That way you will have many more winners.
Following the rules
Now let’s look at the practical problems in following these three “sim- ple” rules. You would think that cutting losses would be simple enough.
It is hardly a difficult concept after all. But it does bring a lot of addi- tional baggage with it. It certainly makes the whole trading approach a lot more complex. But the alternative is to be wiped out – at least for the majority.
We will first look at the basic philosophy. If you risk too big a per- centage of your capital on any one trade, then you are liable to be wiped out. So you must choose an entry mechanism which allows low risk entries, meaning the risk is a low percentage of your capital.
Using stops
Having got to that point novice traders are forced to use market stops because they rarely have the skill to use one of the many alternatives. But immediately trading becomes more complex, because you keep on get- ting stopped out! Unfortunately that is just one of the things traders have to get used to. Particularly so when the market triggers your stop and then goes off in the direction you intended. That will happen a lot as well!
But I think the philosophy is obvious and I have yet to hear a good argument for not using stops in derivative markets, although I accept that some traders work better without them. It is different with stocks, where the gearing is not in place, and it can be different when trading with fundamentals. But beginners do not have the pockets or the expe- rience to do this.
Now to the practical problems of using stops. These come in a whole range of shapes and forms. Let’s start with the most simple human urge,
The three simple rules (or trading secrets)
as expressed in everyday life. When we see something we want, we grab it; when we see something we dislike, we often drive it from our minds – let’s forget about it, it will probably go away. In the real world this may not hurt too much, but in the markets, losses that are treated this way tend to get bigger. It is a basic human urge to ignore bad things, thus we are pre-programed not to take losses, but we are also pre-pro- gramed to take profits as soon as we see them. Think about your life so far and the way you live it. How easy do you think it would be to change some of your basic behavioral characteristics? Pretty tough? Well that is what you have to do to follow the first two simple rules.
Losses
Then there is the dear old ego. Guess what? Most of us do not like being wrong. Most of us associate losing money with being wrong. Guess what? We would rather avoid taking a loss, which will then probably get worse, than admit we might be wrong. Some traders talk about how much a novice trader is prepared to pay before admit- ting he is wrong. What is your price,
$1000, $2000, $5000, or are you in the $100 000 category along with some others I know? Before starting to trade make sure you are happy being wrong a lot of the time – it might save you a fortune.
But a lot of traders I know agree with all this and still big losses some- how creep up on them. They have on me in the past. Normally this occurs when we change something about our trading. Perhaps we increase position size, perhaps we start trading a new market, perhaps we hold overnight for a change. Whatever it might be it is often a stum- bling block. Something is a little different and until you are experienced and well practiced, the smallest thing can get in the way between you and properly operating your stop policy. So be on your guard.
Most traders learn their lessons the hard way and learning to cut losses is usually the hardest of all because it is the most painful. Most traders admit to that one trade that went horribly wrong, and I suspect those that don’t admit it also experienced it. They just prefer to hide it
Section 1 ã The underlying philosophy
Before starting to trade make sure you are happy being wrong a lot of the time – it might save you a fortune.
away, maybe even from themselves. Far better to be open, especially with yourself.
The sequence of events is that we take a trade and we do not put a stop in the market. Or if we do put a stop in place we do not do it GTC (good till cancelled) and it would have got hit the next day. Whatever, the trade goes against us and we suddenly find that the loss is bigger than we planned. That is the first problem area. We have, in effect, rehearsed taking a loss of x, but 2x was not envisioned. We go through stages of fear, denial, hope, and the rest. We can’t afford to lose that much so we have to stay with the trade. Wrong, we have already lost that much and we have to get out of the trade, although I would nor- mally suggest placing another stop to effect this, thus giving the trade a chance. But this is something of a stopgap measure, it is easier for the suffering trader to do this than get out
outright. If the trader does not do this then a long period of suffering can ensue, sometimes going on for weeks. Eventu-
ally the pain gets so bad that it exceeds the other pain. That other pain is the pain of accepting the loss, admitting it is yours and taking it.
Traders are unwilling to take a loss because they don’t want to admit the loss and hope it will go away, that they will not have to confront it, and accept their own stupidity. Far better to accept we are all pretty stupid upfront, before we start to risk money, but this is something we find dif- ficult to do. Humility definitely has a high value in the markets.
It so happens that when this point is reached it is often a major turn- ing point in the market. So the trader feels doubly stupid. Not only has he made a big loss, by holding far too long, he also got out at just the wrong time. Incidentally the damage this does to self esteem is a prob- lem the trader will have to deal with before he can make it, any psycho- logical “flaw” like this will impact on trading because it is liable to create “driven” trades from time to time. I define any emotional trading as being driven as the trader has no real control. Self esteem problems can raise their head if anything threatens that already weakened self esteem, like an argument for example. What better way to make you feel better than to trade the market!
Back to that suffering trader who got out just at the wrong time. The
The three simple rules (or trading secrets)
Humility definitely has a high value in the markets.
market is a manifestation of human psychology. Most market partici- pants are making emotionally driven decisions. How everyone views the market at any one time is purely within their own minds. Market extremes are reached at peaks of emo- tion. Fear at lows, greed at highs. Human beings are all fairly similar in many ways. If a number of us were sitting in a room and a tiger entered, we would all have very similar impulses. If there was a window we may well all rush for it. It is therefore not surprising that a peak or trough in a market will create the maximum emotion which will cause the novice trader to finally exit a losing position. Surely that extreme emotion is almost bound to have that effect, and having drawn in the last buyer or seller (in this case the novice trader) the market will reverse.
So cutting losses is not easy and is a skill to be developed, as with all market skills. But eventually we master this and then it comes time to move onto crucial skill number two, running profits. There are two obvious problems here. First, running profits is an entirely different skill from cutting losses, and indeed is almost the converse. One involves actively watching the trade and being ready to act when necessary; the other involves a more passive role, mainly involving trying not to act.
The trader needs to have really learnt how to cut losses before starting to let profits run. It is a different order of skill. Running profits is not something a novice should really try to do, too hard, because it might well cause problems cutting losses and that is the foremost priority at that stage. Once the skill of cutting losses has been acquired it is the time to worry about running profits.
Running profits
The second problem is the one mentioned above about wanting to grab nice things when we see them, when we want them. We have done that all our lives, now we have to change the habits of a lifetime. It is not easy. Some methodologies overcome these difficulties. For example my option trading approach does so to an extent because it is relatively short term, often a maximum of two weeks, and I have precise goals. I sell time value and close when it has all but gone. Simple. It is far more
Section 1 ã The underlying philosophy
The market is a manifestation of human
psychology.
difficult to run a futures position and it is something which has to be learnt to the core of your being. The difficulty is that markets are always testing, probing for business in either direction. You have got to be fairly stalwart to stay with it through these tests and that is a skill you have to experience to learn. You also have to have a feel for the depth of correc- tion you are prepared to accept, and define a trend reversal you will not.
Part of this is what you see when you look at a chart. Do you see the tops and bottoms, or do you see the trends? You may think this is an odd way of looking at things but it is, in fact, critical. If you see both you will probably have trouble running profits. If you see tops and bottoms then you will be programed to see tops and bottoms. If so you are liable to see them all the time, you will get out of good trending trades. This goes fairly deep. I am not saying you have to brainwash yourself, but you need to be aware of how your mind is working.
Another factor is relaxation. I have come to the conclusion that humil- ity and relaxation are as important in trading as are Money Manage- ment, Risk Control and the rest. If you are not relaxed then you will always be tempted to take action, taking action is the enemy of running profits.
Trading selectively
The third simple rule “Trade Selectivity” is simpler in concept but is the culmination of all the work you do as a trader. You are only going to become good at this once you have served your apprenticeship and become an expert. This whole book is about that process and so I do not intend to dwell on this here at length.
Trading with the trend
Nor do I intend to say too much about trading with the trend. Indeed this is something of a truism. Trends tend to continue, that is what they do. Thus if you trade with it you are going to have much better odds in your favor. Of course there are different trends within every timescale.
So first you must decide on your timescale. Then you must devise meth- ods of entering trades. These must be low risk. Once positioned you should stay with it until that trend changes, again according to your timescale. It’s really very simple, it’s just doing it that causes problems!
The three simple rules (or trading secrets)
SUMMARY
■ To cut your losses is the first lesson you must learn. In many ways it is important to concentrate on this alone at the start.
■ To run your profits is the second skill you must learn, and this is, in many ways, the opposite of the first skill.
■ Trade selectivity is the final skill and this comes when you are an expert in your approach. “Your” is the key word.
■ Trading with the trend will generally give you greater chances of suc- cess, depending on your strategy.
■ It is important to be aware of the practical and psychological problems in following these rules, and to learn to overcome them.
Section 1 ã The underlying philosophy
In the market there are two types of risk. There is the risk of losing money and there is the risk of losing a lot of money. As there are no free lunches you can expect the three trading vehicles which we are dis- cussing to offer a balance against these two types or risk and this is what we find. If we buy options we have a nil risk of losing a lot of money (defined as more than your original stake) as all we can lose is what we paid for them in the first place. But if we buy options we find that we normally lose money. If we decide to write options (which I am treating as a separate trading vehicle) we find that our risk of loss is low, as option writers win most months. But when we lose we can get wiped
C h a p t e r 1 0