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47

THE $4017 HAIR DRYER

One day in 1979,1 was day trading the commodities when I got a call from my friend, Susan. I was long 40 wheat contracts, and the market was moving, so I had to watch the position intensely. I had a mental stop set to get out and limit my losses. An)way, Susan calls me, shes hysterical-crying, sobbing, sniffling-to the point that I cant understand what she is saying.

Naturally, I was concemed. I thought that maybe she and her husband had been fighting, that some real crisis had occurred. Then the tmth came out.

Through sobs and sniffs I heard, "Mmm ... my hairdryer, its ... ittsss ... its broken!"

I just couldnt believe my ears. "Your HAIRDRYER! Is THAT why youre so upset!" I looked over at my good friend and longtime partner. Norman Tandy, he just rolled his eyes. "Susan," I said, "Susan, calm down. How much do hairdryers cost"" "Sniff ...17 dollars."

At this point. Im amazed, and on the verge of bursting out laughing, "If it will make you feel any better, Ill buy you another one."

Naturally, any time someone gets so upset over a hairdryer, something else is really wrong. So, I started talking to Susan, trying to help her come to terms with whatever was really bothering her. In the process, I lost my mental focus.

I looked at my screen, and wheat had dropped 2 cents below my mental stop. Thats $100 times 40-4000 bucks. I immediately called and sold the position, losing $4000 more than I had mentally allowed. A $4017 hair dryer, and I didnt even get to pick out the olor.

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I couldnt help but laugh about it then, and I still laugh about it now. The point is that there are all kinds of ways to lose money that you never think about. To paraphrase the song, "Fifty Ways to Leave Your Lover," there must be 50 ways to lose your money.

The single biggest way traders lose money, however, is by not following the mles, by somehow thinking that "this one time" there is an exception. Its a mistake that everyone makes, but one that is controllable. If you understand the mles, and more importantly, why they exist, its a mistake that is possible to avoid 99% of the time.

TRADING RULES AND THE REASONS BEHIND THEM

Many people make the mistake of thinking that market behavior is tmly predictable. Nonsense„Trading in the markets is an odds game, and the object is to always keep the odds in your favor. Like any other odds game, in order to win, youve got to know the mles and stick to them. Unlike other games, however, the single biggest reason mles are necessary is to keep a check on your emotions. Assuming you have the knowledge you need to take a position with confidence, the hard part is executing the trade correctly. Thats what the mles are for.

There are so many factors affecting market behavior that, with just a little mental energy, you can twist and distort them, even if only slightly, and rationalize yourself into taking unwarrante d risks or closing a position too early or too late.

Just recently, on an S&P futures trade, I went short 10 minutes after the opening with a stop set 5 ticks above the days high. In the next 30 minutes, the market went down about 10 ticks from where I sold them and then looked like it might rally. I did not have a clear buyback signal on the trade at all, but, emotionally, I didnt want the small profit to tum into a loss, and I had my assistant buy them back at a 10-tick profit ($250 per contract).

Just 15 minutes later, the market broke down two full handles (a handle on the S&P futures is I full

There Must Be Fifty Ways to Lose Your Money



point, which is 20 ticks or $500 per contract). If I had followed the rales, I would have made five times more profit than I did. My thinking process was something like, "This market looks like it is going to rally, so I better bail out and take the profit while I have the chance." But that was really just a rationalization which was shielding my fear of being wrong in the trade. The market did, in fact, rally just a little bit, but it never even approached my stop-the point where the market would prove I was wrong.

The purpose of rales is to make market executions as objective and consistent as humanly possible. Without them, youll end up imposing your wishes n your trading decisions and, nine times out of ten, your wishes will fly in the face of market action. The purpose of this chapter is to outline the major trading rales and the reasons behind them. Ill also discuss a few ways to lose money that you dont hear people talk about very much.

THE RULES DEFINED

Rule Number 1: Trade with a plan and stick to it.

Before you make any trade, it is absolutely essential that you know your objective and how you intend to reach it. This means not only identifying the risVreward, but also defining all possible courses the market might take and then defining your response. In other words, you have to know, before you ever enter the trade, all the possible outcomes. Confusion is your biggest enemy during a trade; it will cause you anguish and emotional turmoil as the trade progresses. But confusion, by definition, comes from ignorance, from not understanding what is going on or how to respond to it.

The main thing you have to ask yourself in forming your plan is whe re, timewise, your interest is in making the trade. That is, you have to decide if you are taking the position as a day-trade (open and close the position within the day), a short-term trade (held for days to weeks), an intermediate term speculation (held weeks to months), or a long-term investment (held months to years).

This decision determines which trend you focus your concentration on and therefore where you set your stops (see Rule Number 3). Once you decide, then identify all possible scenarios in te rms of the price movement and determine what your response to each scenario will be. Specifically, identify where you will place your stops, price objectives to take profits or to increase the size of the position, and so on.

There are sometimes sources of confusion you cant control-another of the 50 ways to lose your money. For example, one day, while trading at Interstate, I was long 40 or so stocks, in lots of 2000 or more. I owned calls on the indexes. I had futures positions. I was trading very, very intensely. Then suddenly ... everything went black.

No, some goon didnt come in and knock me on the head. The power went out. We had a backup system, but it failed too. Somehow, the phones were connected to the electrical system, so even they didnt work.

Now, Im dealing with several exchanges, several different brokers, and I dont know what the hell is happening on the market. I ran out into the hallway and down the stairs, fumbling in my pocket, trying to find quarters for the payphone. I didnt even have the numbers to the pits I was trading in, because I had direct lines to them in my office.

So there I was, out in the middle of the street at a pay phone, closing my positions in a panic. Can you imagine calling directory assistance and asking for th e number-of the S&P futures pit in Chicago? Its funny now, but it was awful then. And, as Murphys Law would have it, the markets had moved against me. Now thats a kind of confusion you cant control, but you may want to make sure your system has double back-up.

Rule Number 2: Trade with the trend. "The trend is your friend!"

This is probably the most well-known rale of all. But as simple as it seems, it is easier to violate than you might think. Remember, there are three trends-the short-term, the intermediate term, and the long-term. Each trend is moving all the time and may be going in a direction opposing the other two. The short-term trend changes more rapidly and more often than the intermediate trend, and the



intermediate trend changes more rapidly and more often than the long-term trend.

Know which trend you are involved in and its correlation with the other two. Identify, using the 1-2-3 change of trend criterion, the point at which the trend has reversed. If the market hits that price -get out! Also watch for 2B pattems and other technical indicators that can give you an earlier indication of a probable trend reversal.

Rule Number 3: Use stop loss orders whenever practical.

Before opening a trade, you should know the point at which the market proves you are wrong. One of the hardest things for many traders is to close the trade when the market hits that point. One way to avoid this problem is to trade with stop loss orders. A stop order is one which converts to a market order when the price stated in the stop order is reached.

If you are trading in size, you must use mental stops. If you put huge stop orders in, then you can be sure the locals will hit them if they can.

So, once you open a position, you should place a second order to close the position at a stop. The exact way to do this depends on what trend you are involved in. As a general mle, stop orders are valid until the close on the day you place them. But you can place a stop order with the addendum "good til cancel," or GTC, which means that the order is good until you cancel it.

In fact, you really have to watch both yourself and your broker when you place any order. My good friend, John Malley, who is a trader, tells me about people who call up and say things like, "Sell me 500 IBM at the market." So John replies, "Mmm ... sell me, that means youre a buyer, you want me to sell to you 500 IBM?" And, of course, the customer impatiently replies, "No, no, no, Im a seller!"

But John is right. When you "buy puts," youre short. When you sell them, youre long. "Get me 10 December S&Ps at the market," doesnt mean anything. Words have definite meaning, especially when youre placing an order in the markets, so make sure you get it right, and make sure your broker understands you.

Rule Number 4: When in doubt, get out!

Another way of stating this mle is that when you are evaluating your positions, every long position you hold should be a buy today, and every short position you hold should be a sell today. It also means that you should never enter a position without confidence.

It is only natural to experience a little bit of fear or anxiety when your money is on the line, and by no means should you close a position every time you feel

an inkling of doubt. But if changing conditions start to pile the odds against you and you are plagued with nagging doubt and uncertainty, then close the position.

This mle also has a second meaning. There is a fine line between fear and justifiable doubt. It may sound harsh, but if, because of fear, every position you take fills you with doubt and uncertainty, then get out of the markets! You have no business trading if you cant trade with confidence, at least most of the time. Chronic fear and doubt will take a dreadful toll on you physically, emotionally, and probably financially. Its nothing to be ashamed of; its just a personality trait that is not conducive to being successful in the markets.

The single best way to avoid doubt during a trade is to have all the possible information you can on your side. Sometimes, though, even that is not enough.

I was told a story about a very wealthy man who dealt with a takeover analyst and usually did very well by him. The analyst had been talking about several stocks as a buy: Northwest Airlines and Ces sna among them, both potential takeover stocks at the time. One day, the rich man got a call from the analyst, who said, "I just got the scoop, this thing is on. Buy the plane."

The rich man proceeded to go out and buy 400,000 shares of Northwest Airlines at $60 per share. Thats $24 million worth of stock. The next day, the stock went to $59, then to $58. The rich man called the analyst.

"Whats going on here, I thought the deal was on?" The analyst was very busy, "Yep, yep, its still a go ... real bus y... gotta move," and he hangs up.



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