iration ($/oz)
Profit/loss at expiration ($)
1,000
25,000
12,500
−12,500
−25,000
0
1,050 1,100 1,150 1,200 1,250
Long futures
Short 2 puts
Long 2 calls
.20
.18
.16
.14
.12
.10
Probability
.08
.06
.04
.02
1,300 1,350 1,400
548A COMPleTe gUIde TO THe FUTUreS MArKeT
 FIGURE  35.26 “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss
Profi les for Three Alternative Bearish Strategies
 “Bearish/Nonvolatile” expected Probability distribution and Profi t/loss
Price of August gold futures at option expiration ($/oz)
Profit/loss at expiration ($)
1,000
25,000
12,500
−12,500
−25,000
0
1,050 1,100 1,150 1,200 1,250
Short futures
Short 2 calls
Long 2 puts
.20
.18
.16
.14
.12
.10
Probability
.08
.06
.04
.02
1,300 1,350 1,400
 FIGURE  35.27 “Bearish/V olatile” expected Probability distribution and Profi t/loss Profi les
for Three Alternative Bearish Strategies
Price of August gold futures at option expiration ($/oz)
Profit/loss at expiration ($)
1,000
25,000
12,500
−12,500
−25,000
0
1,050 1,100 1,150 1,200 1,250
.20
.18
.16
.14
.12
.10
Probability
.08
.06
.04
.02
1,300 1,350 1,400
Short futures
Short 2 calls
Long 2 puts
549
OPTION TrAdINg STrATegIeS
 FIGURE  35.28 “Neutral/Nonvolatile” expected Probability distribution and Profi t/loss
Profi les for Two Alternative Neutral Strategies
 “Neutral/Nonvolatile” expected Probability distribution and Profi t/loss
Price of August gold futures at option expiration ($/oz)
Profit/loss at expiration ($)
1,000
10,000
5,000
−5,000
−10,000
0
1,050 1,100 1,150 1,200 1,250
.20
.18
.16
.14
.12
.10
Probability
.08
.06
.04
.02
1,300 1,350 1,400
Long straddle
Short straddle
 FIGURE  35.29 “Neutral/V olatile” expected Probability distribution and Profi t/loss Profi les
for Two Alternative Neutral Strategies
Price of August gold futures at option expiration ($/oz)
Profit/loss at expiration ($)
1,000
10,000
5,000
−5,000
−10,000
−15,000
0
1,050 1,100 1,150 1,200 1,250
.20
.18
.16
.14
.12
.10
Probability
.08
.06
.04
.02
1,300 1,350 1,400
Long straddle
Short straddle
550
A Complete Guide to the Futures mArket
One problem with the graphic approach described thus far is that it may not always be visually
clear which is the best strategy for the given price distribution assumption. Obviously, a more precise
method of determining the optimal trading strategy would be desirable. Intuitively, it might appear
that expected gain would provide such a relative measure.
expected gain is the expected gain (or loss)
on a trade and can be expressed as follows:
Expected g ain =
=
∑ () ()PXii
i
n
1
where Pi = probability of price interval i
 Xt = average gain (or loss) of interval i
 n = number of intervals
Unfortunately, expected gain has a major defect as a relative measure: it is dependent upon posi-
tion size. The expected gain of any strategy that has a positive expected gain could always be improved
by trading a multiple of the position. Thus, in comparing alternative strategies with positive expected
gains, the indicated optimal strategy would vary depending on the assumed position sizes. Such arbi-
trariness in a relative measure is obviously unacceptable.
The use of expected gain as a relative measure can lead to some ludicrous conclusions. For exam-
ple, a strategy that had a 50 percent probability of a $1,000 gain and a 50 percent probability of a
$900 loss would be judged better than an alternative strategy with a 50 percent chance of a $100 gain
and a 50 percent chance of a $10 loss (an expected gain of $50 vs. an expected gain of $45). Obvi-
ously, virtually any trader would prefer the second strategy, despite its lower expected gain.
The dependency of expected gain on position size actually reflects a more fundamental flaw in this
measure: expected gain does not incorporate a measure of risk. A measure that included risk would
not be dependent upon position size, since doubling the position would not only double the expected
gain, but would also double the risk. One such possible measure is the probability-weighted profit/
loss ratio (PWP
lr), which can be defined as follows:
PWPLR
PG
PL
ii
i
m
jj
j
n=− =
=
∑
∑
() ()
() ()
1
1
where Pi = probability of interval i, where i represents an interval with a net gain at the average
price of the interval
 Pj = probability of interval j, where j represents an interval with a net loss at the average
price of the interval
 Gi = indicated gain at the average price of the interval
 Lj = indicated loss at the average price of the interval
 m = number of intervals with net gain at average price of interval
 n = number of intervals with net loss at average price of interval
551
OPTION TrAdINg STrATegIeS
An implicit assumption in the formulation of the probability-weighted profit/loss ratio is that each
price in a given interval has an equal probability of occurrence.4
Note that the PWPlr will be totally unaffected by position size. This is true because increasing the
position will affect the numerator and denominator of the PWPlr equally, thereby leaving the ratio
unchanged. Tables 35.23 through 35.28 evaluate the strategies graphically analyzed in Figure 35.24
through 35.29. The conclusions are equivalent, but the advantage of this method is that it yields pre-
cise, unambiguous results. T o select an optimal strategy, the trader would merely define his estimate
of the probability distribution for prices and then calculate the PWP
lrs for each alternative trading
approach.
4 It is worth noting that the probability-weighted profit/loss ratio will yield the same ordering of strategies as
the ratio of the expected gain to the expected loss on losing trades, where the expected loss on losing trades is
defined as: () ()PLjj
j
n
=
∑
1
. This can be demonstrated as follows:
Expected g ain
Expected gain
Expe
=−
==
∑∑() () () ()PG PLii
i
m
jj
j
n
11
ccted loss on losing trade s =−
=
=
=
∑
∑
() ()
() ()
PG
PL
P
ii
i
m
jj
j
n
1
1
1
W WPLR − 1
tabLe 35.23 probability-W eighted profit/Loss ratio Comparis


e expected gain to the expected loss on losing trades, where the expected loss on losing trades is
defined as: () ()PLjj
j
n
=
∑
1
. This can be demonstrated as follows:
Expected g ain
Expected gain
Expe
=−
==
∑∑() () () ()PG PLii
i
m
jj
j
n
11
ccted loss on losing trade s =−
=
=
=
∑
∑
() ()
() ()
PG
PL
P
ii
i
m
jj
j
n
1
1
1
W WPLR − 1
tabLe 35.23 probability-W eighted profit/Loss ratio Comparisons for “bullish/Nonvolatile” expected
probability Distribution
Long Futures Long Call Short put
price range
($/oz)
average
price
($/oz)
assumed
probability
Gain/Loss at
average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
1,050–1,099.9 1,075 0.05 –12,500 –625 –3,880 –194 –8,630 –431.5
1,100–1,149.9 1,125 0.15 –7,500 –1,125 –3,880 –582 –3,630 –544.5
1,150–1,199.9 1,175 0.2 –2,500 –500 –3,880 –776 1,370 274
1,200–1,249.9 1,225 0.2 2,500 500 –1,380 –276 3,870 774
1,250–1,299.9 1,275 0.2 7,500 1,500 3,620 724 3,870 774
1,300–1,349.9 1,325 0.15 12,500 1,875 8,620 1,293 3,870 580.5
1,350–1,399.9 1,375 0.05 17,500 875 13,620 681 3,870 193.5
Probability-weighted profit/loss ratio:4,750/2,250 = 2.11 2,698/1,828 = 1.48 2,596/976 = 2.66
552
A Complete Guide to the Futures mArket
tabLe 35.24 probability-W eighted profit/Loss ratio Comparisons for “bullish/V olatile” expected
probability Distribution
Long Futures Long Call Short put
price range
($/oz)
average
price
($/oz)
assumed
probability
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
950–999.9 975 0.04 –22,500 –900 –3,880 –155 –18,630 –745.2
1,000–1,049.9 1,025 0.06 –17,500 –1,050 –3,880 –233 –13,630 –817.8
1,050–1,099.9 1,075 0.08 –12,500 –1,000 –3,880 –310 –8,630 –690.4
1,100–1,149.9 1,125 0.1 –7,500 –750 –3,880 –388 –3,630 –363
1,150–1,199.9 1,175 0.12 –2,500 –300 –3,880 –466 1,370 164.4
1,200–1,249.9 1,225 0.18 2,500 450 –1,380 –248 3,870 696.6
1,250–1,299.9 1,275 0.14 7,500 1,050 3,620 507 3,870 541.8
1,300–1,349.9 1,325 0.12 12,500 1,500 8,620 1,034 3,870 464.4
1,350–1,399.9 1,375 0.1 17,500 1,750 13,620 1,362 3,870 387
1,400–1,449.9 1,425 0.06 22,500 1,350 18,620 1,117 3,870 232.2
Probability-weighted profit/loss ratio:6,100/4,000 = 1.53 4,020/1,800 = 2.23 2,486/2,616 = 0.95
tabLe 35.25 probability-W eighted profit/Loss ratio Comparisons for “bearish/Nonvolatile” expected
probability Distribution
Short Futures Short Call Long put
price range
($/oz)
average
price
($/oz)
assumed
probability
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
1,000–1,049.9 1,025 0.05 17,500 875 3,880 194 13,630 681.5
1,050–1,099.9 1,075 0.15 12,500 1,875 3,880 582 8,630 1,294.5
1,100–1,149.9 1,125 0.2 7,500 1,500 3,880 776 3,630 726
1,150–1,199.9 1,175 0.2 2,500 500 3,880 776 –1,370 –274
1,200–1,249.9 1,225 0.2 –2,500 –500 1,380 276 –3,870 –774
1,250–1,299.9 1,275 0.15 –7,500 –1,125 –3,620 –543 –3,870 –580.5
1,300–1,349.9 1,325 0.05 –12,500 –625 –8,620 –431 –3,870 –193.5
Probability-weighted profit/loss ratio: 4,750/2,250 = 2.11 2,604/974 = 2.67 2,702/1,822 = 1.48
553
OPTION TrAdINg STrATegIeS
tabLe 35.26 probability-W eighted profit/Loss ratio Comparisons for “bearish/V olatile” expected
probability Distribution
Short Futures Short Call Long put
price range
($/oz)
average
price
($/oz)
assumed
probability
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at average
price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss
at
average
price ($)
probability-
W eighted
Gain/Loss ($)
950–999.9 975 0.06 22,500 1,350 3,880 233 18,630 1,117.8
1,000–1,049.9 1,025 0.1 17,500 1,750 3,880 388 13,630 1,363
1,050–1,099.9 1,075 0.12 12,500 1,500 3,880 466 8,630 1,035.6
1,100–1,149.9 1,125 0.14 7,500 1,050 3,880 543 3,630 508.2
1,150–1,199.9 1,175 0.18 2,500 450 3,880 698 –1,370 –246.6
1,200–1,249.9 1,225 0.12 –2,500 –300 1,380 166 –3,870 –464.4
1,250–1,299.9 1,275 0.1 –7,500 –750 –3,620 –362 –3,870 –387
1,300–1,349.9 1,325 0.08 –12,500 –1,000 –8,620 –690 –3,870 –309.6
1,350–1,399.9 1,375 0.06 –17,500 –1,050 –13,620 –817 –3,870 –232.2
1,400–1,449.9 1,425 0.04 –22,500 –900 –18,620 –745 –3,870 –154.8
Probability-weighted profit/loss ratio: 6,100/4,000 = 1.53 2,494/2,614 = 0.95 4,025/1,795 = 2.24
tabLe 35.27 probability-W eighted profit/Loss ratio Comparisons for “Neutral/Nonvolatile” expected
probability Distribution
Long Straddle Short Straddle
price range
($/oz)
average
price ($/oz)
assumed
probability
Gain/Loss at
average price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss at
average price ($)
probability-
W eighted
Gain/Loss ($)
1,000–1,049.9 1,025 0.05 9750 488 –9,750 –488
1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475
1,100–1,149.9 1,125 0.15 –250 –38 250 38
1,150–1,199.9 1,175 0.2 –5,250 –1,050 5,250 1,050
1,200–1,249.9 1,225 0.2 –5,250 –1,050 5,250 1,050
1,250–1,299.9 1,275 0.15 –250 –38 250 38
1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475
1,350–1,399.9 1,375 0.05 9,750 488 –9,750 –488
Probability-weighted profit/loss ratio: 1,925/2,175 = 0.89 2,175/1,925 = 1.13
554
A Complete Guide to the Futures mArket
hedging applications
The entire discussion in this chapter has been approached from the vantage point of the speculator.
However, option-based strategies can also be employed by the hedger. T o illustrate how options can be
used by the hedger, we compare five basic alternative strategies for the gold jeweler who anticipates a
requirement for 100 ounces of gold in August. The assumed date in this illustration is April 13, 2015,
a day on which the relevant price quotes were as follows: spot gold = $1,198.90, August gold futures
= $1,200,

eBooks\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads\A Complete Guide to the Futures Market Technical Analysis, Trading Systems, Fundamental Analysis, Options, Spreads.pdf


ategies can also be employed by the hedger. T o illustrate how options can be
used by the hedger, we compare five basic alternative strategies for the gold jeweler who anticipates a
requirement for 100 ounces of gold in August. The assumed date in this illustration is April 13, 2015,
a day on which the relevant price quotes were as follows: spot gold = $1,198.90, August gold futures
= $1,200, August $1,200 gold call premium = $38.80, August $1,200 gold put premium = $38.70.
The five purchasing alternatives are:
5
 1. Wait until time of requirement. In this approach, the jeweler simply waits until August
before purchasing the gold. In effect, the jeweler gambles on the interim price movement of
gold. If gold prices decline, he will be better off. However, if gold prices rise, his purchase price
will increase. If the jeweler has forward-contracted for his products, he may need to lock in his
raw material purchase costs in order to guarantee a satisfactory profit margin. Consequently, the
price risk inherent in this approach may be unacceptable.
tabLe 35.28 probability-W eighted profit/Loss ratio Comparisons for “Neutral/V olatile” expected
probability Distribution
Long Straddle Short Straddle
price range
($/oz)
average
price ($/oz)
assumed
probability
Gain/Loss at
average price ($)
probability-
W eighted
Gain/Loss ($)
Gain/Loss at
average price ($)
probability-
W eighted
Gain/Loss ($)
950–999.9 975 0.05 14,750 738 –14,750 –738
1,000–1,049.9 1,025 0.08 9,750 780 –9,750 –780
1,050–1,099.9 1,075 0.1 4,750 475 –4,750 –475
1,100–1,149.9 1,125 0.12 –250 –30 250 30
1,150–1,199.9 1,175 0.15 –5,250 –788 5,250 788
1,200–1,249.9 1,225 0.15 –5,250 –788 5,250 788
1,250–1,299.9 1,275 0.12 –250 –30 250 30
1,300–1,349.9 1,325 0.1 4,750 475 –4,750 –475
1,350–1,399.9 1,375 0.08 9,750 780 –9,750 –780
1,400–1,449.9 1,425 0.05 14,750 738 –14,750 –738
Probability-weighted profit/loss ratio: 3,985/1,635 = 2.44 1,635/3,985 = 0.41
5 There is no intention to imply that the following list of alternative hedging strategies is all-inclusive. Many other
option-based strategies are also possible. For example, the jeweler could buy a call and sell a put at the same
strike price—a strategy similar to buying a futures contract (see Strategy 15).
555
OPTION TrAdINg STrATegIeS
 2. buy spot gold. The jeweler can buy spot gold and store it until August. In this case, he locks
in a purchase price of $1,198.90/oz plus carrying costs (interest, storage, and insurance). This
approach eliminates price risk, but also removes the potential of benefiting from any possible
price decline.
 3. buy gold futures. The jeweler can purchase one contract of August gold futures, thereby
locking in a price of $1,200/oz. The higher price of gold futures vis-à-vis spot gold reflects the
fact that futures embed carrying costs. Insofar as the price spread between futures and spot gold
will be closely related to the magnitude of carrying costs, the advantages and disadvantages of
this approach will be very similar to those discussed in the above strategy.
 4. buy an at-the-money call. Instead of purchasing spot gold or gold futures, the jeweler could
instead buy an August $1,200 gold futures call at a premium of $38.80/oz. The disadvantage of
this approach is that if prices advance the jeweler locks in a higher purchase price: $1,238.80/
oz. However, by purchasing the call, the jeweler retains the potential for a substantially lower
purchase price in the event of a sharp interim price decline. Thus, if, for example, spot prices
declined to $1,050/oz by the time of the option expiration, the jeweler’s purchase price would
be reduced to $1,088.80/oz (the spot gold price plus the option premium).
6 In effect, the pur-
chase of the call can be viewed as a form of price risk insurance, with the cost of this insurance
equal to the “premium.”
7
 5. buy an out-of-the-money call. As an example, the jeweler could purchase an August
$1,300 gold futures call at a premium of $9.10/oz. In this case, the jeweler forgoes protection
against moderate price advances in exchange for reducing the premium costs. Thus, the jeweler
assures he will have to pay no more than $1,309.10/oz. The cost of this price protection is $910
as opposed to the $3,880 premium for the at-the-money call. In a sense, the purchase of the
out-of-the-money call can be thought of as a price risk insurance policy with a “deductible.” As
in the case of purchasing an at-the-money call, the jeweler would retain the potential of benefit-
ing from any interim price decline.
As should be clear from the above discussion, options meaningfully expand the range of choices
open to the hedger. As was the case for speculative applications, the choice of an optimal strategy will
depend on the trader’s (hedger’s) individual expectations and preferences. It should be stressed that
this section is only intended as an introduction to the concept of using options for hedging. A compre-
hensive review of hedging strategies would require a far more extensive discussion.
6 T echnically speaking, since gold futures options expire before the start of the contract month, the effective
purchase price would be raised by the amount of carrying costs for the remaining weeks until August.
7 The use of futures for hedging is also often described as “insurance.” However, in this context, the term is
misapplied. In standard application, the term insurance implies protection against a catastrophic event for a cost
that is small relative to the potential loss that is being insured. In using futures for hedging, the potential cost is
equivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against
a $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on
his hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the
standard concept of


ures for hedging, the potential cost is
equivalent to the loss protection. For example, if the jeweler buys gold futures, he will protect himself against
a $10,000 increase in purchase cost if prices increase by $100/oz, but he will also realize a $10,000 loss on
his hedge if prices decline by $100/oz. In this sense, the use of the call for hedging comes much closer to the
standard concept of insurance: the magnitude of the potential loss being insured is much greater than the cost
of the insurance.

Practical tradiNg
guideliNes
Part VII

559
Cha P ter 36
If making money is a slow process, losing it is quickly done.
—ihara saikaku
i
f the amount of money you risk in futures trading represents a minuscule fraction of your net
worth, and your major motivation for speculation is entertainment, the shoot-from-the-hip ap-
proach might be fine. However, if your major objective in futures trading is to make money, an
organized trading plan is essential.
this assertion is not just a platitude. search out successful futures
speculators, and you will no doubt find that they all use a well-defined, disciplined trading approach.
the following seven steps provide general guidelines for constructing an organized trading plan.
 ■ Step 1: Define a Trading Philosophy
How do you plan to make your trading decisions? if your answer is something vague like, “When my
friend gets a hot tip from his broker,” “When i get a trade idea from reading a blog,” or “On market
feel while watching the trading screen,” you’re not ready to begin trading. a meaningful strategy
would be based on either chart analysis, technical trading systems, fundamental analysis, or some
combination of these approaches.
the same method will not necessarily be used in all markets. For
example, in some markets a trader might use a synthesis of fundamental and chart analyses to make
trading decisions, while in other markets decisions may be based on chart analysis only.
the more specific the trading strategy, the better. For example, a trader who plans to base his trades
on chart analysis should be able to specify the types of patterns that would signal trades, as well as other
details, such as confirmation rules. Of course, the most specific trading strategy would be one based on
a mechanical trading system; however, such a fully automated approach may not appeal to all traders.
the Planned trading
approach
560
A Complete Guide to the Futures mArket
 ■ Step 2: Choose Markets to Be Traded
after deciding how to pick trades, you must choose which markets to follow . For most traders, con-
straints on time and available funds will significantly limit the number of markets that can be moni-
tored and traded. three factors might be considered in selecting markets.
Suitability to trading approach
traders should choose those markets that appear to have the best potential for satisfactory perfor-
mance, given their planned approach. Of course, such a determination can be made only on the basis
of either past trading experience or historical testing of a specific trading strategy.
Diversification
the multiple benefits of diversification were fully discussed in chapter 16. However, the essential
point here is that diversification provides one of the most effective means of reducing risk. diversi-
fication can be enhanced by choosing markets that are not closely related. For example, if you knew
that you wanted to trade gold, then silver and platinum would be poor choices for additional markets,
unless your available funds were sufficient to permit you to trade many other markets as well.
V olatility
a trader with limited funds should avoid extremely volatile markets, since the inclusion of such
markets in a portfolio will severely limit the total number of markets that can be traded. (V olatility
here refers to dollar volatility per contract.
consequently, high volatility could imply relatively large
price swings, large-size contracts, or both.) unless your approach is better suited to a given volatile
market, you will be better off trading a wider variety of less volatile markets (diversification again).
 ■ Step 3: Specify Risk Control Plan1
the rigid control of losses is perhaps the most critical prerequisite for successful trading. a risk con-
trol plan should include the following elements.
Maximum risk per trade
traders can substantially increase their probability of long-term success by restricting the percent-
age of total funds allocated to any given trade.2 the maximum risk on any trade should be limited to
1 risk control is typically referred to as “money management,” although i believe the former represents the more
descriptive label.
2 the implicit assumption here is that the trader’s expected net profit per trade (eNPPt) is positive. if a trader’s
eNPPt is negative, the laws of probability will assure failure if he trades long enough. such a situation would be
analogous to the roulette player whose expected gain per bet is negative.
561
tHe PlaNNed tradiNg aPPrOacH
2 percent of total equity and, ideally, 1 percent or less. For smaller accounts, adhering to such a guide-
line will require restricting trading to less volatile markets, mini contracts, and spreads. speculators
who find that they must risk 3 percent or more of their equity on individual trades should seriously
reconsider their financial suitability for futures trading.
the maximum risk per trade can be used to determine the number of contracts that can be initi-
ated in any given trade. For example, if the maximum risk per trade is 1 percent of equity, and the
trader’s account size is $200,000, a crude oil trade that required a stop point $1/barrel below the
market would imply a maximum position size of two contracts. (
the crude oil contract represents
1,000 barrels, so each $1 move equates to $1,000 per contract.)
Stop-Loss Strategy
Know where you’re going to get out before you get in. the importance of this rule cannot be over-
emphas


ity, and the
trader’s account size is $200,000, a crude oil trade that required a stop point $1/barrel below the
market would imply a maximum position size of two contracts. (
the crude oil contract represents
1,000 barrels, so each $1 move equates to $1,000 per contract.)
Stop-Loss Strategy
Know where you’re going to get out before you get in. the importance of this rule cannot be over-
emphasized. Without a predetermined exit point, you can find yourself vulnerable to procrastinating
in the liquidation of a losing position.
at the wrong time, one such lapse of trading discipline could
literally knock you out of the game.
ideally, you should place a good-till-canceled (gtc) stop order when entering a trade. However,
if you are fairly certain you can trust yourself, a mental stop point can be determined at trade entry,
and thereafter adjusted only to reduce risk. For a more detailed discussion of stop-order placement
strategies, see
chapter 13.
it should be noted that a system trader does not necessarily need to employ stop-loss rules in
order to achieve risk control. For example, if a trading system automatically reverses the position
given a sufficient trend reversal, the system will inherently perform the major function of a stop-loss
rule—the prevention of catastrophic losses on individual trades—without such a rule being explicit.
Of course, large cumulative losses can still occur over many trades, but the same vulnerability would
also apply if stops were used.
Diversification
Because different markets will experience adverse moves at different times, trading multiple markets
will reduce risk.
as a very simple example, assume you have a $100,000 account and you are using
a system that experiences average drawdowns of $5,000 in both gold and euro futures. if you traded
two contracts of either market, the average drawdown would be equal to 10 percent ($10,000 ÷
$100,000), whereas if you traded one contract of each, the average drawdown would invariably be less
(possibly even less than for one contract of a single market if the markets were inversely correlated).
in
fact, the average drawdown could reach 10 percent (assuming average drawdowns remain at $5,000
for each market) only if the drawdowns in the two markets proved to be exactly synchronized, which
is exceedingly unlikely. Of course, the risk-reduction benefit of diversification would increase if more
unrelated markets were added to the portfolio.
also, as noted in chapter 16, the concept of diversi-
fication applies not only to trading multiple markets but also multiple systems (or approaches) and
multiple system variations (i.e., parameter sets) for each market, assuming equity is sufficient to do so.
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A Complete Guide to the Futures mArket
although our focus in this section is risk control, it should be noted that diversification can also
increase return by allowing the trader to increase the average exposure in each market without increas-
ing overall risk. in fact, the addition of markets with a lower average return than other markets in an
existing portfolio can actually increase the return of the portfolio if the risk reduction gained by diversifica-
tion is greater than the decline in return and the trader adjusts exposure accordingly. two other benefits
of diversification—ensuring participation in major trends and “bad luck insurance”—were discussed in
chapter 16.
reduce Leverage for Correlated Markets
although adding markets to a portfolio allows a trader to increase leverage, it is important to make
adjustments for highly correlated markets. For example, a currency portfolio, consisting of the eight most
active currency futures contracts (euro, Japanese yen, British pound,
australian dollar, canadian dollar,
u.s. dollar index, Mexican peso, swiss franc), would be subject to much greater risk than a more broadly
diversified eight-market portfolio because of the very strong correlations between some of these markets.
consequently, the exposure level (as measured by the margin-to-equity ratio or other risk metric) of such
an all-currency portfolio should be adjusted downward vis-à-vis a more diversified eight-market portfolio
with equivalent individual market volatilities.
Market V olatility adjustments
the number of contracts traded in each market for any given equity size should be adjusted to account
for volatility differences. there are two aspects of this rule. First, fewer contracts would be traded in
more volatile markets. second, even for a single market, the number of contracts would vary in con-
junction with fluctuations in volatility. Of course, since contracts can’t be traded in fractions, traders
with small accounts will be unable to make such volatility adjustments, which is one reason why small
accounts will be subject to greater risk. (Other reasons include the unavoidability of the maximum
risk per trade exceeding desired levels and an inability to diversify sufficiently.)
adjusting Position Size to equity Changes
Position size should also be adjusted in accordance with major fluctuations in equity. For example, if
a trader’s position size in the corn market was equal to four contracts when the account equity was at
$200,000, then a $50,000 decline in the account equity should result in the corn position size being
reduced to three contracts. (Of course, if equity rose instead, the position size should be increased.)
Losing Period adjustments (Discretionary traders Only)
When a trader’s confidence is shaken because of an ongoing losing streak, it is often a good idea to
temporarily cut back position size or even take a complete trading break until confidence returns.
in this way, the trader can keep a losing phase from steamrolling into a disastrous retracement. this
advice would not apply to a system trader, however, since for most viable systems, a losing period
563
tHe PlaNNed tradiNg aPPrOacH
enhances the potential for favorable performance in


od idea to
temporarily cut back position size or even take a complete trading break until confidence returns.
in this way, the trader can keep a losing phase from steamrolling into a disastrous retracement. this
advice would not apply to a system trader, however, since for most viable systems, a losing period
563
tHe PlaNNed tradiNg aPPrOacH
enhances the potential for favorable performance in the ensuing period. Or to put it another way,
confidence and frame of mind are critical to the performance of a discretionary trader but are not
relevant to the performance of a system.
 ■ Step 4: Establish a Planning Time Routine
it is important to set aside some time each evening for reviewing markets and updating trading
strategies. in most cases, once the trader has established a specific routine, 30–60 minutes should be
sufficient (less if only a few markets are being traded). the primary tasks performed during this time
would be:
 1. Update trading systems or review charts. at least one of these should be employed as an
aid in making trading decisions. in those markets in which fundamental analysis is employed,
the trader will also have to reevaluate the fundamental picture periodically after the release of
important new information (e.g., government crop report).
 2. Plan new trades. determine whether any new trades are indicated for the next day, which
could be defined as either including or excluding the preceding night session. if new trades are
indicated, decide on a specific entry plan. (this step applies to discretionary trading only, since
any systematic approach should include a specific trade entry approach.) in some cases, a trad-
ing decision may be contingent on an evaluation of market behavior on the following day. For
example, assume a trader is bearish on corn, and a modestly bullish crop report is received after
the close.
such a trader might decide to go short if the market is trading lower on the day at any
point within one hour of the close.
 3. Update exit points for existing positions. the trader should review the stops and objec-
tives on existing positions to see whether any revisions appear desirable in light of the current
day’s price action.
in the case of stops, such changes should be made only to reduce trade risk.
 ■ Step 5: Maintain a Trader’s Spreadsheet
the planning routine discussed in the previous section implies some systematic form of record keep-
ing. Figure 36.1 provides one sample of a format that might be used for a trader’s spreadsheet.
the first four columns simply identify the trade. column 5 would be used to indicate the intended
stop point at time of entry. revisions of this stop would be entered in column 6. the reason for main-
taining the initial stop point as a separate item is that this information may be useful in any subsequent
trade analysis. For example, traders may wish to check whether their initial stops tend to be too wide
or too close.
columns 7 through 10 provide a summary of the implied risk on open positions. By adding these
entries for all open positions, a trader can assess current total exposure—information critical in con-
trolling risk and determining whether new positions can be initiated.
564a cOMPlete guide tO tHe Futures MarKet
 the use of objectives (columns 11 and 12) is a matter of individual preference. although in some
cases the use of objectives will permit a better exit price, in other circumstances objectives will result
in the premature liquidation of a trade. consequently, some traders may prefer to forgo the use of
objectives, allowing the timing of liquidation to be determined by either a trailing stop or a change
of opinion.
 liquidation information is contained in columns 13 through 15. the reason for maintaining the
exit date is that it can be used to calculate the duration of the trade, information that may be useful in
trade analysis. column 15 would indicate the profi t or loss on the trade after deducting commissions.
 columns 16 and 17 provide room for capsule comments regarding the reasons for entering the
trade (made at that time) and a hindsight evaluation of the trade. (Of course, entries for these two
columns would require much greater space than shown in Figure 36.1 .) the observations noted in
these two columns can be particularly helpful in detecting any patterns in successes and failures. Fur-
thermore, a more extensive description of the trade would be contained in a trader’s diary, which is
discussed in the next section.
 the novice will usually benefi t from a period of paper trading before plunging into actual trading.
the trader’s spreadsheet is ideally suited to this purpose, since it would not only provide an indication of
potential trading success, but it would also get the new trader into the habit of approaching speculation
in a systematic and disciplined fashion. thus, when the transition is made to actual trading, the decision
process will have become routine. Of course, the diffi culty of trading decisions will increase dramati-
cally once real money is at stake, but at least new traders who have established a routine of maintaining a
trader’s spreadsheet will have a decisive advantage over their typically ill-prepared counterparts.
 FIGURE  36.1 sample Page from a trader’s spreadsheet
(1)
Trade
Entry
Date
Long
or
Short
Entry
Price
Exit
Date
Exit
PriceC omment
Reasons
for
Entering
Trade
Net
Profit
or
LossUnits Mar ketI nitialC urrent
Stops
Cumulative
Implied Risk
(2)( 3) (4)( 5) (6)( 7) (8)( 9) (10) (11) (12) (13) (14) (15) (16) (17)
InitialC urrent
As Percentage
of Equity
InitialC urrent
Objective
InitialC urrent
565
tHe PlaNNed tradiNg aPPrOacH
 ■ Step 6: Maintain a Trader’s Diary
the trader’s diary should contain the following basic information for each trade:
 1. reasons for trade. it is important that the reasons for the trade are entered at the time the trade
is taken so that this summary provides an accurate description of the o


rrent
As Percentage
of Equity
InitialC urrent
Objective
InitialC urrent
565
tHe PlaNNed tradiNg aPPrOacH
 ■ Step 6: Maintain a Trader’s Diary
the trader’s diary should contain the following basic information for each trade:
 1. reasons for trade. it is important that the reasons for the trade are entered at the time the trade
is taken so that this summary provides an accurate description of the original trade rationale,
unbiased by hindsight and trade outcome. Over time, this information can help traders deter-
mine whether any of their trading strategies are particularly prone to success or failure.
 2. trade exit comments. trade exit is as important as trade entry. Here, the trader would note
both good and bad decisions made in exiting trades. For example, if a close stop was used on the
trade, did it result in getting stopped out of a good trade, or did it reduce the loss on what would
have been a losing trade even with a wider stop?
as another example, if a trailing stop was used,
did it result in premature exit or did it avoid a larger surrender of open profits? comments in
this section can help the trader determine whether the exit strategies employed are benefiting
or hurting performance.
 3. Lessons. a trader should itemize the mistakes or correct decisions made in the course of the
trade. the mere act of keeping such a written record can greatly help a trader to both rein-
force good trading habits and avoid repeating past mistakes—particularly if repeated errors
are denoted in bold or in capital letters.
the trader’s diary should be reviewed periodically to
help reinforce these observations. after a while, the lessons will sink in. speaking from personal
experience, this approach can be instrumental in eradicating frequently repeated mistakes.
it may also be very useful to augment the written diary with charts illustrating trade entry and
exit points.
 ■ Step 7: Analyze Personal Trading
traders must not only analyze the markets, but also their own past trades in order to isolate the
strengths and weaknesses of their approach. Besides the trader’s diary, two useful tools in such an
analysis are analysis of segmented trades and the equity chart.
analysis of Segmented trades
the idea behind segmenting trades into different categories is to help identify any patterns of sub-
stantially above- or below-average performance. For example, a trader who makes decisions based on
chart patterns could segment trades by the type of chart pattern that signaled the trade.
this exercise
could potentially reveal that some patterns provide much more reliable signals than others, allowing
the trader to make appropriate strategy adjustments.
as another example, by breaking down trades into buys and sells, a trader might discover a predilec-
tion toward taking long side trades, even though past short trades have a higher average profit. such a
combined observation would obviously imply the desirability of correcting a bias toward the long side.
566
A Complete Guide to the Futures mArket
as a third example, after breaking down performance results by market, a trader might discover
a tendency to consistently lose money in a specific market. such evidence might suggest the trader
could improve overall performance by not trading this market. segmenting trading results by market
can be an extremely important exercise, since many traders have a poor intuitive sense of their rela-
tive degree of success in various markets. the cessation of trading in poorer performing markets need
not be permanent. the trader could attempt to identify the reasons for the disappointing results in
these markets and then research and test possible trading adjustments.
as a fourth example, a trader who combines day trading and position trading might find it par-
ticularly instructive to compare the net results of each category. My suspicion is that if such analysis
were performed by all traders to whom the exercise is relevant, the population of day traders would
shrink by 50 percent overnight.
Of course, there are many other criteria that can be used to segment trades.
two other examples
of relevant comparisons are fundamentally versus technically oriented trades, and trades that were
in agreement with the position of a given trading system versus those that were not.
in each case,
the trader would be searching for patterns of success or failure. the process of analyzing segmented
trades can be greatly simplified by utilizing the previously described trader’s spreadsheet.
equity Chart
the equity chart is a close-only type of chart in which the indicated value for each day represents
the account equity (including the equity on open positions). the primary purpose of such a chart is
to alert the trader when there is a precipitous deterioration of performance. For example, if after an
extended, steady climb, the account equity experiences a sudden, steep decline, a trader might well
be advised to lighten positions and take time to reassess the situation.
such an abrupt shift in per-
formance might reflect a transformation of market conditions, a current vulnerability in the trader’s
approach, or a recent predilection toward poor trading decisions.
a determination of the actual cause
is not essential, since any of these factors could be viewed as strong cautionary signals to reduce risk
exposure.
in short, the equity chart can be an important tool in mitigating equity retracements.
traders can create equity charts for their accounts, as well as access other performance charts and
statistics, cost-free at fundseeder.com.3
3 For the sake of full disclosure, i have a financial interest in Fundseeder.
567
Live long enough and you will eventually be wrong about everything.
—Russell Baker
F
ew things are easier to ignore than trading advice. Many of the most critical trading rules have
been so widely circulated that they have lost their ability to provoke any thought in the new trader.
Th


cost-free at fundseeder.com.3
3 For the sake of full disclosure, i have a financial interest in Fundseeder.
567
Live long enough and you will eventually be wrong about everything.
—Russell Baker
F
ew things are easier to ignore than trading advice. Many of the most critical trading rules have
been so widely circulated that they have lost their ability to provoke any thought in the new trader.
Thus, valid market insights are often dismissed as obvious clichés.
Consider the rule “Cut your losses short”—perhaps the single most important trading maxim.
Lives there a speculator who has not heard this advice? Y et there is certainly no shortage of specula-
tors who have ignored this rule. Not surprisingly, there is also no shortage of speculators whose
accounts were virtually obliterated by one or two losing trades.
The truth is that most speculators will ignore advice until they have “rediscovered the wheel”
through their own trading experience. Moreover, most traders will repeat a mistake many times before
the lesson finally sinks in. Thus, I have no illusions that the advice presented in this and the next chapter
will spare the reader from committing basic trading errors. However, it is hoped that several readings
of these chapters (particularly following periods of negative trading results) will at least help some
novice traders reduce the number of times these mistakes are repeated—hardly a trivial achievement.
The observations in this chapter are based on personal experience. Thus, the following list of rules
should be viewed in their proper perspective: empirically based opinions as opposed to proven facts.
Overall, there will be substantial overlap with other published expositions of trading guidelines. This
is hardly surprising, since a wide range of rules (many of them mundane) are based on such sound
Seventy-Five Trading
Rules and Market
Observations
Chapter 37
568
A Complete Guide to the Futures mArket
principles that they are almost universally accepted as trading truths. For example, I have never met
a successful trader who did not believe that risk control was essential to profitable trading. However,
some of the rules listed below reflect a subjective view that is contradicted by other writers (e.g.,
using market orders instead of limit orders). In the final analysis, traders must discover their own
trading truths. It is hoped that the following list will help speed the process.
 ■ Entering Trades
 1. Differentiate between major position trades and short-term trades. Focus on major position
trades, since these are usually far more critical to trading success. The average risk allocated
to short-term trades (as implied by number of contracts in position and stop point) should be
significantly smaller. A mistake made by many traders is that they become so involved in trying
to catch the minor market swings (generating lots of commissions and slippage in the process)
that they miss the major price moves.
 2. If you believe a major trading opportunity exists, don’t be greedy in trying to get a slightly bet-
ter entry price. The lost profit potential of one missed price move can offset the savings from 50
slightly better execution prices.
 3. Entry into any major position should be planned and carefully thought out—never an intraday
impulse.
 4. Find a chart pattern that says the timing is right—now. Don’t initiate a trade without such a
confirming pattern. (Of course, this rule applies only to traders who base their trading decisions
on charts.)
 5. Place orders determined by daily analysis. If the market is not close to the desired entry level,
either enter a good-till-canceled (GTC) order at the appropriate price or record the trade idea
and review it each day until the trade is entered or the trade idea is no longer deemed attractive.
Failure to adhere to this rule can result in missing good trades. One common occurrence is that
a trade idea is recalled once the market has moved beyond the intended entry, and it is then dif-
ficult to do the same trade at a worse price.
 6. When looking for a major reversal in a trend, it is usually wiser to wait for some pattern that
suggests that the timing is right rather than fading the trend at projected objectives and support/
resistance points. This rule is particularly important in the case of a market in which the trend
has carried prices to long-term highs/lows (e.g., highs/lows beyond a prior 100-day range).
Remember, in most cases of an extended trend, the market will not form V-type reversals.
Instead prices will normally pull back to test highs and lows—often a number of times. Thus,
waiting for a top or bottom to form can prevent getting chopped to pieces during the topping
or bottoming process—not to mention the losses that can occur if you are highly premature in
picking the top or bottom. Even if the market does form a major V top or V bottom, subsequent
consolidations (e.g., flags) can allow favorable reward/risk entries.
 7. If you have an immediate instinctive impression when looking at a chart (particularly, if you are
not conscious about which market you are looking at), go with that feeling.
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SEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS
 8. Don’t let the fact that you missed the first major portion of a new trend keep you from trading
with that trend (as long as you can define a reasonable stop-loss point).
 9. Don’t take positions counter to recent price failure patterns (e.g., a long position after a bull
trap or a short position after a bear trap), even if there are many other reasons for the trade.
 10. Don’t trade counter to the first wide-ranging day (i.e., day with a range far exceeding the recent
average range) of a price move. For example, if you are waiting to enter a trade on a correction,
and the correction then forms on a wide-ranging day, don’t enter the trade.
 11. In most cases, use market orders rather than limit orders. This rule is especially importa


r reasons for the trade.
 10. Don’t trade counter to the first wide-ranging day (i.e., day with a range far exceeding the recent
average range) of a price move. For example, if you are waiting to enter a trade on a correction,
and the correction then forms on a wide-ranging day, don’t enter the trade.
 11. In most cases, use market orders rather than limit orders. This rule is especially important when
liquidating a losing position or entering a perceived major trading opportunity—
 situations
in which traders are apt to be greatly concerned about the market getting away from them.
Although limit orders will provide slightly better fills for a large majority of trades, this benefit
will usually be more than offset by the substantially poorer fills, or missed profit potential, in
those cases in which the initial limit order is not filled.
 12. Never double up near the original trade entry point after having been ahead. Often, the fact that
the market has completely retraced is a negative sign for the trade. Even if the trade is still good,
doubling up in this manner will jeopardize holding power due to overtrading.
 ■ Exiting Trades and Risk Control (Money Management)
 13. Decide on a specific protective stop point at the time of trade entry.
 14. Exit any trade as newly developing patterns or market action are contrary to trade—even if stop
point has not been reached. Ask yourself, “If I had to have a position in this market, which way
would it be?” If the answer is not the position you hold, get out! In fact, if contradictory indica-
tions are strong enough, reverse the position.
 15. Always get out immediately once the original premise for a trade is violated.
 16. If you are dramatically wrong the first day trade is on, abandon trade immediately.
 17. In the event of a major breakout counter to the position held, either liquidate immediately or
use a very close stop.
 18. If a given market suddenly trades far in excess of its recent volatility in a direction opposite to
the position held, liquidate your position immediately. For example, if a market that has been
trading in approximate 50-point daily ranges opens 100 to 150 points higher, cover immediately
if you are short.
 19. If you sell into resistance or buy into support, and the market then consolidates instead of
reversing, get out.
 20. For analysts and market advisors: If your gut feeling is that a recent recommendation or written
report is wrong, reverse your opinion.
 21. If you’re unable to watch markets for a period of time (e.g., when traveling), either liquidate
all positions or be sure to have GTC stop orders on all open positions. (Also, in such situations,
limit orders can be used to ensure getting into the market on planned buys at lower prices or
planned sells at higher prices.)
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A Complete Guide to the Futures mArket
 22. Do not get complacent about an open position. Always know where you are getting out even if
the point is far removed from the current price. Also, an evolving pattern contrary to the trade
may suggest the desirability of an earlier-than-intended exit.
 23. Fight the desire to immediately get back into the market following a stopped-out trade. Getting
back in will usually supplement the original loss with additional losses. The only reason to
get back in on a stopped out trade is if the timing seems appropriate based on evolving price
patterns—that is, only if it meets all the conditions and justifications of any new trade.
 ■ Other Risk-Control (Money Management) Rules
 24. When trading is going badly: (a) reduce position size (keep in mind that positions in strongly
correlated markets are similar to one larger position); (b) use tight stop-loss points; (c) slow up
in taking new trades.
 25. When trading is going badly, reduce risk exposure by liquidating losing trades, not winning
trades. This observation was memorably related by Edwin Lefèvre in Reminiscences of a Stock
Operator: “I did precisely the wrong thing. The cotton showed me a loss and I kept it. The wheat
showed me a profit and I sold it out. Of all the speculative blunders there are few greater than
trying to average a losing game. Always sell what shows you a loss and keep what shows you a
profit.”
 26. Be extremely careful not to change trading patterns after making a profit:
a.
 Do not initiate any trades that would have been deemed too risky at the start of the trading
program.
b.
 Do not suddenly increase the number of contracts in a typical trade. (However, a gradual
increase as equity grows is O
k.)
 27. Treat small positions with the same common sense as large positions. Never say, “It’s only one
or two contracts.”
 28. Avoid holding very large positions into major reports or the release of important government
statistics.
 29. Apply the same money management principles to spreads as to outright positions. It is easy to
be lulled into thinking that spreads move gradually enough so that it is not necessary to worry
about stop-loss protection.
 30. Don’t buy options without planning at what outright price the trade is to be liquidated.
 ■ Holding and Exiting Winning Trades
 31. Do not take small, quick profits in major position trades. In particular, if you are dramatically
right on a trade, never, never take profits on the first day.
 32. Don’t be too hasty to get out of a trade with a wide-ranging day in your direction. The wide-
ranging day, however, can be used to reset stop to closer point.
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SEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS
 33. Try to use trailing stops, supplemented by developing market action, instead of objectives as a
means of getting out of profitable trades. using objectives will often work against fully realizing
the potential of major trends. Remember, you need the occasional big winners to offset losers.
 34. The preceding rule notwithstanding, it is still useful to set an initial objective at the time
of trade entry to allow the application of the


by developing market action, instead of objectives as a
means of getting out of profitable trades. using objectives will often work against fully realizing
the potential of major trends. Remember, you need the occasional big winners to offset losers.
 34. The preceding rule notwithstanding, it is still useful to set an initial objective at the time
of trade entry to allow the application of the following rule: If a very large portion of an
objective is realized very quickly (e.g., 50 to 60 percent in one week or 75 to 80 percent
in two or three weeks), take partial profits, with the idea of reinstating liquidated contracts
on a reaction. The idea is that it is O
k to take a quick, sizable profit. Although this rule may
often result in missing the remainder of the move on the liquidated portion of the position,
holding the entire position, in such a case, can frequently lead to nervous liquidation on the
first market correction.
 35. If an objective is reached, but you still like the trade, stay with it using a trailing stop. This rule is
important in order to be able to ride a major trend. Remember, patience is not only important
in waiting for the right trades, but also in staying with trades that are working. The failure to
adequately profit from correct trades is a key profit-limiting factor.
 36. One partial exception to the previous rule is that if you are heavily positioned and equity is surg-
ing straight up, consider taking scale-up profits. Corollary rule: When things look too good to be
true—watch out! If everything is going right, it is probably a good time to begin taking scale-up
(scale-down) profits and using close trailing stops on a portion of your positions.
 37. If taking profits on a trade that is believed to still have long-term potential (but is presumably
vulnerable to a near-term correction), have a game plan for reentering the position. If the mar-
ket doesn’t retrace sufficiently to allow for reentry, be cognizant of patterns that can be used for
timing a reentry. Don’t let the fact that the reentry point would be worse than the exit point
keep you from getting back into a trade in which the perception of both the long-term trend
and current timing suggest reentering. The inability to enter at a worse price can often lead to
missing major portions of large trends.
 38. If trading multiple contracts, avoid the emotional trap of wanting to be 100 percent right. For
example, if tempted to take profits on a trade that is still acting well, try to keep at least a partial
position for the duration of the move—until the market forms a convincing reversal pattern or
reaches a meaningful stop-loss point.
 ■ Miscellaneous Principles and Rules
 39. Always pay more attention to market action and evolving patterns than to objectives and
support/resistance areas. The latter can often cause you to reverse a correct market bias very
prematurely.
 40. Whenever you feel action should be taken either entering or exiting a position—act, don’t
procrastinate.
 41. Never go counter to your own opinion of the long-term trend of the market. In other words,
don’t try to dance between the raindrops.
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A Complete Guide to the Futures mArket
 42. Winning trades tend to be ahead right from the start. Along the same line of thought, Peter
Brandt, a successful trader with four decades of experience advises: “Never take a losing trade
home on a Friday.”
 43. Correct timing of entry and exit (e.g., timing entry on a reliable pattern, getting out immedi-
ately on the first sign of trade failure), can often keep a loss small even if the trade is dead wrong.
 44. Intraday decisions are usually wrong. Most traders would be better off keeping their screens
turned off during the day and reviewing markets once daily after the close of the main trading
session.
 45. Be sure to check markets before the close on Friday. Often, the situation is clearer at the end of
the week. In such cases, a better entry or exit can usually be obtained on Friday near the close
than on the following Monday opening. This rule is particularly important if you are holding a
significant position.
 46. Act on market dreams (that are recalled unambiguously). Such dreams are often right because
they represent your subconscious market knowledge attempting to break through the barri-
ers established by the conscious mind (e.g., “How can I buy here when I could have gone long
$2,000 lower last week?”)
 47. Y ou are never immune to bad trading habits—the best you can do is to keep them latent. As
soon as you get lazy or sloppy, they will return.
 ■ Market Patterns
 48. If the market sets new historical highs and holds, the odds strongly favor a move very far beyond
the old highs. Selling a market at new record highs is probably one the amateur trader’s worst
mistakes.
 49. Narrow market consolidations near the upper end of broader trading ranges are bullish pat-
terns. Similarly, narrow consolidations near the low end of trading ranges are bearish.
 50. Play the breakout from an extended, narrow range with a stop against the other side of the
range.
 51. Breakouts from trading ranges that hold 1 to 2 weeks, or longer, are among the most reliable
technical indicators of impending trends.
 52. A common and particularly useful form of the above rule is: Flags or pennants forming right
above or below prior extended and broad trading ranges tend to be fairly reliable continuation
patterns.
 53. If the market breaks out to a new high or low and then pulls back to form a flag or pennant in
the pre-breakout trading range, assume that a top or bottom is in place. A position can be taken
using a protective stop beyond the flag or pennant consolidation.
 54. A breakout from a trading range followed by a pullback deep into the range (e.g., three-quarters
of the way back into the range or more) is yet another significant bull- or bear-trap formation.
 55. If an apparent V bottom is followed by a nearb


t trading range, assume that a top or bottom is in place. A position can be taken
using a protective stop beyond the flag or pennant consolidation.
 54. A breakout from a trading range followed by a pullback deep into the range (e.g., three-quarters
of the way back into the range or more) is yet another significant bull- or bear-trap formation.
 55. If an apparent V bottom is followed by a nearby congestion pattern, it may represent a bot-
tom pattern. However, if this consolidation is then broken on the downside and the V bottom
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SEVENTY-FIVE TRADING RuLES AND MARkET OBSERVATIONS
is approached, the market action can be read as a sign of an impending move to new lows. In
the latter case, short positions could be implemented using protective stops near the top of the
consolidation. Analogous comments would apply to V tops followed by nearby consolidations.
 56. V tops and V bottoms followed by multimonth consolidations that form in close proximity to
the reversal point tend to be major top or bottom formations.
 57. Tight flag and pennant consolidations tend to be reliable continuation patterns and allow entry
into an existing trend, with a reasonably close, yet meaningful, stop point.
 58. If a tight flag or pennant consolidation leads to a breakout in the wrong direction (i.e., a reversal
instead of a continuation), expect the move to continue in the direction of the breakout.
 59. Curved consolidations tend to suggest an accelerated move in the direction of the curve.
 60. The breaking of a short-term curved consolidation, in the direction opposite of the curve path-
way, tends to be a good trend-reversal signal.
 61. A wide-ranging day that closes counter to the main trend can often provide a reliable early signal
of a trend change—particularly if it also triggers a reversal signal (e.g., complete penetration of
prior consolidation).
 62. Near-vertical, large price moves over a period of 2 to 4 days (coming off of a relative high or
low) tend to be extended in the following weeks.
 63. Spikes are good short-term reversal signals. The extreme of the spike can be used as a stop point.
 64. In spike situations, look at chart both ways—with and without spike. For example, if a flag is
evident when a spike is removed, a penetration of that flag is a meaningful signal.
 65. The ability of a market to hold relatively firm when other correlated markets are under signifi-
cant pressure can be viewed as a sign of intrinsic strength. Similarly, a market acting weak when
correlated markets are strong can be viewed as a bearish sign.
 66. If a market trades consistently higher for most of the daily trading session, anticipate a close in
the same direction.
 67. Two successive flags with little separation can be viewed as a probable continuation pattern.
 68. View a curved bottom, followed by a shallower, same-direction curved consolidation near the
top of this pattern, as a bullish formation (cup-and-handle). A similar pattern would apply to
market tops.
 69. A failed signal is more reliable than the original signal. Go the other way, using the high (low)
before the failure signal as a stop. Some examples of such failure patterns are rule numbers 53,
54, 58, and 60.
 70. The failure of a market to follow through on significant bullish or bearish news (e.g., a major
u.S. Department of Agriculture report) is often a harbinger of an imminent trend reversal. Pay
particular attention to such a development if you have an existing position.
 ■ Analysis and Review
 71. Review charts every day—especially if you are too busy.
 72. Periodically review long-term charts (e.g., every 2 to 4 weeks).
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A Complete Guide to the Futures mArket
 73. Religiously maintain a trader’s diary, including a chart for each trade taken and noting the fol-
lowing: reasons for trade; intended stop and objective (if any); follow-up at a later point indi -
cating how the trade turned out; observations and lessons (mistakes, things done right, or
noteworthy patterns); and net profit/loss. It is important that the trade sheet be filled out
when a trade is entered so that the reasons for the trade accurately reflect your actual thinking
rather than a reconstruction.
 74. Maintain a patterns chart book whenever you notice a market pattern that is interesting and you
want to note how you think it will turn out, or you want to record how that pattern is eventually
resolved (in the case where you don’t have any bias concerning the correct interpretation). Be
sure to follow each chart up at a later date to see the actual outcome. Over time, this process
may improve skills in chart interpretation by providing some statistical evidence of the forecast-
ing reliability of various chart patterns (as recognized in real time).
 75. Review and update trading rules, trader’s diary, and patterns chart book on a regular schedule
(e.g., three-month rotation for the three items). Of course, any of these items can be reviewed
more frequently, whenever it is felt such a review would be useful.
575
There is no such thing as being right or beating the market. If you make money, it is because
you understood the same thing the market did. If you lose money, it is simply because
you got it wrong. There is no other way of looking at it.
—Musawer Mansoor Ijaz
T
he methods employed by exceptional traders are extraordinarily diverse. Some are pure funda-
mentalists; others employ only technical analysis; and still others combine the two methodologies.
Some traders consider two days to be long term, while others consider two months to be short term.
Y et despite the wide gamut of styles, I have found that certain principles hold true for a broad spec-
trum of successful traders. This chapter contains a list of 50 observations regarding success in trading
drawn from the lessons I learned and insights I developed in the process of interviewing great traders
over several decades—an endeavor chronicled in four Market Wizards b


o be short term.
Y et despite the wide gamut of styles, I have found that certain principles hold true for a broad spec-
trum of successful traders. This chapter contains a list of 50 observations regarding success in trading
drawn from the lessons I learned and insights I developed in the process of interviewing great traders
over several decades—an endeavor chronicled in four Market Wizards books.
 1. First things first. First, be sure that you really want to trade. It is common for people who
think they want to trade to discover that they really don’t.
 2. Examine your motives. Think about why you really want to trade. If you want to trade for
the excitement, you might be better off riding a roller coaster or taking up hang gliding. If you
are drawn to trading because you think it is an easy way to make a lot of money, the markets are
likely to disabuse you of that assumption.
50 Market Wizard
Lessons*
Chapt E r 38
* This chapter is adapted from the following two sources: Jack Schwager, The New Market Wizards (New Y ork, NY:
Harper Business, 1989), pp. 461–478; © 1989 by Harper Collins Publishers. Used with permission. Jack Schwa-
ger, Hedge Fund Market Wizards (New Y ork, NY: John Wiley & Sons, 2012), pp. 489–499; © 2012 by John Wiley
& Sons Publishers. Used with permission.
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A Complete Guide to the Futures mArket
 3. there is no holy grail in trading. Many traders mistakenly believe there is some single
solution to defining market behavior. Not only did the methods used by highly successful traders
I interviewed vary widely, they were sometimes polar opposites of each other.
 4. Match the trading method to your personality. Trading success is not about finding the
one true method but rather about finding the one method that is right for you. It is critical to
choose a method that is consistent with your own personality and comfort level. If you can’t
stand to give back significant profits, then a long-term trend-following approach—even a very
good one—will be a disaster, because you will never be able to follow it. If you don’t want to
watch the quote screen all day (or can’t), don’t try a day-trading method. If you can’t stand
the emotional strain of making trading decisions, then try to develop a mechanical system for
trading the markets. The importance of finding an approach that fits you cannot be overempha-
sized. Randy McKay, who met success as both an on-the-floor and off-the-floor trader, asserted:
“Virtually every successful trader I know ultimately ended up with a trading style suited to his
personality.”
Incidentally, the mismatch of trading style and personality is one of the key reasons why pur-
chased trading systems rarely make profits for those who buy them, even if the system is a good
one. Why? Because every system will have periods of poor performance. And if you are trading
someone else’s system, particularly a “black box” system where you have no idea why signals are
being generated, you will likely abandon it the first time it does poorly.
 5. It is absolutely necessary to have an edge. Y ou can’t win without an edge, even with the
world’s greatest discipline and money management skills. If you could, then it would be possible
to win at roulette (over the long run) using perfect discipline and risk control. Of course, that
is an impossible task because of the laws of probability. If you don’t have an edge, all that money
management and discipline will do for you is to guarantee that you will bleed to death gradually.
Incidentally, if you don’t know what your edge is, you don’t have one.
 6. Derive a method. T o have an edge, you must have a method. The type of method is irrelevant.
Some of the supertraders are pure fundamentalists; some are pure technicians; and some are
hybrids. Even within each group, there are tremendous variations. For example, within the
group of technicians, there are tape readers (or their modern-day equivalent—screen watch-
ers), chartists, mechanical system traders, Elliott Wave analysts, Gann analysts, and so on. The
type of method is not important, but having one is critical—and, of course, the method must
have an edge.
 7. Developing a method is hard work. Shortcuts rarely lead to trading success. Developing
your own approach requires research, observation, and thought. Expect the process to take lots
of time and hard work. Expect many dead ends and multiple failures before you find a successful
trading approach that is right for you. Remember that you are playing against tens of thousands
of professionals. Why should you be any better? If it were that easy, there would be a lot more
millionaire traders.
 8. Skill versus hard work. Is trading success dependent on innate skills, or is hard work suf-
ficient? There is no question in my mind that many of the supertraders have a special talent
for trading. Marathon running provides an appropriate analogy. Virtually anyone can run a
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50 Market Wizard Lessons
marathon, given sufficient commitment and hard work. Y et, regardless of the effort and desire,
only a small fraction of the population will ever be able to run a 2:12 marathon (or 2:25 for
women). Similarly, anyone can learn to play a musical instrument. But again, regardless of work
and dedication, only a handful of individuals possess the natural talent to become concert solo-
ists. The general rule is that exceptional performance requires both natural talent and hard work
to realize its potential. If the innate skill is lacking, hard work may provide proficiency, but not
excellence.
In my opinion, the same principles apply to trading. Virtually anyone can become a net prof-
itable trader, but only a few have the inborn talent to become supertraders. For this reason, it
may be possible to teach trading success, but only up to a point. Be realistic in your goals.
 9. Good trading should be effortless. Wait a minute. Didn’t I just list hard work as an
ingredient to successful tra


my opinion, the same principles apply to trading. Virtually anyone can become a net prof-
itable trader, but only a few have the inborn talent to become supertraders. For this reason, it
may be possible to teach trading success, but only up to a point. Be realistic in your goals.
 9. Good trading should be effortless. Wait a minute. Didn’t I just list hard work as an
ingredient to successful trading? How can good trading require hard work and yet be effortless?
There is no contradiction. Hard work refers to the preparatory process—the research and
observation necessary to become a good trader—not to the trading itself. In this respect, hard
work is associated with such qualities as vision, creativity, persistence, drive, desire, and com-
mitment. Hard work certainly does not mean that the process of trading itself should be filled
with exertion. It certainly does not imply struggling with or fighting against the markets. On the
contrary, the more effortless and natural the trading process, the better the chances for success.
One trader quoting Zen and the Art of Archery made the following analogy: “In trading, just as in
archery, whenever there is effort, force, straining, struggling, or trying, it’s wrong. Y ou’re out of
sync; you’re out of harmony with the market. The perfect trade is one that requires no effort.”
Visualize a world-class distance runner, clicking off mile after mile at a five-minute pace.
Now picture an out-of-shape, 250-pound couch potato trying to run a mile at a 10-minute pace.
The professional runner glides along gracefully—almost effortlessly—despite the long distance
and fast pace. The out-of-shape runner, however, is likely to struggle, huffing and puffing like a
Yugo going up a 1 percent grade. Who is putting in more work and effort? Who is more success-
ful? Of course, the world-class runner puts in his hard working during training, and this prior
effort and commitment are essential to his success.
 10. trade within your comfort zone. If a position is too large you will be prone to exit good
trades on inconsequential corrections because fear will dominate the decision process.
 11. Money management and risk control. Almost all the great traders I interviewed felt that
money management was even more important than the trading method. Many potentially suc-
cessful systems or trading approaches have led to disaster because the trader applying the strat-
egy lacked a method of controlling risk. Y ou don’t have to be a mathematician or an expert
in portfolio theory to manage risk. Risk control can be as easy as the following four-step
approach:
1.
 Never risk more than 1 to 2 percent of your capital on any trade. (Risking less than 1 percent
per trade is even better if this restriction can be met while still being consistent with your
methodology.)
2.
 Predetermine your exit point before you get into a trade. Many of the traders I interviewed
cited exactly this rule.
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A Complete Guide to the Futures mArket
3. Start with a deliberately small trading stake that you can afford to lose without it causing
any significant financial or emotional impact. If this equity is lost, stop trading. Once you
feel confident and ready to start trading again, begin with another small stake. By rigorously
limiting the worst case in this manner, you will never be knocked out of the game because
of one disastrous trading experience, as happens to so many novice traders.
4.
 If you are in an equity drawdown and feel you are out of sync with the markets or your trad-
ing confidence is shaky, take a breather, analyze what went wrong, and wait until you feel
confident and have a high-probability idea before you begin trading again. For traders with
large accounts, trading very small is a reasonable alternative to a complete trading hiatus.
The strategy of cutting trading size down sharply during losing streaks is one mentioned by
many of the traders I interviewed.
 12. the trading plan. Trying to win in the markets without a trading plan is like trying to build
a house without blueprints—costly (and avoidable) mistakes are virtually inevitable. A trading
plan simply requires combining a personal trading method with specific money management
and trade entry rules. Robert Krausz, a hypnotist who made a specialty of working with traders,
considered the absence of a trading plan the root of all the principal difficulties traders encoun-
ter in the markets. Richard Driehaus, a very successful mutual fund manager I interviewed,
stresses that a trading plan should reflect a personal core philosophy. He explains that without
a core philosophy, you are not going to be able to hold on to your positions or stick with your
trading plan during really difficult times.
 13. Don’t confuse the concepts of winning and losing trades with good and bad
trades. A good trade can lose money, and a bad trade can make money. Even the best trading
process will lose a certain percentage of the time. There is no way of knowing a priori which
individual trade will make money. As long as a trade adheres to a process with a positive edge,
it is a good trade, regardless of whether it wins or loses, because if similar trades are repeated
multiple times, they will come out ahead. Conversely, a trade that is taken as a gamble is a bad
trade, regardless of whether it wins or loses, because over time such trades will lose money.
 14. Discipline. Discipline was probably the most frequent word used by the exceptional traders
that I interviewed. Often, it was mentioned in an almost apologetic tone: “I know you’ve heard
this a million times before, but believe me, it’s really important.”
There are two basic reasons why discipline is critical. First, it is a prerequisite for maintain-
ing effective risk control. Second, you need discipline to apply your method without second-
guessing and choosing which trades to take. I guarantee that you will almost always pick the
wrong ones. Why?


tone: “I know you’ve heard
this a million times before, but believe me, it’s really important.”
There are two basic reasons why discipline is critical. First, it is a prerequisite for maintain-
ing effective risk control. Second, you need discipline to apply your method without second-
guessing and choosing which trades to take. I guarantee that you will almost always pick the
wrong ones. Why? Because you will tend to pick the comfortable trades, and as Bill Eckhardt,
a mathematician turned successful commodity trading advisor (CTA), explained, “What feels
good is often the wrong thing to do.”
 15. Understand that you are responsible. Whether you win or lose, you are responsible for
your own results. Even if you lost on your broker’s tip, an advisory service recommendation, or
a bad signal from the system you bought, you are responsible because you made the decision to
listen and act. I have never met a successful trader who blamed others for his losses.
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50 Market Wizard Lessons
 16. the need for independence. Y ou need to do your own thinking. Don’t get caught up in mass
hysteria. Ed Seykota, a futures trader who multiplied the equity in his accounts a thousandfold
over an 18-year period, pointed out that by the time a story is making the cover of national
periodicals, the trend is probably near an end.
Independence also means making your own trading decisions. Never listen to other opin-
ions. Even if it occasionally helps on a trade or two, listening to others invariably seems to end
up costing you money—not to mention confusing your own market view . As Michael Marcus,
a spectacularly successful futures trader, stated in Market Wizards, “Y ou need to follow your own
light. If you combine two traders, you will get the worst of each.”
A related personal anecdote concerns another trader I interviewed in Market Wizards.
Although he could trade better than I if he were blindfolded and placed in a trunk at the bottom
of a pool, he still was interested in my view of the markets. One day he called and asked, “What
do you think of the yen?”
The yen was one of the few markets about which I had a strong opinion at the time. It had
formed a particular chart pattern that made me very bearish. “I think the yen is going straight
down, and I’m short,” I replied.
He proceeded to give me 51 reasons why the yen was oversold and due for a rally. After he
hung up, I thought: “I’m leaving on a business trip tomorrow . My trading has not been going
very well during the last few weeks. The short yen trade is one of the only positions in my ac-
count. Do I really want to fade one of the world’s best traders given these considerations?” I
decided to close out the trade.
By the time I returned from my trip several days later, the yen had fallen 150 points. As luck
would have it, that afternoon the same trader called. When the conversation rolled around to
the yen, I couldn’t resist asking, “By the way, are you still long the yen?”
“Oh no,” he replied, “I’m short.”
The point is not that this trader was trying to mislead me. On the contrary, he firmly
believed each market opinion at the time he expressed it. However, he was a very short-
term trader and his timing was good enough so that he probably made money on both sides
of the trade. In contrast, I ended up with nothing, even though I had the original move
pegged exactly right. The moral is that even advice from a much better trader can lead to
detrimental results.
 17. Confidence. An unwavering confidence in their ability to continue to win in the markets, was
a nearly universal characteristic among the traders I interviewed. Dr. Van Tharp, a psychologist
who has done a great deal of research on traders and was interviewed in Market Wizards, claims
that one of the basic traits of winning traders is that they believe “they’ve won the game before
they start.”
The trader who has confidence will have the courage to make the right decisions and the
strength not to panic. There is a passage in Mark Twain’s Life on the Mississippi that I find remark-
ably apropos, even though it has nothing to do with trading. In it, the protagonist—an appren-
tice steamboat river pilot—is tricked by his mentor and the crew into panicking in a stretch of
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A Complete Guide to the Futures mArket
river he knows to be the easiest in the entire run. The following exchange then ensues with his
mentor:
“Didn’t you know there was no bottom in that crossing?”
“Y es sir, I did.”
“V ery well then, you shouldn’t have allowed me or anybody else to shake your confi-
dence in that knowledge. Try to remember that. And another thing, when you get into
a dangerous place, don’t turn coward. That isn’t going to help matters any.”
 18. Losing is part of the game. The great traders fully realize that losing is an intrinsic element
in the game of trading. This attitude seems linked to confidence. Because exceptional traders are
confident that they will win over the long run, individual losing trades no longer seem horrible;
they simply appear inevitable—which is what they are. As Linda Raschke, a futures trader with a
high ratio of winning to losing trades, explained, “It never bothered me to lose because I always
knew I would make it right back.”
There is no more certain recipe for losing than having a fear of losing. If you can’t stand tak-
ing losses, you will either end up taking large losses or missing great trading opportunities—ei-
ther flaw is sufficient to sink any chance for success.
 19. Lack of confidence and time-outs. Trade only when you feel confident and optimistic. I
have often heard traders say: “I just can’t seem to do anything right.” Or “I bet I get stopped out
right near the low again.” If you find yourself thinking in such negative terms, it is a sure sign
that it is time to take a break from trading. Get back into trading slowly. Think of trading as a
cold ocean. T est the water before plunging in.
 20. the urge to seek advice.


nt and optimistic. I
have often heard traders say: “I just can’t seem to do anything right.” Or “I bet I get stopped out
right near the low again.” If you find yourself thinking in such negative terms, it is a sure sign
that it is time to take a break from trading. Get back into trading slowly. Think of trading as a
cold ocean. T est the water before plunging in.
 20. the urge to seek advice. The urge to seek advice betrays a lack of confidence. As Linda
Raschke said, “If you ever find yourself tempted to seek out someone else’s opinion on a trade,
that’s usually a sure sign that you should get out of your position.”
 21. the virtue of patience. Waiting for the right opportunity increases the probability of suc-
cess. Y ou don’t always have to be in the market. As Edwin Lefèvre put it in his classic Reminis-
cences of a Stock Operator, “There is the plain fool who does the wrong thing at all times anywhere,
but there is the Wall Street fool who thinks he must trade all the time.”
One of the more colorful descriptions of patience in trading was offered by well-known
investor Jim Rogers in Market Wizards: “I just wait until there is money lying in the corner, and
all I have to do is go over there and pick it up.” In other words, until he is so sure of a trade that
it seems as easy as picking money off the floor, he does nothing.
Mark W einstein, who was interviewed in Market Wizards, provided the following apt analogy:
“Although the cheetah is the fastest animal in the world and can catch any animal on the plains, it
will wait until it is absolutely sure it can catch its prey. It may hide in the bush for a week, waiting
for just the right moment. It will wait for a baby antelope, and not just any baby antelope, but
preferably one that is also sick or lame. Only then, when there is no chance it can lose its prey,
does it attack. That, to me, is the epitome of professional trading.”
 22. the importance of sitting. Patience is important not only in waiting for the right trades, but
also in staying with trades that are working. The failure to adequately profit from correct trades
is a key profit-limiting factor. Quoting again from Lefèvre in Reminiscences, “It never was my
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50 Market Wizard Lessons
thinking that made big money for me. It was always my sitting. Got that? My sitting tight!” Bill
Eckhardt offered a particularly memorable comment on this subject: “One common adage . . .
that is completely wrongheaded is: Y ou can’t go broke taking profits. That’s precisely how many
traders do go broke. While amateurs go broke by taking large losses, professionals go broke by
taking small profits.”
 23. Developing a low-risk idea. One of the exercises Dr. Van Tharp uses in his seminars is
having the participants take the time to write down their ideas on low-risk trades. The merit
of a low-risk idea is that it combines two essential elements: patience (because only a small
portion of ideas will qualify) and risk control (inherent in the definition). Taking the time to
think through low-risk strategies is a useful exercise for all traders. The specific ideas will vary
greatly from trader to trader, depending on the markets traded and methodologies used. At the
seminar I attended, the participants came up with a long list of descriptions of low-risk ideas. As
one example: a trade in which the market movement required to provide convincing proof that
you are wrong is small. Although it had nothing to do with trading, my personal favorite of the
low-risk ideas mentioned was: “Open a doughnut shop next door to a police station.”
 24. the importance of varying bet size. All traders who win consistently over the long run
have an edge. However, that edge may vary significantly from trade to trade. It can be mathemat-
ically demonstrated that in any wager game with varying probabilities, winnings are maximized
by adjusting the bet size in accordance with the perceived chance for a successful outcome.
Optimal blackjack betting strategy provides a perfect illustration of this concept.
If the trader has some idea as to which trades have a greater edge—say, for example, based
on a higher confidence level (assuming that it is a reliable indicator)—then it makes sense to be
more aggressive in these situations. As Stanley Druckenmiller, one of the most consistently prof-
itable hedge fund managers ever, expressed it, “The way to build [superior] long-term returns
is through preservation of capital and home runs. . . . When you have tremendous conviction
on a trade, you have to go for the jugular. It takes courage to be a pig.” For a number of Market
Wizards, keen judgment as to when to really step on the accelerator and the courage to do so
have been instrumental to their achieving exceptional (as opposed to merely good) returns.
Some of the traders I interviewed mentioned that they varied their trading size in accordance
with how they were doing. For example, McKay indicated that it was not uncommon for him
to vary his position size by as much as a factor of one hundred to one. He finds this approach
helps him reduce risk during losing periods while enhancing profits during the winning periods.
 25. Scaling in and out of trades. Y ou don’t have to get in or out of a position all at once. Scaling
in and out of positions provides the flexibility of fine-tuning trades and broadens the set of alter-
native choices. Most traders sacrifice this flexibility without a second thought because of the
innate human desire to be completely right. (By definition, a scaling approach means that some
portions of a trade will be entered or exited at worse prices than other portions.) Some traders
also noted that scaling out enabled them to stay with at least a portion of long-term winning
trades much longer than would otherwise have been the case.
 26. trading around a position can be beneficial. Most traders tend to view trading as a
two-step process: a decision when to enter and


that some
portions of a trade will be entered or exited at worse prices than other portions.) Some traders
also noted that scaling out enabled them to stay with at least a portion of long-term winning
trades much longer than would otherwise have been the case.
 26. trading around a position can be beneficial. Most traders tend to view trading as a
two-step process: a decision when to enter and a decision when to exit. It may be better to
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A Complete Guide to the Futures mArket
view trading as a dynamic rather than static process between entry and exit points. The basic
idea is that as a trade moves in the intended direction, the position exposure would be gradually
reduced. The larger the move and the closer the market gets to a target objective, the more the
position would be decreased. After reducing exposure in this manner, the position would be
reinstated on a market correction. Any time the market retraced to a correction reentry point,
a net profit would be generated that otherwise would not have been realized. The choppier the
market, the more excess profits trading around the position will generate. Even a trade in which
the market fails to move in the intended direction, on balance, could still be net profitable as a
result of gains generated by lightening the total position on favorable trend moves and reinstat-
ing liquidated portions of the position on corrections. This strategy will also reduce the chances
of being knocked out of a favorable position on a market correction, because if the position has
already been reduced, the correction will have less impact and may even be desired to rein-
state the liquidated portion of the position. The only time this strategy will have a net adverse
impact is if the market keeps going in the intended direction without ever retracing to correc-
tion reentry levels. This negative outcome, however, simply means that the original trade was
profitable, but the total profits are smaller than they would have been otherwise. In a nutshell,
trading around a position will generate extra profits and increase the chances of staying with a
good trade the at expense of sometimes giving up a portion of profits when the market moves
smoothly in the intended direction.
 27. Being right is more important than being a genius. I think one reason why so many
people try to pick tops and bottoms is that they want to prove to the world how smart they are.
Think about winning rather than being a hero. Forget trying to judge trading success by how
close you can come to picking major tops and bottoms, but rather by how well you can pick
individual trades with favorable return/risk characteristics. Go for consistency on a trade-to-
trade basis, not perfect trades.
 28. Don’t worry about looking stupid. Last week, you told everyone at the office, “My analy-
sis has just given me a great buy signal in the S&P .
 The market is going to a new high.” Now
as you examine the market action since then, something appears to be wrong. Instead of rally -
ing, the market is breaking down. Y our gut tells you that the market is vulnerable. Whether you
realize it or not, your announced prognostications are going to color your objectivity. Why?
Because you don’t want to look stupid after telling the world that the market was going to a
new high. Consequently, you are likely to view the market’s action in the most favorable light
possible. “The market isn’t breaking down, it’s just a pullback to knock out the weak longs.” As
a result of this type of rationalization, you end up holding a losing position far too long. There
is an easy solution to this problem: Don’t talk about your position.
What if your job requires talking about your market opinions (as mine once did)? Here the
rule is: Whenever you start worrying about contradicting your previous opinion, view that
concern as reinforcement to reverse your market stance. As a personal example, in early 1991,
I came to the conclusion that the dollar had formed a major bottom. I specifically remember
one talk in which an audience member asked me about my outlook for currencies. I responded
by boldly predicting that the dollar would head higher for years. Several months later, when the
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50 Market Wizard Lessons
dollar surrendered the entire gain it had realized following the news of the August 1991 Soviet
coup before the coup’s failure was confirmed, I sensed that something was wrong. I recalled my
many predictions over the preceding months in which I had stated that the dollar would go up
for years. The discomfort and embarrassment I felt about these previous forecasts told me it was
time to change my opinion.
In my earlier years in the business, I invariably tried to rationalize my original market opin-
ion in such situations. I was burned enough times so that I eventually learned a lesson. In the
preceding example, the abandonment of my original projection was fortunate because the dol-
lar collapsed in the ensuing months.
 29. Sometimes action is more important than prudence. Waiting for a price correction to
enter the market may sound prudent, but it is often the wrong thing to do. When your analysis,
methodology, or gut tells you to get into a trade at the market instead of waiting for a correction—
do so. Caution against the influence of knowing that you could have gotten in at a better price in
recent sessions, particularly in those situations when the market witnesses a sudden, large move
(often due to an important surprise news item). These types of trades often work because they
are so hard to do.
 30. Catching part of the move is just fine. Just because you missed the first major portion
of a new trend, don’t let that keep you from trading with that trend (as long as you can define
a reasonable stop-loss point). McKay commented that the easiest part of a trend is the middle
portion, which implies always missing part of the trend prior to entry.
 31. Don’t try to be