This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

The Phantom of the Pits has two big rules. Rule #1 is this:

In a losing game such as trading, we shall start against the majority and assume we are wrong until proven correct! (We do not assume we are correct until proven wrong.) Positions established must be reduced or removed until or unless the market proves the position correct! (We allow the market to verify correct positions.)

This rule is all about cutting losses, sometimes even before they fully happen. This rule is the most important, as it keeps you (and your capital) alive to trade another day. Let the market tell you when you are right–you should proactively know when you are wrong! But now I want to write about POP’s second rule.

Rule #2

After my SOEN trade, I was pondering what Phantom of the Pits said about his Rule #2, which is:

Press your winners correctly without exception.

In its most basic sense, the intent of this rule is to make sure that your net winners are larger than your net losers. The implementation of the rule manifests itself differently depending on your trading system. For day trading, positions tend to come and go very quickly. Putting on partial positions and adding later may not work, especially if there is no “later”. The best implementation of Rule #2 in day trading is in expectancy, where you try to have your winners at your win rate be larger than your losses at your loss rate. A positive expectancy means that you are implementing both Rules 1 and 2 correctly; a negative expectancy means you are not. The higher your expectancy, the better you are implementing the rules. Plenty has been written about expectancy in day trading, so I want to now focus on swing trading–positions held over several days or more.

Swing Trading and Rule #2

In longer term trading, the best implementation of Rule #2 is to make sure that your position is larger when you are right than when you are wrong. This can only happen if you add to a position after it has been proven correct, and that can only happen if you don’t put on your full position in the first place! Putting 2/3 of your position on as an initial entry leaves an extra 1/3 to add if your trade is proven correct. If it goes against you according to your system criteria, then Rule #1 makes you punch out, and you’ve only taken a loss on your 2/3 position size. If the trade is proven to be correct and you have a criteria in your system about when to add, you add the rest of the position according to that criteria.

I took a swing trade in Broadcom Corporation (NASDAQ: BRCM) that illustrates this principle. BRCM pulled a weak rally to the downsloping 20 day ema. It looked like a good place to fade the move. Would I be confirmed correct?

I put on 2/3 of my position size, and waited until the next day for the next step. If it moved in my favor, I would add the final 1/3. If it moved against me, I would get out. Here’s what happened the next day:

Trade Summary:

BRCM Short 33 Shares
Entry: $32.52, Stop: $33.35, Target: $30.00
R: $27.39, Exit: $32.80
P/L: -0.34R, or ($9.24)

The net result is that I was wrong on a position that was 2/3 of normal size. When I am correct on a trade, I’ll be right on a position that is full size. This way of pressing your winners, coupled with cutting your losers will help you maximize your expectancy and give you the greatest chance for success in trading.

Stocks Mentioned In This Article
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This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

I am a retired fighter pilot turned trader. A lot of traders accurately compare trading to flying. As a newbie wanna-be pilot learning to fly a small propeller aircraft, I had to heed my instructor’s every word. To ignore advice would have meant getting killed or worse- failing! I have done my best to follow the trading advice of pros. Maoxian taught me, amongst other things, to always put a stop loss in. Trader X kept me in the markets with the advice to trade thirty minute set-ups and to play only the best trades. I devoured books and watched on-line videos. Still, it wasn’t until a short while back that I applied the axiom, “Cut your losses, and let your winners run!” to my trading. My decision to change trading methodologies came about after a conversation with my wife. She works in sales to supplement her teaching income. She was disappointed that her sales were down. I was trying to cheer her up and said, “Don’t worry. It’s like trading- just a matter of probabilities.” She agreed, “Yeah, and at least I don’t lose money when I have a bad day.” That triggered something in my mind. Phantom of the Pits had written about minimizing loss, and I revisited his words of wisdom:

“Positions established must be reduced and removed until or unless the market proves the position correct.”

I realized that I could and should minimize losses by closing trades that weren’t proving themselves. My P/L has greatly increased since that time.

When I first started trading full-time, I entered the best trade I could find each day. After setting my stop at –R1, I hoped like hell the trade would go my way. If a pick looked weak, I shouted encouragement to it: “Get up there, you piece of @$%&!” I was like a gambler standing beside a roulette wheel. “Come on, red!” I had no idea that I controlled the wager and that I had the power to remove it at any time. If I had let go of my attachment to being right, I could have taken my bet off the table when the ball started bouncing against my position. I just couldn’t seem to apply insights from the best traders in the world to my trading. Paul Tudor Jones said, “I am always thinking about losing money as opposed to making money,” and Victor ‘Trader Vic’ Sperandeo claims, “The key to trading success is emotional discipline. If intelligence were the key, there would be a lot more people making money trading… I know this will sound like a cliché, but the single most important reason that people lose money in the financial markets is that they don’t cut their losses short.”

I was determined to improve my trading by appropriately reducing or removing weak positions. I studied my losing trades. What made them losers? Did I get stopped right away? Did I get slowly chopped up? I looked at my winners. What characteristics did most of them have? Were they successful right off the bat? When I enter trades now, I watch them after every candle print, after every tick. I ask myself if the trade is acting correctly. Is it breaking out similarly to past successful trades? Am I seeing a profit a designated amount of time into the trade? I ask myself if I should stay with the trade. For example, if I enter a trade long off the break of the second bar high and the next candle prints a shooting star what should I do? Should I exit? Is the trade proving correct? When my answer is no, I close the trade. Sometimes a closed trade works out. That’s OK. I prefer moving on to a pick that is proving itself and has an eighty percent chance of winning to keeping a mediocre trade with only a ten percent chance of meeting my expectations. I know that it is always more costly to let the market take out a trade than to close it first. The market is not favorable most of the time, so capital should be protected most of the time instead of hoped away.

I now have criteria for staying with trades. Some are cut and dry and depend on the charts. Some revolve around tape reading and feel. Optimal trades go my way from the get-go. Sometimes certain types of trades will go my way immediately, but they will hit less than R1 before aggressively retracing. That can be a sign of weakness. Sometimes volume drops off. Sometimes a doji signals sideways trading. Sometimes the market shoots against my position. There are hundreds of scenarios that can red-flag a mediocre trade. Recognizing each one just takes screen time.

Phantom of the Pits says:

“In a losing game such a trading, we shall start against the majority and assume we are wrong until proven correct. (We do not assume we are correct until proven wrong.)”

It took me a long while to decipher his words. Now when I see that a trade is showing weakness, I minimize losses by taking all bets off the table.

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com

Arthur L. Simpson, the author of Phantom of the Pits (published in 1997), was an independent trader and a long-standing member of the Chicago Open Board of Trade at the time of writing. He may still be trading, I am not sure. He said that he considered the Phantom of the Pits to be the best trader he knew and perhaps the best trader in the world. So, I am gonna listen to the Phantom. One thing I learned becoming a fighter pilot was that you learn from the best pilots. Your life depends on it.

I read some more of the book last night. This quote hit home:

“Your thinking should be: When your position is right, you have to do nothing instead of doing nothing when you are wrong!”

This post was contributed by a guest author, and does not necessarily reflect the views of Richard or MovetheMarkets.com