michael_selway
Coal & Phosphate, thats it!
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- 20 October 2005
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http://www.frontlinethoughts.com/pdf/mwo012006.pdf
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
The Rules of Trading
1/20/2006 5
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
The Rules of Trading
1/20/2006 7
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!
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
The Rules of Trading
1/20/2006 5
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
The Rules of Trading
1/20/2006 7
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!
Truth: he`s an investor. 
