Think and trade like a champion pdf

defining yourself, 12–13delay, 14–15detachment, 218diaphragmatic breathing, 220Dick’s Sporting Goods (DKS), 163, 164differential disclosure, 99disaster plan, 25 See also contingency planningdiscipline, 45, 52, 113–114, 225–226 and confidence, 230–231 developing sit-out power, 111–112 forcing trades, 111 marching to your own drummer, 109–111diversification, 169–170, 173–175 and superperformance, 205–207 See also position sizingdi-worsification, 173–175double bottom, 163–164downtrends, 156dream pattern, 160–163DryShips Inc. (DRYS), 194, 195Duhigg, Charles, 222Dwyer, Wayne, 110early stage exception, 199–201earnings reports, holding into, 108–109eBay (EBAY), 144eggs, 28–30ego, 51, 214embracing the process, 10–12Emerson, Ralph Waldo, 16emotional forcefield, 218emotional stop-loss, 45emotional triggers, 86emotions, 214 of selling at a profit, 178–179excuses, 89–90exit point. See stop-lossesexpectancy, 61 science of, 57–58expectations, how to set, 61–62exposure, adding without risk, 66–67extended stocks, when not to sell, 32–34failure, building in, 57fear, 178, 218–220 and paralysis, 231 putting the chart into perspective, 179–180 of regret, 69feedback loop, 88–89follow-through buying, 27follow-through count, 31–32forcing trades, 111free roll, 197gain/loss ratio, optimal, 59, 60gains, average gain, 74–75gambling vs. investing, 68–69 Two for the Money, 5–6getting odds, 104Google (GOOGL), 34, 159GoPro (GPRO), 138–139Green Mountain Coffee Roasters (GMCR), 192Green Plains (GPRE), 29, 66Greene, Robert, 228Gupta, Rajneesh, 33healthy habits of trading, 87–89Heebner, Ken, 206high tight flag. See power playholy grail, 60–61Home Depot (HD), 163hope, 21–22How Charts Can Help You in the Stock Market (Jiler), 160–161Humana (HUM), 155IBD. See Investor’s Business Dailyideas, 16Immunogen (IMGN), 106indecisiveness, 41–42, 178information overload, avoiding, 226–227initial stop-loss, 23 See also contingency planning; stop-lossesinvesting, vs. gambling, 68–69Investor’s Business Daily (IBD), 140–141, 162involuntary investors, 46–47Isis Pharmaceuticals (ISIS), 64JetBlue Airways (JBLU), 157Jiler, William L., 160–161“just this one time” moments, 93–94Katie, Byron, 229knowing, 16knowledge, stages of, 16–17laying odds, 104lessons learned, 221line of least resistance, 125, 133Livermore, Jesse, 46, 125lockout rally, 153–154longevity, 104–105long-term uptrends, 115, 123losses, limiting, 47low cheats, 158–160lower lows, 35–36luck factor, 112–113Lululemon Athletica (LULU), 30Lumber Liquidators (LL), 38, 95, 98, 185, 194, 195Lynch, Peter, 10managing stocks, 43market leaders, 142–151 holding after a run-up, 173 which leaders to buy first, 152–153mastery, 228, 233Mastery (Greene), 228Maxygen (MAXY), 158measuring results, 72–73Medivation (MDVN), 50, 196mental rehearsal, 218–219mental stop, 45mentors, 232Mercadolibre (MELI), 133, 134Meridian Bioscience (VIVO), 129–130Merrill Lynch, 22Michael Kors Hldg. (KORS), 123 vs. Coach (COH), 148–149Michaels Companies Inc. (MIK), 134–135Micron Technologies (MU), 41Microsoft (MSFT), 162Minervini, Mark, conversation with Jairek Robbins, 217–233mistakes averaging down, 91–93, 94 the “cheap trap”, 96–98 forcing trades, 111 “just this one time” moments, 93–94 snap decisions, 107–108modeling success, 8–9momentum, 33momentum, volume and price. See MVP indicatorMonster Beverage (MNST), 140, 190monthly tracker, 78MVP indicator, 33, 199natural reactions, 28, 33Netflix (NFLX), 30, 128–129, 145–146 vs. Blockbuster (BLOAQ), 146–147neuro-linguistic programming (NLP), 217, 222New USA Growth Fund, 32–34Newton, Isaac, Sir, 8NLP. See neuro-linguistic programming (NLP)One Up on Wall Street (Lynch), 10O’Neil, William, 32–34opinions, 214opportunity cost, 81–82optimal gain/loss ratio, 59, 60OuterWall Corp. (OUTR), 37overhead supply, 130–132pain/pleasure cycle, 225paralysis, and fear, 231paralysis-regret cycle, 41–42pauses, 156Pavlov, Ivan, 225Pavlov’s dogs, 225percentage ball, 67–68percentage of winning trades (PWT), 56performance four keys to generating big performance, 204–210 four keys to limiting drawdowns, 210–215 three deadly trader traps, 214personal bell curve, 80–81Pharmacyclics Inc. (PCYC), 166, 167Picasso, Pablo, 8pilot buy, 102pivot buy point. See pivot pointpivot point, 132–133 volume at the pivot, 133–135position sizing guidelines, 171 holding market leaders after a run-up, 173 over-diversification, 173–175 overview, 169–171and risk, 170–171 the two-for-one rule, 172positive mental attitude, supporting, 230post-trade analysis, 88–89Power of Habit, The (Duhigg), 222power play, 164–167practice, 10–12preparation for trading day, 220–222preparedness, 22, 113–114 See also contingency planningprice, 33price-to-earnings (P/E) ratio, 98 P/E expansion, 183–186priorities, 13–14 contingency planning, 25profit protection, 105–106protecting your psyche, 83–84pullbacks, 28, 29, 33PWT. See percentage of winning trades (PWT)Qualcomm (QCOM), 187ratio of wins to losses. See batting averagesrationalization, 51RBA. See Result-Based Assumption (RBA)RBAF. See Results-Based Assumption Forecast (RBAF)rebounder, 220–221reentry criteria, 23–24 See also contingency planningregret, 41–42, 178 neutralizing, 84relative strength (RS), 120, 140–141Result-Based Assumption (RBA), 62–63Results-Based Assumption Forecast (RBAF), 84–86return on investment (ROI), 59revenge trading, 213reversal recoveries, 39–41reward/risk ratio, 56–57 See also risk/reward relationshiprisk adding exposure without risk, 66–67 and position sizing, 170–171 respecting, 43 vs. reward, 55–56 why investors fail to limit risk, 69risk-first approach, 43 avoiding rationalization, 46–47 avoiding the emotional stop-loss, 45 backing into risk, 49 and discipline, 45 knowing what you control, 50–51 limiting losses, 47 vs. return-first, 44–45 setting the exit point, 44–45 trading near the danger point, 49–50risk/reward relationship, 209 See also reward/risk ratioRobbins, Anthony, 8Robbins, Jairek, conversation with Mark Minervini, 217–233RS. See relative strength (RS)rules. See trading rulesRyan, David, 32–34, 37, 122, 199safe stocks, 20saucer pattern. See dream patternscaling up trading, 102–103sell signals, 188–190, 193–195 signs of reversal and heavy volume, 191–192sell-half rule, 83–84selling at a profit, 24–25 base count, 180–182 climax top, 186–188 emotions of, 178–179overview, 177–178 P/E expansion, 183–186 putting the chart into perspective, 179–180 selling too soon or too late, 198–199selling into strength, 178–179, 211–212 specific things to watch for, 188–190selling into weakness, 179, 193–195selling rules the back stop, 197–198 the breakeven or better rule, 196–197 early stage exception, 199–201 the free roll, 197SEPA®. See Specific Entry Point Analysis (SEPA®)serial gapper, 122–123Seykota, Ed, 21, 169sit-out power, 111–112slot car racing, 71–72snap decisions, 107–108Southwest Airlines (LUV), 200Specific Entry Point Analysis (SEPA®), 8speculation, 60spreadsheets, 76squats, 39–41stages of a stock, 117–118staggered stops, 63–65statistics to track, 79stock charts Amazon.com (AMZN), 142, 188 Amgen (AMGN), 201 Apple Computer (AAPL), 151, 160 Biodelivery Science Intl. (BDSI), 40 Biogen (BIIB), 192 Bitauto Holdings Ltd Ads (BITA), 32, 126 Blockbuster (BLOAQ), 147 Body Central (BODY), 209 Chipotle Mexican Grill (CMG), 186Cirrus Logic (CRUS), 157 Cisco Systems (CSCO), 96 Coach (COH), 149 Crocs (CROX), 100 Deckers Outdoors (DECK), 183, 185 Dick’s Sporting Goods (DKS), 164 DryShips Inc. (DRYS), 195 eBay (EBAY), 144 Google (GOOGL), 34, 159 GoPro (GPRO), 138stock charts (continued) Green Mountain Coffee Roasters (GMCR), 192 Green Plains (GPRE), 29, 66 Home Depot (HD), 163 Humana (HUM), 155 Immunogen (IMGN), 106 Isis Pharmaceuticals (ISIS), 64 JetBlue Airways (JBLU), 157 Lululemon Athletica (LULU), 30 Lumber Liquidators (LL), 38, 95, 98, 185, 195 Maxygen (MAXY), 158 Medivation (MDVN), 50, 196 Mercadolibre (MELI), 134 Meridian Bioscience (VIVO), 130 Michael Kors Hldg. (KORS), 123, 149 Michaels Companies Inc. (MIK), 135 Micron Technologies (MU), 41 Microsoft (MSFT), 162 Monster Beverage (MNST), 140, 190 Netflix (NFLX), 30, 128, 145, 147 OuterWall Corp. (OUTR), 37 Pharmacyclics Inc. (PCYC), 166 Qualcomm (QCOM), 187 Southwest Airlines (LUV), 200 Tesla Motors (TSLA), 190 Twitter (TWTR), 160Valeant Pharmaceuticals International (VRX), 121 WageWorks (WAGE), 36 Wal-Mart (WMT), 150 Weight Watchers (WTW), 118 WR Grace & Co. (GRA), 201 Yelp (YELP), 28 Zillow (Z), 31stock corrections, 137stop-losses Average True Range (ATR), 58 emotional stop-loss, 45 initial stop-loss, 23 optimal stop-loss placement, 49 setting at the beginning, 44–45 staggered stops, 63–65 when to raise your stop, 65–66 See also back stopstress management, 224Stubborn Trader indicators, 79style drift, 12–13, 227success modeling, 8–9 small successes leading to big successes, 102–103superperformance, 203 four keys to generating big performance, 204–210 four keys to limiting drawdowns, 210–215 three deadly trader traps, 214superperforming stocks the 3-C pattern, 154–155 lockout rally, 153–154 making new highs, 139–140 market leaders bottom first, 142–151 and relative strength, 140–141 which leaders to buy first, 152–153supervised learning curve, 232T. See volatility contraction pattern (VCP)taking action, 14–15taking responsibility, 89–90Taking the Leap: Freeing Ourselves from Old Habits and Fears (Chödrön), 4–5tale of two wolves, 4–5Talent Code, The (Coyle), 11TBA. See Theoretical Base Assumptions (TBA)technical footprints, 126–127 See also volatility contraction pattern (VCP)tennis balls, 28–30Tesla Motors (TSLA), 190Theoretical Base Assumptions (TBA), 61–62Thoreau, Henry David, 109tightness in price, 125–126timing, 204–205Trade Like a Stock Market Wizard (Minervini), 1, 177trader traps, 214traders, types of, 4–5trading directionally, 214trading plans 20-day line, 35 assumptions and expectations, 26–27 avoiding the paralysis-regret cycle, 41–42 building in failure, 57 contingency planning, 22–26 follow-through buying, 27 have a process, 20–21 and hope, 21–22 key elements of, 21 lower lows, 35–36 multiple violations, 38–39 negative developments, 34–39 room to fluctuate, 60–61 volume action, 36–38trading results, 73keeping a journal, 75 keeping yourself honest, 73–75 measuring results, 72–73 monthly tracker, 78 personal bell curve, 80–81 spreadsheets, 76 statistics to track, 79trading rules, 52–53 50/80 rule, 94–96 the back stop, 197–198 the breakeven or better rule, 196–197 the free roll, 197 sell-half rule, 83–84 the two-for-one rule, 172trading small before trading big, 212–214trading strategies, 12–13trading triangle, three legs of, 76–77trampoline, 220–221trapped buyers, 130–132Trend Template, 118–120turnover, 81–82 and superperformance, 207–208Twitter (TWTR), 159–160Two for the Money, 5–6two-for-one rule, 172unbalance, 13–14Uncle Point, 80uptrends, 156Valeant Pharmaceuticals International (VRX), 121VCP. See volatility contraction pattern (VCP)visualization, 218volatile stocks, avoiding, 47–49volatility, science of, 57–58volatility contraction pattern (VCP), 27, 123–124, 205 how the VCP footprint works, 128–130successive contractions, 125–126 technical footprints, 126–127 what the VCP tells you, 132volume, 28, 33volume action, 36–38WageWorks (WAGE), 36Wall, The, 80Wal-Mart (WMT), 150Weight Watchers (WTW), 118Wilder, Welles, 58Williams, Ted, 56winning, the science of, 71–73winning stocks, characteristics of, 32WR Grace & Co. (GRA), 201wrecking balls, traders as, 4–5Yelp (YELP), 27Zanger, Dan, 37Zillow (Z), 31AcknowledgmentsFirst and foremost, I want to acknowledge the two most important people inthe world to me: my wife, Elena, and my daughter, Angelia. You inspire meeach day to be the best version of myself. My thanks to Patricia Crisafulli for her valuable input and editing, and toPatricia Wallenburg for once again doing a fabulous job with the book layout.Thank you, Bob Weissman, for working with passion about trading and doingyour best to ensure that our clients receive the highest level of service, eachand every day. A special thanks to those who travel from all parts of the world to attendour Master Trader Workshops, to our Minervini Private Access members,and to all my friends on Twitter. I hope this content means as much to you asit has to me throughout my life and career. To all my friends and family who have supported me over the years,especially my late mother and father—Lea and Nate—without whom nothingwould have been possible. Thank you all.Table of Contents

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He knew that doing the basics better than everyone else was how games werewon. The stock market is a great way to increase your wealth, and if you’redisciplined, your chances of success are very good. However, before you startthinking about the cars and boats you’re going to buy with the profits, you’dfirst better think about how you will avoid losing your principal. Not losingbig is the single most important factor for winning big. As a speculator,losing is not a choice, but how much you lose is. You’re going to makemany mistakes; we all make mistakes. A mistake isn’t a problem when weacknowledge it, deal with it, and learn from it. But, when we dig in andrefuse to budge, that’s when it all goes down the drain and little problemsturn into big problems. This is true in trading and in life. Long-term success in the stock market has nothing to do with hope orluck. Winning stock traders have rules and a well-thought-out plan.Conversely, losers lack rules, or if they have rules, they don’t stick tothem for very long; they deviate. Remember, always trade risk-first. This is the key rule that keeps you inthe game, playing long after the undisciplined, uninitiated, and unfocused areforced to the sidelines or driven to the poorhouse.SECTION 3Never Risk More Than You Expect to GainWith a flip of a coin you will be wrong just as often as you’re right, 50/50.But what if you could win two dollars on heads and only lose one dollar ontails? With those odds, you would want to flip that coin as many times aspossible, wouldn’t you? Let’s assume that you decide to limit your losses to10 percent maximum, because after that point the losses mathematicallybegin to work against you; the more you descend the loss ladder, the worse itgets. The question now is, have you adequately controlled your risk? Sometraders would probably say yes, that limiting losses at a maximum of 10percent sounds about right. But how can they know? More to the point, how can you know where youshould limit your losses if you only look at one side of the equation? Inorder to set an appropriate stop-loss, you need to know your averagegain, not just what you hope to make on each individual trade, but anumber you can reasonably expect to occur over time on average. You need actual numbers in order to accurately establish your risk versusyour potential reward. Here’s why: Suppose that while you are risking 10percent on the downside, your profitable trades average only about a 5percent gain. Do you really want to risk 10 percent to make 5 percent? Youwould need to be correct on almost 70 percent of your trades to just breakeven. But let’s say you average 10 percent on your winners and you only risk5 percent. Now you can be right on only one out of three trades and still notget in any real trouble.YOUR BATTING AVERAGERisk is not an arbitrary number. The amount you risk must be adjusted basedon the amount you stand to gain. Therefore, losses are a function of expectedgain. Although I infrequently get an outsized loss that goes much beyond myaverage parameters, I rarely take a loss larger than 8 to 10 percent. Onaverage, my losses are about half of that. Now let’s assume that, on average,my gains run about 15 percent. With these percentages—4 to 5 percent lossesand 15 percent gains, on average—it appears I’m keeping my risk in line. Toknow for sure, though, I need one more number: the batting average. As every baseball fan knows, nobody bats a thousand; even batting .500 isan impossibility. Ted Williams, who was considered the greatest hitter of alltime, batted just over .400 in his best season; his career average was .344.Admittedly, baseball isn’t trading, but it does give some perspective on thefact that even people who excel in their fields do not have a perfect trackrecord. Trading certainly follows that truth. In trading, your batting average is simply your percentage of winningtrades (PWT). Although your batting average is not something you havedirect control over—like cutting a loss—other than how well you choosewhat stocks to buy and when to buy and sell them, it’s an important numberand part of the calculation that will determine how much risk you shouldtake. To determine the appropriate percentage to risk, you need to makesure your losses are contained as a factor of your gains, because younever want to risk more than you stand to win. At a 50 percent batting average, you’re right as many times as you’rewrong, so to maintain a 2:1 reward/risk ratio, you need to keep your losses tohalf of your gains. However, at a 40 percent batting average, in order tomaintain the same 2:1 reward/risk ratio, your losses will have to be containedto one-third the level of your gains. For example:50 percent batting average10 percent average gain5 percent average loss 50*10/50*5 = 2:140 percent batting average15 percent average gain5 percent average loss 40*15/60*5 = 2:1BUILDING IN “FAILURE”Most people are surprised when I tell them I would rather be able to maintainprofitability at a 25 percent batting average than a 75 percent batting average.Why? Because it allows me to be wrong many times and still make money; itbuilds “failure” into the system. I try to build as much failure as possible intomy trading in the areas that I don’t have direct control over. You can’t controlyour batting average because you can’t control what a stock does after youbuy it. My way of governing the areas that I don’t directly control is not torely on them too heavily. My edge is maintained by keeping my losses at afraction of my gains. The smaller I keep my losses in relation to my gains,the more batting average risk I can tolerate, which means the more timesI can be wrong and still make money.THE SCIENCE OF VOLATILITY AND EXPECTANCYYou may have heard that when setting a stop-loss you should allow moreroom for volatile price action; you should widen your stops on the basis ofthe volatility of the underlying stock. I strongly disagree. Most often, highvolatility is experienced during a tough market environment. During difficultperiods, your gains will be smaller than normal, and your percentage ofprofitable trades (your batting average) will definitely be lower than usual; soyour losses must be cut shorter to compensate. It would be fair to assume thatin difficult trading periods your batting average is likely to fall below 50percent. Once your batting average drops below 50 percent, increasingyour risk proportionately to your gains will eventually cause you to hitnegative expectancy; the more your batting average drops, the soonernegative expectancy will be realized. A popular indicator that is used to set a stop-loss level is the Average TrueRange or ATR. It’s a measure of volatility introduced by Welles Wilder. Mr.Wilder originally developed the ATR for commodities, but the indicator isalso used for stocks and indexes. Simply put, a stock experiencing a highlevel of volatility will have a higher ATR or wider stop, and a low-volatilitystock will have a lower ATR or tighter stop. I am not a fan of the concept ofadjusting for volatility by widening your stop. Just because your gains arelarger than your losses doesn’t necessarily mean that you will make money,even if your wins are twice as large as your losses. Let me illustrate: At a 40 percent batting average, you make more moneywith 4 percent profits than with 42 percent profits (10 times more), assumingyou maintain the same 2:1 reward/risk ratio. This may sound hard to believe,but it’s true. Why? Because losses work geometrically against you. Once youunderstand this, you will learn one of the great secrets to profitable trading.Do the math! 40 percent batting average 4 percent average gain 2 percent average loss Gain/loss ratio 2:1This results in a net profit of 3.63 percent in 10 trades. 40 percent batting average 42 percent average gain 21 percent average loss Gain/loss ratio: 2:1This results in a net loss of 1.16 percent in 10 trades.NOT ALL RATIOS ARE CREATED EQUALAt a 40 percent batting average, your optimal gain/loss ratio is 20 percent/10percent; at this ratio your return on investment (ROI) over 10 trades is 10.20percent. Thereafter, with increasing losses in proportion to your gains, thereturn actually declines. Armed with this knowledge, you can understandwhich ratio, given a particular batting average, will yield the best expectedreturn. This illustrates the power of finding the optimal ratio. Any less andyou make less money; however, any more and you also make less money. If your winning trades were to more than double from 20 percent gains to42 percent gains and you maintained a 2:1 gain/loss ratio by cutting yourlosses at 21 percent instead of 10 percent, you would actually lose money.You’re still maintaining the same ratio, so how could you be losing? This isthe dangerous nature of losses; they work geometrically against you. At a 50percent batting average, if you made 100 percent on your winners and lost 50percent on your losers, you would do nothing but break even. You wouldmake more money taking profits at 4 percent and cutting your losses at 2percent. Not surprisingly, as your batting average drops, it gets much worse.At a 30 percent batting average, profiting 100 percent on your winners andgiving back 50 percent on your losers, you would have a whopping 93.75percent loss in just 10 trades (Figure 3-1).10 Trade Return on Investment (ROI)Figure 3-1 At a 40 percent batting average, the optimal gain/loss ratio is 20 percent/10 percent; anyhigher or lower and you make less money. At a 50 percent batting average, the optimal reward to riskshifts up to 48 percent/24 percent.REAL-LIFE APPLICATIONIf you’re trading poorly and your batting average falls below the 50 percentlevel, the last thing you want to do is increase the room you give your stockson the downside. This is not an opinion; it’s a mathematical fact. Manyinvestors give their losing positions more freedom, and as a result inflictmuch deeper losses. Their results begin to slip, and they get knocked out of ahandful of trades; then they watch the stocks they sold at a loss turn aroundand go back up. What do they say to themselves? “Maybe I should havegiven the stock more room to fluctuate; I’d still be in it.” This is just theopposite of what you should do. The only time I give my stock positions more room to fluctuate is whenthings are working well, then I may be a little more forgiving because a goodmarket will tend to bail me out from time to time. Conversely, in a difficultmarket environment, profits will be smaller than normal and losses will belarger; downside gaps will be more common, and you will likely experiencegreater slippage. The smart way to handle this is to do the following: Tighten up stop-losses. If you normally cut losses at 7 to 8 percent, cut them at 5 to 6 percent.Settle for smaller profits. If you normally take profits of 15 to 20 percent on average, take profits at 10 to 12 percent. If you’re trading with the use of leverage, get off margin immediately. Reduce your exposure with regard to your position sizes as well as your overall capital commitment. Once you see your batting average and reward/risk profile improve, you can start to extend your parameters gradually back to normal levels.THE “HOLY GRAIL”There is no certainty when speculating in the stock market—that’s why it’scalled speculation. Therefore, speculation is based on certain assumptions.When you buy a stock, you are hoping that others will soon perceive value inthe stock and buy the shares, creating demand that moves the price higher. Managing your reward/risk ratio requires relying on assumptions: Whatamount of reward can you expect versus the level of risk you are taking?Assuming you’re a 50/50 trader, if you are cutting losses at, say, 10 percent,with the assumption that your winners will rise 20 percent on average, butyour upside turns out to be only 8 percent—and not the 20 percent that youanticipated—you are obviously going to lose money over time because youhave a negative expectancy. Expectancy is your percentage of winning trades multiplied by youraverage gain, divided by your percentage of losing trades multiplied by youraverage loss. Maintain a positive expectancy, and you’re a winner. Myresults went from average to stellar when I finally made the choice that Iwas going to make every trade an intelligent risk/reward decision. Thefollowing formula is the only holy grail I know of:PWT (percentage of winning trades)*AG (average gain) / PLT (percentage of losing trades)*AL (average loss) = ExpectancyHOW TO SET YOUR EXPECTATIONSAs we discussed, your risk needs to be determined as a function of yourexpected profits; losses are a function of expected gain. Determining yourupside potential can be accomplished in one of two ways. One way is to useTheoretical Base Assumptions (TBA). Let’s say you foresee a big run in astock—a 50 percent move. Or maybe your expectations are somewhat moremodest, with a projected 20 percent gain. These numbers sound great; but isit realistic to assume that (A) the move will actually materialize and (B) youwill be able to capture it? The problem with the TBA approach is that there isno real-life evidence that you will realize these expectations. Have you in factbeen accomplishing this level of profitability consistently? You pick a stock that’s trading at, say, $30 a share, believing that it willrun up to its old high at $34.50, which would be a 15 percent gain. You wantyour potential reward to be three times the risk, so you put a stop in at $28.50—5 percent below your purchase price. This approach is based solely on atheoretical assumption: What you think should happen based on yourtechnical analysis of the stock, the way the planets are lining up, or someother reason you believe a stock can reach a particular level. You may reachyour target, or you may not. No matter how good your assumptions are,theoretical results are not based on reality, and they do not account for humanerror. Furthermore, emotions can cause you to override your own system. If you use TBA alone, I can almost guarantee that there will be a big gapbetween your assumptions and the truth of your results. It is better to dealwith reality than mere projections.THE RESULT-BASED ASSUMPTIONThe second way to determine your expectations is to use what I call a Result-Based Assumption (RBA). This means examining what you’ve gained, onaverage, on your actual trades. Let’s say that, over the past year, you’veaveraged 10 percent profits on your winning trades, and you’ve beenprofitable on half of your commitments. Can you afford to take a 10 percentloss? No, because you have no edge (based on what you generally produce inprofits). You need to limit your risk to a smaller percentage, such as 5percent. Or, if your average gain is only 4 percent, you will need to cut yourlosses at maybe 2 percent, which might be okay for a day trader. Using RBA,the amount of risk that you take is directly correlated with the actual resultsyou and your strategy produced; if you want to reap twice or three times thereward for the amount of risk, then you would determine that risk based onyour own closed trades. Using RBA to determine your risk takes discipline. Most traders set theirstops based on the crystal ball assumption: what they want to occur. Forexample, let’s say you believe a stock has the potential for a 40 percentreturn. Since you are a 2R trader—winning 2 units for each unit risked—youtell yourself you can set your stop at 20 percent below where you’re gettingin the market. Wrong! Your actual results show an average 10 percent gain.Your stop placement should consider those results, especially if they vastlydiffer from your theoretical-based assumption. Over time, as your actual performance improves, you can adjust your stopaccordingly. However, if your results worsen, you have to tighten your risk.You might be able to make really good assumptions and your theoreticalassumption on one trade or several trades may be excellent, and even workout as expected. But your performance is going to be driven by the resultsthat you are producing over time on average. Your actual resultsencompass not only your strategy, but more important, your foibles,idiosyncrasies, and emotions that often override a portion of even thebest laid-out plans. Whatever your strategies, whether you hold your position for an hour orseveral months, know your results and do the math. Based on that reality, setyour expectations for the next trade you make. Think of your average gain asa pace car that you ride behind, maintaining a certain distance.USING STAGGERED STOPSYou don’t necessarily have to set your stop-loss on your entire position at oneprice. You can use what I call staggered or bracketed stops and still mitigatelosses at your desired level, but have a better chance at maintaining at least aportion of your position in the stock should it move against you. If you wantto limit your risk at say 5 percent, you can set a 5 percent stop, and if it hitsthat level, you’re out. Or, a more conservative approach would be to set astop on one-third at a 3 percent loss, one-third at 5 percent, and one-third at 8percent. Your total loss would still be around 5 percent, but it would give youa chance to stay in two-thirds of the position above a 5 percent loss andmaintain one-third of the position down to an 8 percent stop. In the early stages of a new bull market, a new emerging leader couldmake a huge price move. If you give the stock more room on a portion of theshares, even a small position in a big mover could make a big difference inyour bottom line. The key to using staggered stops is to try to maintain yourline without getting knocked out of the entire position. I like to use staggered stops when I think a stock has a chance of making areally big gain and I want to have the best chance possible to stay in theposition. When market volatility is high and my stops are getting hit, Isometimes bracket my stops to have a chance at staying in two-thirds of theposition at my original stop.Figure 3-2 Staggering stops starts with establishing a level of risk and then bracketing around it. In Figure 3-3, the amount I’m willing to lose on the trade is 6 percent. ButI decided to play it a bit safe and bracket my stops around that number. Usinga 4 percent stop on half the position and an 8 percent stop on the remaininghalf allows the stock a couple more percent to fluctuate on half the position.My total loss on the trade is still 6 percent. You can also do this with cuttingyour stop into three trades or whatever combination you desire.Figure 3-3 Isis Pharmaceuticals (ISIS) 2014. +54% in two months. The stock pulled back 6.10percent, stopping you out completely if you used a 6 percent stop. By bracketing stops, selling half at 4percent and half at 8 percent, you maintained 6 percent risk, but stayed in half the position.WHEN SHOULD YOU RAISE YOUR STOP?I have some general guidelines as to when I raise my stop above the initialplacement. Any stock that rises to a multiple of my stop-loss and is above myaverage gain should never be allowed to go into the loss column. When theprice of a stock I own rises by three times my risk and my gain is higher thanmy average, I almost always move my stop up to at least breakeven. Suppose I buy a stock at $50 and decide that I’m willing to risk 5 percenton the trade ($47.50 stop for a $2.50 risk). If the stock advances to $57.50($7.50 profit = 3 × $2.50), I move my stop to at least $50. If the stockcontinues to rise, I start to look for an opportunity to sell on the way up andnail down all or at least some of my profit. If I get stopped out at breakeven, Istill have my capital—nothing gained but nothing lost. You may feel dumbbreaking even on a trade that was once at a profit; however, you’ll feel alot worse if you turn a good-size gain into a loser. I am also inclined tomove my stop up after the stock price experiences a natural reaction and thenrecovers to a new high. Move your stop up when your stock rises by two or three times your risk,particularly if that number is above your historical average gain (Figure 3-4).This will help guard you against losses, protecting your capital and yourconfidence.Figure 3-4 Green Plains (GPRE) 2014. +150% in eight months. The stock broke out and thenexperienced a natural reaction. The price then moved into new high ground, taking out the naturalreaction high and attaining a decent profit. That’s a good time to raise your stop.ADDING EXPOSURE WITHOUT ADDING RISKI like to try and make as much as I can on a winning stock position. As aresult, I get creative with the ways I pyramid and add to positions. My goal,as always, is to minimize risk and maximize my potential gains. Here’s how Iapply a trade management technique I call the Add and Reduce. In the example in Figure 3-5, I buy 1,000 shares of a stock at $16.50 andset a stop at $15.50, a $1 loss. This means I own 1,000 shares with $1,000 ofrisk. The stock then rallies and sets a new buy point. I then add an additional1,000 shares as the stock moves through the new buy point at $17.50, andthen set a $1 stop on the entire 2,000 shares at $16.50, doubling my sizewhile keeping the same $1,000 risk. What I’m doing is letting my profitsfinance additional risk. If my second buy was at $18.50 with the same $1stop, I would be doubling my size with zero risk of principal. This is how Ikeep my drawdowns low and make big returns by scaling into positions.Figure 3-5 Pyramiding technique uses paper profit to finance a scaled-up trade while keeping dollarrisk constant.ALWAYS PLAY PERCENTAGE BALL The public . . . demands certainties; it must be told definitely . . . that this is true and that is false! But there are no certainties. —H. L. MenckenProfessional baseball players talk about playing “percentage ball.” With thescore 1–0 in the third inning and a man on first base, percentage ball dictatesthat the next batter will bunt. He will probably be thrown out at first base, buthe will advance the other runner to second base, putting him in a position toscore the tying run. Here, the professional thing to do is to “play it safe” totry merely to even the score. In a more desperate situation, percentage ballmay call for the hit and run, home run, or some other long-chance play. Calculating risks shrewdly is the main ingredient for consistent superiorperformance. Pros play percentage ball, and that’s why, in the long run,they are more consistent than amateurs. Therefore, it could be said thatthe difference between an amateur and a pro lies in consistency. Relyingon the probabilities based on a positive mathematical expectation to win(your “edge”) will lead to success. The more times you turn over your edge,the more profit you will make, and the more likely that the probabilities willdistribute correctly—representative of the true probabilities—over time. Professionals understand that stock trading is not dictated by absolutes orcertainties; they make decisions based on probabilities. They choose thecourse of action that seems to offer the highest percentage for success in thecurrent moment. As a stock trader, you shouldn’t hope for perfect answers toeverything; as with most things, there are none. You can only accept or rejectthe wisdom of playing percentage ball.WAIT FOR PREMIUM HANDSImagine you’re in a game of Texas Hold’em and you’re dealt a pair of aces.If you go all-in with your money before the flop, you have an 80 percentchance of winning heads-up. Now, let’s say you follow that strategy, but youdon’t win because another player draws out and makes a higher hand to theriver. Does that mean that the next time you have a pair of aces you’ll say,“Oh, I’m never going to bet on them again”? Of course you’ll bet on the aces,because those are the best two cards in poker; it’s a premium hand. It doesn’tmean you will win every time with that hand. Knowing the mathematicalprobability, however, you know that 8 times out of 10, a pair of aces will bethe winning hand. Your results in poker and in the stock market are all about whathappens over time—not the flukes and outliers. Your goal is to placetrades with the best chances of success at the lowest possible risk. If youapply sound rules, your preparation and criteria will increase your probabilityof success. And if it doesn’t work out, then remember: it’s better to losecorrectly than to win incorrectly. Losing correctly can lead you to a fortune,because you are only a short-term loser; but because of your discipline andmathematical edge, you’re a winner over time, and you will be able tocompound those wins. On the other hand, winning incorrectly only reinforcesbad habits that ultimately fail, and could very well lead you to bankruptcy. That, in a nutshell, is the difference between gambling and investing. Withgambling, the odds are against you, and you will definitely lose over time.With investing, if you follow the right rules, you will achieve success andwin over time because you have a positive mathematical edge or expectancy.But you must not risk more than you can reasonably expect to gain;otherwise, you’re stacking the odds against you, and that’s gambling.WHY MOST INVESTORS FAIL TO LIMIT THEIR RISKInvestors often become emotionally attached to their stock holdings. Whentheir stock takes a dive, it’s a blow to their trader’s ego. This, in turn, leads toexcuses and rationalizing why they should not sell. The reason mostinvestors fail to sell and cut their loss short is because they fear that afterthey sell the stock might go back up and they will be wrong twice. It’sdriven by the fear of regret, which stems from pure ego! Ironically, thesame fear grips investors when they have a profit and feel pressured to selltoo quickly. Why? Because they fear if they don’t sell the stock may go downand erase their gain. To be successful at trading, your vanity must take a backseat, and you mustremove emotion—hope, fear, and pride have no place in a trading plan. Yousimply cannot afford to allow your need to be right to override goodjudgment. It’s a false truth. You are not going to be correct all of the time,and you are going to have losses. In fact, you are probably only going to becorrect about 50 percent of the time, and that’s if you’re good. It’s how youhandle when you’re wrong that will determine your ultimate success. In trading and in life, how you deal with losing is the difference betweenmediocrity and greatness. Remember, losses are a function of expected gain.The key is to keep your losses less than your gains; always think risk versusreward and base your risk on the reality of your trading results. If you can geta reasonable idea of what your gains will be and how often you can expectthem to occur, the stop-loss simply becomes a mathematical equation. But thekey is to remember not to risk more than you expect to gain.SECTION 4Know the Truth About Your Trading A medical research worker, testing the effect of a new drug on cancer in chickens, was overjoyed to find that it seemed to cure in a high percentage of cases. Word of his success quickly spread and he was invited to address a medical convention. In his talk, he described the drug, his techniques, and finally his results. These he reported as follows: “An amazingly high percentage of the chickens, one-third of them showed a complete cure. In another third, there seemed to be no effect . . . and, the other chicken ran away.” —Burton P. FabricandTHE SCIENCE OF WINNINGMany years ago, I became a slot car racing enthusiast. For those of you whoaren’t familiar with it, a slot car is an electric-powered miniature vehicle thatraces on an eight-lane track. A toy, but taken pretty seriously in some circles.There are even slot car competitions, pitting the fastest cars and the mostskilled “drivers” against each other. At the track where I raced on weekends,I became acquainted with a man everyone called Rocky, who was a locallegend in the slot car circle; he had even won a national championship. Intime, he and I became close friends. A few years later, during a dinner after I had just won a local competition,Rocky told a story about the first time he saw me at the slot car track. Hesaid, “I knew when I saw him with a stopwatch and a notebook he meantbusiness. Seeing that, I knew he came to win.” I stumbled upon slot car racing as I was walking through an outdoor stripmall. I looked through the window of a local track and thought to myself,Wow that looks like fun. So, I went in and rented a slot car and was instantlyhooked. Prior to that day, I had never seen a slot car in my life, so I had tolearn by trial and error. I immediately bought a bunch of equipment andstarted racing slot cars. I was challenged by the track’s clock that measuredlap times. I wanted to know what would help me get faster times. So, I woulddo 20 laps and change the tires, and then do another 20 laps and try cuttingthe tires down. Then I would try a different motor or body style and doanother 20 laps. With every lap, I carefully documented the results in anotebook. I made all sorts of adjustments and then logged the times to recordthe effects. Slot car racing was only a hobby for me, but I approached it the same wayI did everything else: I kept track of my results, paying as much attention towhen something went wrong as when everything was right. Unless Imeasured my results, how could I identify my mistakes and know where andhow to improve? How else could I learn what was working and what wascounterproductive? Whether you’re talking about perfecting slot car racing or stock trading,the power of measurement is an invaluable tool for those who have thediscipline to use it routinely. By keeping track of your results, you willgain insight into yourself and your trading that no book, seminar,indicator, or system could ever tell you. Your results are the fingerprints ofeverything you do, from your criteria for identifying trades to your ability andconsistency in executing them. Your results are your personal truth. In business they say, “What gets measured gets managed.” In trading,however, many times things go unmeasured. Many people don’t know whator how to measure their results or they think it’s unnecessary. Most simplydon’t understand how to use the information and apply it in a practical way toimprove their trading. I’m going to show you how.FIRST GET YOUR HEAD OUT OF THE SANDAt my Master Trader Program Workshops, I always ask for a show of handsof how many people know their average gain, average loss, and percentage ofwinning trades. In every seminar I’ve given over the years, I never get morethan a few hands. The vast majority attest to the sad truth: few traders knowthe truth about their trading! Think about that for a moment: If you don’t know your own tradingresults, how can you intelligently set expectations? It’s like flying a planewithout an instrument panel; how would you know if you’re level? If youdon’t know the kind of gains you’re making, how will you know how muchyou should risk? You might as well sling darts at a dartboard—blindfolded! Few individuals go beyond the buying and selling of stocks based on gutfeeling, rumors, tips, or news stories. Even fewer put in place a disciplinedapproach for measuring the key aspects of their trading results, which iscrucial for arriving at reasonable assumptions and achieving consistenttrading success. The fact is, measuring results is not very popular becausemost people don’t like to look at their bad trades; they choose to just forgetabout them as if they are going to magically improve with little effort andstudy. This is lazy and a big mistake. The first step to success in the stockmarket is to get your head out of the sand, and that starts with post-analysisof your results. The most valuable information about your trading is yourtrading!KEEPING YOURSELF HONESTIt’s a fact of life in the stock market: what you think should happen veryrarely materializes perfectly. Those rose-colored glasses can skew your viewof your own trading results. That is, unless you keep things in perspective andkeep yourself honest. Whether you’re a new trader just starting out in the market or you’ve beenat it for a while, you should definitely keep a spreadsheet of your results—every trade (and not just the trades you want to remember). Record whereyou bought and where you sold every single trade. Pretty soon you’ll have atrack record of average losses and average wins, and the frequency of thewins and losses. I also keep track of my largest gain and largest loss eachmonth, as well as my average holding time for all my gains and losses. As you collect this data and calculate your numbers, don’t mix strategies.If you were a day trader for a few months, and then switched to swing tradingor to long-term investing, you don’t want to compute an average across allthose results. Keep your records strategy-specific. This way you can controlthe risk/reward ratio for each trade, not letting your losses get larger than “x”percent, because you’re only gaining “y” percent, with a frequency of “z”percent. This is precisely what insurance companies do, with an actuarial approachto projecting the life expectancy of people grouped together by certaindemographics and other factors, such as age, lifestyle, and health status. Afteranalyzing all the characteristics of the group, the insurance company knowsthat, on average, life expectancy for this group of people will be, say, 77years old. Given the current age of the person, the insurance company canproject how many years before it will likely pay a death benefit payment. Itcan then establish the amount of premium to be collected over time to coverthe death benefit and make a profit. Of course, the insurance company can’t be absolutely sure that everyperson in that group will die at 77, just as you won’t know the precise amountof profit of any one of your winners. However, insurers have mastered thescience of making actuarial projections based on where the bulk of the dataaligns. Think of your trades the same way, using real data. Certain events willstick out: like that 60 percent return you made on a trade that jumped up on abuyout. But determining your risk based on your best trade provides noprotection. Your average gain is the important figure to base your riskon; you should know this number. That’s the best way to determine howmuch risk you should take per trade. Just as insurance companies adjustpremiums to account for life expectancy, you can adjust your stop-loss toaccount for the life expectancy of your gains—where they tend to expire onaverage. If your gains average 15 percent and you want to maintain a 2:1reward/risk ratio, then your stop would need to be set at no more than 7.5percent.LOG A JOURNALI always insisted that anyone who worked for me never show up to a meetingwithout a pad and pen. It was mandatory that everyone take accurate notesand keep a journal. People who think they can remember even a fractionof what they hear and see in any one day are arrogant and delusional.You must write things down! When you go to hear someone speak, recordit (if allowed) or take a lot of notes. Same goes for your trading. You shouldkeep a daily journal and commit to updating it regularly without fail. I’vemade it a habit to have a pen, a pad, and a digital recorder on me always. Thisis one of the surest ways to determine immediately if someone really wants tobe a winner. A few years ago, I met with a young man who was getting involved in thestock market. When we went out to dinner together, he started asking mequestions about stocks. As I started to answer his question, he stopped me.“Hold on one second,” he said and whipped out a little pad and a pen. “Okay,continue.” As I started talking, this lad wrote down every word I said. Ithought to myself, this kid is going to be a winner. He wasn’t neglecting onepiece of information. Winners don’t take things for granted. They realize that every experiencegood or bad is a precious gold nugget, a lesson that should be studied andbuilt upon. They realize the limitation of only committing things to memory.They are always prepared, and they keep a journal they can reflect upon andcompare expectations to reality.LET THE SPREADSHEET MAKE ITS WAY INTO YOUR TRADINGYour spreadsheet is more than just a record of past performance to tuck awayor glance at every now and then. It is the precise guide for handling your nexttrades. When you are cognizant of your numbers, you will weigh the impactof every trade against your own records. Your stats will literally make theirway into your trading and guide you. For example, a stock moves againstyou, from a 5 percent loss to 8 percent and then 10 percent. Suddenly, a bellgoes off in your head: You’re going to have to log that loss in yourspreadsheet and look at it (and its impact on your average) every time youexamine your numbers. Not only is a larger average loss going to hurt yourperformance, but you will need bigger gains in the future to offset it. Beforethat happens, with your spreadsheet in mind, cut your losses before theyreach the maximum level. Every time I’m about to make a tradingdecision, I ask myself, how is this going to look on my spreadsheet? On the flip side, let’s say you’re at a gain. The stock shoots up quickly,rising 15 percent and keeps moving, until it’s up 20, 25, and then 30 percent.Your win is now three times your historical average of say 10 percent. Asgreed starts to take over, you wonder, how high can this go? This is preciselywhen you need to let the spreadsheet make its way into your trading and bemindful of the reality of your own math. Logging a 30 percent gain would dowonders for your average win column. Given that prospect, you wouldn’twant to let your profits slip back to 10 percent, or even worse, lower.THE TRADING TRIANGLEIn photography, one of my newfound passions, the three variables are ISO(“film speed” or sensitivity to light), the f-stop (the size of the cameraaperture to let in light), and the shutter speed (how fast the shutter “clicks”).This “triangle” of factors determines the exposure. These three dynamics (thesides of the triangle) will affect whether the picture will be under- oroverexposed. You will need to adjust them in relation to each other so thatyou get the optimal exposure for the visual effect you’re going for. In trading, we can think of the triangle in much the same way. Instead ofISO, f-stop, and shutter speed, the three legs of the trading triangle (Figure 4-1) are: Your average win size: how much do you win, on a percentage basis, across all your winning trades? Your average loss size: how much do you lose, on a percentage basis, across all your losing trades? Your ratio of wins to losses: your percentage of winning trades, or what is referred to as your “batting average.”Figure 4-1 By balancing the trading triangle to arrive at a positive mathematical expectation or edge,you can improve and optimize your results. You need to start with the reality of your actual trading results in order tomaintain an edge or mathematical advantage in any given trade. Each leg ofthe trading triangle will show you where you need to put your focus in orderto maintain that edge. For example, if your batting average is .500 (half winsand half losses) and your average loss is say 6 percent, that’s not bad. But ifyou find that your average gain is only 5 percent, to be profitable you willneed to either make more on your winning trades, win more often, or tightenup your stop and lose less on your losing trades.THE MONTHLY TRACKERThere are a few key stats that I continually track. I have my own software thatcalculates the numbers after I input my trades, which is also available to ourMinervini Private Access members. My average gain is very important tomonitor regularly because I base my risk in large part on that number. I alsotrack my batting average (percentage of profitable trades) (Figure 4-2). Ifthose numbers start to deteriorate, I adjust my stops accordingly. During adifficult trading environment your gains will be smaller and lessfrequent than during a healthy market. When this occurs, rememberthree words (with a nod to Nike): “Adjust” Do It! Always think risk inrelation to reward. You must adjust your risk as a function of potentialreward.Figure 4-2 Using a monthly tracker allows me to track my trading results month by month. This helpsme keep perspective and troubleshoot my approach day by day.A FEW MORE IMPORTANT NUMBERS TO TRACKThe next relevant numbers are the largest gain and loss in any one month andthe number of days my gains and losses are held. I call them the “StubbornTrader” indicators. Don’t pay much attention to any one month, but whenyou look at the average over a 6- to 12-month period, the net result should bepositive. For example, if your largest gainers are smaller than your largestlosers on average, this means you’re stubbornly holding losses and onlytaking small profits, the exact opposite of what you should be doing. If youraverage hold time on your gainers is less than the amount of time you holdyour losers, again, it’s an indication that you hold onto losses and sellwinners too quickly. This is valuable information, but few traders even trackthese numbers. Tracking this data will keep you honest and give you a true read on what’shappening within your trading. This is the discipline of champion traders.They don’t stick their head in the sand; they want to know the truth so theycan improve on their weaknesses and optimize their efforts. By developingemotional distance, separating myself from my results, I gain insight intomy trades, without rationalizing or making excuses. Monitor your resultsand do the math; as the saying goes: the truth will set you free. Statistics you should track include Average win Average loss Win/loss ratio Batting average (percentage winning trades) Adjusted win/loss ratio (adjusted for batting average) Largest wins Largest losses Number of days gains are held Number of days losses are heldYOUR PERSONAL BELL CURVEOver time, it’s all about the “curve”: the distribution of your gains and losseswill determine your performance. Your trading results will distribute along abell curve, and hopefully your curve is skewed to the right. To maintain aprofitable bell curve, your stop-loss should be based on what you havereturned on average on your winning trades and how often these wins occur.As I already said, I recommend that you continually track your battingaverage and average gain and average loss. Doing so will allow you todetermine quickly if your recent trading is deviating from your own historicalnorms and if you’re maintaining your losses in line with your gains. This willgive you the necessary feedback to make adjustments in response to yourlosses. I cannot emphasize enough how valuable this information is in helping youmaintain a consistent and profitable long-term trading track record. The moredata you have from your trading results, the more significant it is—and themore likely your results will end up close to your assumption over time.Closely tracking your own results allows you to keep a finger on the pulse ofyour trading. If I want to contain my losses to 10 percent or less, that means I should seevery little to no data to the left of minus 10 percent on my bell curve. On theright side, I want to see as much data as possible. What I’m looking toachieve is a curve “skewed” to the right (Figure 4-3). That means I containmy losses (on the left side of the curve), while I let my profits run (on theright side of the curve). I look at a bell curve of my trades regularly to see ifI’m maintaining an edge.Figure 4-3 The ideal distribution is to have as many outliers as possible on the right and the fewest onthe left, attaining a “skewed” curve. I call the minus-10 percent mark on my bell curve The Wall. Some peoplecall it the Uncle Point. It’s the largest loss I ever want to take. Not theaverage loss, the largest. My goal is to never let losses get through “TheWall.” Over time you will have some penetration of your own personal wall.Occasionally, you will have a loss get out of hand due to a fast-breakingstock and slippage. But you should have more data on the right side of yourcurve than you do on the left side. Knowledge, as they say, is power. Knowledge of your own trading willempower you, reinforce your emotional discipline, and make you a bettertrader. It will get you thinking how your gains and losses distribute in relationto each other. As a result, you will make better trading decisions because youwill have a vivid picture in your mind of the effect your losses will have onyour distribution curve and the toll they take against your gains. Think ofyour distribution curve as a game of tug-of-war, and you want the “rightside” to win the battle.TURNOVER AND OPPORTUNITY COSTIn the stock market, time is money, as is lost opportunity. I learned early thatyou should not underestimate the power of “small” gains compounded overtime. Higher turnover of relatively small gains can mean significantly higherreturns compared to lower turnover with higher gains. It’s all a matter of whatcan be accomplished in a given time frame. Let’s say within a 120-day periodyou feel pretty confident that you can find a stock to buy that will go up 40percent. The question is, can you find three stocks that go up 20 percent orsix stocks that go up 10 percent? It’s certainly easier to find stocks that go up10 percent than it is to find a 40-percent gainer. The real question is: doesmore frequency make mathematical sense? Six 10 percent gains compoundedwill yield almost double the total return of one 40 percent winner, and justthree 20 percent winners will yield almost as much as six 10 percent winners. The amount of turnover is directly related to the average gains and lossesand your batting average. If you’re turning your portfolio over very rapidly,you can have smaller gains and losses and a lower win/loss ratio than ifyou’re turning it over less. You’re getting the benefit of your “edge” moreoften. This is the same concept as a retailer who sells a low-priced or low-margin product versus another who sells a higher ticket item with lessinventory turnover. The lower-priced merchandise may produce more profitthan the higher-priced goods if the retailer can make up for the profitdifference through higher sales volume. Day traders work on very smallmargins, averaging only fractions per trade while making thousands of tradesper year, turning over that small edge frequently enough to produce a tidyprofit. As an investor, your merchandise is stocks. Your objective is to buy sharesthat are in strong demand and sell them at a higher price. How much of aprofit margin you make will depend a lot on the type of portfolio you arerunning. You may be like Walmart, which operates on very small marginsbut does a tremendous amount of volume. Or you may be like a boutique thatoffers unique and trendy merchandise and earns higher margins on muchlower volume. You may be making numerous trades for a small gain, but bysheer volume you turn in an impressive return at the end of the year. Or youmay be a long-term investor with select merchandise that also produces asolid return. In the end, it all comes down to having your gains on averagebe larger than your losses, nailing down a profit, and repeating theprocess. This is the basic objective of any business endeavor. Are you looking to bag the big one, even though a handful of smallerprofits would make you just as much or even more money? Every strategy isdifferent, so it’s important to calculate opportunity cost and determine whatthe optimal time frame and turnover rate should be. Again, understandingyour numbers is the key. So, start doing some math. Analyze your results andoptimize your efforts.A WIN/WIN SOLUTION TO PROTECT YOUR PSYCHEAs I’ve already pointed out, a trader’s mindset fluctuates mainly between twoemotions, indecisiveness and regret. And a trader’s emotional state vacillatesbetween greed and fear—and mostly fear. As we’ve touched on previously,there is the fear of missing out, which leads traders to chase a stock that’salready had a big run-up in price. They try to squeeze every dime out of atrade because they’re afraid of selling too soon, fearing that a stock they sellat $20 will become the next Google. Or, a stock that they bought at $45 dropsto $40 and then to $35, which leads to regret for not selling at $40—so theyhang on, hoping the stock will recover some of its lost ground. Compoundingthis problem, most traders sell too soon and take small profits because theyfear the stock is going to erase their gains, but they hold losses because theyfear they might sell the stock and it will then turn around and go up. The only antidote to combat anxiety and calm fears are rules and realisticgoals. With steadfast rules, your decisions will not be emotionally based, butgrounded in reality. Remember, trading is not about buying at the absolutelow and selling at the all-time high. It’s about buying lower than you sell,making profits that are larger than your losses, and doing it over and overagain. When you fully grasp this foundational aspect of trading, you willremove a big psychological barrier to successful investing. One of the most common questions I’m asked is when to take a profit,particularly if the stock has made a decent run. Your specific price target ofwhere to sell should be based on technical rules that are part of your specificstrategy (Section 9 addresses selling). There is, however, an overarching rulethat applies to all strategies: Protect your psyche! Don’t let yourself becomeconsumed with regret or shackled with indecisiveness. Deploy the “sell-half” rule. Let’s say a stock you’re holding is up 20 percent—twice your average gainof 10 percent and almost three times your risk of 7 percent. You have a niceprofit, but you aren’t sure if you should sell. You like the company and thinkit could go higher. But it has just started to slip back a little bit (let’s say itwas up 25 percent at one point). Indecisiveness sets in as you debate withyourself about what to do. The solution is easy: sell half your position. Using this example, if you sell half your position at 20 percent, comparedto your average gain of 10 percent, it’s very difficult to lose on the trade. Halfof your trade is booked at a 20 percent profit. Even if you only break even onthe remaining half, you will still make 10 percent (right in line with youraverage gain), and you’ll still be ahead of the game. In fact, you could suffera 10 percent loss on the remaining position and still be okay with no loss onthe trade. After selling half, you can see where the stock goes with the remainingposition. No matter the outcome, you are a winner from a psychologicalstandpoint, without any regrets. When you sell half, if the stock goes higheryou say to yourself, “Thank goodness I kept half.” If the stock goeslower, you’ll say, “Thank goodness I sold half.” Psychologically, it’s awin/win either way. Neutralizing regret is only possible if you sell half. If you sell 75 percent ofthe position and keep 25 percent and the stock goes higher, you’ll have theregret of, “Oh, I wish I kept more.” Conversely if you sell less than half andthe stock goes lower, you’ll kick yourself saying, “Oh, I wish I’d sold more.”Sell half and you equalize the rationale and protect your psyche in bothdirections. One word of caution—selling half does not work on the downside whenyou’re at a loss. When your stop is hit, you get out! You shouldn’t sell halfon the downside and gamble with the rest of your position, hoping the stockwill turn around. When a position moves against you and hits your defensivesell line, there is no wiggle room—only disciplined, decisive action.RESULTS-BASED ASSUMPTION FORECASTYour results tell you a lot: where you should be cutting your losses, whetheryour position size is too big or too small, whether you are improving or doingworse than you have been historically, and how much you are deviating fromyour goal. To see these insights, however, you must track your stats. I calculate and track my results regularly. Not only do I know that myaverage gains have been “x” and my average losses have been “y,” I also seemy actual returns over time. Then, based on the numbers I see, I can projectwhat I can expect in the future. If these results match my objective, then myapproach is good. If I’m falling short of where I want to be, then I can seewhat adjustments need to be made. Working with actual results, you canexperiment with the numbers and determine what is realistic and what is not. For example, let’s say you have a $200,000 portfolio and your positionsize is 25 percent (Figure 4-4). Your desired return is 40 percent. Youraverage gain is 14 percent, and your average loss is 7 percent, with a battingaverage of 46 percent. Now, based on these results, to achieve that 40 percentgoal, you would need to do about 60 trades.Figure 4-4 Using Result-Based Assumption Forecast (RBAF), you can pinpoint exactly what it willtake to achieve your goal and determine how various adjustments will affect the outcome. Now you need to ask yourself, with your style of trading, how long will ittake to find 60 opportunities to trade? Based on your own history, it may belikely that you could find 80 or 90 trading opportunities per year, or maybemore. If so, you have the opportunity not only to achieve that 40 percent, butmaybe even double or triple it. Or, perhaps you think you should change your position size. If youincrease your position size to 50 percent, you’ll only have to do 30 trades. Ifyou decrease it to 12.5 percent, you will need to do 120 trades to accomplishthe same return. Based on your own results, you can determine what it willtake in terms of position size and number of trades to achieve your desiredperformance. If you are a short-term trader, you’re going to have a lot more tradingopportunities. However, your gains and losses will likely be much smallerthan those of a swing trader or longer-term investor. You might be in and outfor a 1- or 2-point gain or a half-point loss. However, you’ll be doing thatrepeatedly. If you’re a long-term term trader, you will have far feweropportunities, but your average gain will be larger. The key is to figure outthe optimum way to maximize your results. Obviously, to develop a Results-Based Assumption Forecast (RBAF), youneed some data; the more the better. When you’re starting out, you will nothave many results to analyze. So, the sooner you get started, the sooner youwill be armed with valuable data. The most important reason to study your results is for the insight you willgain into yourself. Just as people have different thresholds for physical pain,the same goes for your emotional thresholds when enduring losses orcontrolling greed. These emotional triggers are what dominate your tradingstrategy more than anything. Show me one person who takes every singletrade that his or her system identifies. Unless you have a black box operatingin your trading room and all you do is print out the P&L at the end of the day,your emotions influence your decisions. Your emotional makeup is the threadthat goes through everything you do. Your results, therefore, are the net of everything: your strategy, yourexecution, your commissions, and your emotions. The numbers you see onyour spreadsheet are produced by everything that goes into your trading,including your emotions. What matters, therefore, is the ultimate number—your results. It doesn’tmatter if your strategy is capable of capturing 100 percent, but you get outafter a 10 percent profit. The only thing that matters is the bottom line of yourresults. And based on what you’ve done thus far, you can employ a RBAF todetermine where you can potentially go and what it will take to get there.TO COMPOUND OR NOT TO COMPOUNDThey say if you torture numbers long enough, they will tell you whatever youwant to hear. Before you risk your hard-earned capital, I suggest that you notonly torture the numbers, but fully comprehend them. When dealing withrisk, there are some interesting things to understand, such as whether tocompound or not. I show you this example mainly to illustrate how importantit is to understand the math behind your trading, because it’s powerful stuff.If you don’t believe me, consider the following: Two traders, Larry and Stuart, each start with $100,000. And they eachmake 24 trades following the exact same system. They buy and sell at theexact same time and at the exact same prices. Twelve of the 24 tradesproduce a 50 percent gain each. The other 12 trades produce a 40 percent losseach. The gains and losses alternate from up 50 percent to down 40 percent,back and forth, until 24 trades are complete. Now for the results: One tradermakes a profit of 120 percent, bringing his account up to $220,000. The otherloses 71.75 percent, or $71,750, leaving his account at a measly $28,250.How is this possible? Trader Larry decides not to reinvest his return. He simply bets a fixedamount each trade (based on the $100,000 capital) and does not reinvest theprofits. Trader Stuart, on the other hand, reinvests his capital, thuscompounding his returns. Which is the better strategy, to not reinvest or toreinvest and compound? The results might surprise you (see Figure 4-5). Non-compounded CompoundedFigure 4-5 As this example shows, there are powerful insights to gain from tracking your actual results,knowing the reality of the math behind risk, and not relying solely on assumptions about what youthink will happen.DO WHAT MOST TRADERS DON’T DOA healthier lifestyle, we’ve all been told, comes from developing healthierhabits. It’s not the crash diet or suddenly deciding you’re going to go out andrun a marathon without training. Being healthy is the sum total of all thethings you do every day: how you eat, how often you exercise, drinking inmoderation, and so forth. In time, you won’t even have to make a choiceabout what to do or not do; your healthy habits will be deeply engrained. In trading, too, there are healthy routines—I call them Lifestyle Habits—that need to become second nature. Just like getting up in the morning andbrushing your teeth or heading to the gym for a workout, these habits willbecome part of your trading lifestyle. And once developed, these habits willhelp you progress and expand your comfort zone. One of the healthy habits of trading is conducting a post-analysis of yourresults on a regular basis. Another is cutting your losses without fail toprotect your capital from devastation. This is more involved than merelykeeping a trading log. Regularly analyzing your results provides you with afeedback loop. The basic premise of any feedback loop is that it allows forregulation or self-governing within a system. Feedback also facilitateslearning; knowing what has been successful in the past allows you to applythat same approach in the present and future. For your feedback loop to be relevant, it must be employed consistentlyand regularly. For example, as part of my post-trade analysis discipline, I doquarterly and annual evaluations to gather as much information about mytrades as possible. Your feedback loop must have a schedule, just like yourplan. If you only plug in occasionally for feedback, the data will be randomand unreliable. When you’re making progress and trading is going well, doing a post-tradeanalysis is painless; in fact, you’ll probably feel pretty good about yourself.But when you aren’t trading so well, the analysis gets difficult, to the pointthat you will probably try to avoid doing it. It’s like any other difficultepisode, such as working with a psychotherapist to analyze an unsuccessfulrelationship or a childhood trauma. It’s painful! But analyzing what wentwrong in that failed relationship or what happened during that difficult phaseof your life will yield powerful and even transformative lessons that will helpyou become more successful in your current life and your future. The samegoes for trading; growth comes from having the courage to look at thedifficult times and dissect what went wrong.YOU CAN MAKE MONEY OR YOU CAN MAKE EXCUSESAs you now know, I’m a photographer in my spare time. It’s a hobby, but Itake my photography pretty seriously, and my goal is to produce great imagesjust as my goal is to produce great results trading. I have state-of-the-artequipment. Not that I think having the best equipment is going to make me agreat photographer; it won’t any more than a fast car will make someone agreat race car driver. But it does eliminate the “excuse factor.” One of the biggest roadblocks to trading success and to success in generalcan be summed up in a single word: excuses. I want to make sure I take fullresponsibility for my results in everything I do in life. I know the power ofowning my results. So, when I get all the best gear, I have nothing left to doexcept take responsibility. I can’t say that another photographer is producingbetter pictures than I am because he has a better camera or lens. Takingpersonal responsibility is the most empowering thing I can do to be a betterphotographer—and it’s the single most important thing you can do to becomea super-trader. It’s an acknowledgment that you have the ability to respond. In the stock market, you can make money or you can make excuses, butyou can’t make both. Do whatever it takes to eliminate your own personalexcuses. Your road to success starts by taking responsibility. Don’t blameoutside factors for your lack of success. The best way to take control of yourtrading is to understand the math behind your results. This will put you on theroad to success, because you will know the truth and become empowered.SECTION 5Compound Money, Not Mistakes You’re going to buy things that go to zero and sell things that go to infinity. —Paul Tudor JonesWhen I started trading more than three decades ago, my goal was to make thebiggest return in the shortest period of time so I could achievesuperperformance. To do that, I needed to learn how to really compound mymoney. But early on, I committed the typical rookie error: I compoundedmistakes instead of compounding capital. I did what many investors do, committing the deadliest mistake of all:when a stock I held declined in price, instead of cutting my loss, I boughteven more. The rationale was that by “averaging down,” I could lower mycost, so that when it eventually came back (I assumed it had to come back) Iwould recoup my red ink even faster than I lost it in the first place. Thisthinking is common in investing: If you liked the stock at $20 a share, you’lllove it at $15. But that’s precisely how accounts get blown up and investorsgo broke, because you’re compounding a mistake instead of compoundingmoney. When a position moves against you and you’re at a loss, especially rightafter you buy, it’s simple—you made a mistake. It may be that you’remissing an element in your selection criteria, or your timing could be off.Perhaps the general market is under distribution. When you buy more underthese conditions, your attempt to “average down” on a losing position is truly“throwing good money after bad,” as they say. Unfortunately, it happens allthe time. And it wipes out more accounts than just about any other practice intrading. Many investors know they should cut their losses to control their risk. Yetthey convince themselves that they should hang in there: But it’s a bullmarket! But every time I cut my loss, the stock turns around and goes higher.But, if instead of selling, I buy even more, then I can really make a lot ofmoney when the stock goes up again. Once again, the fear is of selling andthen having the stock turn back up, and thus missing a bigger winner. Theyequate selling in these circumstances to “chickening out.” When thishappens, ego is taking over. You want to be right, and you want to believethat you will eventually be right. So you convince yourself it’s okay to breakthe rules. You think to yourself four very dangerous words, “Just this onetime.” Welcome to the slippery slope. When you tell yourself, I’m going to breakmy rule just this once, you open the door to losing discipline, because it’snever just “one time.” It’s like an alcoholic saying “just one drink” or anaddict saying “just one shot of heroin.” Occasionally, this will work, but it’sunfortunate, because being rewarded for bad habits only reinforces them. Astock you hold falls by 5, 10, then 20 percent, but instead of obeying yourstop-loss, you convince yourself to hold, or worse, buy more. The stock turnsaround, recovers the lost ground, and goes up 20 percent. You tell yourselfyou’re a trading genius! Oh sure, you took a 20 percent risk—assuming youwere even going to sell around that level—for a 20 percent gain. If these arethe kind of trades you’re making, then I’m afraid you’re in for a very rudeawakening. The danger is your stock could be headed for real trouble, then your losscompounds to 30, 40, 50 percent—or more. Chances are, if you did this withone stock, you probably have done it with others as well. In the stock market,when bad habits get rewarded it leads to ruin. If “just this one time” worksout, then heaven help you, because you’ll convince yourself that the endjustifies the means, and you should do it again. Then my friend, you aredoomed.NOT ALL OUTCOMES ARE CREATED EQUALHere’s the easiest and quickest way I know to illustrate this point: Twopeople attempt to cross a road; one looks very carefully both ways, runsacross, and gets hit by a car. The other person covers his eyes and blindlyruns right into heavy traffic, but makes it to the other side safely. Does thatmean the person who made it safely across the road did a smart thing? Whatwould happen if this scenario was repeated 100 times? Who do you thinkwould have a higher success rate of making it to the other side? The resultdoes not justify the means. How many times have you had a “just this one time” moment? You knowwhat I’m talking about: You’re in a losing trade, it reaches your stop, youknow you should sell, but you really like the company and you’re sure thestock will turn around. So, “just this one time,” you tell yourself, you’regoing to hold a little longer and stretch the rules, even though you know youshould just get out. So, you keep holding. Now ask yourself: Have youbecome rich from these “just this one time” moments? “Just this one time” violates your rules and undermines your discipline. It’slike starting a diet, but after three days you decide to cheat “just this onetime,” and order dessert at lunch. Pretty soon you’ve packed away extracalories, and the scale moves in the wrong direction the next morning.Trading is challenging enough without sabotaging your own rules. Stayingdisciplined means you have to take lots of small losses to protect yourself,which makes you feel like you’re going in the wrong direction when youreally want to catch a big wave. But “just this one time” will put you on aslippery slope that won’t end with one trade, one time. You will eventuallyget rewarded for breaking a rule, and then you’ll bend and break more rules,until you end up like the guy who runs across the highway with his eyesclosed and his ears covered—a hood ornament! You’re not going to make just one trade, so don’t think in a vacuum. Thinkabout the big picture. My performance went from mediocre to stellarwhen I made up my mind and decided once and for all to never have a“just this one time” moment ever again. I said to myself: That’s it, nomore, I’ve had enough! No more breaking rules; it doesn’t pay.STRONG WORDS TO LIVE BYPaul Tudor Jones is arguably one of the greatest money managers of all time.I have the greatest respect for him. Many years ago, I came across aphotograph of him with a sign over his trading desk: “Losers average losers.”Those three words contain hugely impactful wisdom: only losers averagedown on losing positions. That message struck me for a couple of reasons. First, it’s a big statementthat you’ll be a loser if you average down. But if Paul Tudor Jones makesthat statement, then it’s probably worth paying attention. Second, if one ofthe greatest traders of all time needed to post a sign with those words in bigletters on his wall, that’s evidence of just how seductive it is to “averagedown,” and how important it is to remind yourself not to do it. You know thetemptation: a stock you liked at $25 is now $20, so your instinct is to love itall the more—what a bargain! Such thinking, though, is only a delusion tokeep from admitting that the stock is going in the wrong direction. Get overyour ego—and get out while your loss is small, before it turns into a seriousloss. It’s true, only losers average losers, plain and simple.THE 50/80 RULETo compound money, and not your losses, you need to be aware of aninsidious probability I call the 50/80 rule. Here it is: Once a secular marketleader puts in a major top, there’s a 50 percent chance that it will declineby 80 percent—and an 80 percent chance it will decline by 50 percent. Think about these probabilities for a moment. After a stock makes a hugeupward move, it will almost assuredly drop by 50 percent when it ultimatelytops out. And it’s a flip of a coin whether that downward move will be asmuch as 80 percent. Once big market leaders top, they experience an averagedecline of more than 70 percent! I’m not making a point about timing here.This story is a cautionary tale about paying attention to the first loss to hityour radar. Every major decline starts as a minor pullback. If you have thediscipline to heed sound trading rules, you will limit your losses whilethey’re small and you will not throw good money after bad. But if yourationalize all the reasons why your stop should be ignored or why youshouldn’t use a stop in the first place, then the damage will be far greaterwhen the stock keeps dropping. And if you “average down” through thatdrop, thinking, this stock just has to turn around at some point, then theuncontrolled losses will devastate you psychologically and eventuallydecimate your trading account. Holding onto a sharply falling stock or, worse, buying more when the pricegoes lower may make you money once, twice, or a few times. But at somepoint, your stocks will keep on falling (Figure 5-1). You won’t have just aloss on your original position; you’ll also lose on the additional shares you’vebought. At this point, you might really compound your mistakes byconvincing yourself, this has to be the bottom, so you buy even more! Someinvestors are so egotistical about accepting mistakes that they double downseveral times. Amateur traders strive to be right; pros strive to make money.Figure 5-1 Lumber Liquidators (LL) 2008–2016. The stock was a leader that succumbed to the 50/80rule, topping out in late 2013 before plummeting more than 90 percent. The guy who doubles down on a falling stock is the same as the pokerplayer who takes a raise to play a pair of deuces. Holding firm with 2-2 in thehopes of beating another player who is betting strong is a rank amateur move.Pros play the percentages; they’re consistent, and they avoid the bigerrors. Most of all, they avoid risking money on low probability plays.They bet when the odds are in their favor and fold when they’re not. They’renot Monday morning quarterbacks who, after the hand is dead, ask the dealerto see the next card so they can find out if they would have come out awinner if they had held. Pros focus on being consistent. They know that theprobabilities will distribute correctly over time, and if they play lowpercentage hands, they will surely lose. Buying broken leaders may work for you at some point. But the reality is,you’re compounding mistakes—not money—and eventually, this behaviorwill bite you hard and ultimately destroy any chances you have for stellarperformance. That’s a guarantee!THE “CHEAP TRAP”On a visit to your favorite department store, something catches your eye—asweater, a jacket, a pair of shoes. The quality is superb, the fit is perfect, andit has a designer label. Then you look at the price tag—ouch! Way beyondyour budget. But you know from experience that this store has great sales, soyou just wait. Sure enough, a few weeks later, the store advertises a big saleand you receive a loyal customer discount of an extra 20 percent off. On thefirst day of the sale, you find that item you liked so much—only this time it’sdiscounted by 30, 40, or even 50 percent. You’re a happy buyer, at a farlower price. What works in the department store, however, does not apply to the stockmarket. When you invest in stocks, something that is suddenly “cheaper”is not necessarily a bargain—but it could trap you in the stock if you’rebuying solely because it’s cheap. Instead of being a real “find” (like thatArmani jacket on sale), a “cheap” stock could be declining for a good reason.If you buy that stock, believing that you’ve found a great bargain—particularly if you’ve fallen in love with the company and its story—you’relikely to face big losses if the stock keeps dropping. When you buy a stockbecause it’s cheap, it’s difficult to sell if it moves against you becausethen it’s even cheaper, which is the reason you bought it in the firstplace. The cheaper it gets, the more attractive it becomes based on the“it’s cheap” rationale. The problem can be one of perception. It’s hard to resist the allure of a“cheap” stock, particularly when it’s a big name or had been a highflier in thepast. You tell yourself, “No way is that high-quality company (GeneralElectric, Coca-Cola, Starbucks, etc.) going out of business.” But a companydoesn’t have to go out of business for it to suffer a major decline in its stockprice (Figure 5-2). It can go down and stay down—and your position is“under water” for years, and in some cases for decades.Figure 5-2 Cisco Systems (CSCO) 1990–2016. After topping in 2000, the stock declined by awhopping 90 percent, and then moved sideways for 16 years. In more than 33 years of trading, I can’t tell you how many stocks I’veseen plummet and never come back again. Even professional value playersstruggle with picking lows. Some of the best value managers suffered hugelosses in 2008, buying “cheap” stocks on the way down; except those stockskept falling and got even cheaper. There’s no way of telling if a stock isreally at the bottom based solely on valuation. When a stock market leader tops, the stock may look cheap after a periodof decline, but it’s actually expensive (Figure 5-3). The reason is that stocksdiscount the future. In most cases, falling stocks that appear cheap turn out tobe very expensive, even after the price declines precipitously. Usually theprice-to-earnings (P/E) ratio soars after the stock suffers a big declinebecause negative earnings comparisons, or even worse, losses start showingup on the balance sheet. By that time, it’s too late.Figure 5-3 Lumber Liquidators (LL) 2011–2016. When Lumber Liquidators looked pricey the stocktripled, and when it appeared “cheap” it fell 90 percent.MAKING SENSE OF A SWIFT DECLINEI’ve seen it happen countless times: A company seems to have a great story.It’s entering new markets, a promising line of new products is beinglaunched, improving margins outpace the competition—all of it adds up to acompelling growth narrative. When the quarterly earnings report comes out,everything looks even better because revenues and profits are up bigcompared to the prior quarter and the year-ago period. But the stock immediately declines. In fact, it drops significantly. It justdoesn’t make sense to you. The company is growing and the numbers weregreat. And, a big well-respected brokerage firm just put the stock on its buylist. At this point, you may be tempted to believe that the market is wrong, andthat you have found a bona fide investment opportunity. You tell yourselfthat this stock is cheaper than it’s been in months, and you should really loadup on shares. Why not? The answer comes down to “differential disclosure,” which in this contextmeans you don’t know what the big institutional players know (the playersresponsible for that big drop). In the absence of that knowledge, you’d bewise to stay away. The term “differential disclosure” is used in forensic accounting. Inessence, it means the information reported in one document, such as thecompany’s annual report, differs from what is disclosed in, say, its tax returnor in other Securities and Exchange Commission (SEC) filings. Needless tosay, it’s a red flag when a company says one thing to shareholders andanother to the SEC! Here, I apply the concept of differential disclosure in another context. Let’ssay the earnings for XYZ Corp. just came out. Results beat estimates by agood margin, and yet the stock drops 15 percent on the largest volume seen inyears. When that happens, there is no possible way I’m going to buy thisstock, even if it was one of the top names on my watch list. Clearly, there is some “differential disclosure” going on, between what thecompany reported and how institutional players view those results. It doesn’tmatter what I think. The institutions are dumping that stock. I want to be instocks that the institutions are buying, which will propel those sharessignificantly higher. Now, it is certainly in the realm of possibility that this pullback will end upbeing a missed buying opportunity. However, it is more likely that thecompany has run into some trouble, and what had been a glowing growthstory has dimmed quite a bit. We may only find out later and in hindsight.Trading decisions are made in the now. To trade successfully, you can’t be aMonday morning quarterback who calls the plays after the fact, when youknow how it all turned out. You must manage your risk in real time. In themoment, you have to ask yourself: If the company is so great, the storysounds wonderful, and the earnings and sales are strong, then why is thestock going down so much? In the stock market, there is no truth without believers. That’s why youshould never buy the story and never buy the numbers without priceconfirmation. It’s simply unnecessary to do so when there are manycompanies out there that have all the right criteria lined up. To compoundyour money, and not your mistakes, your goal is to buy on the way up—noton the way down. Even if your strategy involves buying at a support level ora pullback to the moving average, it’s better to wait until the stock startsturning up again than to get in when shares are in a nosedive, because younever know how far a stock will fall (Figure 5-4).Figure 5-4 Crocs (CROX) 2008. On November 1, 2007, Crocs reported earnings up 144 percent. Thestock, however, closed down 36 percent that day on the heaviest volume since its IPO. It also ended theweek with the largest weekly decline on the largest volume. With stock trading, the fundamentals and the story are not as important ashow institutional investors (the ones that move stock prices significantly)perceive the numbers and the narrative. Stories, earnings reports, andvaluation do not move stock prices; people do. Without a willing buyer,stocks of even the highest-quality companies are just worthless pieces ofpaper. Learn to trust your eyes, not your ears. If the stock’s price action isnot confirming the fundamentals, stay away!MOVE THE BALL ACROSS THE NET Every great man never sought to be great; he just followed the vision he had and did what had to be done. —100 Great LivesNow that we’ve seen how investors compound losses, how can we realize ourtrue goal of compounding money? First and foremost, this objective isaccomplished by sticking to your discipline and applying strict trading rulesto your strategy. More important, you need to learn how to do what mostinvestors don’t do. When I was in my early twenties, I loved reading books and listening totapes on business and negotiating. I remember listening to Roger Dawson,who is the head of the Power Negotiating Institute. To stay focused on what’simportant during a negotiation, he suggested reflecting on what determinesthe outcome of a tennis match—the movement of the ball across the net. Theplayer who moves the ball across the net and keeps it in play the longest winsthe match. This is true for negotiating and for trading. You must stay focused on whatyou’re trying to accomplish. Making money is the result of effectivelycarrying out a well-thought-out plan. Focusing on the outcome will onlydistract you from the process—the work you need to do to achieve thedesired result. A baseball player at bat needs to stay focused on the ball inorder to make contact. Looking up at the scoreboard will distract him fromthe critical task at hand. I went from mediocre to a stellar performer when I told myself: To heckwith worrying about the money and obsessing over the scoreboard. I’m justgoing to focus on being the best trader I can be and sticking to the rules.Then the money followed.SMALL SUCCESS LEADS TO BIG SUCCESS I long to accomplish a great and noble task, but it is my chief duty to accomplish small tasks as if they were great and noble. —Helen KellerBig success in life is the result of a series of small successes all linkedtogether over time. Stock trading is no different. It’s not an on-off business.You don’t have to make all-or-nothing decisions. You can move inincrements. I rarely, if ever, jump into the stock market with both feet. Igenerally start with a “pilot buy,” initiating a relatively small position first. Ifit starts to work, I may add to the trade or add a couple more names, and if Ihave success on a number of trades, I will then increase my overall portfolioexposure and get more aggressive. This is the way you keep yourself out oftrouble and make big money when you’re right. When first entering the market from a cash position, you should notincrease your trading size and overall exposure until you gain some tractionon your initial commitments. I have a very simple philosophy on scaling upmy trading: If I’m not profitable when I’m 25 percent or 50 percentinvested, why would I move up my exposure to 75 percent or 100 percentinvested or use margin? It’s just the opposite: I look to scale down myexposure if things are not working out as planned, or maybe I’ll hold what Icurrently own. By following the right trading rules and progressively scaling back whenthings aren’t working, you’ll be trading your smallest when you’re tradingyour worst. That’s controlling risk! But if you add exposure when thingsaren’t working, then when you’re trading at your worst, you’ll be tradingbigger size, which can be disastrous. This discipline is not just defensive. By following this rule, stepping upyour exposure when trades are working, when you’re trading at your best,you will also be trading your larger positions. That’s how you achievesuperperformance. Instead of compounding losses, you’ll compound money,but only if you have the discipline to stick to the rules. Bottom line: there really is no intelligent reason to increase your tradingsize if your positions are showing losses. On the other hand, when things areworking, use the profits to finance risk and build on success. Here’s how: I usually start off with a quarter position (see Figure 5-5). Onthe heels of each win, I double my position size until I’m trading full-sizepositions. I scale up on winners and scale back on losers.Figure 5-5 A typical example of how I scale from smaller to larger positions and use profits to financemy increased risk. If I keep my risk at 2:1, I can be right just as often as I’m wrong and notget in any trouble. If I can scale up three consecutive winning trades—winning on a quarter, half, and one full position will give me the opportunityto finance three full positions and one half position (see Figure 5-6).Figure 5-6 By scaling up on the heels of profits, those wins can finance risk on my larger trades.NEVER LAY ODDSWhen you play poker, you should always look at how much is in the pot inrelation to how much you are going to bet or call. Good poker players alwaystry to get odds on their money. Would you risk 150 to win 50? Not if you’resmart. You would much rather risk $150 to win $550. If your hand has a50/50 chance of winning, then you need to get better than 2:1 odds on yourwager to justify making the bet. Stock trading is no different. Assuming your trade has a 50/50 chance of success, taking a 20 percentrisk to make 20 percent is only going to lead to losses over time; you willbreak even on the trade, but lose on trading costs. The key is to always getodds, and never lay odds. Keep your risk to a fraction of your gains and youwill enjoy a mathematical advantage and have an “edge” (Figure 5-7).Figure 5-7 Trader A allows the stock to drop 20 percent and then nails down a 20 percent profit, a 1:1reward/risk ratio. Trader B, in contrast, makes 4:1 on his money, risking 5 percent for a 20 percentreturn. Which trader do you think will be the bigger winner over many trades?LONGEVITY IS THE KEYIn my first book, I told the story of achieving a 259 score during my very firstyear playing in a Wednesday night bowling league. My point was that anyonecan have short-term success like I did that night, but I never came close tothat score ever again. Consistency differentiates the pros from the amateurs.You may be able to step on the basketball court and hit a three-point shot, butMichael Jordan did it consistently and reliably, and under pressure. Your goalin trading is to execute a strategy you can rely on consistently, knowing thatthe outcome of any one trade does not determine your success; rather, it’s thecollective outcome of all your decisions and trades over time. A consistentapplication of discipline leads to longevity and repeatability.NEVER LET A GOOD-SIZE GAIN TURN INTO A LOSSOnce a stock moves up a decent amount from my purchase price, I go intoprofit-protection mode. At the very least, I protect my breakeven point. Therule is never let a good-size gain turn into a loss. Suppose I buy a stock at $50and the stock advances to $65; I will then move my stop to at least $50. If thestock continues to rise, I start to look for an opportunity to sell all or a portionon the way up to nail down a profit. If I get stopped out at breakeven, I stillhave my capital; nothing gained, but nothing lost. My priorities in order ofimportance are: 1. Protect myself from a large loss with an initial stop 2. Protect my principal once the stock moves up 3. Protect my profit once I’m at a decent gain I have some general guidelines: Any stock that rises to a multiple of mystop-loss and above my average gain should never be allowed to go into theloss column. When the price of a stock I own rises by three times my risk, Ialmost always move my stop up, especially if that number is above myhistorical average gain. If a stock rises to twice my average gain, I alwaysmove my stop up to at least breakeven, and in most cases I back stop theposition equal to my average gain. This will help guard you against lossesand protect your profits and your confidence. It doesn’t feel great breaking even on a trade that was once a profit, but itfeels a lot better than when you let a good-size gain turn into a losing trade.One of the most demoralizing experiences is to watch a stock you ownskyrocket and then tumble, taking back all your profit and then turning into aloss. Remember, your goal is to make a decent profit, not to get in at the lowor get out at the high. You need to give your stock room to fluctuate, but youmust move your stop up and protect your principal once you have a good-sized gain. To achieve consistent profitability, you must protect your gains andyour principal; I don’t differentiate between the two. Once I make aprofit, that money belongs to me. Yesterday’s profit is part of today’sprincipal. Amateur investors treat their gains like the market’s money instead of theirmoney, and in due time the market takes it back. I avoid this by protectingmy breakeven point and my profits when the stock is up a decent amount.Sometimes I nail down a portion of my profits and then free roll the rest for alarger gain. I allow my stock positions enough room to go through a naturalreaction, but I never want to hold a stock that is not acting right. But, as I’vesaid, I’m certainly not going to let a good gain turn into a loss (Figure 5-8),and I’m never going to buy more of a stock that has completely wiped out agood-size gain.Figure 5-8 Immunogen (IMGN) 2015. The stock fully retraced a 30 percent profit. In this scenario, ifyou made the mistake of not selling and nailing down a profit when you had the chance—your priorityshould shift to protecting your principal.AVOID THE AUDIBLEThe football team is on the 40-yard line. As the offensive linemen take theirpositions, the quarterback notices a shift in the defense. He suddenly changeshis mind about running the play. Just before the snap, he yells out signals tothe offense. A new play is instantly put in motion. The ball is snapped, theoffensive makes its move, and the team gains 12 yards for a first down. With the right players and an experienced quarterback, that last-minutechange of play, known as “calling an audible,” may work well in football.But it is definitely not something you want to do when trading stocks,especially if you are a beginner. Even pros should stick with a plan, with veryfew exceptions. An audible, in the case of trading, is rarely a strategic or defensive movecaused by a sudden shift in the marketplace. Rather, it means that a trader ismaking an on-the-spot decision; when money, ego, and emotions areinvolved, that’s rarely a good move. How many times have you made a hastysnap decision that yielded great results? Even though I’ve traded professionally for the better part of my adult life—33 years and counting—I never stray from the basics of rule number one ofalways going in with a plan. I do my homework beforehand. I find stocks thatmeet the criteria of my strategy. I define my entry points. I know where I’mgetting out if I’m wrong, and I know what I need to see to hold. It’s a fullplan, ready to be executed. That’s why my success has been consistent overthe years.This level of preparation cannot compare with a knee-jerk reaction to buysome stock, just because I heard an interview with a company CEO onCNBC or there was sudden breaking news. When I buy a stock, I want to beunemotional, with no pressure to do something quickly or irrationally withoutthinking it through. When my money is on the line, I’m as fully prepared as Ican be to enter the market. I know from experience that “calling anaudible” and making on-the-spot snap decisions can get me into a lot oftrouble, simply because I haven’t done the full research. So, I don’t do it! Even when a company appears to have very positive “surprise” news, younever know how the market is going to react. Maybe that news was alreadypriced in. Or maybe the market was expecting something else. When newsbreaks, volatility rises; wide swings can whip you in and out of a trade.You’re likely to get emotional, which doesn’t mix well with trading. Concentrate on executing your plan. If you start tweaking it in the middleof the trading day, you’ll be at risk of rationalizing why you should deviatefrom your original blueprint. That could invite trouble. When you’re out ofthe trade, your head is clear and your emotions are calm—then you can do athorough analysis of what happened. Based on those insights, you can makeimprovements to your existing plan and formulate a new plan if necessary.As for calling audibles, they’re best avoided.SHOULD YOU HOLD INTO AN EARNINGS REPORT?One of the benefits of day trading is going flat at the end of every day andtaking no overnight risk. When you swing trade, holding for longer than justan intraday move, you take the risk of news coming out somewhere betweenwhen the stock closes and when it reopens the following day. When anearnings report is about to be announced, you open yourself up to the risk ofa gap in price. A great report can send a stock soaring, just as a poor reportcan cause a stock to unravel and decline well below your stop before you canget a chance to react. Why companies are allowed to report earnings afterhours, as opposed to during the day when the market is open, is beyond mylogical reasoning. But those are the current rules. My general rule of thumb is never hold a large position going into amajor report unless I have a reasonable profit cushion. If I have a 10percent profit on a stock, then I could usually justify holding into mostearnings reports. However, if I have no profit, or worse I’m at a loss, Iusually sell the stock or cut down my position size to guard against thepossibility of a 10 to 15 percent gap against me. Regardless of how well youknow the company, holding into earnings is always a crapshoot. I’ve seenstocks beat earnings estimates by a healthy amount and still get slammed onthe open. Bottom line: there’s a degree of luck involved when you hold intoearnings. If you have a decent profit in the stock, you are at least insulatingyour principal and mitigating some of the risk. Size positions accordingly andnever take big risks going into a major report.MARCH TO YOUR OWN DRUMMERThe great American writer-philosopher Henry David Thoreau surely was notspeaking about trading when he wrote his classic Walden. And yet, becauseThoreau’s wisdom is universal, we can find a direct application to stockinvesting in one of his most famous quotations: “If a man does not keep pacewith his companions, perhaps it is because he hears a different drummer. Lethim step to the music which he hears, however measured or far away.” In other words, “March to your own drummer.” All too often traders get pushed into deviating from their strategy and,therefore, making the wrong decisions about their trades because they’vesuccumbed to the influence of outside forces. The marketplace is full ofpropaganda and hyperbole. Watching television, reading tradingcommentary, searching the Internet, and keeping up with the latest marketletters will inundate you with “news” about what other people are saying. What some fund manager is doing, or how many trades a friend of yourshas made is irrelevant when it comes to your own trading. Your friend mightbe doing great, making money while you’re still waiting for a stock to set upaccording to your plan. That doesn’t mean you should second-guess yourapproach and do something prematurely just because you’re feelingimpatient. It doesn’t matter what anyone else is doing in the market; thestocks you’re watching and trading don’t know it. There are many distractions that can cloud your judgment whentrading. Your job is to keep your thinking pure and focused on whatmatters within your own circle of competence. The hallmark of a pro isto operate within this circle and ignore everything else. To trade successfully, you must learn to make your own decisions. Youneed to shut out all the distractions in the market, starting with the talkingheads and so-called experts who spend more time “discussing” the marketthan actually trading it. Your best and most potent immunity is to have astrategy and rules that dictate your actions, so you won’t be tempted to followtips and commentary about a particular stock (Figure 5-9). Can you beassured that the same person who said to buy will be there to tell you when tosell?Figure 5-9 Fighting off the penetrating forces that challenge your discipline is even more importantthan your strategy. Without discipline, you have no strategy, leaving only hope and luck. Marching to your own drummer means insulating yourself fromextraneous influences that would otherwise cause you to deviate fromyour own discipline. In the words of the late Dr. Wayne Dyer, “beindependent of the good opinion of others.” If you don’t stick with your ownrhythm, you’ll soon find yourself out of step with your strategy and ledastray. One of the biggest distractors of all is the market itself. You can driveyourself crazy watching the Dow Jones Industrial Average, the S&P 500,Nasdaq 100, and all the rest of the indexes. Just because the index numbersare green and the arrows are pointing up doesn’t mean that the stocks youtrade are in a buyable position based on your own rules and strategy. There have been weeks and even months when the Dow was up and yet Idid nothing, because the stocks on my watch list had not set up according tomy strategy. Other times, the Dow was sideways or even down, afterdigesting a previous big upward move, and I made some of my biggest gains.What the Dow does or doesn’t do is little more than background noise. It’scertainly not my “drumbeat.”DON’T “FORCE” TRADESYou have your watch list containing the best possible candidates for yournext potential trades. Let’s say that one or two appear to be setting up nicelyaccording to your criteria. They’re almost there—but not quite. So, shouldyou just jump in anyway, because you’re impatient, and you figure that it’s“close enough” to act? No way! One of my major rules is never force trades. Instead, let the market come to you. Wait for the stock to meet the criteriathat your strategy demands. You need patience to confirm that the stock will,indeed, reach the entry point you have identified and behave in the mannerthat your strategy prescribes. Many times, I’ve seen a stock almost hit myentry, then reverse course. Had I forced that trade prematurely, I would havebeen stopped out almost instantly with a loss that was completelyunnecessary—and all because I couldn’t wait. If you find it difficult to be on the sidelines, waiting for your setup,remember it’s not about the action. It’s about the money. The problem is,your own need to do something can be the biggest enticement of all todeviate from your plan. You tell yourself, I’ll take a small position. This kindof self-talk is self-delusion that leads to the very bad habit of “going rogue”instead of sticking to your strategy.DEVELOP SIT-OUT POWERLike a cheetah waiting in the bush for the right set of circumstances (awounded antelope upwind) to pounce on, you must develop what I call sit-outpower. This is another hallmark of a pro—the ability to wait patiently for theright set of circumstances before entering a trade. The cheetah can bestarving, but it still knows that to eat, it must exercise patience and wait forthe right moment. The cheetah is smart enough to know not to waste itsenergy on a low-probability kill. If you circumvent your rules and discipline, you have no strategy. If youforce trades and, as a result, take losses, you will dig yourself into a hole thatwill require a lot of work just to climb back to even. Trust your discipline anddevelop sit-out power. Then, when the moment is right, you make yourmove. To make money consistently, you must stay disciplined. Followyour strategy and the trading rules that keep you from enteringpremature, ill-timed, and risky trades for no other reason than you justwant to be in the market.LUCK IS FOR VEGASIf you want to roll the dice, go to Las Vegas. There you will need all the luckyou can get. If you want to be successful in the market, you need to removethe “luck factor” as much as possible. How? Once again—do your research.Know what you need to know about the stocks you’re buying and beprepared for every outcome before you even enter a trade. If you love action and you’re only interested in “taking a shot,” you mightget “lucky” in the market. You could even stumble into something at afortuitous time and make a decent return—without really knowing what youdid, how, or why. But how long do you think that kind of luck will last? Youcan’t count on any consistency because there is no real basis to yourapproach. The bigger problem with a lucky shot is that it reinforces bad habits. Youtell yourself, this is easy. You take bigger risks, buying stocks for no otherreason than having a “hunch” or because of “something” you heard. It mighteven work on occasion. Unfortunately, at some point, everybody getsrewarded for a bad habit in the market. In that moment, you feel like you justcan’t lose. That’s the seductiveness of the market: it’s like the Venus fly trapthat looks so beautiful and then—gulp—it swallows you whole if you fly bythe seat of your pants. Rules trump luck over time. It doesn’t matter how much you win on alucky shot; that end does not justify the means. If you throw a dart at a list ofstocks pinned to a dartboard, and you make 30 or 40 percent on the one you“picked,” that doesn’t mean you made a good decision. You will certainlygive back your lucky profits eventually, and your easy money will only be adistant memory. Instead, you want rewards that come from a consistent andsustainable approach that will produce results now and in the future; astrategy that can pay you for life. Luck is a short-term phenomenon. In thelong run, luck is for losers.WINNERS ARE PREPAREDYour fifth-grade teacher was right: do your homework. Every night, I preparefor the next day’s trading. That means looking at what I currently own: Howare my stocks performing compared to my plan? What new candidates have Iidentified, and are they nearing the entry point for executing a trade? If you don’t stay on top of your portfolio, you will expose yourself tountold risks: stocks that suddenly gap down on bad news or stocks that aregoing nowhere, no matter how much the talking heads on television discuss

or hype their prospects. I’d rather miss some decent candidates that aren’t on