics are how you exploitthat weakness.
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Think of your trading system or methodology as a strategic attempt toconsistently ﬁnd a weakness in the market and exploit it. It really doesn’tmatter  what  it  is;  it  simply  needs  to  be  consistent.  Your  trading  plan  ismore like the “if–then” tactical response to conditions as they change inreal time and as you learn more about a particular trade’s potential as itdevelops. Your trading system is designed to help you ﬁnd the edge; yourtrading  plan  is  designed  to  help  you  keep  your  edge  or  recognize  whenyou don’t have it at a particular moment.
Your trading plan is where your rules are used to maximize your win-ning  advantage  when  you  have  it  and  minimize  your  losses  when  youdon’t.  What  is  never in  question  is  that  winning  the  war  involves  bothstrategy and tactics; sometimes tactics save the strategy, and sometimesthe strategy needs very little tactics. Knowing this balance is also impor-tant because, as we discuss later, all analysis of the markets will have astrategic advantage but also a strategic limitation. Your trading plan givesyou the tactical advantage of knowing which strategy will work best, un-der which conditions, and what is most likely to be your best initial moveto keep pushing your advantage into more and more proﬁtable positions.The major goal is, of course, to cut losses and let proﬁts run.
SO HOW DO I CREATE A SOUND TRADING PLAN?
Every  trader  must  make  several  critical  distinctions  when  creating  asound  trading  plan.  We  discuss  some  of  the  more  crucial  aspects  ingreater detail throughout each rule in the book but there are several ini-tial  ones  you  can  focus  on  to  start  creating  your  unique  trading  plan.Starting from the assumption that you can’t participate at all if you losetoo much of your trading capital, the ﬁrst concern is how to minimizeyour  participation  when  you  are  losing.  This  is  different  than  cuttingyour losses. Cutting losses is part of your trading system and after youhave had a signiﬁcant amount of those individual losses for you person-ally it is time to consider a few things. First, are you using the system ormethodology correctly? Part of your trading plan should be a regular re-assessment of whether you are fudging on the system in some way. Areyou taking trades the system wouldn’t take? Are you hesitating on tak-ing every signal? Are there some trades in there that you waited on andwere “late”?
A  solid  trading  plan  is  a  guideline  to  help  you  maintain  focus.  Yourﬁrst and best clue that you are not maintaining your best trading focus is aseries of losses that are outside the limits of the trading systems’ probabil-ities.  At  that  point,  you  as  the  trader  must  decide  what  your  rules  are
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when  you  are  experiencing  an  irregular  drawdown.  Some  of  the  betterthings to do include taking a step back and observing if the market itselfis operating in a manner that is no longer consistent with the trading sys-tem or method hypothesis. If you are using a trend-following strategy, sup-pose the market is no longer trending? A trend-following system will getchopped to pieces during a period of consolidation. What is your plan fora tactical change at such a time? Only you can answer that question com-pletely but the theme of your trading plan must consider a “what if” sce-nario  for  the  outside  chance  that  the  quality  of  the  market  has  changedenough to lower the probability of your system performing. Part of yourtrade plan is some method of standing aside.
There  are  times  in  every  trader’s  life  when  the  worst  possible  thingthat trader could do is participate. Your trading plan should address thepossibility that outside life issues or pressures can inﬂuence your abilityto trade well. What can you do to protect yourself when your emotional ormental sharpness is potentially dropping? When you lose control of yourfocus, you run the risk of missing a critical piece of information about themarket structure at just the wrong point, creating a loss. Your trading planmust address your personal and emotional needs as well as the ﬁnancialrisks you are taking. It might be a good idea to plan regular trading breaksfrom time to time, regardless of how you are doing in the markets. If youare planning a major life event such as getting married or sending one ofyour children off to college for the ﬁrst time, your trading plan should ad-dress those needs in such a way that will prevent you from getting care-less. All traders at some point have had something throw them off, and ifthey continued trading at that point, in most cases that stress or pressureaffected them negatively as far as their trade selection and execution areconcerned.
Everyone  has  heard  the  stories  of  the  lucky  individual  who  won  alarge  amount  of  cash  in  a  state  lottery.  Suddenly,  without  any  advancewarning,  some  fortunate  soul  has  several  million  dollars  in  cash.  Beingcompletely  unprepared  for  such  an  event,  many  of  these  people  havemade serious ﬁnancial mistakes with those monies and in the end, wereworse  off  ﬁnancially  than  before  they  had  won  that  money.  Your  tradeplan should also address how to participate best if you are doing well atsome point. A large degree of ﬁnancial success can have a negative impacton a trader just as easily as large losses can.
To  ensure  your  continued  success  it  would  be  wise  to  adopt  somemethod of reducing your participation until you have mentally and emo-tionally processed that success. There is a temptation to think that whatcreated your success and the size of that success can easily be duplicatedand  will  always  be  the  state  of  your  trading.  This  happens  a  lot  to  newtraders with little experience who, unbeknownst to them, were just lucky.
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They make a large amount of cash by accident and confuse that with truetrading skill—or worse, think they have found the perfect system. If theyare not careful, their lack of skill will cause this trader to “give it all backplus more.” Additionally, this trader will not be sensitive to the possibilitythat the quality of the market has changed and his “system” is no longereffective,  nor  will  he  know  when  it  might  become  effective  again.  Yourtrading plan should address what to do when you are far enough ahead tocreate a possible problem for yourself. In other words, what do you do ifyour money gets “bigger than your head”?
If  you  are  thinking  along  these  lines,  you  are  beginning  to  draw  theconclusion that all of the rules we discuss here, together as a group, arewhere your trade plan initially comes from. In the ﬁnal analysis, your trad-ing plan is a reﬂection of your willingness to properly use the rules whenyou need controls on your behavior. Your rules can change and your trad-ing plan can continue to evolve, but your willingness to consider your sideof  the  ledger  equally  as  important  as  your  trading  system  is  the  key  towriting an effective trade plan. Following is an example of what I wouldconsider to be a well-written trading plan.
My goal is to earn 100% on my trading equity before the end of theyear. To maintain my focus I will set a near-term goal every quarterto be at a 25% gain and I will plot my equity daily. If I reach myquarterly goal ahead of the last trading day of the quarter I will takea two-day break. I will hold any open positions that are at a proﬁtbut  any  open  trade  losses  I  will  close  at  that  point  before  I  take  abreak.
If my open-trade gains continue into the new quarter I will addto those winning positions by a factor of 25%. I will move my pro-tective stops up to reduce my exposure on the entire position.
If I am behind on my trade goal for the quarter, I will take a ﬁve-day break. I will reevaluate my trade system and ask the question:“Has my market quality changed to something in which my systemis not able to perform at its best?”
During the year I will not trade more than three markets. I have
learned I cannot focus well on more than three markets at a time.
If I have more than four losing trades in a row in any of mythree markets I will take a trading break for ﬁve days. Again, I willleave  open  position  winners  alone  in  the  other  markets  but  closeall  losing  positions.  I  will  again  roll  protective  stops  to  reduce my risk.
When I take a trading break, I will enter resting limit orders inthe  open-trade  winners  to  take  the  objective  proﬁt  should  I  be  un-available and the market reaches those levels during my break.
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If I am ahead of my plan for the year at any point I will take abreak. I will take 30% of the new equity out of my account and placethat into a secure place. If I am behind I will not add equity underany circumstances. If I reach a 40% drawdown from my high equityI will quit for the year.
I will record my daily trade activity in my trading log and re-view  this  weekly.  I  will  know  my  ratios  and  results;  I  will  look  toimprove them by 5% each quarter.
I will trade only from the bull side because my analysis tells methat all three of the markets I have selected have more than a year ofsolid bullish fundamentals. I will learn how to use options this yearbecause I see from last year I could have protected more trades if Ihad a solid grasp of when to use options and when not to. I will in-vest two hours a week on option knowledge.
My son is leaving for Europe in May. I will not trade the weekbefore he leaves or the week after. I plan to join him in the fall forOktoberfest for one week and will not trade the three days before Ileave or when I get back. I know I suffer from jet lag so the week af-ter I am back I am not at my best. I have blocked out these times onmy trade calendar so I will not be tempted to trade anyway.
This was an actual trade plan written by a friend of mine who trades E-mini futures. He uses a simple technical approach and has a very thoroughrisk control method. His trading plan addresses the need for 100% personaldiscipline. Notice that it makes no mention of the technical approach heuses. The approach is his strategy. His plan speciﬁes how to maximize hisside of the equation—the tactical advantage he personally needs.
When developing your own trading plan, remember that your system-ized  methodology  won’t  have  100%  winners  no  matter  how  you  slice  it.The  one  thing  you  always  have  100%  control  over  is  your  participation.Your trading plan should focus on your participation, not your execution.
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RULE #3
Think in Termsof Probabilities
There is an ambush everywhere from the army ofaccidents; therefore the rider of life runs with loos-ened reins. . . .
—Haﬁz
Because we live in a world where often certain things appear to be
commonplace and “normal,” we have developed a greater feeling ofcertainty as it pertains to our daily lives. Human beings ﬁnd a senseof certainty in the belief that our day-to-day world is natural and is simplythe way things are. Some of us have grown so accustomed to this feelingthat we have a routine that actually bores us, and some of us go out of ourway to do something, anything, to break free of the grip of the ordinary inour lives.
Often when the unexpected happens, we feel that the odds are some-how  changed,  but  this  is  usually  seen  as  temporary.  Often  the  truly  ran-dom nature of things is not regularly apparent enough for us to see thatwhatever  happened  could  have  occurred  at  any  time  and  that  we  are  atrisk in that manner at all times every day. For example, because most peo-ple will be in a car wreck perhaps only once in their lives, the everydayrisk of driving seems to be very low. If we do have a car wreck, we con-sider it a “random” event that only seemed manifested to us “by accident.”We feel this way because normally we drive every day without incident.We have come to feel that it is more of a certainty that each day will passwithout the random event occurring to us personally. If it does occur, wethink it is a ﬂuke.
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The  fact  is,  most  people  create  the  “accident”  that  they  ﬁnd  them-selves  in  by  failing  to  make  the  connection  between  their  actions  andwhat happens next. For example, most people who drink and drive don’tbelieve the problem was entirely theirs, yet it was their impaired judgmentthat increased the odds that the seemingly random event would happen tothem. Because they drive sober and without incident 95% of the time, theyfail  to  recognize  that  during  the  5%  of  the  time  they  are  not  sober,  theprevious  95%  success  rate  is  now  null  and  void.  The  rules  of  the  gamehave changed. They are in an entirely different environment that bears noresemblance at all to the previous degree of certainty.
Our mistake is not so much in our perception of reality, but in un-derstanding the nature of how probabilities affect us all day, every day.There are very few things in life that involve certainty, and the fact thatsome things only happen to each of us individually maybe once in ourlives does not change the probability that they will happen every day tosomeone.
Indeed,  the  entire  business  of  actuary  analysis  is  an  attempt  to  ana-lyze  how  best  to  spread  the  risk  of  an  event  that  will happen  across  asmany people as possible to whom it might happen. Insurance companiesmake money by diluting the risk in this way, and they do best by writingpolicies to people to whom the event will almost certainly never happen.As an example, the reason active scuba divers pay much more in life in-surance premiums is that a certain percentage of scuba divers will drowneach  year.  If  you  don’t  scuba-dive,  your  risk  of  accidental  drowning  islower;  therefore  your  premiums  are  lower.  But  the  fact  is,  someone willdrown this year, and the odds that are a regular percentage of those peo-ple will be scuba divers. Ask scuba divers what they think of that risk andall of them will most assuredly say, “Not me . . . I don’t do anything stupidwhen I dive.” Those divers have a sense of certainty that “drowning won’thappen to me.”
This  issue  of  perception  regarding  certainties  and  probabilitieschanges  completely  when  we  begin  trading.  We  leave  the  comfort  of  aworld that usually works a certain way and enter into a world where thetruly random and unexpected can happen at any time. The events are ran-dom  and  unexpected  not  because  the  market  is  indeﬁnable  or  becauseprice  action  is  somehow  so  mysterious  as  to  defy  explanation,  but  be-cause we as individual traders cannot possibly know everything about themarket at all times; therefore we have a percentage of risk that is certain.Reducing this risk is not about more study or more knowledge. Reducingthis risk is about knowing probabilities.
All attempts to proﬁt from a trade are in reality a best guess regardingfuture price action. It really doesn’t matter what your methodology is or
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which technical or fundamental approach you ultimately settle on as theright combination of risk/reward system right for you. Because the natureof trading markets involves risk and uncertainty, it is impossible to knowexactly  how  any  one  trade  will  eventually  play  out  through  price  actionuntil it gets there. Markets are not deﬁnable past a certain point, and nomatter the depth or scope of pretrade analysis or research, there is alwaysthe  possibility  that  prices  won’t  respond  in  the  anticipated  direction  orwon’t respond in a time frame you are willing to trade in. Wall Street andLaSalle Street are full of traders who were right too soon, waited too long,got out too soon, got in too late, and so on. All of those kinds of results—whether this means small proﬁts, no proﬁts, small losses or big losses—are  simply  because  whatever  systematized  approach  was  being  reliedupon had reached its unique limit or the trader failed to appreciate thatlimit. They were all “best guesses,” and that means they don’t work 100%of the time to begin with.
Reducing your options to the best probability before you enter a tradeis a function of several things. First, if you have done a proper assessmentof general conditions according to your trade plan, there will be a pointwhere prices are more favorable for an entry and will respond by an ad-vance in the direction of conditions. Waiting for that point and then exe-cuting immediately is your best option, but where is that point?
When  entering  a  trade  we  don’t  have  the  beneﬁt  of  knowing  if  ourexecution  point  was  the  best  price  area;  we  ﬁnd  out  sometime  later.  Toimprove your odds of timing your entry better, develop a series of “if–then”scenarios and ask yourself which is more likely.
Let’s take an example from a potential bullish market condition. Wecould start with the hypothesis, “If conditions are bullish, and the tradingpopulation  responds  accordingly,  then  prices  should  rise.”  I  know  thatsounds  overly  simplistic,  but  let’s  look  at  the  various  psychological  as-pects of such a simple statement and how that could play out in day-to-day price action.
If  prices  are  at  the  moment  still  declining,  this  means  either  mosttraders don’t feel conditions are bullish just yet, shorts are still in controlof the market, or some combination of short-term