2 The importance of an Investment Strategy
Back in 1967, I received the following letter, part of it read: Q ‘A New York friend sent me your World Sugar Market Letter of October 17, which I found interesting and subsequently quite proﬁtable. The quotation from Jesse Livermore reminded me of my late and lamented father, who when I was a boy I asked how he rnade money on the futures market, his answer was, "You have to be bold and you have to be right." l then said, "What if you are bold and wrong?" and he said, “Then you go down with the ship." HIis father did just that, unfortunately.
The ongoing dialogue with stock and commodity speculators has been an enjoyable and rewarding aspect of my career, and through diverse contacts, spanning a period exceeding 30 years, one recurring theme seems to surface. Even the least successful traders occasionally experience the big proﬁts that are in the market-elusive and tough to capture — but there. And, if the considerable hazards of the big wipe-out can be avoided it is possible to take home large proﬁts. But the question is how to avoid the ﬁnancial disaster, the big wipe-out, that is all too common in the world of the serious ﬁnancial speculator? Or, as expressed more poignantly in the above, letter, how to avoid ‘going down with the ship?’ Ever since people got together and battered stone tablets, tools, or just something to eat or to wear, there have been winners and losers in the trading game. Yet, despite the obvious proﬁt potential and high leverage, most speculators including many professionals, end up losers. Aside from the small number of professional operators, who scalp in large volume and pay only negligible commissions or clearing fees, the traders who make the big money on a consistent basis are the longer-term position traders. They tend to be trend followers. I have been fortunate to have been on the right side of some big positions and big proﬁts, some of them held for as long as eight or ten months and, as related later, one actually held long for ﬁve years.
The necessity of a ﬁrst class, viable strategy is part of success in most ﬁelds of endeavour. It is no less relevant in ﬁnancial speculation than it is in marathon running, tournament tennis, chess competition or corporate take-overs. The common denominator lies in the fact that success, or victory involves both technical as well as strategic considerations. With so many players nowadays equally qualiﬁed in the technical aspects of their trade or profession, the thing that will distinguish the winner from the almost-winner is the consistent and disciplined application of ﬁrst class strategy and viable tactics. The correct utilization of good strategy is especially crucial in stock and commodity speculation. The basic rules are commonly known, but consider those traders who have never experienced a winning year regardless of how long they've been at it. Unfortunately, it's a relatively high percentage of speculators. Yet, they have surely heard and can probably recite verbatim, some of those tried and tested maxims: ‘the trend is your friend,’ ‘cut your losses and let your proﬁts run,’ ‘the first loss is the cheapest loss,’ and so on. Here is winning strategy in its most basic form, and probably all traders know them from memory. But, while consistent winners share a single-minded adherence to these basic winning strategies, consistent losers on the other hand, are just as purposeful in their avoidance and violation of the strategies.
2. 1 Basic Strategies
In summarizing the strategies and tactics you need to avoid the big wipe-out and to stand proudly in the ‘winners’ circle,’ the following constitutes the essence of a basic strategy:
1. Participate only in those markets which are trending strongly or which are in the process of developing into a major trending formation. Identify the major ongoing trend of each market and take positions only in the direction of this dominant trend or stand aside (see Figures
2.1 and 2.2).
2. Assuming that you are trading in the direction of the trend, initiate your position either on a signiﬁcant breakout (such as a gap opening on high volume) from the previous or sideways trend, or on a measured reaction from the ongoing major trend.
(a) In a major downtrend: sell on minor trend rallies into overhead resistance or against a strong down trendline, or on a
Figure 2.1 An Uptrending Market. Commencing December of 1995, SEPTEMBER COPPER broke out on the upside. An uptrending market is typically characterized by a succession of higher highs and higher lows. Traders should not be anxious to sell their long positions and revert to
short because bull markets generally go higher than most traders anticipate. The market, and your technical indicators, will “tell” you when Qthe top has been seen.
45% to 55% rally (or the third to ﬁfth day of the rally) from the recent reaction bottom.
(b) In a major uptrend,: buy on minor trend reactions into support or against a strong up trendline, or On a 45% to 55% reaction (or the third to ﬁfth day of the reaction) from the recent rally high. In this regard, it is imperative to note that, if you misread or choose to ignore the trend of the market, and are buying against an entrenched bear market or selling against an entrenched bull market, you are likely to spill lots of red ink, and feel pretty silly, as well.
3. Your with-the-trend position could result in a big favourable move, so you should try to remain aboard for the ride. By premising that every with-the-trend position could result in the big move, you will be encouraged to resist the many temptations to trade for the minor swings, or to scalp against-the-trend trades.
Figure 2.2 A Downtrending Market. Commencing early February 1994, SEPTEMBER U.S, BONDS broke out on the downside, continuing down till late-April, when the trend changed to a broad sideways direction. A downtrending market is typically characterized by a succession of lower highs and lower lows. These bear markets generally continue lower than most traders anticipate; the market, and your technical indicators, will "tell" you when the top has been seen.
4. Once the position is going your way and the favourable trend has been conﬁrmed by your technical analysis, you can add to the position (pyramid) under speciﬁc conditions, as noted in Chapters 11I and 15.
5. Maintain your position until you are stopped out, and your trend analysis indicates that the trend has reversed. At that point, if you have been attentive to the market, you should be positioned for the newly formed trend.
In Chapters 11 and 15, the speciﬁc and detailed tactics of exiting a position will be discussed. However, if you have liquidated a position and subsequent market action indicates that the major ongoing trend is still intact and that you have liquidated prematurely, get back on board. But, do it carefully and objectively, again initiating with-the-trend positions as discussed elsewhere in this book, notably in Chapters 11 and 15.'
6. But, what if the market moves adversely, not with you as it's ‘supposed’ to? First of all, how will you know if it's a position gone sour? If you can't work it out, the daily equity run will ‘tell’ you in no uncertain terms. As a rule of thumb, you should probably not risk more than 40% of margin on a stock trade, or 70% on a futures trade. Dickson Watts, a famous turn-of-the-century commodity speculator once said, ‘run quickly or not at all.’ He may have had a deep bankroll or been enough of a masochist to include the, ‘or not at all’ part. My advice is to heed his words, minus the ‘or not at all.’
And ﬁnally, while a consistent, viable strategy is clearly the main-stay of successful speculation, three additional traits are required:
discipline, discipline and discipline.
The balance of this book is devoted to presenting and proving the above theses. I can patently attest, from personal (and painful) experience, that whenever I was careless or foolish enough to stray from these tenets, I lost money. On the other hand, it should come as no surprise that I generally made money when operating according to the strategies and tactics set forth here, for these are universal guidelines.