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.Incorrectly identifying a market cycle with either the four major cy-cles we ve listed or by using Elliott wave theory can be a costly situa-tion.For example, if you incorrectly determined that a market entereda new trend, but in fact it was consolidating, you might enter a trendtrade and immediately get stopped out.For this reason, market expe-rience is the best teacher.Your best plan of action is constant ob-servation.With that, you will continually improve your ability to readmarket cycles. P1: PIC/b P2: c/d QC: e/f T1: gc06 JWBK182-McDowell April 25, 2008 15:54 Printer: Yet to come54 A TRADER S MONEY MANAGEMENT SYSTEMFIGURE 6.6 The ART Software Identifies a Market Correction with MP, minorpyramid trading point triangles.Source: eSignal.www.eSignal.comRemember, the right side of the chart is always an unknown quan-tity until it reveals itself.Hindsight is generally 20/20.Trying to predict themarkets can be an elusive and impossible endeavor.So do not berate your-self if the ability to correctly identify market cycles takes you some time todevelop.YOUR TRADING SYSTEM IS YOUR BESTFRIEND A man s best friend is his dog, as the saying goes.In the markets, thetrader s best friend is a sound trading system.If you take the time andenergy to develop a winning system it will reward you with a lifetime ofcompanionship and consistent profits. P1: PIC/b P2: VEV/d QC: e/f T1: gc07 JWBK182-McDowell April 25, 2008 15:58 Printer: Yet to comeCHA PT E R 7Stop-LossExit Rulesne important way to control your trading risk is by setting stop-lossexits.A stop-loss exit is a practical tool used in managing risk, andOthere is an art to developing the right strategy.On the one hand, youdon t want to set stops that are so tight that you constantly get bumped outof the market.On the other hand, you don t want to be too liberal with yourstops so that you never lock in profit.The solution is to find an approach that is a balance of these two goalsand is based on market dynamics.Your stop loss strategy should be de-signed to let your trade breathe and fluctuate with the normal ebb and flowof the market.THERE S A WORLD OF RISK INTRADING: A RISK LIST TO LIVE BYThe value of having a stop-loss exit in place prior to entering the market isthat you can unemotionally determine the best exit possible for the typesof risk listed here.If you enter a trade before you think about where youare going to get out, you are dancing with the devil.Here s a risk list thatyour stop exits can help protect you from:Trade risk.The calculated risk you take on each individual trade isadjusted by changing your trade size.This is the only risk you can55 P1: PIC/b P2: VEV/d QC: e/f T1: gc07 JWBK182-McDowell April 25, 2008 15:58 Printer: Yet to come56 A TRADER S MONEY MANAGEMENT SYSTEMcontrol.A good rule of thumb is to never risk more than 2 percentof the capital in your trading account on any one trade.(Advancedtraders, see important note following this list.)Market risk.Theinherent risk of being in the market is called marketrisk and we have absolutely no control over this type of risk.It includesthe entire gamut of risk possible when in the markets.Market risk maycause your carefully calculated trade risk to be much larger than antic-ipated.Market risk can be far greater than trade risk.For this reasonit is best that you never trade with more than 10 percent of your networth.This type of risk encompasses catastrophic world events andmarket crashes that create complete paralysis in the markets.Eventscausing market gaps in price against your trade are also considered tobe market risk.Margin risk.This involves risk where you can lose more than the dol-lar amount in your margined trading account.Because you are lever-aged, you then owe the brokerage firm money if the trade goes againstyou.Liquidity risk.If there are no buyers when you want to sell, you willexperience the inconvenience of liquidity risk.In addition to the incon-venience, this type of risk can be costly when the price is going straightdown to zero and you are not able to get out, much like the experienceof Enron shareholders in 2001.Liquidity risk can be caused by or ag-gravated by a market risk event.Overnight risk.For day traders, overnight risk presents a concernin that what can happen overnight, when the markets are closed, candramatically impact the value of their position.There is the potential tohave a gap open at the opening bell where the price is miles away fromwhere it closed the day before.(See the sidebar Rules of Engagement later in this chapter for determining how to hold trades overnight.) Thisgap possibility can negatively impact your account value.Volatility risk.A bumpy market may tend to stop you out of tradesrepeatedly, creating significant drawdown.Volatility risk occurs whenyour stop-loss exits are not in alignment with the market and are notable to breathe with current price fluctuations.IMPORTANT NOTE: For some advanced traders, it is beneficial torisk more than 2 percent of their trading account.The amount thesetraders risk must be carefully calculated depending on their provenhistorical performance statistics.See Chapter 9 for the formulas todetermine if your payoff ratio and win ratio performance warrant ahigher risk than 2 percent
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