If you have a losing position that is making you uncomfortable, get out, because you can always get back in. There is nothing better than a fresh start.
Don't be too concerned about where you got into a position. The only relevant question is whether you are bullish or bearish on the position that day . . . . Who cares where I was long from? That has no relevance to whether the market environment is bullish or bearish right now, or to the risk/reward balance of a long position at the moment.
The most important rule of trading is to play great defense, not great offense. Every day I assume the position I have is wrong. [If my positions] are going against me, then I have a game plan for getting out.
Don't be a hero. Don't have an ego. Always question yourself and your ability. Don't ever feel you are very good. The second you do, you are dead.
Thus we have in five paragraphs not only the essence of Jones's thinking but a concise account of the characteristics of other great traders. The idea of only playing defense, for example, is another way of saying the number one objective is to protect your capital. So too is the statement, "I always assume every position I have is wrong." When later asked to provide advice to a novice trader, Jones replied in the same vein. "Don't focus on making money," he said, "focus on protecting what you have." He considers himself to be a market opportunist developing an idea on the market and pursuing it from a low-risk standpoint until he has been repeatedly proven wrong or until he changes his viewpoint.
Pride of opinion, as described in Chapter 4, can cause devastating financial losses. When questioned by Schwager about what made him different, Jones said, "I don't really care about the mistake I made three seconds ago. What I care about is what I am going to do from the very next moment on. I try to avoid any emotional attachment to any market. I avoid letting my trading opinions be influenced by comments I may have made on the record about a market."
This last statement is somewhat remarkable for there are few people who do not worry about what they are on record as saying. It shows the investor's ability to change his mind and not be married to a particular situation merely because he once held that belief. After all, flexibility is a virtue that keeps appearing in the psyche of great traders. Whereas loyalty to people is a great virtue, disloyalty to a market that does not act well is also to be recommended. To quote Jones once again: "[Cutting emotional attachment to a market] is important because it gives you a wide-open intellectual horizon to figure out what is really happening. It allows you to come in with a completely clean slate in choosing the correct forecast for that particular market."
Bob Prechter
Bob Prechter does not conveniently fit into the great trader category, because his primary career has been in the business of writing a market letter. Nonetheless, he won the U.S. Trading Championship in 1984, setting an all-time profit record with a four-month gain of 440% in a monitored, real-money options account. This does not compare with the consistent long-term gains of a Buffet, Seykota, or Jones, but many successful traders subscribe to his market letter and follow his Elliott Wave Methodology. More to the point, he is lucid and has provided his subscribers a list of trading requirements (as opposed to a list of trading rules).
I have already outlined several of the roles recommended by Prechter but this merely underlines that certain characteristics or requirements contribute to making a great trader. The more times we can see them surface in different successful individuals the more we will appreciate their relevance. The following are Bob Prechter's trading requirements:
1. A Method. By a "method," he is referring to an objectively defined mechanism that helps you to make a trading decision. Buffet's and Templeton's methods focus on the simple concept of buying undervalued companies that possess good potential for growth. Seykota has a short-term mechanical/ technical system. All the money masters and marked wizards have some kind of method or philosophy on which to base their decisions. None is perfect, but when properly applied they earn their practitioners substantial profits.
2. The Discipline to Follow the Method. We have talked about discipline earlier in great depth so there is no need to elucidate further, except to say, as Prechter puts it, "Without discipline you really have no method in the first place."
3. The Mental Fortitude to Accept That Losses Are Part of the Game. Most people blame outside forces for their losses: Insiders, unexpected news events, stock manipulators, and the like are often singled out for abuse. Rarely are losses accepted as part of the game. We do not expect a baseball player to hit every ball so why should we expect to win on every trade? Prechter's point is that we should not only accept losses but also should anticipate them through sound money management.
4. The Mental Fortitude to Accept Huge Gains. This is his way of saying, "Let your profits run." The concept theorizes that you make a series of small trades with mixed results. Then a big one comes along where you make twice the usual profit. Your best friend and your broker tell you not to be greedy, but your system or method says to stay in. You get out but find that when the system goes negative you have lost the potential of the trade of a lifetime.
No doubt there has been some repetition in this chapter, but that's all to the good. The more emphasis placed on the charac teristics that contribute to the makeup of a great trader or investor, the more believable they will become. And the more believable these attributes become, the more likely you will be to put these rules into practice and to adopt the characteristics. The most difficult hurdle is understanding that these money masters are in the game less for the money than they are for the challenge of the game and their passion for that challenge. This factor probably distinguishes most of us from these exceptional players, because we usually play the market for the money first and the challenge and love of the game second.
12
Nineteen Trading
Rules for
Greater Profits
l revious chapters have described how markets have a habit of finding out our weaknesses and exploiting them to the fullest. Successful traders are those who not only know the workings of the markets but who also have the will to put a plan into action and follow it religiously. Since trading in the market is basically a process of dealing with probabilities and beating the odds, anyone who participates in the market must make a conscious effort to set up some kind of structure that will help him master his emotions. If you recognize that you have a problem before taking on a trading position or making a longterm investment you will be in a better position to spot potential pitfalls. In this chapter, we will outline some rules that will help you do this. But remember that reading and understanding the rules is not enough. You must also put them into practice.
The rules described here are not the only ones, but they are generally considered to be the most important. It is assumed that at this stage you already have some rudimentary knowledge of how markets work and also a method for making trading decisions. It could be a technical, fundamental, or behaviorist approach. The vehicle is not important as long as it has been tested and as long as you feel comfortable with it. All the world's great religions try to lead us to essentially the same place (i.e., discovery of the truth), but their paths are different. So it is with methods and markets. All approaches have greater profitability as their objective, but each individual has to choose his own path. It is no good using a method practiced by a prominent trader or market newsletter writer if you do not feel completely comfortable with it, because when things become difficult, as they will surely do, you are far less likely to stay with it. Also, if you are lucky enough to choose a trading style or approach with which you feel totally at home, the chances are good that you will find the incentive to work a lot harder at it.
Selecting a methodology is usually not hard; executing it is. Mastering emotion is precisely what the rules are designed to do. Once you have a position in the market, it's easy to play mental games to avoid the pain of losing. Let's say you buy one gold contract at $350, expecting it
to rally to $370. Instead, the price of gold falls to $345. This decline is justified by the media (which always has to have an excuse for price movements) as being due to Russian selling. An immediate emotional response by most people is to rationalize that the selling is probably over. After all, why would the Russians announce they were major sellers if they had not already sold? Consequently, hope for a rally would now replace the original analysis as a basis for being long in anticipation of a rise in the price. The rationalization and the hope are really protecting the trader from the dual pain of having to admit he was wrong and has to take a loss. This process also involves some denial of the reality of the situation. After all, the market did not move in the expected direction, and this implies that the original decision to go long was incorrect.
Another example of denying reality may occur where a trader, to get in with less risk, stalks a possible trade for several days, waiting for a small correction. Let's say that the item in question is the deutsche mark. Each day, the price works its way slowly and tantalizingly higher. Finally, a very bullish news story appears in the wire services saying that the German balance of payments has moved into surplus. This is the last straw for our now impatient trader. He can no longer control his enthusiasm and plunges into the market at substantially higher prices than he was prepared to pay only two or three days previously. It's a good bet that this represents an exhaustion move, since the market had been rallying in the previous week in anticipation of this good news. Naturally, the mark peaks out and leaves our trader with a nasty loss and the need to make an objective decision of where to limit the damage. It is very difficult to obtain an objective viewpoint in an emotionally charged climate. Better to establish and follow some rules that are aimed at preventing such a situation from arising.
Rules won't eliminate losses, but they will help reduce the level of emotion as they increase objectivity and consistency. If you can be more objective, there will be far less room for hope, greed, and fear to crowd out your better judgment. In Chapter 14, we list trading rules proposed by many different but knowledgeable sources. No one can truly learn the benefit of any set of rules or principles except through actual experience in the marketplace, so the listing and explanation of some of the guidelines in this chapter are really starting points to which you will hopefully return. Studies show that advertising is far more powerful when it is repeated on a sustained basis than when it appears in one or two isolated ads. The message being portrayed then stands a better chance of being embedded in the mind of the consumer. The inclusion of the trading rules in Chapter 14 is a way to mount a sustained advertising campaign on you. These same principles have been expounded by history's great traders and investors, all of whom have struggled with the difficult task of mastering their emotions. Because each person has his own style and approach, the lists are slightly different. But they all have the same objective, namely, maintaining objectivity, and clear independent thinking and achieving sound money management practices. That these same principles come from so many different sources, separated by time and professional pursuits, cannot be discounted as a mere coincidence. They are on the list because they work. They worked for legends such as Jesse Livermore and Bernard Baruch as well as successful traders practicing today. They can and will work for you, but only if you give them a chance. You are encouraged to refer to Chapter 14, but the remainder of this chapter will summarize the rules I think are most important. Before we begin, please remember that no rule will work unless it is put into practice. If the road to hell is paved with good intentions, almost certainly the road to financial ruin is, as well.
The following 19 rules can be roughly categorized into those that help you to master your emotions and those that aid in risk control. In other words, personal psychological management and money management.
Psychological Management
Rule 1. When in Doubt, Stay Out
When trading the markets, it is important to have a certain level of confidence in what you are doing. Too much confidence will lead to carelessness and overtrading and is unwelcome. On the other hand, if you enter a position with little or no enthusiasm, you are setting yourself up for some knee-jerk reactions when bad news breaks. If there is the slightest doubt in your mind about entering a trade, then you should not initiate it, because you will not have the emotional fortitude to stay with it when things begin to go wrong. For instance, if you are in doubt, you will tend to concentrate on any negative breaking developments. As prices decline, you will get more and more discouraged. Consequently, when the price falls to a support, or buying, zone, you will be in more of a frame of mind to sell than to buy.
Alternatively, you may get into a position based on some solid research and in a confident, but not overly enthusiastic mode. Later, some new evidence comes to the fore that causes you to be less optimistic than before. In short, some doubt about the validity of the original rationale for getting in begins to creep in to your mind. It does not matter whether the position is above or below where you got in. The important thing is that you now begin to doubt your original rationale. Under such circumstances there is only one logical course of action-get out. You no longer have the fortitude that comes from a strong conviction. This means that you will most likely head for the exits at the first sign of trouble.
It is important to remember that the principal reason that you are in the market is to make a profit. If the odds of that happening have decreased, then you have little justification for maintaining the position. After all, this is not your last chance to trade; there will always be another opportunity down the road.
Rule 2. Never Trade or Invest Based on Hope
This topic was covered in Chapter 2. It bears repeating as a trading rule since so many of us hold on to losing positions well after the original rationale for their initiation has vanished. The only reason for not selling is hope, and markets usually reward the hopeful with losses. When you find yourself in this situation, sell promptly.
Rule 3. Act on Your Own Judgment or Else Absolutely and Entirely on the Judgment of Another
It was established earlier that if you do not enter a trade or investment with total confidence, you are likely to be spooked out at the first sign of trouble. If you find yourself relying on your broker or friends for tips and advice, the chances are that you will not have carefully considered all of the ramifications. This means that you will not have the emotional fortification to be totally committed to the trade if things appear to go wrong. It is much better to consider all the arguments, both bullish and bearish, prior to making a commitment. In this way, you will be in a good position to judge whether the latest price setback is a result of a fundamental change in the overall situation or if it is merely part of the normal ebb and flow that any market goes through.
Brokers, friends, and others that you respect can be helpful in providing you with ideas but you are the one who should make the final decision. This means balancing out the pros and cons, listening to this opinion and that before coming to a carefully considered independent conclusion of your own. After all, if things go wrong, it's you who lose the money, not your friends.
This rule also cautions you from following tips or insider information. I have found that people invariably lose when they trade on such information. In the case of stocks, such tips usually revolve around takeover activity, the announcement of betterthan-expected corporate earnings, or a lucrative contract. In a publicly held company, the chances that you as an individual will be privy to such information will be remote. Others will usually have been there before you, the news being already factored into the price. Moreover, the "good" news often gets exaggerated as it gets passed around. Quite often, the story is false or the event in question fails to materialize. Even if you do manage to obtain some insider news from which profits can be obtained, it is basically unethical and unfair to buy stock from someone who would not be selling it at that price had he been privy to the same information as yourself. This is far different
from two people deciding to make an exchange based on an honest difference of opinion concerning the outlook for the company in question.
If you cannot make a decision based solely on your own judgment of the facts, and opinions of colleagues, friends, and brokers, you are better off turning your portfolio over to someone whom you have checked out thoroughly for integrity and competence.
Rule 4. Buy Low (into Weakness), Sell High (into Strength)
Everyone knows that if you buy low and sell high you are bound to make money. This is clearly not as easy as it sounds otherwise you wouldn't be reading this book. The idea that I am trying to get over here is something a little different; it might be better expressed as "Buy on weakness, sell on strength." When prices rise, so does confidence. Prices that progressively fall, on the other hand, attract a greater and greater amount of concern. The reason is that rising prices are usually accompanied by positive news making us feel more comfortable. We tend to downplay our fears at such times and therefore take on more risk. In his classic book, Psychology of the Stock Market, G. C. Selden explains it so: "The greatest fault of ninety-nine out of one hundred active traders is being bullish at high prices and bearish at low prices. Therefore refuse to follow the market beyond what you consider a reasonable climax, no matter how large the possible profits that you may appear to be losing by inaction." These words are as true today as in 1912, when they were originally written. This is the way both the crowd and individuals tend to react. However, as discussed in Chapter 7, it pays to go the opposite way to the crowd whenever you can. Generally, this means buying on weakness and selling on strength. This rule is applicable for both initial positions and when adding.
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