When the market trading environment
is confusing, irrational, rotating from one sector to another for no apparent
reason; it might be time to review your personal Rules of Trading. I
highly recommend reading Dennis Gartman's Rules of Trading!
Dennis Gartman's Rules of Trading
The "Not-So-Simple" (But
Really Utterly So) Rules of Trading
The world of investing/treading,
even at the very highest levels, where we are supposed to believe that wisdom
prevails and profits abound, is littered with the wreckage of wealth that has
hit the various myriad rocks that exist just beneath the tranquil surface of
the global economy. It matters not what level of supposed wisdom, or education,
that the money managers or individuals in question have. We can make a
list of wondrously large financial failures that have come to flounder upon
these rocks for the very same reasons. Let us, for a bit, have a moment of
collective silence for Long Term Capital Management; for Baring's Brothers; for
Sumitomo Copper... and for the tens of thousands of individuals each year who
follow their lead into financial oblivion.
I've been in the business of trading
since the early 1970s as a bank trader, as a member of the Chicago Board of
Trade, as a private investor, and as the writer of The Gartman Letter,
a daily newsletter I've been producing for primarily institutional clientele
since the middle 1980s. I've survived, but often just barely. I've made
preposterous errors of judgment. I've made wondrously insightful
"plays." I've understood, from time to time, basis economic
fundamentals that should drive prices--and then don't. I've misunderstood other
economic fundamentals that, in retrospect, were 180 degrees out of logic and
yet prevailed profitably. I've prospered; I've almost failed utterly. I've
won, I've lost, and I've broken even.
As I get older, and in my mid-50s,
having seen so much of the game--for a game it is, with bad players who get
lucky; great players who get unlucky; mediocre players who find their slot in
the lineup and produce nice, steady results over long periods of time;
"streak-y" players who score big for a while and lose big at other
times--I have distilled what it is that we do to survive into a series of
"Not-So-Simple" Rules of Trading that I try my best to live by every
day ... every week ... every month. When I do stand by my rules, I
prosper; when I don't, I don't. I am convinced that had Long Term Capital
Management not listened to its myriad Nobel Laureates in Economics and had
instead followed these rules, it would not only still be extant, it would be
enormously larger, preposterously profitable and an example to everyone. I am
convinced that had Nick Leeson and Barings Brothers adhered to these rules,
Barings too would be alive and functioning. Perhaps the same might even be said
for Mr. Hamanaka and Sumitomo Copper.
Now, onto the Rules:
NEVER ADD TO A LOSING POSITION
R U L E # 1
Never, ever, under any circumstance,
should one add to a losing position ... not EVER!
Averaging down into a losing trade
is the only thing that will assuredly take you out of the investment business.
This is what took LTCM out. This is what took Barings Brothers out; this is
what took Sumitomo Copper out, and this is what takes most
losing investors out. The only thing that can happen to you when you
average down into a long position (or up into a short position) is that
your net worth must decline. Oh, it may turn around eventually and your
decision to average down may be proven fortuitous, but for every example
of fortune shining we can give an example of fortune turning bleak and
deadly.
By contrast, if you buy a stock or a
commodity or a currency at progressively higher prices, the only thing that can
happen to your net worth is that it shall rise. Eventually, all prices tumble.
Eventually, the last position you buy, at progressively higher prices, shall
prove to be a loser, and it is at that point that you will have to exit your
position. However, as long as you buy at higher prices, the market is
telling you that you are correct in your analysis and you should continue to
trade accordingly.
R U L E # 2
Never, ever, under any circumstance,
should one add to a losing position ... not EVER!
We trust our point is made. If "location,
location, location" are the first three rules of investing in real estate,
then the first two rules of trading equities, debt, commodities, currencies,
and so on are these: never add to a losing position.
INVEST ON THE SIDE THAT IS WINNING
R U L E # 3
Learn to trade like a mercenary
guerrilla.
The great Jesse Livermore once said
that it is not our duty to trade upon the bullish side, nor the bearish side,
but upon the winning side. This is brilliance of the first order. We must
indeed learn to fight/invest on the winning side, and we must be willing to
change sides immediately when one side has gained the upper hand.
Once, when Lord Keynes was appearing
at a conference he had spoken to the year previous, at which he had suggested
an investment in a particular stock that he was now suggesting should be
shorted, a gentleman in the audience took him to task for having changed his
view. This gentleman wondered how it was possible that Lord Keynes could shift
in this manner and thought that Keynes was a charlatan for having changed his
opinion. Lord Keynes responded in a wonderfully prescient manner when he
said, "Sir, the facts have changed regarding this company, and
when the facts change, I change. What do you do, Sir?" Lord
Keynes understood the rationality of trading as a mercenary guerrilla, choosing
to invest/fight upon the winning side. When the facts change, we must change.
It is illogical to do otherwise.
DON'T HOLD ON TO LOSING POSITIONS
R U L E # 4
Capital is in two varieties: Mental
and Real, and, of the two, the mental capital is the most important.
Holding on to losing positions
costs real capital as one's account balance is depleted, but
it can exhaust one's mental capital even more seriously as one holds to the
losing trade, becoming more and more fearful with each passing minute, day and
week, avoiding potentially profitable trades while one nurtures the losing
position.
GO WHERE THE STRENGTH IS
R U L E # 5
The objective of what we are after
is not to buy low and to sell high, but to buy high and to sell higher, or to
sell short low and to buy lower.
We can never know what price is
really "low," nor what price is really "high." We can,
however, have a modest chance at knowing what the trend is and acting on
that trend. We can buy higher and we can sell higher still if the trend is up.
Conversely, we can sell short at low prices and we can cover at lower prices if
the trend is still down. However, we've no idea how high high is, nor how
low low is.
Nortel went from approximately the
split-adjusted price of $1 share back in the early 1980s, to just under
$90/share in early 2000 and back to near $1 share by 2002 (where it has hovered
ever since). On the way up, it looked expensive at $20, at $30, at $70, and at
$85, and on the way down it may have looked inexpensive at $70, and $30, and
$20--and even at $10 and $5. The lesson here is that we really cannot tell what
is high and/or what is low, but when the trend becomes established, it can run
far farther than the most optimistic or most pessimistic among us can
foresee.
R U L E # 6
Sell markets that show the greatest
weakness; buy markets that show the greatest strength.
Metaphorically, when bearish we need
to throw our rocks into the wettest paper sack for it will break the most
readily, while in bull markets we need to ride the strongest wind for it
shall carry us farther than others.
Those in the women's apparel
business understand this rule better than others, for when they carry an
inventory of various dresses and designers they watch which designer's work
moves off the shelf most readily and which do not. They instinctively mark down
the work of those designers who sell poorly, recovering what capital then can
as swiftly as they can, and use that capital to buy more works by the
successful designer. To do otherwise is counterintuitive. They instinctively
buy the "strongest" designers and sell the "weakest."
Investors in stocks all too often and by contrast, watch their portfolio shift
over time and sell out the best stocks, often deploying this capital into the
shares that have lagged. They are, in essence, selling the best
designers while buying more of the worst. A clothing shop owner would
never do this; stock investors do it all the time and think they are wise
for doing so!
MAKING "LOGICAL" PLAYS IS
COSTLY
R U L E # 7
In a Bull Market we can only be long
or neutral; in a bear market we can only be bearish or neutral.
Rule 6 addresses what might seem
like a logical play: selling out of a long position after a sharp rush higher
or covering a short position after a sharp break lower--and then trying to play
the market from the other direction, hoping to profit from the supposedly
inevitable correction, only to see the market continue on in the original
direction that we had gotten ourselves exposed to. At this point, we are not
only losing real capital, we are losing mental capital at an explosive rate,
and we are bound to make more and more errors of judgment along the
way.
Actually, in a bull market we can be
neutral, modestly long, or aggressively long--getting into the last position
after a protracted bull run into which we've added to our winning position all
along the way. Conversely, in a bear market we can be neutral, modestly
short, or aggressively short, but never, ever can we--or should we--be the
opposite way even so slightly.
Many years ago I was standing on the
top step of the CBOT bond-trading pit with an old friend Bradley
Rotter, looking down into the tumult below in awe. When asked what he thought, Brad replied,
"I'm flat ... and I'm nervous." That, we think, says it all...that
the markets are often so terrifying that no position is a position of
consequence.
R U L E # 8
"Markets can remain illogical
far longer than you or I can remain solvent."
I understand that it was Lord Keynes
who said this first, but the first time I heard it was one morning many years
ago when talking with a very good friend, and mentor, Dr. A. Gary Shilling, as
he worried over a position in U.S. debt that was going against him and
seemed to go against the most obvious economic fundamentals at the time.
Worried about his losing position and obviously dismayed by
it, Gary said over the phone, "Dennis, the markets are illogical
at times, and they can remain illogical far longer than you or I can remain
solvent." The University of Chicago "boys"
have argued for decades that the markets are rational, but we in the markets
every day know otherwise. We must learn to accept that irrationality, deal
with it, and move on. There is not much else one can say. (Dr. Shilling's
position shortly thereafter proved to have been wise and profitable, but not
before further "mental" capital was expended.)
R U L E # 9
Trading runs in cycles; some are
good, some are bad, and there is nothing we can do about that other than accept
it and act accordingly.
The academics will never understand
this, but those of us who trade for a living know that there are times when
every trade we make (even the errors) is profitable and there is nothing we can
do to change that. Conversely, there are times that no matter what we do--no
matter how wise and considered are our insights; no matter how sophisticated
our analysis--our trades will surrender nothing other than losses. Thus, when
things are going well, trade often, trade large, and try to maximize the good
fortune that is being bestowed upon you. However, when trading poorly, trade
infrequently, trade very small, and continue to get steadily smaller until
the winds have changed and the trading "gods" have chosen to smile
upon you once again. The latter usually happens when we begin following the
rules of trading again. Funny how that happens!
THINK LIKE A FUNDAMENTALIST;
TRADE LIKE A TECHNICIAN
R U L E # 10
To trade/invest successfully, think
like a fundamentalist; trade like a technician.
It is obviously imperative that we
understand the economic fundamentals that will drive a market higher or lower,
but we must understand the technicals as well. When we do,
then and only then can we, or should we, trade. If the market fundamentals as
we understand them are bullish and the trend is down, it is illogical to buy;
conversely, if the fundamentals as we understand them are bearish but the
market's trend is up, it is illogical to sell that market short. Ah, but if we
understand the market's fundamentals to be bullish and if the trend is up, it
is even more illogical not to trade bullishly.
R U L E # 11
Keep your technical systems simple.
Over the years we have listened to
inordinately bright young men and women explain the most complicated and
clearly sophisticated trading systems. These are systems that they have labored
over; nurtured; expended huge sums of money and time upon, but our history has
shown that they rarely make money for those employing them. Complexity breeds
confusion; simplicity breeds an ability to make decisions swiftly, and to
admit error when wrong. Simplicity breeds elegance.
The greatest traders/investors we've
had the honor to know over the years continue to employ the simplest trading
schemes. They draw simple trend lines, they see and act on simple
technical signals, they react swiftly, and they attribute it to their knowledge
gained over the years that complexity is the home of the young and
untested.
UNDERSTAND THE ENVIRONMENT
R U L E # 12
In trading/investing, an
understanding of mass psychology is often more important than an understanding
of economics.
Markets are, as we like to say, the
sum total of the wisdom and stupidity of all who trade in them, and they are
collectively given over to the most basic components of the collective
psychology. The dot-com bubble was indeed a bubble, but it grew from a small
group to a larger group to the largest group, collectively fed by mass mania,
until it ended. The economists among us missed the bull-run entirely, but that
proves only that markets can indeed remain irrational, and that economic
fundamentals may eventually hold the day but in the interim, psychology holds
the moment.
R U L E # 13
Bear Market Corrections Are More
Violent and Far Swifter Than Bull Market Corrections: Why they are is still a mystery to us, but they are; we
accept it as fact and we move on.
R U L E # 14
There Is Never Just One Cockroach: The lesson of bad news on most stocks is that more
shall follow... usually hard upon and always with detrimental effect upon
price, until such time as panic prevails and the weakest hands finally exit
their positions.
R U L E # 15
Be Patient with Winning Trades; Be
Enormously Impatient with Losing Trades: The older we get, the more small losses we take each year...
and our profits grow accordingly.
R U L E # 16
All Rules Are Meant To Be Broken.... but only very, very infrequently. Genius comes in
knowing how truly infrequently one can do so and still prosper.
And finally the most important rule
of all:
THE RULE THAT SUMS UP THE REST
R U L E # 17
Do more of that which is working and
do less of that which is not.
This is a simple rule in writing;
this is a difficult rule to act upon. However, it synthesizes all the modest
wisdom we've accumulated over thirty years of watching and trading in markets.
Adding to a winning trade while cutting back on losing trades is the one true
rule that holds--and it holds in life as well as in trading/investing.
If you would go to the golf course
to play a tournament and find at the practice tee that you are hitting the ball
with a slight "left-to-right" tendency that day, it would be
best to take that notion out to the course rather than attempt to re-work your
swing. Doing more of what is working works on the golf course, and it works in
investing.
If you find that writing thank you
notes, following the niceties of life that are extended to you, gets you more
niceties in the future, you should write more thank you notes. If you find
that being pleasant to those around you elicits more pleasantness, then be more
pleasant.
And if you find that cutting losses
while letting profits run--or even more directly, that cutting losses and
adding to winning trades works best of all--then that is the course of
action you must take when trading/investing. Here in our offices, as we trade
for our own account, we constantly ask each other, "What's working today,
and what's not?" Then we try to the very best of our ability "to do
more of that which is working and less of that which is not." We've no set
rule on how much more or how much less we are to do, we know only that we are
to do "some" more of the former and "some" less of the
latter. If our long positions are up, we look at which of those long positions
is doing us the most good and we do more of that. If short positions are also
up, we cut back on that which is doing us the most ill. Our process is
simple.
We are certain that great--even vast--holes can and will be proven in our rules
by doctoral candidates in business and economics, but we care not a whit, for
they work. They've proven so through time and under pressure. We try our best
to adhere to them.
This is what I have learned about the world of investing over three decades. I
try each day to stand by my rules. I fail miserably at times, for I break them
often, and when I do I lose money and mental capital, until such time as I
return to my rules and try my very best to hold strongly to them. The losses
incurred are the inevitable tithe I must make to the markets to atone for my
trading sins. I accept them, and I move on, but only after vowing that
"I'll never do that again."
Updated
November 2013
Dennis Gartman, editor and publisher
of the Gartman Letter, has 19 rules of trading from 2013.
But these hold true
in general.
Here they are verbatim:
1.
NEVER,
EVER, EVER ADD TO A LOSING POSITION: EVER!: Adding to a losing position eventually leads to ruin,
remembering Enron, Long Term Capital Management, Nick Leeson and myriad others.
2.
TRADE
LIKE A MERCENARY SOLDIER: As
traders/investors we are to fight on the winning side of the trade, not on the
side of the trade we may believe to be economically correct. We are pragmatists
first, foremost and always.
3.
MENTAL
CAPITAL TRUMPS REAL CAPITAL: Capital comes in two forms... mental and real... and
defending losing positions diminishes one’s finite and measurable real capital
and one’s infinite and immeasurable mental capital accordingly and always.
4.
WE
ARE NOT IN THE BUSINESS OF BUYING LOW AND SELLING HIGH: We are in the business of buying high and
selling higher, or of selling low and buying lower. Strength begets strength;
weakness more weakness.
5.
IN
BULL MARKETS ONE MUST TRY ALWAYS TO BE LONG OR NEUTRAL: The corollary, obviously, is that in bear
markets one must try always to be short or neutral. There are exceptions, but
they are very, very rare.
6.
"MARKETS
CAN REMAIN ILLOGICAL FAR LONGER THAN YOU OR I CAN REMAIN SOLVENT:" So said Lord Keynes many years ago and he
was... and is... right, for illogic does often reign, despite what the
academics would have us believe.
7.
BUY
THAT WHICH SHOWS THE GREATEST STRENGTH; SELL THAT WHICH SHOWS THE GREATEST
WEAKNESS: Metaphorically,
the wettest paper sacks break most easily and the strongest winds carry ships
the farthest, fastest.
8.
THINK
LIKE A FUNDAMENTALIST; TRADE LIKE A TECHNICIAN: Be bullish... or bearish... only when the
technicals and the fundamentals, as you understand them, run in tandem.
9.
TRADING
RUNS IN CYCLES; SOME GOOD, MOST BAD: In the “Good Times” even one’s errors are profitable; in the
inevitable “Bad Times” even the most well researched trade shall goes awry.
This is the nature of trading; accept it and move on.
10. KEEP YOUR SYSTEMS SIMPLE: Complication breeds confusion; simplicity
breeds elegance and profitability.
11. UNDERSTANDING MASS PSYCHOLOGY IS ALMOST ALWAYS
MORE IMPORTANT THAN UNDERSTANDING ECONOMICS: Or more simply put, "When they’re cryin’ you should be
buyin’ and when they’re yellin’ you should be sellin’!"
12. REMEMBER, THERE IS NEVER JUST ONE COCKROACH: The lesson of bad news is that more shall
follow... usually hard upon and always with worsening impact.
13. BE PATIENT WITH WINNING TRADES; BE ENORMOUSLY
IMPATIENT WITH LOSERS: Need
we really say more?
14. DO MORE OF THAT WHICH IS WORKING AND LESS OF
THAT WHICH IS NOT: This works well in
life as well as trading. If there is a “secret” to trading... and to life...
this is it.
15. CLEAN UP AFTER YOURSELF: Need we really say more? Errors only get
worse.
16. SOMEONE’S ALWAYS GOT A BIGGER JUNK YARD DOG: No matter how much “work” we do on a
trade, someone knows more and is more prepared than are we... and has more
capital!
17. PAY ATTENTION: The market sends signals more often than not missed and/or
disregarded... so pay attention!
18. WHEN THE FACTS CHANGE, CHANGE! Lord Keynes... again... once said that “
When the facts change, I change; what do you do, Sir?” When the technicals or
the fundamentals of a position change, change your position, or at least
reduced your exposure and perhaps exit entirely.
19. ALL RULES ARE MEANT TO BE BROKEN: But they are to be broken only rarely and
true genius comes with knowing when, where and why!
Source: http://www.businessinsider.com/dennis-gartmans-19-rules-of-trading-2013-11
