Trading Messages From Mars

Back in the late 1960s, I was a young commodity broker at E. F. Hutton and Co. Our office was a brand-new high-tech office (for its time) that was considered the “flagship office” for E.F. Hutton.

In this office about 30 brokers and as many clients shared one very large boardroom, and there were no private offices. The brokers had elegant and expensive desks, and the clients had a comfortable seating area in the front of the office where they could hang out and watch the tapes and monitor our state of the art commodity “clacker board.”

Sitting at my desk near the front of the boardroom, I could read my Wall Street Journal and keep track of the commodity markets without looking at the board. By just listening to the rhythm and tempo of the mechanical clicks as the prices changed, I could easily tell when anything important was going on, because the tempo of the clicks would increase noticeably. Just in front of my desk were a half-dozen comfortable sofas facing a high mahogany-paneled wall with the tapes and the “clacker board.” A gallery of traders, mostly retired “old-timers” who were trading real commodities like grains and pork bellies, lounged around on the sofas plotting their charts and talking about life and the markets. They typically arrived early to get a good seat in their usual spot and then spent the day trading, exchanging commentaries and offering unsolicited advice to one another on any subject.

For the most part, they were a very sociable group who would take coffee breaks together and greeted each other on a first-name basis. These traders enjoyed the elegant atmosphere and treated our well-appointed boardroom as their private men’s club. (Were you aware that women were not allowed to trade commodities back in those days? My, how times have changed!) One of these “old-timers” kept to himself and was not interested in becoming a member of the friendly and often boisterous social circle. He usually sat quietly by himself, intently watching the price changes on the commodity board and holding an old glass Coke bottle up near his ear.

The vintage-shaped Coke bottle had been emptied many years before and now contained only a 12-inch tube of bent and broken radio antennae, which extended awkwardly out of the top of the bottle. Keep in mind that in the 1960s no one had yet heard of cellphones, so the purpose of this Coke bottle was a real mystery to everyone. When the trader would talk to the bottle from time to time, all the heads would turn, and the traders nearby would try to listen to the conversation. But the trader spoke very softly, and no one was able to eavesdrop on his conversations with the bottle. The traders knew that the fellow with the Coke bottle was a client of mine, and eventually a representative of the group came to me and said they were extremely puzzled about this guy and his Coke bottle and asked me if I knew what was going on. I didn’t know the purpose or meaning of the Coke bottle, but I was as curious as anyone was, and I promised I would find out. The next

time the client came back to my desk, I promptly placed his order and then politely asked him about the Coke bottle. With a serious expression and no embarrassment, he explained to me that the Coke bottle was an inter-planetary communication device that had been given to him by aliens. He said the aliens were very interested in our commodity markets and they often gave him trading advice from their various observation points on other planets. He said he had just had a message from Mars and they were buying soybeans, so he had also purchased soybeans. After revealing his unique trading methodology, he returned to his seat and resumed his whispered conversations with the Coke bottle. As soon as I revealed my discovery of the meaning of the Coke bottle to the other traders, all attention was immediately focused on the Coke bottle trader and the soybean market. The soybean market proceeded to go the wrong way, and the trade from Mars was eventually closed out at a loss. The other traders had no sympathy and were quick to begin ridiculing the trader and to poke fun at his beliefs.

The next trade, however, turned out to be a big winner, and the Coke bottle trader went from sofa to sofa telling his story and pointing to the clacker board while waiving his Coke bottle and bragging about the profitability of his most recent message from outer space. Because he was making money now, his previous critics had to endure his bragging about his success on the current winning trade. After a few winning and losing trades later, a clear pattern of behavior began to emerge. The Coke bottle trader was ridiculed unmercifully on his losing trades but was able to get his revenge and the last laugh during the winning trades. This trader might have been a little bit crazy, but he wasn’t stupid. He soon learned that his only defense against ridicule was to hold on to winning trades as long as possible and to quickly get out of his losses.

As long as he was sitting on his sofa with a winning trade, no one could tell him he was crazy and make cruel jokes about his messages from Mars. In fact, while he was winning he was quick to wander around the room and ridicule the methods of the other traders who were not making as much money as he was. He displayed the profits in his trading account as hard evidence of the validity of his methods and offered copies of his statements as irrefutable proof that he was getting valuable advice from his alien contacts. Who could argue when his advice from other planets was obviously working? For a young broker, this experience and the firsthand observation of the Coke bottle trader who suddenly became profitable gave me my first important lesson about the importance of exits. I knew the entry signals had nothing at all to do with his success. His batting average was not any better than that of any other trader. However, this crazy old trader seemed to be able to make money consistently, while other traders with more “sanity” and more valid entry methods were losing.

Before long I was able to recognize that this man had become a successful trader simply by his efforts to avoid ridicule. He knew he was vulnerable during his losing trades, so he closed them

out very promptly. His winning trades became his shield against the ridicule of the other traders, and he kept his winners much longer than before his unorthodox methods were revealed. In the many years since this experience, I have encountered many claims of success for entry methods that probably have even less validity than the Coke bottle messages. I have learned to look only briefly at the entries of winning traders and to examine their exit strategies very carefully. I am very fortunate that more than 30 years ago I learned from the Coke bottle trader that success in trading depends on our exits and not our entries.

Don't Neglect Your Exits

By Chuck LeBeau

Futures and options traders have always had to be concerned about exit timing because futures

contracts and options have a very limited holding period prior to expiration. Stock traders on the other

hand have not been faced with this problem and may have become complacent about their exits. With

the increasing volatility evidenced in the stock market recently we think that stock traders will benefit

greatly from an increased awareness of the importance of good exit timing.

Those who have read our book and followed our work over the years will recall that we have long been

outspoken advocates of the importance of good exits. In our opinion exits are much more important

than entries yet the majority of new traders spend most of their time seeking the ideal entry strategy as

if the entry determined the outcome of the trade. This assumption might be true for a buy and hold

investment but this is definitely not the case for traders. System traders in particular will find entries

have very little influence in determining the result of a system.

In the System Building workshops that I teach with Dr. Van Tharp, we play an exit game where everyone

enters a series of trades at the same price and then each student implements their own exit strategy as

new prices are reported to the group. After about ten quick trials of this game the results typically range

from one extreme to the other. A few traders make a lot of money; a few lose a lot of money and most

fall somewhere in between. It is rare for any two players to have the same results and the point of this

simple exercise is to illustrate the effect of exits on our trading results. In this game everyone has

identical entries yet the final performance of the simulated trading ranges from large losses to large

profits. (read more.....)

The same is true in actual trading. Exits determine the outcome of our trading far more than anyone

realizes. In fact our research shows that exits have more impact on the results of a system than any

other factor, including money management (position sizing). Not even the best money management

strategy can make a losing system into a winner but a minor change in the exit strategy can work

miracles. We first observed the impact of exits years ago when attempting our research of popular

indicators we were testing as entries. We found that even a minor variation of the exit strategy would

drastically affect the number of trades, the size of the winners and losers, the percentage of winners,

the size of the drawdown and the total profitability. Although we set out to test entries, we quickly

discovered that the performance data was entirely dependent on the exits we used and the entries had

little if anything to do with the results.

To make our research more meaningful we eventually began isolating, as best we could, the testing of

entries and exits. We now evaluate our entries based solely on the percentage of winning trades they

produce when exiting after a specified number of bars. This method of testing entries evolves from our

conclusion that the primary purpose of entry timing is to get the trade started in the right direction as

accurately as possible. Everything that happens after the entry is determined by our exit strategies.

Ideally we want our entries to accomplish only one purpose and that is to get our new trades started in

the right direction as quickly as possible. This function is easy to measure and the higher the winning

percentage after a few bars in the trade, the better the entry. But how do we measure the efficiency of

our exits? How can we tell if one exit is better than another? What is a good exit? What is a bad exit?

Which is better: exit A or exit B?

To better quantify the relative merit of various exits we created the Exit Efficiency Ratio and several

years ago we contributed an article on this topic to Futures magazine. Here is our original version of the

Exit Efficiency Ratio.

You need to start by keeping or creating a record of your winning trades. You must also keep a record of

the total number of bars in the trade from entry to exit. As an example, lets assume that we made a

profitable trade that lasted 12 bars from entry to exit and the trade captured $1500 of gross profit.

The next step is to go back and look at our entry point and 24 bars of data after our entry. Our

theoretical holding period is now twice the actual holding period. We then use perfect hindsight to

identify the best possible exit point within this theoretical holding period. Don't be shy, pick the

absolute best tick for the theoretical exit and compute the theoretical gross profit. In this case lets

assume that somewhere in the period we could have exited the trade with a $2500 profit at the

absolute high point of the theoretical trade.

The Exit Efficiency Ratio is then calculated by dividing the actual gross profit by the theoretical gross

profit. We divide 1500 by 2500 to arrive at an Exit Efficiency Ratio of 60%. This tells us that we actually

captured 60% of the profit that might have been possible for this trade.

Those of you using Omega's Portfolio Maximizer software you will recognize that the Exit Efficiency

Ratio utilized in that program is quite similar except that it varies from the original formula in one

important feature. The Portfolio Maximizer formula measures only the efficiency during the actual

holding period. I suspect that this modification is for practical reasons because the trade by trade data

used for the Portfolio Maximizer calculations would not include any data that was outside the time

period of the actual trade.

When calculating the best theoretical exit point, the doubling of the holding period is critical to

evaluating the exit fairly because most traders are inclined to err on the side of exiting their profitable

trades much too soon. By extending the theoretical holding period beyond the actual exit bar we can

see if this was the case. In our example we exited the actual trade after 12 bars and let's assume that

the ideal exit point was on the 20th bar. If we only measured the bars in the actual trade our ideal exit

point might have been on the 12th bar where we closed out our trade just as we were reaching a new

peak. Measuring only the duration of the actual trade would incorrectly credit us with an exit that was

100% efficient without any penalty for closing out the trade much too soon. The tendency of any

calculation based only on the bars during the trade would be to reward us for exits prior to the peak and

to penalize us for exits that were more profitable but were implemented after the peak.

For example if the open profit sequence for each bar were $500, $800, $1000, $1500, $2,000, and

$1700, an exit at $1000 would appear to be more efficient (100%) than the more profitable exit at

$1700 (85%). By doubling the holding period in our theoretical calculation of the ideal exit point we can

easily see if we closed out any of our trades too soon.

Unfortunately the Exit Efficiency Ratio can only be applied to profitable trades and applying it to your

trading and research will require some additional effort and record keeping. Whether you use this

valuable calculation or not, we suggest that emphasizing and improving your exits is the quickest and

most effective method to improve the performance of your system.

Adaptive Money Management Stops By Chuck LeBeau

In order to study and develop money management stops that are adaptive to current market volatility, it is necessary to move away from the standard dollar stops and examine other ways to place the protective stop based on some measure of market volatility.

One starting point is to use the price action itself to determine the stop placement. For instance, the lowest low or highest high of the last X number of days could be used as a money management stop. We call this a Channel Stop. The Channel Stop is very adaptive to current market conditions, since it changes with trendiness and with volatility. The Channel Stop is further away from the market in times of higher volatility and higher trendiness and closer to the market in times of lower volatility and lower trendiness. This stop is also based on strong logic: we already know that a breakout of a significant highest high or lowest low will often signal an important trend reversal. Therefore our stop-loss placed at a highest high or lowest low point provides a valid technical reason to exit a losing trade.

However one possible disadvantage of this stop is that in a strongly trending market, the stop may be placed too far away. Reflecting the strength of the trend the market might have moved a significant distance from its previous highs or lows. On the other hand, during non-trending

periods, the stop may be placed much closer to the markets. As you can see, the actual dollar value of the stop would vary considerably depending on where prices have moved from their last high or low point. This variation might make dollar estimates of the risk per trade difficult to predict until it is actually time to enter the market.

Another adaptive strategy would be to use significant support and resistance levels to define the money management stop position. One could use a significant pattern in the market, such as a pivot low or pivot high, as the position for a money management stop. The advantage of using price and technical points to determine the position of the money management stop is that the stop is placed in a logical position, where adverse price movement exceeding the stop would constitute a logical reason for terminating the trade.

Another way of adjusting money management stops is to use a measure of the current market volatility. We could use the Average True Range over a period of time or the Standard Deviation of prices over a period of time and multiply that by a factor to determine how far away the stop should be placed from our entry price. One of our favorite stops is to simply take the Average True Range over a number of days and to multiply that by a factor and place the stop at that distance from the entry point of a trade. To avoid random price movement, it would be recommended to place the stop more than one AverageTrue Range from the entry price. The advantage of using a stop determined by Average True Range is that it is highly adaptive to current market conditions. The distance from our entry point to the stop would increase in periods of high market volatility, and decrease in periods of lower volatility. In actual practice we have found that most problems with the ATR stop tend to arise when the short term average true range becomes unusually small and our tight stops cause us to be whipsawed. To avoid these dreaded whipsaws we calculate both a short term ATR (3 or 4 days) and a longer term ATR (15 or 20 days) and we always set our stops using whichever of the two ATRs is the largest. This allows the stops to move away quickly but prevents them from moving in too close after a few unusually quiet days. (See Bulletin #14 for a discussion of ATR exits. See Bulletin #10 for instructions on how to calculate ATR.)

Another version of an adaptive money management stop would be to use the Standard Deviation of the past prices as the measure of price volatility. For example, the standard deviation of a past number of closing prices may be calculated, multiplied by a factor, and the money management stop could be placed at this distance away from the entry price. The rationale of this stop is similar to the Average True Range stop. The goal is to place the stop out of the reach of random price movements yet cut our losses when prices move away from our entry by a significant amount.

Adaptive stops that change with market volatility have a significant role in money management. The dollar amount of the potential loss can quickly be calculated before we enter the trade and we can be confident that the size of the potential loss is appropriate for the current market conditions. As an example, suppose our system calls for the placement of a stop at 1.5 times the 20-day Average True Range from our entry point. If we were trading the S&P 500 market back in 1990 where one Average True Range was only $1,250 in dollar terms we would have been placing our stops $1,875 away from the entry point. Now suppose we had an account of $100,000, and we were willing to risk 10% of our capital on each trade. Based on the volatility in

1990 we would have been trading 5 contracts, thereby risking $9,375 of our capital. Now suppose we are in 1999 trading the same system, and one Average True Range in the market is $5,600. This would call for a stop of $8,400. If we were still trading the same $100,000 account with a 10% risk tolerance, we could now trade only 1 contract. As you can see, the adaptive money management stop is an excellent guide to managing risk during periods of changing market volatility.

Why Use Multiple Exits? by Chuck LeBeau

A recent message from one of our members questioned our use of multiple exits and the fact that the

exits in a particular system were very complex and would sometimes move closer to the prices and then

suddenly move farther away. The member questioned whether the exits were working properly and

wondered about the logic of having so many different exit strategies operating within one system. I sent

the member a brief reply and promised to write a Bulletin that explained our philosophy and procedures

about the use of multiple exits in more detail.

When we develop trading systems the entry is usually just a few lines of code but the exit strategies and

coding are often very complex. We may have a system with only one very simple entry method and that

system may have a dozen or more exit strategies. The reason for devoting so much effort and attention

to achieving accurate exits is that over our many years of trading we have come to appreciate both the

importance and the difficulty of accurate exits.

Entries are easy. Before we enter any trade we know exactly what has occurred up to that point and if

those conditions and events are satisfactory according to the rules of our system we can generate a

valid entry signal. Entries are easy because we are able to set all the conditions and the market must

conform to our rules or nothing happens. However, once we have entered a trade anything can happen.

Now that we are in the market the possible scenarios for what might happen to our open position are

endless. It would be extremely na?ve to expect to hope to efficiently deal with all possible trading

events with only one or two simple exit strategies. However, that seems to be the common practice and,

in fact, many popular trading systems simply reverse the entry rules to generate their exits.

We believe that good exits require a great deal of planning and foresight and that simple exits will not

be nearly as efficient as a series of well planned exits that allow for a multitude of possibilities. Our exit

strategies need to accomplish a series of critical tasks. We want to protect our capital against any

catastrophic losses so we need a dependable money management exit that limits the size of our loss

without getting whipsawed. Then if the trade is working in our favor we would like to move the exit

closer so that the risk to our capital is reduced or eliminated. As soon as possible we need to have a

"breakeven" exit in place that prevents our profitable trade from turning into a loss.

In most of our systems, our goal is to maximize the size of our profit on each trade so we do not simply

take a small profit once we see it. This goal means that we need to implement an exit strategy that

protects a portion of our small profit while allowing the trade to have the opportunity to become a

much bigger profit. If the trade went in our favor every day the exits could be greatly simplified but

unfortunately that is not the way markets typically trade. We have to allow room for some minor

fluctuations on a day to day basis. In order to facilitate our objective of maximizing the profit of each

trade, in some cases we may decide to move our exit point farther away to avoid getting stopped out

prematurely. For example, lets look at our Yo Yo exit that is based on the theory that we never want to

stay in a position after a severe one-day move against us. (See Bulletin number 14 for an explanation of

the Yo Yo exit.)

This highly efficient exit is based on measuring the amount of price movement from the previous day's

close. For example we may want to exit immediately if the adverse price movement reaches one and a

half Average True Ranges from the previous close. This volatility-based exit will move away indefinitely

as the result of a series of adverse closing prices caused by days where the price moved against us but

our volatility trigger was never quite reached. Obviously an exit that can move away from prices

indefinitely is no use at all in limiting the size of our losses so the Yo Yo exit must always be used in

conjunction with other exit strategies that do not move away. Now that we have implemented the Yo Yo

exit to protect our trade from a severe one-day reversal in direction, we have still not addressed the

question of taking profits. So far, we have exits in place to protect from large losses, to lock in a break-

even point and to get us out on a sudden trend reversal but we still have not addressed the important

issue of taking some profits on the trade.

We like to shoot for big profits and the bigger the profits become the closer we like to protect them.

This strategy calls for multiple profit-taking exits. If we have a $1,000 profit we might want to protect

50% of it and be willing to give back $500 of our open profit. We can place an exit at $500 above our

entry price. This will allow us to hold the position in the hope that the profit will grow. However if we

have a $10,000 open profit I'm sure we wouldn't want to give back 50% of that. Also, let's hope that our

exit stop is not still sitting back there at $500 above our entry price. For best results our exits need to

adjust at various levels of profitability.

Many traders have asked us about the robustness of a system that has a many exit rules. The general

perception is that a system with fewer rules is likely to be more robust. However I would disagree with

applying that common belief without careful thought. Look at the exits in these two over-simplified

systems:

System A:

Use a $1500 money management stop. (Limits loss to $1500.)

When profit reaches $5,000, exit with a stop at entry plus $4500.

System B:

Use a $1500 money management stop. (Limits loss to $1500.00)

When profit reaches $1,000, exit with a stop at entry price.

When profit reaches $2,000, exit with a stop at entry plus $1,250.

When profit reaches $3,500, exit with a stop at entry plus $2,500.

When profit reaches $5,000, exit with a stop at entry plus $4500.

When profit is greater than $7,500 exit with a stop at the previous day's low.

Some system traders might argue that since system A has fewer rules it should be more robust (most

likely to work in the future.) We would suggest that system B is much more likely to work in the future

even though it has more rules. System A is not going to make any money at all if the open profit never

reaches $5,000. Once the profit exceeds $5,000 the only exit is at the $4,500 level. System A is very

limited in what it is prepared for. It either makes $4,500 or it loses $1500.

As you can see, system B is obviously prepared for many more possibilities. It is conceivable (but not

likely) that system A may somehow produce better test results on a historical basis because of an

accidental (or intentional) curve fit. However, we would much rather trade our real money with system

B. Simpler is not always better when it comes to exit planning.

The Importance of Exits Exits are important because your exit strategy will determine:

· Size of your profits

· Size of your losses

· Length of your trades

· Amount of your risk

· Size of your position

· Your percentage of winners

· Your total return

For most traders exits are more difficult than entries. Why are exits difficult?

· We have unrealistic expectations

· We expect to sell at tops

· We tend to apply too much hindsight

· We sense lack of control

· We can enter trades on our own terms

· We must exit trades on terms set by the market Solution: We need to have realistic expectations and take control of our exits. Exit priorities:

· Initial stop loss

· Trailing stop loss

· Moves up from initial stop to reduce risk

· Protects us at break-even point

· Profit protection stop

· Keeps winning trades from becoming losses

· Locks in a portion of the open profit

· Profit maximizing exit

· Attempts to exit without giving back profits

Exit priorities: (Number one) - Initial stop loss

· Determines your risk and allows you to correctly determine the size of your position

· Protects your capital and provides peace of mind

· Keeps you from “falling asleep”

· Determines winning percentage

· Wide stops are usually best because they will tend to provide a higher percentage of winning trades

· Tight stops can be bad because they often cause us to exit trades that would eventually be profitable

Initial stop advice: Plan to start with wide stops and then move stops higher. Exit priorities (Number two) - Trailing stop loss (May be same as initial stop if initial stop moves upward over time.)

· As your trade becomes profitable the trailing stop moves up to gradually reduce your risk.

· The trailing stop will allow you to lock in a break-even point.

· The trailing stop will gradually start locking in a small profit. Trailing stop advice: Be patient at the beginning of the trade and don’t try to raise the stop too

fast. Exit priorities (Number three) - Protect your open profits

· Decide a specific level at which point you will begin to protect some portion of your open profits with a stop that is tighter than your previous trailing stop. Here are some ideas on when to start using tighter stops:

· When open profits reach twice your initial risk.

· When open profits reach four or more ATRs.

· When open profits reach 25% of the capital invested (or pick any percentage that makes you feel the trade is worthwhile).

Advice: Try to give the trade a reasonable amount of room so that the profit still has a chance to grow. What is a “reasonable amount”? For example – you might want to risk up to 25% of your open profit in hopes that you open profit may double. Another definition of “reasonable amount” would be to risk one ATR. Exit priorities (Number four) - Take large profits efficiently

· Never let a large profit turn into a small profit.

· The bigger the profit the tighter the exit.

· You need to have some practical definition of “large profit” so you will know when to start guarding it very closely or even exiting on strength.

· The definition of “large profit” is a very personal definition and will vary according to your personal trading objectives and your preferred time frame for trading.

Most common exit mistakes: Initial stop is set too close

· The initial stop should allow plenty of room and give the trade a chance to become profitable.

· Wide stops at the beginning of the trade will lead to a high percentage of winners and more total profit in the long run. As nice as it sounds to have very small losses, that strategy doesn’t work for most traders.

· Those small losses tend to add up fast. Profit taking exit is set too far away

· Once a trade has become highly profitable the majority of the profit needs to be protected.

· Remember - the tight stop is used at the end of the trade and not at the beginning. Unfortunately most traders get this backwards. They risk too little at the beginning and give back too much at the end. This leads to a pattern of many small losses and an occasional small winner. That is not a pattern for a successful trader.

Average True Range (ATR)

Definition of ATR – Average True Range is the largest of the following:

· The difference between today’s high and today’s low.

· The difference between today’s high and yesterday’s close.

· The difference between today’s low and yesterday’s close.

· True range is always considered to be a positive number. Benefits of Average True Range

· ATR adapts to changes in volatility

· ATR works same on a $2 stock or a $200 stock

· ATR works same across markets - yen, soybeans, gold, stocks, bonds, etc.

· Use ATR whenever possible to make systems adaptive and robust

· ATR works particularly well for setting stops and deciding profit objectives

· ATR has many other uses – it can even be used to identify trends The “Chandelier” Exit

· Most trailing exits come up from underneath prices and are based on previous low points

· The focus on low points causes these exits to lag badly when prices are rising strongly

· The Chandelier exit is effective because it hangs down from the high point of the trade

· The Chandelier exit moves up proportionally whenever a new high is made Setting up the Chandelier Exit

· The stop is set 3 (?) ATRs below the highest high (or highest close) since the trade was entered

· The stop moves upward whenever a new high is made

· The “chain” on the “Chandelier” will contract and expand slightly as the ATR adjusts to changes in volatility

Adjusting the “Chandelier” Exit

· We usually start new trades with the default ATR of 3. (High minus 3 ATRs)

· As the trade moves in our favor and becomes profitable the exit moves up

· At some point of profitability we will no longer want to risk 3 ATRs so we will shorten the “chain” on the Chandelier by reducing the number of ATRs

· Example: After we have reached 4 ATRs of profit we will reduce the “chain” to only 2 ATRs

Summary:

· Exits determine the outcome of our trades

· You will probably need multiple exit strategies to do the job properly

· You need an initial exit to protect capital and determine position sizes for your trades

· You need a trailing exit to reduce risk as market moves in your favor

· You need an exit that attempts to protect and to maximize the profits

The Real Secret of Millionaire and Billionaire Traders

Here are some quotes from some great traders and investors:

“I haven’t met a rich technician” – Jim Rogers.

“I always laugh at people who say “I’ve never met a rich technician” I love that! Its such an arrogant, nonsensical response. I used fundamentals for 9 years and got rich as a technician” – Mary Schwartz.

“Diversify your investments” – John Templeton.

“Diversification is a hedge for ignorance” – William O’Neil.

“Don’t bottom fish” – Peter Lynch.

“Don’t try to buy at the bottom or sell at the top” – Bernard Baruch

“Maybe the trend is your friend for a few minutes in Chicago, but for the most part it is rarely a way to get rich” – Jim Rogers.

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.” – Paul Tudor Jones.

So here we have a group of guys who have collectively taken billions of dollars out of the market and they don’t agree on a damn thing regarding how to make money. Not one. So what is a person to do? Is there anything they do agree on? Just one:

“My basic advise is don’t lose money” – Jim Rogers.

“I’m more concerned about controlling the downside. Learn to take the losses. The most important thing about making money is not to let your losses get out of hand.” – Marty Schwartz.

“I’m always thinking about losing money as opposed to making money. Don’t focus on making money, focus on protecting what you have” – Paul Tudor Jones.

“Rule number one of investing is never lose money. Rule number two is never forget rule number 1″ – Warren Buffet.

There really are a lot of ways to make money in the market. There are tons of seminars you can pay for that will tell you “How I made $1 katrillion dollars in the stock market” and its sister book “How I Double my Money Every Hour” is available in many different forms too for only $29.95. All of these will tell you some patterns that will work sometimes and won’t others. Some might have you going long with Jimmy Rogers, while others will have you doing it with Bernard

Baruch, but when it gets right down to it the most critical part of making money, is not losing much. You’re always going to take stops and lose some. But you don’t want to lose much, because you won’t make a penny tomorrow if you go broke today.

One of the most common mistakes traders will make is that of “risking the whole wad”. There is not a faster way to have bad things happen to you than to do this. Studies have been done that suggest the most you should risk on any one trade is 2%. And most pros will tell you that is way too much and they risk 1/4 % to 1% on each trade. The idea here is that no one trades is going to really effect you either way. You’re not going to get rich, but your also not going to have to sell the house, as has happened to people.

One other benefit of small positions is that it allows you some freedom from worry. If you are risking a fairly small amount, you're not going to get shaken out. You’re also not going to find yourself in a position where you say “Shesh, I can’t lose this much money” and you turn bad trade into a terrible investment. So, if you are serious about this, if you want to make it long term you will practice sound money control. Before you ever enter a trade, the first thing you should ask yourself is how much am I risking here because, remember that while we are here to make money, we won’t make any if we go broke.

The key to not going broke is to respect risk, take small positions that won't allow you to blow out. You must always keep in mind that in trading you are only playing the odds. You may have a setup that is correct 75% of the time but each trade is a random event. It doesn’t take into account the last trade. If you have a 75% system, you can still be wrong 10 times in a row, and if you trade for any amount of time it will happen.

I once thought I had a foolproof way to make money at roulette. I would bet on black and red. I would sit at the table, and after the ball had landed on black or red 5 times in a row I would start to bet on the opposite color (so if it were 5 reds in a row I would start to bet on black) Then, if I was wrong, I would go ahead and double down, meaning that if my starting bet is $1, the next time I will be $2, then $4, then $8, then $16 ect. Eventually I would win, and would come out $1 ahead. So I am 13 years old and really thinking I have the Holy Grail. If its so easy for a 13 year old to figure out, why is it that all the casinos are not out of business and we are all millionaires Simple. It does not work.

If we are flipping coins heads has a 50% chance of turning up on each roll, and so does tails. But each flip is independent of the last. The last coin toss has nothing to do with the one before it. It’s a random event. There is a certain chance heads will occur on this roll, or that tails will. But which of them it is that comes up is a random occurrence. Each time you flip a coin it is one flip of a coin amongst the billions of times coins have been flipped. That’s why you can roll 100 heads in a row if you do it long enough. That’s why the first time I played roulette black came up 19 times in a row and I went home defeated.

Trading is the same. We have a certain percentage of our trades that will work out, and a certain percentage that will not. But your next trade has nothing to do with your last one. So even if you have the world’s most accurate method, over time you will go broke if you don’t practice good money management and risk control.

So now that we all understand why money management and risk control are very important lets cover exactly how to apply these rules to your trading. As I stated before, you shouldn’t ever risk more than 2% of your account on one trade. But, as I also said, that’s a bit much for most people and I’m in that group of most people. I like to keep my risk to around 1%. So lets focus our attention on risking 1% of your account on a trade. For the sake of this example let’s just assume you have a very average account size, $25,000:

Say you are scanning tonight and come across XYZ which looks like it might be a great swingtrade buy if it trades at 15 3/16. The low of the prior day is 14 1/2. This means you will place your stop at 14 7/16, risking 3/4 of a point on this trade. Assuming a $25,000 trading account you can lose up to $250 per trade. You will use this number to determine how many shares you can buy, which in this case is up to, but not more than 333. Most people don’t like to do odd lots, so would round down to 300. Never round up because then you throw the risk control out the window.

Let me leave you with a few more quotes on risk control:

“If you have an approach that makes money, then money management can make the difference between success and failure… … I try to be conservative in my risk management. I want to make sure I’ll be around to play tomorrow. Risk control is essential.” – Monroe Trout

“If you personalize losses, you can’t trade.” – Bruce Kovner

“The best traders have no ego. You have to swallow your pride and get out of the losses.” – Tom Baldwin

“Never risk more than 1% of your total equity in any one trade. By risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.” Larry Hite.

While all of these guys have different methods for making money, each of them agrees that risk control is the single most important aspect of trading. These individuals are the best in the world and the only thing they agree on is risk control. Think about it…