The Rules: Rule Number Two

Rule One (September 20) is to determine overall market direction before trading. Ignore that Rule and you can get killed right off the bat. But assuming you observe Rule One, and you are putting money into the market, the next most important Rule is Number Two: Protect Your Capital by minimizing losses!

There are three keys to observing this Rule, which is the Rule most commonly ignored by novices. First, I establish a stop-loss for each stock when I buy it. Under some circumstances, this can be as little as 50 cents below the purchase price. But it is never less than 7-8% below the purchase price, given that I have observed Rule One and am buying into a rising market.

Second, I look for market tops in my stock and in the market indices overall. I watch for volume increases on down days, and I tighten up stop losses if there are gaps down even if my position is profitable.

Third, I sell all positions if the Dow, Nasdaq, or S&P 500 experience 4 distribution days in a 4-5 week period. That signals at least the end of a rally if not an overall change in direction. A distribution day is a day in which the market closes more than .7 % lower than the previous day on significantly greater than average volume. Don't worry, you'll know one when you see it.