Step 7. Getting Out
In this phase, the rule of cutting your losses and letting profits run really begins to apply. Cutting losses applies when you have reached your point of maximum loss. One thing you cannot afford to do is take a big loss. Not only will it affect your mental balance for the next transaction but it also is the fastest way to lose principal. As I mentioned earlier, the first objective of any trading or investment program is to preserve your capital. Only risk capital when a low-risk/high-reward opportunity comes along.
A second reason that justifies liquidating a position occurs when the original rationale for entering the trade or investment market no longer exists. After all, if you bought XYZ Company because you were expecting profits to improve and they actually deteriorate, there is no reason for holding it any longer. In our minds, though, we often have difficulty in accepting this. Perhaps the price is down and we are unwilling to take a loss. Perhaps we feel uncomfortable in calling our broker and letting him know that what was a long-term investment is actually a short-term trade. Where pride of opinion is concerned, our minds can play many tricks on us.
Uncertainty is another factor that should influence you to get out. There is an old trading adage: "When in doubt get out." In any situation, there is always going to be some element of doubt. What we are talking about in this instance is a degree of doubt and uncertainty that is far greater than when the position was initiated. If you are unsure, then you have lost a great deal of the confidence and objectivity needed to continue. Under such circumstances, it is appropriate to reconsider whether it is in your best interest to continue with the position.
Letting profits run is a commendable objective, but you must remember that prices do not move up forever. It is therefore a good idea to establish some objectives at the outset as to what level to take profits. Originally, the position would have been initiated because the risk was considered to be low. If, because of a price rise, the risk is now judged to be correspondingly high, the position should be at least partially liquidated. Moreover, if you have run into some personal emotional problems, it means that your judgment will hampered. After all, if a poor psychological condition can be used as a justification for not entering the market, surely it is equally valid for protecting profits.
The task of taking profits should also be a natural consequence of following the plan. If you plan to buy a stock when it has a price-earnings multiple of 8 and sell it when it gets to 15, then the plan calls for liquidation when it reaches that point. Of course, the situation can be reassessed when the objective has been reached. Perhaps there are very good reasons for maintaining the position for greater gains, but you should at least go through the exercise.
The main thing is to focus on setting realistic goals and being consistent in trying to achieve them. This means staying with the plan and modifying it when necessary. Low-risk ideas are so few and far between that this fact in itself will protect you from the pitfalls of overtrading. Even when you have put the plan into action and have achieved some degree of success, you still must implement one more procedure.
Establishing a Review Process
The principal objective of the review process is to establish whether you have faithfully followed the plan and to see whether it may have to be modified. This process has nothing to do with whether you made or lost money. It is there to examine whether you followed the rules. If you didn't follow the rules, then you have made mistakes. You need to ask yourself why you were unable to follow the rules. Perhaps you anticipated what the market was going to do rather than waiting for the market to give its signal as called for by the rules. Perhaps the plan did call for a specific purchase, but when you called your broker he was able to talk you into buying something else. The reason is not important so long as you are able objectively to examine what went wrong and make a mental effort not to repeat your folly. This is a much better approach than going through a selfrecrimination exercise, pointing out how much money you would have made by doing such and such. Reviewing your progress in that way does not teach you anything, and, moreover, it doesn't change the past. In short, it is a waste of mental energy. What has happened has happened, and all you can do is try to learn from the experience and use it as a base on which to build profits for the future.
Another alternative is to go back to the point at which you made the mistake and ask yourself what your options were at the time. Then mentally go through those possibilities, working them through to their possible outcomes. When you have discovered two or three scenarios with positive outcomes, remember them for the next time you are faced with a similar market condition.
This review process should be written down, for it is very easy to forget or to distort what actually went on at the time.
The second part of the review process critiques the plan and the rules themselves. It is a good idea to do this when you are not reflecting on a previous transaction or campaign because it is unreasonable to critique your performance and the plan at the same time. If you feel, with good reason, that the plan and or your objectives need to be changed, then by all means go ahead. Perhaps market conditions or your financial position have changed; perhaps you discover that your tolerance for risk taking is greater or less than you had originally envisaged. Alternatively, you may have just been exposed to a new kind of investment or trading philosophy that you have researched and feel comfortable with. There are many reasons why you might want to change the plan. Be warned against flippant and thoughtless changes, because they will do more harm than good. Treat your plan rather like the U.S. Constitution. It is a solid document, which can be amended only through an arduous process as times and conditions change.
14
Classic Trading Rules
If you are intelligent the market will teach you caution and fortitude, sharpen your wits, and reduce your pride. If you are foolish and refuse to learn a lesson, it will ridicule you, laugh you to scorn, break you, and toss you on the rubbish-heap.
-Frank J. Williams
Ten Rules from Bernard Baruch
Baruch listed these rules in his autobiography Baruch: My Own Story. Starting as an office boy at the age of 19, Baruch made his first million by the age of 35. He then went on to be a trusted counsel for several Presidents. He states that he was skeptical about the usefulness of advice and was therefore reluctant to lay down any hard and fast rules. He offered the following as some points learned from his personal experience that "might be worth listing for those who are able to muster the necessary selfdiscipline." The rules are simple and self-explanatory.*
"Being so skeptical about the usefulness of advice, I have been reluctant to lay down any 'rules' or guidelines on how to invest or speculate wisely. Still, there are a number of things I have learned from my own experience which might be worth listing for those who are able to muster the necessary self-discipline:
1. Don't speculate unless you can make it a full-time job.
2. Beware of barbers, beauticians, waiters-of anyonebringing gifts of 'inside' information or 'tips.'
3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.
4. Don't try to buy at the bottom and sell at the top. This can't be done-except by liars.
5. Learn how to take your losses quickly and cleanly. Don't expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.
6. Don't buy too many different securities. Better have only a few investments which can be watched.
7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.
8. Study your tax position to know when you can sell to greatest advantage.
9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.
10. Don't try to be a jack of all investments. Stick to the field you know best."
Eleven Rules f
rom Robert Meier
Bob Meier has spent many years writing about and trading futures. He is a personal friend and has given me much encouragement in writing this book. He offers several simple but important rules. Number 10, "Never trade with serious personal problems," is extremely sound. In this day of fast moving technology and high stress, the potential for personal problems is much greater than it ever was. It is impossible to maintain a sense of objectivity when you are down emotionally. Far better in the long run not to trade at all until you can regain a sense of psychological wellbeing; confident objective decisions are then easier to make.*
The following rules are by Robert H. Meier:
1. Ask yourself what you really want. Many traders loose money because subconsciously their goal is entertainment, not profits. If you are serious about becoming a successful speculator, carefully examine your trading to eliminate destructive compulsiveness such as constantly calling your broker when there is no legitimate reason, and putting on trades "just to be in the market."
2. Assume personal trade responsibility for all actions. A defining trait of top performing traders is their willingness to assume personal responsibility for all trading decisions. People who habitually blame their broker, the market itself, bad order fills, or insider manipulation for losses, are never successful.
3. Keep it simple and consistent. Most speculators follow too many indicators and listen to so many different opinions that they are overwhelmed into action. Few people realize that many of the greatest traders of all time never rely on more than two or three core indicators and never listen to the opinions of others.
4. Have realistic expectations. When expectations are too high, it results in overtrading underfinanced positions, and very high levels of greed and fear-making objective decision-making impossible.
5. Learn to wait. Most of the time for most speculators, it is best to be out of the markets, unless you are in an option selling (writing) program. Generally, the part-time speculator will only encounter six to ten clear-cut major opportunities a year. These are the type of trades the savvy professionals train themselves to wait for.
6. Clearly understand the Risk/Reward Ratio. The consensus is that trades with a one to three or one to four Risk/Reward Ratio are sufficient, but this is not true unless you are a floor trader in the pit. There are trades with Risk/Reward Ratios as attractive as one to ten that periodically present themselves to those willing to exercise the ongoing market monitoring discipline required. That is what professionals do.
7. Always check the big picture. Before making any trade, check it against weekly and monthly as well as daily range charts. Frequently, this extra step will identify major longer-term zones of support and resistance that are not apparent on daily charts and that substantially change the perceived Risk/Reward Ratio. Point & Figure charts are particularly valuable in identifying breakouts from big congestion/ accumulation formations.
8. Always under-trade. It is easy to forget just how powerful the leverage is in futures and options. It is not uncommon to find speculators holding positions two or three times larger than is justified by their account size. By consciously under-trading, that is taking positions much smaller than you might be able to, you will gradually learn to hold back until you find the real moneymaking opportunities and stay with major trends.
9. Define your broker relationship. A full-service commodity broker can be a valuable ally, but should not be pushed into the position of making your final decisions. Never tell a broker "do what you think best and call me later."
10. Never trade with serious personal problems. Ignoring this rule is a prescription for disaster. The clarity of thought and emotional control required even for part-time speculator is so great that it is impossible to handle along with serious personal problems. Likewise, trading should not be attempted during periods of ill health, even including a bad head cold.
11. Ignore the news media. The true goals of the national news media are to shock, agitate, entertain, and editorialize a socialist agenda-not provide usable information. Many of the finest traders avoid all contact with public news, knowing how profoundly it can undermine a trading plan. The more important trading profits are to you, the less you can afford to follow the it "news.
Seventeen Rules from S. A. Nelson
S.A. Nelson wrote around the turn of the century. Some of his rules relate to concepts that are different from today's; trading in "10 share lots" for example. Nevertheless, human nature remains more or less constant, so the general undertone of these rules is as valid in the current environment as it ever was.*
1. Bull markets and bear markets run four and five years at a time. Determine by the average prices, which one is under way.
2. Determine the stock or stocks to trade in. They should be railroad stocks, dividend payers, not too low, nor too high, fairly active, and for the bull side below their value; for the bear side above their value. Values are determined roughly by the earnings available for dividends.
3. Observe the position of your stock with relation to recent fluctuations. In a bull market, the time to begin to buy is when a stock has had four or five points decline from the last previous top. In a bear market, the time to begin to sell is when such a stock has had three or four points rally from the bottom.
4. Stick to the stock bought until a fair profit or until there is good reason for deciding that the first estimate of value was wrong. Remember than an active stock will generally rally from 3/8 per cent. to 5/8 per cent. of the amount of its decline under adverse conditions and more than that under favorable conditions.
5. Have money enough to see a decline through without becoming uneasy or over-burdened. $2,500 ought to take care of a ten-share scale every point down-that is to say, supposing the first lot to be bought five points down from the top, $2,500 ought to carry the scale until the natural recovery from the low point brings the lot out with a profit on the average cost. It will not do to expect a profit on every lot, but only on the average. In a bull market it is better to always work on the bull side; in a bear market, on the bear side. There are usually more rallies in a bear market than there are relapses in a bull market.
6. Do not let success in making money in ten-share lots create a belief that a bolder policy will be wiser and begin to trade in 100-share lots with inadequate capital. A few hundred-share losses will wipe out a good many ten-share profits.
7. There is not usually much difficulty in dealing in tenshare lots on the short side. If one broker does not wish to do it, another probably will, especially for a customer who amply protects his account and who seems to understand what he is doing.
A close student of speculation in all its forms as conducted on the exchanges of this country has arrived at the following conclusions, which, he says, in application to speculation are "universal laws." He divides his conclusions into two groups, laws absolute and laws conditional.
Laws absolute. Never overtrade. To take an interest larger than the capital justifies is to invite disaster. With such an interest, a fluctuation in the market unnerves the operator, and his judgment becomes worthless.
1. Never "double-up"; that is, never completely and at once reverse a position. Being "long," for instance, do not "sell out" and go as much "short." This may occasionally succeed, but is very hazardous, for should the market begin again to advance, the mind reverts to its original opinion and the speculator "covers up" and "goes long" again. Should this last change be wrong, complete demoralization ensues. The change in the original position should have been made moderately, cautiously, thus keeping the judgment clear and preserving the balance of mind.
2. "Run quick" or not at all; that is to say, act promptly at the first approach of danger, but failing to do this until others see the danger hold on or close out part of the "interest."
3. Another rule is, when doubtful reduce the amount of the interest; for either the mind is not satisfied with the position taken, or the interest is too large for safety. One
man told another that he could not sleep on account of his position in the market; his friend judiciously and laconically replied: "Sell down to a sleeping point."
Rules conditional. These rules are subject to modification, according to the circumstances, individuality and temperament of the speculator.
1. It is better to "average up" than to "average down." This opinion is contrary to the one commonly held and acted upon; it being the practice to buy and on a decline buy more. This reduces the average. Probably four times out of five this method will result in striking a reaction, in the market that will prevent loss, but the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss-a loss so great as to bring complete demoralization often ruin.
But "buying up" is the reverse of the method just explained; that is to say, buying at first moderately and as the market advances adding slowly and cautiously to the "line." This is a way of speculating that requires great care and watchfulness, for the market will often (probably four times out of five) react to the point of "average." Here lies the danger. Failure to close out at the point of average destroys the safety of the whole operation. Occasionally (probably four times out of five) a permanently advancing market is met with and a big profit secured. In such an operation the original risk is small, the danger at no time great, and when successful the profit is large. This method should only be employed when an important advance or decline is expected, and with a moderate capital can be undertaken with comparative safety.
Investment Psychology Explained Page 24
