Let’s Talk Strategy

“it is utterly useless for us on the outside, who buy and sell comparatively small blocks of stock, to conjecture about what “they” are doing.   We cannot know what the insiders intend to do, but we can see their orders on the tape when they execute them.   That is why my plea is for everyone of us to have no mere opinions of his own, but to allow the actions of the market to tell him what is passing.”
(Humphrey B. Neill, Tape Reading & Market Tactics, 1931, New York: B.C. Forbes Publishing Company; 14th printing, 2003, Vermont: Fraser Publishing Company)

When Nicolas Darvas was interviewed by Time Magazine in the early 60’s and it came out that he made almost 2 million dollars in the market in 18 months (while he was dancing around the world!), he noted that he read and reread Neill’s book (along with Gerald Loeb’s).   Neill’s book has been reprinted many times and I happened to find it on the shelf of my local Barnes and Noble store.   Neill dedicates his book, “to my losses, with a deep appreciation for the experience and knowledge which each loss has brought me.”

If anyone tells you that the market is different today, refer them to the successful traders from the 1929 post-crash era–Livermore, Baruch, Loeb.   Darvas, who made his fortune in the 60’s, clearly learned something from Neil’s original writings–and so have I.   Livermore used to say that when you lose you were paying the tuition required by the market. As a college professor, I see some students who pay tuition (more accurately, their parents pay) but are not focused on learning.   Losses can provide knowledge–but you have to look for it.

Perhaps the most important thing I did a few years ago was, after a series of losses, to print out their charts and note down my precise buy and sell points.   It looked like I had followed exceptionally accurate rules that flawlessly led me to buy at the top and sell at the bottom of moves!   So what did I do?   I reversed what I was doing and began to trade profitably.   Every great trader (including IBD publisher William O’Neil) urges us to study our losses.   However, most of us rarely do this important exercise in the market, or in the rest of our lives.

I have received many emails asking for details about my trading strategies.   So, I will begin today by reprinting some of the comments originally published in The Worden Report on November 7, 2003 under the pseudonym of The Silent Knight.   The Worden Report is published daily along with the data downloads for TC2005 (www.worden.com), the charting and analysis program that I use and find to be an invaluable tool.

My trading strategy;   Part 1, of many

I have been trading since my college student days in the mid sixties.   When I began, I used to make money in bull markets only to lose all of my profits and more in the ensuing bear markets.   I began a methodical study of the markets and my trading that continues to this day.   Five books, described below, have had a huge impact on my trading.   I devised a set of rules that have helped me to reduce (not eliminate) risk and to enhance the probability of success. TC2000 (now TC2005) is my invaluable analytic tool.

In my early years I read the accepted stock market books available to the masses.   Buy conservative stocks with low PE’s and stable dividends.   Diversify your portfolio and blah, blah, blah.   I never made money following these commonly disseminated rules.   I did not begin to understand the markets until I read that great classic, How I Made 2 Million Dollars in the Stock Market, by Nicolas Darvas (recently reprinted).   That book and his next little known book, Wall Street the Other Las Vegas, opened my eyes.   I often times reread the books for their insights. From Darvas, I learned such things as to buy stocks at all time highs, with great products and a vision of the future.   I learned about stop loss orders, cutting my losses, and to blot out the opinions of Wall Street and other pundits.

I applied Darvas’ techniques with some early success.   However, while Darvas had written that his techniques worked in bull markets, he never described the market averages or trends during his huge run.   It was only after I used TC2000 to trace the DOW during Darvas’ trading that I realized that he made his fortune from 1957-61 when the DOW moved to new heights, from the low 400’s to the low 700’s.    I discovered that I had often been using his techniques to buy when the market was not experiencing a prolonged bull move.   This experience taught me a most valuable lesson:   the same buying techniques that work in a bull market do not work in a bear market. This theme is also reflected in William O’Neil’s CANSLIM strategy (in his book, How to Make Money in Stocks), where the M stands for the general market trend.   If one is out of step with the market’s general trend, one’s odds of success are greatly reduced.   I can’t tell you how many losses I took because I was buying the right stocks while the market was trending down.

I therefore vowed never to be long when my general market trend indicators suggest a declining trend.   I sell all of my holdings and sometimes buy puts.   Using TC2000 I have been able to go back to prior periods and calculate that more than 70% of all stocks move in the same direction of the trend in the major indexes.   It makes no sense to go long when 70% of the stocks can be expected to decline.   It makes so much more sense (and cents) to place my bets consistent with the market trend, when the odds are in my favor.

The books by Darvas and O’Neil   taught me to cut my losses quickly and ruthlessly.   While O’Neil was a very successful trader early in his career, his book presents a sample of his trades over a winning period.   I was amazed to see so many more losses than gains even though he made a net profit. Most important, his losses were small and his gains were very large. The fact that a successful trader like O’Neil could have so many losses somehow gave me the freedom and confidence to have many small losses.   My motto is that every loss brings me closer to the next gain.   I can turn on a dime and it does not cost dearly because I use a deep discount broker.   And by trading in a tax sheltered IRA, I am not concerned with tax consequences and wash sales rules.   I love to buy back a stock I have sold after a small loss, even the same day, if it resumes its up trend.   Such trades have often been among my most profitable. One has to give oneself permission to admit mistakes and then correct them quickly—there is no place for a big ego in a successful trader.

Lefevre’s classic book about the great trader, Jesse Livermore, (Reminiscences of a Stock Operator) also offers a number of extraordinary trading insights.   One must stay with the major trend and not trade too often—do not lose your position.   Sit tight with a winning trade because you need to make big money those few times when you are right.   And perhaps most important, make a pilot buy and do not buy more until the stock has moved in the predicted direction.   Average up, never average down.   I control my risk by betting the most dollars on the few stocks that have proved me right over time.   I buy more and more shares as the stock moves up.   I never bet all of my money at once.   A winning stock will continue rising for weeks or months and give me plenty of time to get aboard and to take on my full position.   Too much diversification guarantees mediocre results.   Concentrate on your few winners.

Another book that made a real difference to my trading is, Secrets of Profiting in Bull and Bear Markets, by Stan Weinstein.   This book shows a simple way to use charts and moving averages.   Weinstein uses the 30 week moving average to determine trends and describes a successful approach called stage analysis.   I have found his methods to be very useful.   His book provides a nice introduction to technical analysis without getting too complex.   I have found that the simple statistics are most useful to me, in my professional research and in my stock trading.

That’s enough for today.   I hope you find my insights useful. My goal in sharing is to stimulate you to develop your own methods that work for you.   If you just want a recipe for trading, you may be disappointed.   Profitable trading requires a lot of study, experience, self-knowledge, independent thinking and a willingness to learn from your mistakes. In the coming months I will explore with you in more detail the role these attributes have played in my trading.

Will post again on Sunday.