Within the next two days, the stock went to $55, and the rich man called again. This time the analyst wasnt so busy.

The rich man asks, "When is this thing going to happen?" "Day after tomorrow."

"At what price?" confusion in the rich mans voice. "Above the market."

"I dont get it then," says the dumfounded rich man, "the stocks down five bucks, at $55." The analyst is surprised: "What do you mean, $55, Cessna is at $24!" "Cessna!... CESSNA!"

"Yeah, Cessna! I told you to buy the plane," says the analyst in shock. And the rich said, "But Northwest flies, too!" The rich man blew out his position, losing 2 million dollars. All along, his doubts were justified. One more story to verify the rule, "When in doubt, get out!"

Rule Number 5: Be patient. Never overtrade.

Frankie Joe used to say that there were usually three or four excellent trading opportunities per year in any given market, including individual stocks. Frankie was a speculator; he traded primarily in the intermediate term. But the essence of his point applies to every trend. You can flip a coin and say, "heads long, tails short," and trade one hundred times a day if you want to. But if you do, the only way youre going to win is through sheer luck.

The way to make money is to watch the markets you are interested in and wait until as many factors as possible are in your favor before taking a position. For example, in day-trading the S&P futures, there is usually a maximum of two or three good trading opportunities each day. Sometimes there are none.

Each market index, each stock, and each commodity has its own unique pace, rhythm, and trading characteristics. Dont trade until you feel familiar with the price action of your market(s) and then wait for opportunities that promise large profits if you are right and small losses if you are wrong. Observe, watch patiently, and when all the factors come into play in your favor, act without hesitation.

Another aspect of this rule is that, if you are trading ju st on-your own account, it is prudent to limit yourself to under ten stocks if you are active in the stock market, or to under five commodities if you are trading in the futures. The biggest reason for this is a simple matter of focus.

How many phone numbers do you know off the top of your head? Maybe as many as eight or ten. Well, if its that hard to remember phone numbers, imagine trying to maintain the intensity required to stay on top of more than ten or so trades at once. Awareness of your positions a nd what they are doing is key to performing well. For most of us, thinking about five things at once is plenty of challenge.

Rule Number 6: Let your profits run; cut your losses short.

Of all the trading rules, this is the most important, most commonly s tated, and the most commonly violated rule of them alL

The market is like a courtroom where you are the accused-innocent until proven guilty. That is, when you initiate a trade, you have to assume that you are right until the market proves you wrong. It proves you wrong when the price hits your stop or your mentally chosen exit point, which is as absolute as a Supreme Court ruling-no appeal is possible, your freedom to act is gone, you must close out the position.

When you are right, you have to "Let freedom reign!" When you trade on a one to three risVreward criterion, then as a general rule you should either lose one or win at least three, as I described in an earlier chapter. The exceptions are covered by Rule Number 7.

In a sense. Rule Number 6 is a restatement of all the rules covered so far. If you have a plan, then you know when to take profits, when to double up on a position, and when to close out. If you trade with the trend, then your loss limits are objectively definable by the change of trend riterion. If you trade with stops, you will automatically cut your losses short. If you trade with confidence, you are unlikely

to take profits too early. If you dont overtrade, you will both minimize losses and stand a better chance of catching the winners and riding them out. If you really understand "Let your profits run; cut your losses short," then youve rolled at least four rules into one-good mental economics.

Rule Number 7: Never let a profit run into a loss. (Or always take a free osition if you can.)

This is a tough one because you have to define "profit" in your own trading terms. To generalize the rule, consider it in terms of the I to 3 tisVeward context. If you are up 2 to I, then Rule 6 says to let your profits run. But if the price trend reverses and you end up getting stopped out, then youve violated Rule 7! What are you supposed to do?

What I recommend is that any time you are up two to one on a trade, raise your stop, even if just mentally, slightly above cost and take the free position! In a sense, this gives you a zero risVeward relationship. You have everything to gain and nothing to lose. If the trade continues going your way and reaches the I to 3 objective, then close out one-half or one-third of the position and raise your stop to lock in a two to one profit on the rest of the position. If the trade still continues to go your way, then you can move your stop to lock in higher and higher levels of profits. And if you are playing the long term, depending on the exact nature of the market, you might even want to expand the size of your position at strategically selected points.

Rule Number 8: Buy weakness and sell strength. Be just as willing to sell as you are to buy.

This rule is primarily applicable to speculating and investing, and to a smaller degree in short-term trading. It is a corollary to Rule 2, trading with the trend. If you are speculating on the intermediate trend, the way to maximize profit potential is to sell during minor rallies and buy during minor sell-offs. If you are investing in the long-term trend, you should sell during intermediate rallies in bear markets and buy during intermediate sell-offs in bull markets.

The same reasoning holds true for adding to a profitable position in either the intermediate or long-term trend. Ideally, of course, you want to try to sell near minor rally highs and buy near minor sell-off lows when speculating in bear and bull markets, respectively; and sell near intermediate highs and buy near intermediate lows when speculating in bear markets and investing in bull markets, respectively. The 2B criterion is excellent for employing this strategy in many cases.

Many market participants are either predominantly bulls or bears and have a tendency to always be long or always be short. In fact, most market participants avoid playing the short side like a plague. This is a big mistake that defies the nature of market action. If "the trend is your friend," then playing both sides of the market is the best way to maintain a successful and lasting personal relationship. Any adept long-side player has, at least implicitly, the knowledge to play the short side-all he has to do is use converse reasoning. And when playing the short side, profits can accrue more quickly because downside movements occur faster than upside movements.

Rule Number 9: Be an investor in the early stages of bull markets. Be a speculator in the latter stages of bull markets and in bear markets.

An investor is a person looking for a long-term retum and/or an income flow

from the placement of capital in the market. The investors concem is primarily with eamings, dividends, and equity appreciation.

A speculator, on the other hand, is primarily concemed with price movement and how to profit from it. Looked at from a tisVeward standpoint, the best time to be an investor is at the early stages of bull markets because, from every fundamental dimension, the chances for growth are the best.

As the market ages, entering the third, fourth, and latter legs, your emph asis on price levels should become more predominant, and the pmdent market player will tum to speculation. The reason for this is that, as I discussed in Chapter 10, the progression of a bull market induced by credit expansion is such that, at some point, value appreciation ends and price inflation begins as businesses compete with

more dollars for scarce resources.

In bear markets, it is always prudent to speculate. By definition, it is really impossible to be an "investor" if you are playing the short side. Long-term selling in bear markets is a means of profiting from investment liquidation; it is not investing per se. That aside, the best way to play bear markets is by moving in and out of the market, playing the short side during primary legs and the long side during secondary corrections. Bear markets are generally shorter than bull markets, and the primary swings in bear markets move similarly in extent, but shorter in duration than in bull markets.

If you manage your money carefully, you can make si milar percentage profits in bear markets in shorter time with no more, and perhaps even less, risk than on the upside in bull markets. By the nature of the business cycle, youll never see a "Black Monday" on the upside, so in that sense, bear markets are safer.

Rule Number 10: Never average a loss-dont add to a losing position.

"Averaging down" is nothing more than a rationalization either to avoid admitting being wrong or to hope to recover losses against all odds. It is called "averaging down" becaus e it is a process of adding to a losing position such that the net percentage loss on the entire position is less than it would be if the losses were calculated on the basis of the price on the opening trade. The rationalization takes the form of "This stock (bond, future, whatever) is going up (down). Im losing money now, but if I add to the position, then Im getting a bargain and Ill end up making lots of money!"

Rule 10 is really just a corollary of Rule 6-cut your losses short. But averaging down is such a common error that it deserves its own "dont" rule to remind you that it is an error.

There are cases, however, that may at first appear like averaging down, but really arent. For example, if you are looking for an intermediate shorting opportunity in a bear market, Ive already said that the best time to go short is into a minor rally. Assuming that the stock market has been down four days in a row at what looks like the beginning of a primary leg in a bear market, a good way to short is to sell the market on the first up day. If the market is up two days, then the

odds of its being up a third day are relatively low, so you could increase the size of the position on the second up day. If it is up a third day, then the odds of its being up a fourth are less than 5%, so you could short again. But if the market is up four days in a row, then there is a strong possibility that the intermediate trend is in fact going up, and its time to close the position.

The difference between this strategy and averaging a loss is that you have a plan and a point at which you admit that you are wrong. Part of the plan would include an evaluation of the extent of each daily move as well as the number of days. From the outset, you would consider not only the number of days, but you would also have established an exit point in terms of the price level that would prove you wrong. Averaging down is without limits, and closing the position becomes a subjective, emotional decision.

Rule Number 11: Never buy just because the price is low. Never sell just because the price is high.

Unlike shopping at a grocery store for fruit, there is no such thing as a "bargain " when it comes to trading. Either a trade is good or it isnt; the price of the instrument has almost nothing to do with it. The only times price comes into play are if you simply cant afford a position because of margin requirements, or if there are. by comparison, other trades available with greater leverage and equal or better tisV reward ratios.

Avoid thinking in terms like, "This thing is at historical lows, it just cant go any lower!" or "This thing just cant go any higher, Ive got to sell it!" The fact is, unless you see some sign of a change of trend, the chances are that the trend will continue. When a market is at historical highs or lows, but there is no sign of a change of trend, my advice is to leave it alone and wait for signs of a change of trend. Trade with the trend and be patient.

Rule Number 12: Trade only in liquid markets. A lot of people who live in the Northeast right now might tell you that they live in a $500,000 house.