I use the Rule of 3 to smooth out my equity curve and to pyramid safely.
In this post, I’ll explain the first use. It’s important to understand that the Rule of 3 will reduce my bottom line in strongly trending markets. But in markets such as I have been trading recently, it prevents heavy losses and often allows me to exit positions at breakeven or with a small loss.
The Rule as set out in this post is not set in stone. I’ll vary the process to suit my perception of the trade’s risk.
My trader’s timeframe is the 18-day swing (monthly trend). My favourite entry is Negative Development on the First Lower Timeframe i.e. on the 5-d. Figure 1 shows the ideal pattern with a small variation – the trader’s timeframe is the 12-month and the First Lower Timeframe the 13-week.
Figure 1 Crude Oil 12-M
Entry is with 3 contracts or multiples thereof. Let’s assume we bought at 60 and had a stop at 52. We exit the first 1/3 as soon as we cover the stop on the remaining 2 contracts. Since our stop is 8 points per contract and we have 2 contracts, we need 16 points. 16 + 60 = 76. We exit the 2nd contract at the Primary Zones, in this case the Primary Sell Zone.
The Primary Sell Zone ranges from 79.35 to 76.54. So I’d exit the contract somewhere in that area. When I exit the second contract, I raise the stop on the third contract to breakeven.
The third contract I hold. This is the contract that gives me a position in case the market breaks out. Most times I’ll get stopped out but the occasions I don’t get stopped out more than makes up for the loss of the profits when I do. Figure 2 shows what happened when the market broke out: at that stage, I have pocketed profits on 2 contracts, holding a third and looking for a retracement to re-enter with 3 contracts and start the process all over again.
Figure 2 Crude Oil 12-M
I’ll exit the third contract when my trailing stop is hit or there is a change in trend pattern.
What I have described is the optimal Rule of 3. But as I said, I vary the process based on my estimate of the risk of the trade.
In the current ES trade for example, I believed that while an upside breakout was likely, it would not result in a sustained trend. In that situation, I looked to take profits on one contract much earlier. I’d do this by looking for an opportunity to bring the stop on one contract to breakeven. In this way, the second contract need only cover the costs of one stop. I would also take profits on the second contract much earlier and exit the third at the Primary Sell Zone.
Pete Steidlmayer used to have a phrase ‘behavioural parameters: patterns that we can rely on in our trading. Pete taught some behavioural parameters in sideways markets that I find extremely helpful to the Rule of 3…..but that’s a story for another day.