Trade within Your Capital

In trading, everyone makes mistakes. Even the best, most experienced traders occasionally misread the market. In addition, you may do everything right on a trade, but something happens out of the blue that causes the market to reverse direction. Either occurrence—a market misread or an out-of-the-blue event—will result in a losing trade. Losing trades are part of the business. They happen to everyone, and they will happen to you. That being the case, you always want to lose small.

To lose small, you must trade small relative to your overall capital. If you have a $20,000 account, you don't want to risk $2,000 on a single trade. It's too much of a hit to take given your overall capital. A small series of $2,000 losses is going to destroy your confidence and likely will cause you to stop trading entirely or take too much risk on an all-or-nothing trade in hopes of recouping your losses. To stay in the market for the long haul, you need to trade small.

I've often seen traders increase the size of their trades following a series of winning trades. Think about the logic of that for a moment. It's axiomatic that losing trades are inevitable. After a series of winning trades, do you think a losing trade or series of losing trades is more or less likely? In my experience, a winning streak is usually followed by a losing period or at least a few losing trades. If you increase the size of your trades, you're likely to give everything back and then some.

Beginning traders often come into the market with unrealistic ambitions. They think they will consistently make money, continually raise the size of their trades as their account grows, and within a short period of time, they'll amass a small fortune. A more realistic goal for a beginning trader is to learn the business while making modest profits and taking small losses. First, you learn to survive. Then you learn to thrive. Yes, you can grow your account and, at some point, increase your size. But you have to go after it like a turtle, not like a Ferrari.

There is another element to trading small. Every trader has a position size that he/she cannot exceed without endangering his or her emotional discipline. I call it my core position. Although I can trade much larger, my core position is 10 E-mini contracts, which is equivalent to two Standard & Poor's (S&P) contracts. This is my maximum position. If I trade larger, I'll begin to lose my emotional discipline.

You need to find a position size that allows you to execute your trades objectively, unemotionally, and consistently. It may be much smaller than what you're currently contemplating. It might be 10 shares of a $100 stock. That's fine. As you get comfortable, you can increase your position size—within reason. The point is that you never want to trade at a size where the emotions of hope, greed, and fear overwhelm your rational mind and objective decision-making process.

The business of trading is all about controlling emotions. You should not fight the market or other traders. You should not fight yourself. You need to keep greed and fear low and discipline high. Hope is a great emotion in other aspects of life, but not in trading. Find your core position and stick with it.

Quiet Confidence

Of course, we are emotional creatures and we can't completely strip emotions out of trading. The feeling that I recommend you cultivate is quiet confidence.

Quiet confidence comes from following your trading rules and faithfully executing high-probability trades. It comes from trading within your capital and exercising emotional discipline. And it comes from the knowledge that if you do the right things in trading, good results will follow.

When you have quiet confidence, you are in complete control of your trades.

At a gambling casino, you have less than a 50/50 chance of winning. The odds always favor the house. I've read that a player's odds in most Las Vegas establishments are about 46/54. What that means is that once you've rolled your dice at the craps table, you're committed to a bet where the odds are stacked against you and you can't do a darn thing about it. You never want to do that in trading.

In trading—at least the way I go about it—you never really let go of the dice. You wait for the high-probability trade to materialize. You make the trade. You monitor the position. Depending on market action, you get out of the trade with either a profit or, at worst, a small loss. In a sense, you never really let go of the dice in this type of trading. You remain in control throughout the process.

When you lack confidence, you can't win. The quickest way to lose your confidence is to violate one of your trading rules. It's OK to make an incorrect call on the market. But it is not OK to violate a trading rule. Once you start making excuses for violating your rules, the entire foundation of your trading will crumble and you'll be back to square one.

You are most vulnerable to breaking your rules following a string of good trades. For a period of time in the late 1970s and early 1980s, I found myself doing much better than normal. I attributed my improved results to better trading on my part. Thinking that I had now reached a higher level of trading proficiency, I increased my trading size. I remember getting emotional and little greedy. Then the inevitable happened. The market went against me and I took a big hit. Lesson learned.

If you are making more money than usual, it's probably because the market conditions are creating more trading opportunities, not because you're a better trader. When you're doing well, refocus your energy on following your trading rules and avoid thinking about money. Don't let quiet confidence develop into overconfidence.

Similarly, confidence should not cause you to become too committed to a market view. Market conditions can change several times during an active day. A trader needs to be pliable and adjust his/her viewpoint in concert with changing market conditions. You can't think that you know better than everyone else and you know better than the market. That's not confidence—that's arrogance. And arrogant traders never win.

When you are quietly confident, you can trade without beating yourself up over setbacks or getting too high after successes. Assuming you have a good trading process in place, you should trade the same regardless of your recent results. Don't become more aggressive, and don't become more cautious following success or failure. Don't dwell on the past. Focus on the now and the next trade that's in front of you.

Sell Too Soon, Not Too Late

I'm an in-and-out trader. I focus on short-term situations where I have an 80 percent chance of winning. On a typical day I make three or four trades. Given my style, it's important for me to grab a quick profit or liquidate a trade if it doesn't move in my favor. I exit quickly.

Good traders don't worry about missing a chunk of a big move. They take their profits without regrets. They know they can always get back into the market. In a sense, they're content with taking a piece of the pie and coming back for seconds.

In trading, everyone agrees that you should cut your losses. However, you sometimes hear or read that you should “let your profits run.” The idea is that you wait until the move is exhausted before selling. I don't agree with this tactic at all. Here's why:

It's a rare event for a market to make a move early in the morning and then continue in that direction the entire day. Typically, there are pullbacks or small consolidation points along the way. Sometimes the market reverses, sometimes the trend continues, and sometimes the market transitions into a trading range. The patterns are endless. The trader who had the mind-set of letting his/her profits run is, in essence, hoping for an unusual market structure: a trend day that moves strongly in one direction and never looks back. Those days happen, but they are a rarity.

In most circumstances, if you “let your profits run,” you'll end up waiting too long and selling after a protracted pullback. You're likely to give back a good portion of your profits on the trade. Moreover, by overstaying the trade, you may miss out on the next trade. The pullback where you exited may be setting up for another 80/20 trade.

The best time to sell is when the momentum is in your favor. You see the 80/20 trade. You get in. The market moves in your direction, and you have a nice profit on the trade. Take it. Get out and get ready for the next trade. Do this three or four times a day and you'll end up winning most days and nearly every week. That's how a lot of professional traders make a living.

You never want to find yourself wishing or hoping for the market to do something. You want to remain in control of the trade and in control of your emotions. Winners come into a trade for a quick profit. If it doesn't work out, they get out. Losing traders hold on to hope. And if the trade doesn't work for them, their hope usually turns to regret or despair over losing money. That's not a path to long-term trading success.

As you gain experience in the market, you'll get a better sense of market action and the right time to get out. There will be times when you catch a trade just right and the momentum is very strong in your favor. In those cases, you can hold on a little longer than usual. In other cases, where the market doesn't move much at all after putting on a trade, you might elect to get out earlier with maybe a scratch or a small profit.

You always want to control your trade. If you have doubt about a trade, get out of it right away and stay out until the situation becomes clearer to you. You always want to strive for an objective appraisal of the market and unemotional trade execution. Hope, doubt, fear, and greed are enemies of good trading.

Take Personal Responsibility for Your Trading

You alone are responsible for your results in trading. You get to pick how to trade, what to trade, and when to trade. You are the reason you succeed or fail in trading. A sure sign of a bad trader is one who places blame on factors other than himself for his results.

Bad traders can come up with a variety of excuses for a losing trade:

• I got a bad tip.
• The pros went gunning for stops—and they got mine.
• My broker gave me a bad fill.
• My computer crashed.
• The price quotes were delayed.
• I was interrupted or distracted.
• A news event caused the market to reverse.
• And on and on.

Again, losses are inevitable in trading. You need to learn to handle them without getting down on yourself or blaming an external factor. While it's fine to analyze a losing trade to understand what went wrong, don't dwell on it. Don't dwell on winners either. Get back to the market and get ready for the next trade.

I make about 15 trades on the average week. I expect about 12 of them to be profitable. Some will be marginally profitable, and some will be very profitable. The losses on the losing trades will be small. At the end of the week, I'm almost always in the black. That said, I do have losing days. That's acceptable. If I have a losing week (which is very rare), I examine what I've done to see if some bad habits have crept into any aspect of my trading. A bad month is completely unacceptable.

Wait for 80/20 Trades

As I've said, the heart of my approach is to trade high-probability setups, which I define as trades that have an 80 percent chance of winning. I have created templates, which I share in later chapters, to recognize these trades. The key for me is to wait patiently for the high-probability trade to materialize before putting on a trade.

There will be many times when you have a strong feeling that the market is going to move in a particular direction. Maybe the market has broken out from a trading range and looks ready to go higher. Or maybe an up move has run out of steam and the market is turning the other way. These types of situations happen all the time, and it's natural as an observer of market action that you get a sense of the market's next move. However—and I can't emphasize this enough—do not trade on these feelings until they are corroborated by the 80/20 trading template.

I like to say I'm a “sore loser.” I do not trade 60/40 situations, and you shouldn't either. At the end of the day, the profit margins are too small to make these trades worthwhile. And when you lose 40 percent of the time, you're more prone to losing streaks, losing days, and losing weeks. Also, when your loss rate is 40 percent, you are more likely to second-guess your signals and have difficulty pulling the trigger.

It's OK to stay on the sidelines when the market is giving you mixed signals. I trade the market by my own set of rules. If the current market action doesn't give me the kind of opportunity I demand, then I don't play.

Play Great Defense

A good trader is more focused on controlling risk than maximizing profit. He or she does this by accomplishing the following:

• Controlling emotions so that fear and greed do not undermine the decision-making process
• Getting out of losing trades quickly
• Following the trading rules
• Trading small relative to the size of his/her capital.

It's very important to get out of bad trades quickly. Always keep in mind that the market continually presents new opportunities. If you overstay a bad trade, chances are you'll miss the next good opportunity. Similarly, when a trade is working for you, don't inflate the potential profits. Don't expect too much from a single trade. Take your profits while they are ripe on the vine—when the momentum is still in your favor.

Everybody has good days in this business. And everybody has bad days, too. By thinking defensively all the time, you can limit the damage done on bad days. When you handle bad days well, you are on your way to becoming a good trader.

Pull the Trigger

Trading is not for the weak-minded. You need to do the necessary background work before the market opens, and you need to have your trading templates in place. You need to monitor the market and anticipate 80/20 situations. And once the situation presents itself, you have to be decisive. Trading well requires a sense of urgency.

Don't fall victim to the “paralysis of analysis.” You have to act when the opportunity presents itself. If you get a buy or sell signal on the template, then make the trade. Generally speaking, the better the opportunity, the shorter the time it will be available. There are many good traders in the market. When a great opportunity materializes, many of these traders will recognize the situation and act on it. As a result, the market will move quickly and decisively in one direction. If you wait too long to analyze the opportunity, it will pass you by.

Opinions Are for Pundits, Not Traders

Everywhere I go, people have an opinion about the stock market: on television, the Internet, and even on the golf course. It gets to the point where it's hard for me not to have an opinion. People who know I'm a trader naturally ask me about the market. I'm sure the same thing happens to many of you. Remember, whatever your opinion is, we trade 80/20 opportunities, not our opinions.

I come into each day with an open mind, ready to go long or short as the market action dictates. Based on my background work, I may think that there's more potential for the market to go in one particular direction, but I don't let that view prevent me from trading in the opposite direction if the opportunity presents itself.

Strictly Follow Technical Data

The financial press usually attributes every move in the stock market to something in the news, most frequently an economic report. And security analysts look at corporate fundamentals to determine whether a stock is fairly valued. I purposefully ignore both economic and corporate fundamentals. It's simply not my game.

Technical indicators and charts record all the buying and selling activity in the market, organized in a manner that allows me to spot high-probability trading situations. That's all I need to focus on to make money in the market. As a trader, you can't follow everything. Charts are very important for short-term trading because they show the underlying market psychology. And technical indicators help to time exit and entry points. Both are indispensable.

To get a better picture of market dynamics, it's valuable to assess the market one time frame greater than your trading time frame. For example, if you are trading with a 5-minute chart, use a 30-minute chart to gain additional perspective.

You want to be sure to get confirmation from technical indicators and charts before taking a position. For example, don't buy or sell a market only because prices have dropped or risen substantially and the market seems hugely under- or overvalued. Wait for the indicators and charts to signal a buy or sell.

As you gain experience with charts and technical indicators, you'll develop a sense of anticipation about changes in trend. You'll see momentum flagging, spot divergences, and sense that the balance of power between buyers/sellers is shifting from one side to the other. When you see the trend changing, get focused on your trading templates and get ready to trade.

Market Entry Tactics: Use Limit Orders, Buy/Sell Zones, and Position Scaling

Regardless of the time frame that you trade, it's very difficult to pick a precise top or bottom. Instead, based on your analysis, you should target a buy and sell zone where you project it's safe to be long or short.

Whenever possible, you should use limit orders to establish a position in your buy/sell zone. A limit order guarantees that you'll get in at your price or better. While it's possible that your limit order will not get filled and the market may move quickly in the direction you anticipated, I've found that rarely happens if I placed my limit order at a reasonable price.

In many cases, I'll scale into a position. For example, I may place a limit buy order for two E-minis. If I've caught the beginning of a strong move, I may purchase another two E-minis at a higher price and then perhaps another two E-minis at an even higher price.

Use Defensive Stops

I advocate the use of stops to limit potential losses. You can set them at specific prices or at values created by your technical indicators. You need to be disciplined about setting stops with every trade so that you don't allow a small loss to turn into a big loss.

I typically place my initial stop two points away from my entry price. Once the market moves in my favor, I move my stop to lock in a profit. I won't wait for the market to slow down or retreat before exiting. I'll get out with the momentum still in my favor. If you're trading on a longer time frame, your stops should be larger, more in the order of 5 to 10 points.

There will be times when you are right about market direction, but you're wrong on market timing. In those situations, you may very well get stopped out of your trade. There's nothing wrong with getting back in the market shortly thereafter if another 80/20 setup materializes.

If the market moves in your favor, you should adjust your stops to lock in gains. Markets can move against you quickly; you don't want to transform a nice profit into a loss. Again, if you get stopped out on a minor pullback after adjusting your stop, you can always get back in.

If a trade is showing a loss toward the end of the day, I'll liquidate the position before the market closes. I don't want to hold losing positions overnight.

I may average up or down in certain situations; however, I do not average up or down above my core position. To average down means that you buy additional stocks or contracts at a lower price after the market has dropped below your initial purchase price. To average up means you sell additional contracts at a higher price after the market has risen above your initial short position. Again, my core position is my maximum position based on my psychological comfort level. For me, it's 10 E-mini contracts.

Track Your Results

At the end of each trading day, I note my profits and losses (P&L) for the day, for the week, and for the month. I'm very precise in my record keeping. I feel that precision carries over into my trading and helps keep me focused. I'm always aware of how each new trade contributes or detracts from my P&Ls. By focusing on high-probability trades, my P&Ls typically show continuous growth, with a few relatively small down periods. However, the returns are not consistent.

You can extract from the market only what the market gives you, and your returns will vary depending on market conditions. You cannot demand consistency in your returns; it's just not in the nature of the business. New traders, particularly those with a background in a structured business environment, need to understand and accept that their weekly and monthly P&Ls likely will show a wide range of returns.

But while your returns will vary, you must demand consistency in your discipline and adherence to your trading rules. You should review your trades daily to determine if you acted in concert with your rules. You should reread and study your trading rules on a regular basis. Make them part of your trading DNA. They are the blueprint for your success.

Managing Your Trading Account

If you are showing consistent profits, for psychological reasons, it's a good idea to pay yourself something from your trading account. You deserve to be rewarded for your success. It will help to keep you motivated and give you positive feelings about your trading.

You should not intermingle your trading account with your investment account. In-and-out trading and long-term investing are two distinctly different disciplines. By having the two activities in the same account, you may be tempted to change a trading position into an investment position, which is usually not a good idea. In addition, with the two accounts intermingled, it's more difficult to segregate the trading P&L and evaluate your trading performance.

Take Advantage of Market Conditions

Trending markets and trading range markets present different opportunities and require different strategies and tactics.

First and foremost, you should be aggressive in trending markets in establishing a position in the direction of the trend. Given the profit potential in a trend, you can afford to give up a tick or two to get into the market.

Be aware that prices usually move faster in downtrends than uptrends. In downtrends, protective stops get hit and investors close long positions. To avoid losses, there is often a rush to the exits. In uptrends, investors are faced with a less pressing situation: establish a new long position, add to an existing long position, or close a long position for a profit. Investors have more time to make a decision. As a result, there's a slower pace of buy orders and slower price movement on uptrends.

There are times that the market goes into what I call a “white heat” condition where prices move very rapidly, sometimes gapping up or down. If you're fortunate enough to have a position in the direction of white heat, my advice is to take advantage of the situation and close your position while the momentum is still with you. If you wait until the white heat move loses steam, it very well may gap in the opposite direction.

In trading range markets, you should be more selective in establishing a position. To the degree possible, you want to buy at the bid and sell at the offer. The profit potential in trading range markets is smaller than in trending markets, so you want to get the best possible trade location.

If a market has been in a trading range for three or four days, it's likely that the market will make a big move when it finally breaks out of the range.

In most situations, it's best to trade in the direction of the short-term trend. However, you want to avoid chasing the market. Usually, there will be a pullback where you can get a better price than jumping on a breakout.

As you gain experience in markets, you'll develop a sense of market sentiment. When the majority opinion is either bullish or bearish—and the market doesn't move in the direction of the market consensus—the market will likely move strongly in the opposite direction.

My indicators are sensitive to changing market conditions and will sometimes get me into positions a little early. Generally, that's a good thing. You get a better feel for the market once you have a position.

And assuming the indicators were right, being early usually translates into a more profitable trade.

Review the Rules Every Week

Please don't read these rules, nod your head and agree that they make sense, and then pretty much forget about them. These rules are the product of my years of experience in the markets. If I had had the rules when I first started trading, my path to consistent profitability would have been much shorter. Read the rules regularly and make them your own.