TRADING 101   REVISED 11-18-2012 | 2nd REVISION 04-20-2013

Trade Desk

Trading Rules 101 is a combination of patterns and observations we have learned on the trading floors of the Chicago Board of Trade and the Chicago Mercantile Exchange over the last 35 years. Much of it was made up during the time the desk worked the phone for Marty “The Pit Bull” Schwartz. It was an amazing time back then. Today the roar of the S&P pit is gone, but long after electronic trading took over, the rules continue to be a vital part of our trading toolbox.

MrTopStep’s NO. 1 RULE is not to trade in a closet. Find a trading buddy, share ideas and most of all be patient. While our trading rule E-book may not cover everything, we do think it’s a good beginning of a new way to look at the markets. With algorithm and program trading making up over 75% of the trading volume, we feel the more tools you have, the better off you are.

MUTUAL FUND MONDAY: Over many years of watching, we have concluded that the mutual funds use Mondays as a favored day for the portfolio managers to buy stock. Part of the theory is traders look to buy on Friday and hold into Monday/Tuesday’s open.

TURNAROUND TUESDAY: Tuesdays are also part of the early week strength. The thought process is that the markets tend to rally early in the day and early in the week. This especially applies during a bear market. Following Mutual Fund Monday’s performance, there is a tendency for morning strength.

ACTIVE MONTHS: The best 6-month performance period for the stock market begins in November and lasts through April.

10 HANDLE RULE: After many years of doing index arbitrage in the S&P futures (program trading) we noticed that the S&P often moves in 10-handle increments. For example, the S&P opens unchanged at 1194, downticks down to 1192 and starts moving back up. If the low is good the S&P will generally move 10 handles off the low, in this case back up to the 1202 level. That is when the 10 handle rule (market tendency) goes into effect. Ten-handle moves in the S&P also tend to be what we consider “inflection points.” Many times when the S&P reaches an inflection point, exhaustion takes place on the first test, at least briefly. The number of times the 10-handle increments play out depends on the market volatility, but with each 10-handle move, there tends to be a short-term high or low made. We look for this to work in both upside or downside price action.

COUNTER-TREND FRIDAY: Over the years this trade works best on monthly NFP jobs Friday when the S&P futures gap sharply higher or lower on oversized pre-market Globex volumes of +400k ES contracts before the 8:30 am CT open. This is a fade, “the bus is too full” type trade. Example: The S&P is down 6 handles at 6:00 am and then down another 8 or more handles after the jobs number is released. Now, the S&P is down 14 handles or more at the 8:30 am open. With 400k+ minis traded before the open, this tells us that traders have already voted (sold). Depending on the price action, the idea is to buy a sharply lower open or allow for another 2-4 handle drop just after the open. The idea behind this is that with so many minis traded and it being a Friday and knowing most traders can’t hold the futures over the weekend, they put in buy stops and the algorithms go right for the buy stops. With all the selling used up pre-open, the ES will start to short cover into the buy stops that lift the offer side of a buy program.

THE THURSDAY/ FRIDAY LOW THE WEEK BEFORE EXPIRATION: This is a Pit Bull trading rule. The S&P tends to make a low on the Thursday or Friday the week before the expiration (more so on the quartiles). The rule is to look to buy weakness on that Thursday or Friday, looking for a low to hold into Monday or even into the expiration itself. Generally, the trade is to buy on Friday and hold into Monday.

THE 5-MINUTE RULE: This requires a pivot to be settled / converted above or below on a 5-minute basis to avoid the whipsaw of being stopped out only to have been correct regarding the market direction. It is just a filter to avoid that humbling situation of being out, but right.

BUS TOO FULL: This is a street guy’s term for when the markets are overbought or oversold. When everyone is bearish and the markets are going crazy, we are looking for buying opportunities. We sometimes use “the bus is too full” instead of the terms “oversold” or “overbought” as the bus tends to accelerate to extremes in either direction.

EVERYONE IS TOO LONG or TOO SHORT: We often use these terms when traders in the pit and retail have gone from long into the rally to short into the decline. This generally means we think the markets are nearing a top or bottom, at least in the short term. This would be where we would look to fade the crowd. This leaves the market susceptible to snapping back. Another example of how this works: When the S&P moves at least 8 or more handles and the locals and small paper get long during the rally or short on the decline, the market may be temporarily overextended. Basically, this equals overbought/oversold conditions, aka “thin chowder.”

NO STOPS GO UNTOUCHED IN THE S&P: Over the years, both in the open outcry and electronic platforms, there is a tendency to “run the stops” as most traders can certainly attest to! Scalpers tend to use 3-5 handle stops and when the markets are moving they trail the stops up or down based on the direction of the move. Most algorithm and program trading systems are set to move in the direction of those stops on a daily basis, so the short-term stops are the easiest targets, but eventually, mid- and long-term stops fall like dominoes. We like those extremes!

THIN CHOWDER: This is from our East Coast traders. It is a term used as the market nears or tests highs or lows of the move and instead of creating energy to extend to punch through to new highs or new lows, the trade becomes thin and lacks conviction. Bostonians “don’t like thin chowder” so they are likely to send it back. Hence, the market refusing to “make a new low or a new high” is basically equal to a rejection.

T+3: T+3 is commonly in reference to “window dressing or window smashing” as the calendar nears the three days prior to month, quarter and/or year end. It stands for “trade date +3 days until settlement.” Depending on how the month, quarter or year end is shaping up, many portfolio managers add to winners and sell losers (or vice versa) in this precarious time in the calendar. The “Of Course We Owned That Hot Stock This Quarter” is not that easy a trade!

TRADING THE 3’s RULE: Just like music, photography, and many other arts and sciences, trading has its rules of threes. Maybe it’s just human nature. This rule of threes is straightforward and should help you set exit targets and understand price action between pivot points.
First, look at where the market is trading at a given time (or where we came from if you’re looking at recent patterns).
Then look for the prices ending in 3 on either side. This Rule of Threes says that we may often go to a three, but we won’t stay there. Instead, we’ll go to a 7.
In a down market, this means that a market that has dropped to a price ending in 3 is likely to break below the 00 and pause at the 7 under it.
This happens even if price breaks past the 7 above and goes to the next whole number (00). It will break up from the 3, trade the 00, continue past the 00, and end up at the next 3. But rather than staying there for very long (as in the 10-Handle Rule) it has momentum enough to take it up to 7.
Magicians have long known that if you ask people to pick a number between 1 and 10, they most often pick seven. The second most often picked is three. Why?
Don’t think of this as a hard and fast rule. Just an insight into market psychology.

THE WALKAWAY TRADE: This is an end of the quarter trade. On the last day of the quarter, the portfolio managers have a tendency to run out of money after marking up stocks earlier. So, by 12:00-1:00ish CT this leaves the S&P susceptible to a decline later in the day. Traders look to set up a short position in the early to mid afternoon, as the professional money managers walk away, leaving the equities ready for an afternoon fade.

THE UNCHANGED GAME: This rule comes from one of Wall Street’s largest OTC desks. Because big bank desks make prices for options and stocks, they have what is called a “Long and Short” book.

Example: A large hedge fund calls the bank’s desk for a price on 500k shares of IBM. The desk makes a price and if the hedge fund likes the price the bank’s desk sells the 500k shares. When the trade is made, the customer is long the stock and the bank desk is short the stock. When the S&P futures are up, the long side of the book doesn’t need adjusting, but as the market goes higher, the short book needs to buy protection. The desk trader has two choices;

1) Take some profits on the long book, which actually adds more upside risk, or

2) Buy S&P futures, if the S&P sells off to unchanged or lower. This is the main reason that sometimes there are so many big bids around unchanged. If the markets continue to fall or rally, they buy or sell the necessary protection for the long/short book on the 3:00 CT cash close.

THE FIVE BUY or SELL PROGRAM:  Back in the ’80s and ’90s when we used to do a large part of the program business we noticed how the S&P would get exhausted after three buy or sell programs.

Example: The S&P’s are selling off and the SPH is trading at a big discount.  As the SPH sells off all the program traders would put their bids in. Once the first bids were hit out, the cash would drop until the next set of program bids showed up. The first sell program was easy to get off and the second one would usually go OK too, but into the third or fourth sell program the bids would start to show up all over the place, thus causing a low / short covering rally. This would work the other way on the upside; after three or four buy programs the offers would pile up and with no outright buyers the S&P would lose premium and sell off again.

THE PLUNGE PROTECTION TEAM (PPT): For years people laughed at who the buyers were at the bottom of a crash and the PPT was always front and center. We heard the term used during the ’87 crash and every other steep decline since. The definition below came from Investopedia:

A colloquial name given to the Working Group on Financial Markets. The Plunge Protection Team (PPT) was created to make financial and economic recommendations to various sectors of the economy in times of economic turbulence. The team consists of the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve, the Chairman of the SEC and the Chairman of the Commodity Futures Trading Commission.

“Plunge Protection Team” was the nickname given to the Working Group by The Washington Post in 1997. The team was initially perceived by some to have been created solely to shore up the markets or even manipulate them. The team was created in response to the 1987 market crash.

S&P 500 FAIR VALUE: Fair value is the premium of the futures over (above) the
index. Fair value is exactly what it implies; a value where futures are ‘fairly’ priced relative to
the stocks themselves, which is the underlying ‘commodity’ for this type of commodity futures
contract. The Program trading in the ES gets going when speculators “bid up” or “offer down”
the ES above or below FV (Fair Value) The idea behind this is simple: when speculators bid up
the ES well above fair value it makes it possible to make a profit buying the stock and selling the
future locking in the spread at a profit. Years ago this was done by hand signal but today is
mostly automated.

EXAMPLES OF STOCK INDEX ARBITRAGE: (AS OF Nov 12 2013) Assume that today fair value of the front-month S&P December futures contract is -3.45 (3.45 points); i.e., SPX is at 1766.50 and Dec S&P futures should theoretically be trading at 1763.05 which they are at this point. The ‘trigger’ point or level for buy programs may be at – 3.85, meaning that IF the premium of Dec SPX futures ran up to -3.85 points above or over the actual index , it would become profitable for index arbitrage trading groups to buy futures and sell stock which would be a ‘buy program’. The buy program works when the index arbitrage group can ‘lock in’ that spread difference of -3.85 points as they’ve calculated that after their transactions costs and by the time of the expiration of December index futures, the futures price will converge or become equal to the actual index.

THE LATE FRIDAY “RIP”: We’ve written often about the Friday Effect, including this description:

The Friday Effect is something MrTopStep noticed earlier in the year and it happened again on Friday’s close. It doesn’t matter if the S&P is up or down on the day, whether the S&P is short-covering into the close or it’s doing just like on Friday, chopping higher. What I have noticed over several weeks was the S&P futures just taking off to the upside going into the 3:00 PM CT cash close. I don’t know enough about why it happens, but I think it has to do with the late-day futures flow rather than the actual cash market.


The Friday Rip is the fast, dramatic move that happens on Friday afternoon near the close. It is generally to the upside, but sometimes involves a sell-off. The MiM often shows a strong signal in one direction. If the market hasn’t yet fulfilled the move the MiM is predicting, there’s a good chance it will wait until almost the last possible minute and then RIP! hit every buy or sell stop and run. 

All of which is to say, “Beware.” Do not leave a trade unattended just because it’s Friday and the market has slowed down and there is very little volume. Remember the thin-to-win rule. Traders can more easily push a thinly traded market around and buy and sell programs often are programmed to take advantage of such opportunities. Even if you’re leaving a trade on over the weekend, make sure your stops are placed such that you don’t get stopped out by a dramatic rip in a way that you hadn’t planned. Either stay on the market or be prepared for a big fluctuation in price.

What causes the rip? It could be a combination of factors: traders closing out positions they don’t want to carry into the Sunday electronic session, a Friday in which funds must adjust their books and want to take on positions they want to report and get out of positions they don’t want to show.

Traders have noticed for decades that what happens on Friday near the close tends to continue on Sunday evening and into Monday.


1. Do not over-trade

2. Do not take a loss home

3.  Never add to a bad trade

4.  Once you have a profit in a trade, never let it become a loss.

5.  When making a new trade, set loss idea – don’t overstay or start hoping.

6.  Don’t be a one-way trader. Be flexible.

7.  Concentrate on one pit.

8.  You’re trading to make money, not for fun and games.

9.  Add to good trades only.

10. Learn quirks of all traders and brokers.

11. Learn runners and brokerage houses.

12. Try to avoid trading in the market in the middle of the session unless it is really busy.

13. When carrying a position in the market, don’t leave the floor without leaving a stop loss order.

14. Never buy rallies or sell breaks when initiating a new trade – only do this when liquidating a bad trade.



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