"Know your game well"- Every trader's edge

Hello forum mates,

This is a compiliation of about 25 valuable lessons on the subject. This I wanted to share with you all.

LESSON 1 - KNOW YOUR GAME.​

A key to making the rules work is an understanding of the psychology behind the Rules, knowing where they work best, and knowing if that is congruent with our personal trading style. The psychology behind the rule is what it is, in part, because the psychology of the market itself is what it is. I dont think we can make our rules work at their best without a solid understanding of this underlying market psychology.

Critical to that assessment is understanding our own personal psychology. No matter where you personally are on the scale of trader evolution or your application of your developing skills, you will eventually discover that your own personal psychology is by far the single most important variable to your lasting success as a trader. Indeed, only a trader who accepts this point of view about his own psychology will be able to
successfully make his trading rules workbecause the rules are selfcreated, self-enforced, and self-defeating. Without a solid grasp of both market psychology and personal psychology, your results will most likely be net losses, even if you have a winning systematic approach and good rules.

Regardless of your current level of sophistication or trading background, there is one indisputable fact about the underlying structure of trading markets that you need to thoroughly understand before you place yourself at risk. Futures, options on futures, and cash foreign exchange (FOREX), the markets most readers will be trading are all zero-sum markets.

The price action and cash management take place in an environment where no money is ever made or lost; gains or losses accrue as a cash debit or credit between accounts on deposit after trades are cleared. In other words, a winning trade is paid its cash credit from the exact opposite losing trade. The clearing corporation of the exchange simply assigns a cash credit to the account with the winning trade and assigns a cash
debit to the account with the losing trade.

In the final analysis, it is the losers who pay the winners. You cannot accrue a cash credit increase in your trading account unless some other trader (or group of traders) somewhere, trading through the same exchange with you in the same market, has lost the exact same amount. In order for you to make $10,000 from your trading, someone else (or a group of someone elses) had to lose $10,000. You cant participate in Zerosum trading without accepting that risk.

It is the very nature of zero-sum transaction trading that makes using and applying trade rules so critical to lasting success. If you personally dont know enough about what you are doing, or the risk you are really taking, you will be the loser who pays some other winning trader. The market does not function any other way.

Lets take a look at the psychology behind price action. I believe this is much deeper than the simple fact that for every winning trade there is a loser. Zero-sum trading presents some fascinating insights into crowd behaviour and what is really needed or required to exploit price action profitably.

Lets start with the basics:

Buyer→ $2.33 ←Seller
You enter a buy order to open a position in corn at $2.33/BU. In order for you to receive a fill on your buy order, it must be matched against a sell order at that price. For the sake of illustration, lets assume there is also a sell order to open a position. Therefore, two separate traders have put themselves at risk, and a new long position and a new short position are now active. What happens next?

Another set of orders comes in, and those are matched, but if at that moment there is an imbalance in the order flow, the market is requoted to reflect the imbalance. In other words, if there are more buy orders left over after the sell orders are matched, the market ticks higher and is matched with sell orders at higher prices, if they are there. The remaining buy orders are then matched at that new higher price. If there are more buy orders left over again, another tick higher results.

Of course, this illustration is conceptual. As most traders know, those buy and sell orders are constantly coming in and are combinations of stop orders, limit orders, and market orders from both sides; the mix is always changing. What we are concerned with is the pressure on the price as the net order flow is processed from one moment to the next. If the order imbalance remains on the buy side, the market will continue to tick higher until the imbalance is corrected and the buy/sell orders are about evenly
matched again. If, at that point, the sell orders overwhelm the buy orders, the market will begin to tick lower and will continue to do so until the buy and sell orders again become about evenly balanced with the sell orders.

The ebb and flow of price action comes from these order imbalances, and what we call an uptrend or downtrend is in reality a net imbalance lasting for some period of time.

So lets assume after a period of time, the net order imbalance for that period of time has resulted in a new price for corn at that point:

→ $2.38/BU ←

Your open-trade long now has a profit of $0.05 per bushel. The open short from your executed order (the other trader speculating) has an open-trade loss of exactly the same $0.05 per bushel. If, at that exact moment, both of you choose to liquidate your positions, and your orders offset each other at that point, your account will be credited and his account will be debited the exact same dollar amount (less any fees, of course).

This is all easily understandable, but there is a completely other world at work in that process. That other world is the psychology of the traders involved and how that creates their urge to action resulting in them placing the orders in the first place.
What is not immediately apparent in price action is perceptionhow that net credit or debit is affecting the account holder, what that account holder is thinking, and what he must do next. What is certain is that at some point, both traders must liquidate; no one can stay in the market forever.

When the losing position is liquidated at some point, the losing trader must do an equal but opposite trade against himself. In other words, if I have bought the market, and prices are moving lower, I must sell to liquidate my loss, adding power to the dominant force in control of the market at that point. My mental and emotional state is in direct conflict with my desire for a profit, and my only choice really is to liquidate
now or risk a bigger loss. If I wait it out I am trying to anticipate the market will reverse and eventually show a profit on the trade for me (thereby making a loser out of the original short who initially had the open-trade profit).

But all of this thinking or emotion is going on inside my mind and has nothing to do with what is driving the market. In order for prices to advance or decline, there must be more orders on that side of the market Prices can advance only if there are more buy orders than sell orders at that moment. Prices can decline only if there are more sell orders than buy orders at that moment. How that order flow personally affects my
account balance or my emotional state does not concern the net orderprocessing function of the market. In any attempt to profit from any perceived opportunity in a zero-sum transaction market, you simply must be on the right side of the eventual net order flow from that moment forward until you liquidate. If you are on the wrong side of the net order flow, you will have an open trade loss until you liquidate.

None of what happens inside the mind of the trader during that time can affect the market in any way; it can only affect the net balance controlled in some way by the trader in some way. This is why you must have rules and know how to follow them. You cannot know for certain until later, after you enter your position, whether you are on the right side of the net order flow.

The important thing to remember is that there is an emotional pressure at work in most traders that will influence their perception of price action. They all entered their trades expecting to win, but in most cases they will have to consider liquidating at a loss. All of the emotional or psychological stress involved in trading boils down to When do I get out?

Because the owner of the winning position has a lead on the market, he is under less of this stress than the loser. In most cases, when the pain of holding the losing hand gets too big for the losing trader, he will liquidate in the same direction as the winning position. A simple example is a market slowly advancing higher as more buy orders overwhelm the sell orders, until the market hits the liquidating buy stops above the market placed by the sellers who are holding a losing position. The market now
advances further on that buying pressure.

None of the above-described background to price action has anything to do with market study, risk control, trading systems, or technical analysis. It has to do only with the fact that if you are going to be in the market, you run the risk that you will be on the wrong side of the order flow. What does that do to the traders emotions? What will he do? What will you do?

Because you cannot profit consistently in a zero-sum market unless you are on the correct side of the order flow, your entire analysis and trade plan must take into consideration some way to identify where the order flow is and what to do if you are on the wrong side of it. The issue of cutting losses is essentially to have some method of negating any emotional conflict created by a losing trade, in such a way that you will not hesitate to get out of the way of the actual order flow if you are on the
wrong side of it. Part of how you participate on your trade, regardless of your unique approach to finding a trade opportunity, must always answer the question: Where is the order flow? Most of the studies done on net trader performance come to the inescapable conclusion that around 90% of traders will close their accounts at a net loss. None of those traders expected to lose, and yet they did. Part of their losses came from the emotional conflict created in their minds when the market moved against them, creating pressure on their execution.

Every trader has had the frustration of finally throwing in the towel and liquidating his position, only to see the market reverse shortly thereafter and prices move favorably, if only he had stayed in. All that really happened is that the order flow dried up in one direction and then turned the other way. For that particular trader it resulted in a net loss to his account. That particular trader will now be tempted to just ride it out on
the next trade until prices eventually return. Of course, the one time this doesnt happen will result in a total loss in the account. It only takes one just ride it out to ruin that particular trader.

To avoid being that trader, and to master the game of successful speculation, you must know what you are really capitalizing on when you identify a trade opportunity. You must accept and trade from the point of view:

Where is the order flow? and you must have a method of getting out of the way when you are not on the right side of the order flow. All the analysis or study you could ever do must answer these two central questions.

One assumption you can make to know your game is that most traders do not know the game they are playing. About 80 to 90% of price action is simply the losers liquidating their losing trades. When you begin each day, and before you place a trade, ask yourself this question: Where is the loser?

In the final analysis, the game you are playing is Beat the Loser. The great trader J. P. Morgan said it best: Anyone who is unaware of the fool in the market probably is the fool.

LESSON 2 - PLAN YOUR TRADE​

I have had the privilege of seeing almost everything there is to see in the business of trading. I have met some very well-known traders, big names in business or finance; Ive been on several trading floors, visited the trading pits numerous times, worked side-by-side with some tremendously successful market participants, and seen all the catastrophes, mayhem, blowouts, and financial blunders capable of novice traders. I have asked all the right questions and all the wrong questions. In my experience, I have to say that there was very little critical difference between the net winning traders and the net losing traders in most areas. All of them had good understanding of basic market fundamentals, used a solid technical analysis or research of some kind, and exercised a lot of
personal discipline.

The one thing that stood out, the one thing that separated the net winner from the net loser, all things being equal, was that the net winner had a trading plan in addition to his other skills. The net winner knew he was up against not just the market and his competitors, but he was up against himself, too. To guard against the possibility that he (the trader) could blow himself out of the water at any time if he wasnt careful, that trader had a plan.

A trading plan is different from a trading system. A trading system is designed to find an inequality in the market and offer a better buy or sell entry than at some other time. A trading plan takes into account what happens after that. Once we have identified what we think is an opportunity, it is how we participate from that point forward that makes all the difference. A trading plan will address and Complement a systemized approach much better if it is seen as an equally important part of a strong market presence.

A trading plan addresses the parts of trading that are most fully in your control. For example, when and where you do your market study or analysis; when and where you place or move a stop-loss order; when you take a trading breakbasically anything that involves you taking action or not taking action, independent of the actual market itself, is spelled out in a trading plan.

A trading system is only designed to exploit perceived inequalities in the market, but it can never be 100% accurate or find exactly where every potential top or bottom is in the time frame you are working with. If a system could do that, no other discussion of rules would be needed. Once you have executed and placed yourself at risk, you have moved into the area of your systems probabilities and limitations. You as an individual cannot extend control over price action; you can only control how you use price action or how you participate in price action. Once the trade is taken, the die is cast so to speak. Whether you win or lose at that point is completely out of your control.

Because your system is not capable of finding each and every turn there is to profit from in real time, a trading plan is needed to prevent you as a trader from getting reckless or from placing yourself in lower-probability trades, and what to do when the unexpected happens. A trading plan needs to address your particular trading strengths and weaknesses; it in no way diminishes the need for a systemized methodology, nor is it designed to replace one.

Your trading plan can be followed 100% of the time because it is an expression of the sum total of what your rules are designed to create; it controls your behavior, which is a function of discipline and willingness to follow those rules. Your trading system may never be more than around 55% predictive in finding winning trades, but you can follow your trading plans rules 100% of the time. When your trading system is wrong, your trading plan will help you minimize the loss. When your trading system is right, your trading plan will help you maximize the gains.

A qualified trading plan is both concise and flexible. It adapts to market conditions as needed and is concerned with protecting the trader. You can think of a trading system as strategic and a trading plan as tactical. To use a military illustration, winning the war is the goal, strategy involves finding the enemys weakness, and tactics are how you exploit that weakness.

Think of your trading system or methodology as a strategic attempt to consistently find a weakness in the market and exploit it. It really doesnt matter what it is; it simply needs to be consistent. Your trading plan is more like the ifthen tactical response to conditions as they change in real time and as you learn more about a particular trades potential as it develops. Your trading system is designed to help you find the edge; your trading plan is designed to help you keep your edge or recognize when you dont have it at a particular moment.

Your trading plan is where your rules are used to maximize your winning advantage when you have it and minimize your losses when you dont. What is never in question is that winning the war involves both strategy and tactics; sometimes tactics save the strategy, and sometimes the strategy needs very little tactics. Knowing this balance is also important because, as we discuss later, all analysis of the markets will have a strategic advantage but also a strategic limitation. Your trading plan gives you the tactical advantage of knowing which strategy will work best, under which conditions, and what is most likely to be your best initial move to keep pushing your advantage into more and more profitable positions.

The major goal is, of course, to cut losses and let profits run.

SO HOW DO I CREATE A SOUND TRADING PLAN?

Every trader must make several critical distinctions when creating a sound trading plan. We discuss some of the more crucial aspects in greater detail throughout each rule in the book but there are several initial ones you can focus on to start creating your unique trading plan.

Starting from the assumption that you cant participate at all if you lose too much of your trading capital, the first concern is how to minimize your participation when you are losing. This is different than cutting your losses. Cutting losses is part of your trading system and after you have had a significant amount of those individual losses for you personally it is time to consider a few things. First, are you using the system or methodology correctly? Part of your trading plan should be a regular reassessment of whether you are fudging on the system in some way. Are you taking trades the system wouldnt take? Are you hesitating on taking every signal? Are there some trades in there that you waited on and
were late?

A solid trading plan is a guideline to help you maintain focus. Your first and best clue that you are not maintaining your best trading focus is a series of losses that are outside the limits of the trading systems probabilities.

At that point, you as the trader must decide what your rules are when you are experiencing an irregular drawdown. Some of the better things to do include taking a step back and observing if the market itself is operating in a manner that is no longer consistent with the trading system or method hypothesis. If you are using a trend-following strategy, suppose the market is no longer trending? A trend-following system will get chopped to pieces during a period of consolidation. What is your plan for a tactical change at such a time? Only you can answer that question completely but the theme of your trading plan must consider a what if scenario for the outside chance that the quality of the market has changed enough to lower the probability of your system performing. Part of your trade plan is some method of standing aside.

There are times in every traders life when the worst possible thing that trader could do is participate. Your trading plan should address the possibility that outside life issues or pressures can influence your ability to trade well. What can you do to protect yourself when your emotional or mental sharpness is potentially dropping? When you lose control of your focus, you run the risk of missing a critical piece of information about the market structure at just the wrong point, creating a loss. Your trading plan must address your personal and emotional needs as well as the financial risks you are taking. It might be a good idea to plan regular trading breaks from time to time, regardless of how you are doing in the markets. If you are planning a major life event such as getting married or sending one of your children off to college for the first time, your trading plan should address those needs in such a way that will prevent you from getting careless.

All traders at some point have had something throw them off, and if they continued trading at that point, in most cases that stress or pressure affected them negatively as far as their trade selection and execution are concerned.

Everyone has heard the stories of the lucky individual who won a large amount of cash in a state lottery. Suddenly, without any advance warning, some fortunate soul has several million dollars in cash. Being completely unprepared for such an event, many of these people have made serious financial mistakes with those monies and in the end, were worse off financially than before they had won that money. Your trade plan should also address how to participate best if you are doing well at some point. A large degree of financial success can have a negative impact on a trader just as easily as large losses can.

To ensure your continued success it would be wise to adopt some method of reducing your participation until you have mentally and emotionally processed that success. There is a temptation to think that what created your success and the size of that success can easily be duplicated and will always be the state of your trading. This happens a lot to new traders with little experience who, unbeknownst to them, were just lucky.

They make a large amount of cash by accident and confuse that with true trading skillor worse, think they have found the perfect system. If they are not careful, their lack of skill will cause this trader to give it all back plus more. Additionally, this trader will not be sensitive to the possibility that the quality of the market has changed and his system is no longer effective, nor will he know when it might become effective again. Your trading plan should address what to do when you are far enough ahead to create a possible problem for yourself. In other words, what do you do if your money gets bigger than your head? If you are thinking along these lines, you are beginning to draw the conclusion that all of the rules we discuss here, together as a group, are where your trade plan initially comes from. In the final analysis, your trading plan is a reflection of your willingness to properly use the rules when you need controls on your behavior. Your rules can change and your trading plan can continue to evolve, but your willingness to consider your side of the ledger equally as important as your trading system is the key to writing an effective trade plan. Following is an example of what I would consider to be a well-written trading plan.

My goal is to earn 100% on my trading equity before the end of the year. To maintain my focus I will set a near-term goal every quarter to be at a 25% gain and I will plot my equity daily. If I reach my quarterly goal ahead of the last trading day of the quarter I will take a two-day break. I will hold any open positions that are at a profit but any open trade losses I will close at that point before I take a break.

If my open-trade gains continue into the new quarter I will add to those winning positions by a factor of 25%. I will move my protective stops up to reduce my exposure on the entire position.

If I am behind on my trade goal for the quarter, I will take a fiveday break. I will reevaluate my trade system and ask the question:

Has my market quality changed to something in which my system is not able to perform at its best?

During the year I will not trade more than three markets. I have learned I cannot focus well on more than three markets at a time. If I have more than four losing trades in a row in any of my three markets I will take a trading break for five days. Again, I will leave open position winners alone in the other markets but close all losing positions. I will again roll protective stops to reduce my risk.

When I take a trading break, I will enter resting limit orders in the open-trade winners to take the objective profit should I be unavailable and the market reaches those levels during my break.

If I am ahead of my plan for the year at any point I will take a break. I will take 30% of the new equity out of my account and place that into a secure place. If I am behind I will not add equity under any circumstances. If I reach a 40% drawdown from my high equity I will quit for the year.

I will record my daily trade activity in my trading log and review this weekly. I will know my ratios and results; I will look to improve them by 5% each quarter. I will trade only from the bull side because my analysis tells me that all three of the markets I have selected have more than a year of solid bullish fundamentals. I will learn how to use options this year because I see from last year I could have protected more trades if I had a solid grasp of when to use options and when not to. I will invest two hours a week on option knowledge.

My son is leaving for Europe in May. I will not trade the week before he leaves or the week after. I plan to join him in the fall for Oktoberfest for one week and will not trade the three days before I leave or when I get back. I know I suffer from jet lag so the week after I am back I am not at my best. I have blocked out these times on my trade calendar so I will not be tempted to trade anyway.

This was an actual trade plan written by a friend of mine who trades Emini futures. He uses a simple technical approach and has a very thorough risk control method. His trading plan addresses the need for 100% personal discipline. Notice that it makes no mention of the technical approach he uses. The approach is his strategy. His plan specifies how to maximize his side of the equationthe tactical advantage he personally needs.

When developing your own trading plan, remember that your systemized methodology wont have 100% winners no matter how you slice it. The one thing you always have 100% control over is your participation. Your trading plan should focus on your participation, not your execution.