Discipline, knowledge, and experience are the pillars to trading success.
Wall Street is looked at by many as the global guru of all that is financial. And, indeed, over the decades many practical rules of thumb have surfaced. These axioms, as some call them, are based on years of accumulated experience and trial-and-error results. The simple truth is that these axioms do have merit and should be outlined in a book on trading and as such should be incorporated in your personal trading rules.
So, some of the more important Wall Street axioms have been especially selected for this volume. However, I prefer to start with golden rules of Wall Street that are interesting and certainly can be used as part of your rules.
The Nine Essential Golden Rules
Golden Rule 1: Never Buy
Never buy a share that won’t rise in a bull market.
If traders who have extensive knowledge of the market start selling shares, should you follow or should you buy? For whatever reason, these traders are not buying that stock, so there surely must be a reason, which may not be apparent, but it exists anyway.
Golden Rule 2: Shorting Bears
Never sell a stock short that won’t decrease in a bear market.
Those traders “in the know”—let’s call them Insiders—are selling a stock—should you not follow?
Sell a stock short that won’t increase in a bull market the moment the market turns bearish.
A stock that can’t attract buying support when everything else is moving ahead must have something radically wrong with it. Therefore, the stock would be vulnerable in a bear trend.
Golden Rule 4: Bears
Buy a stock that won’t decrease in a bear market.
It is believed that these shares will lead the next market upswing. This is in my opinion one of the most effective rules on Wall Street. It simply suggests that a share that is supported by the masses is so strong that new buying will push it up when bulls return to the market.
Golden Rule 5: Sympathy Stocks
Don’t buy the “sympathy” stock. It is seldom profitable.
If XYZ Widget Corp’s share is rising, but ABC Widget’s is not, don’t buy ABC just because it has a similar name. Stocks do tend to move in industry groups, but something may be happening at XYZ that has no bearing on ABC.
Golden Rule 6: Bulls to Bears
When a bull market turns to bear, sell the stock that has risen the most.
The technical traders suggest that stock which have risen the most have created the largest gap in the market. Therefore, these stocks should react the most to a downswing. This may seem to be a contradiction, but it isn’t. Actually, stocks that have had the greatest percentage rise frequently have created the largest gap between fair value and current price, so also have a great percentage potential correction or downswing.
Golden Rule 7: Increasing Stocks
Sell the stock that has increased the least.
Shares that falter and do not increase in price, eventually fall. This is in agreement with Rule No. 3. If the stock can’t attract buyers, it often attracts sellers, as traders and investors buy shares for an expected capital growth. A share that isn’t moving is an opportunity cost.
Golden Rule 8: Bears to Bulls
When a bear market turns to bull, buy the stock that has decreased the most, and also the stock that has decreased the least.
These two principles are not contradictory. Instead, they illustrate two extremes, showing the greatest percentage declines are normally due for percentage previous gains. Stocks that have held up best have a reason for doing so, hence, are in a position to attract new support.
Golden Rule 9: Take Immediate Action
If a stock is a purchase or a sale, action should be taken at once.
The market does not consider your trade in its fluctuations. In other words, if buying or selling is imperative, action should be taken at once. Such transactions should be made immediately at the price offered by the market.
Wall Street Axioms
Axiom 1: Vigilance
Eternal vigilance is the price of safety.
Successful traders in the past believed that they should watch the market constantly and religiously. Above all, they emphasized the sense of timing. As Jay Gould, the famous U.S. speculator put it: “The perfect speculator must know when to come in; more important, he must know when to stay out; and most important, he must know when to get out once he is in!”
Axiom 2: Speculation and Investments
A good investment is a good speculation, but if it is not a good speculation, it is not even a safe investment.
While speculation has its place in markets, there should always be an element of analysis, whether fundamental or technical. Anything else is pure guesswork.
Axiom 3: Taking Profits
No man ever makes himself poor by taking profits.
This was a favorite axiom of old Commodore Vanderbilt. It certainly paid off handsomely in his experience. The Commodore was fond of remarking that “paper profits can quickly turn into losses, unless carefully supervised and acted on.”
Axiom 4: Minds of Men
The market is made by the minds of men. What the minds of men have made, your mind can solve.
As constantly emphasized, the psychological factor in trading is critical. Stocks sell on the basis of what investors think at a given time. Above all, try to sense, to evaluate, investor psychology at all times.
Axiom 5: Do Nothing
If you do not see the way clear, do nothing.
Daniel Drew, an 1880s’ speculator, believed fervently in this principle. He used to say that unless the way looked clear, buying stocks in those circumstances “was like buying cows by candlelight.”
Axiom 6: Tomorrow
The market will be here tomorrow.
A missed opportunity is not a crisis.
Andrew Carnegie had special talents for “watching and waiting.” He would calculate all his operations, whether in industry or in the stock market; but would bide his time until the “right moment.” Even if you miss an opportunity today, new ones are always developing in the marketplace.
Axiom 7: Free Resources
Always have some resources free for bargains.
This is one great difference between the successful and unsuccessful traders. Baron Rothschild made it an iron clad rule to keep a good part of his capital free for such bargains to be able to “buy when others are selling” … so that he could later “sell when others are buying.”
Axiom 8: Sleeping Point
If your stocks worry you, sell to the sleeping point.
When you can’t sleep because you are worried about the value of your portfolio, it means that you are too heavily invested in selected stocks. Under such circumstances, you should “sell to the sleeping point.”
This is the point where you are no longer kept awake by worrying about your shares. In other words, a practical example would be to sell enough of a share that has risen rapidly, to recoup your original cost. That way you retain the share that is rising, but have no cost associated; that is, these shares are effectively free.
Axiom 9: Grist and Mills
No grist can be ground with water that has run past the mill.
For those who do not know what a grist is: A corn that is ground to make flour.
It is important to learn from investment mistakes, but as important to forget that an opportunity has been lost. They are indeed gone forever. Instead, focus on the future and your next trade. That is a much better use of your energy.
Axiom 10: Speculation and Certainty
Speculation begins where certainty ends.
All trades and investments have an element of risk. Remember the old adage: The higher the expected reward, the higher the associated risk. As you go down the scale of market cap, the element of stability and certainty reduces and risk increases proportionately.
Axiom 11: Caution
Caution is the father of security.
Many experts suggest that the more careful you are, the better your chances of trading success. While it is a matter of record that most of trading losses are by careless amateurs, operating blindly and without an intelligent plan. Put differently, stick to a set of strategic variables and that will take care of decision making. In this way you are automatically careful and avoid making mistakes based on emotions.
Axiom 12: Right and Wrong
Nobody is always right, but successful people are more often right than wrong.
This is a truism: even master traders make mistakes. The difference is that their overall average of making profits is higher than losses. That is the quintessence of success in the stock market; make profits most of the time.
Axiom 13: Strikes
Never sell stocks on account of a strike.
The logic underlying this rule is that strikes (no matter how serious) are temporary affairs. Sooner or later, they are settled. Of course, a long strike can hurt the share price, but as a trader, look at these as opportunities to get a stock that will ultimately rise again.
Axiom 14: Inactivity
Do not sell a security, which has long been inactive, just as soon as it begins to move forward.
Find the reason why a stock has been inactive. A sudden movement suggests a change in corporate activity.
Axiom 15: Cut Losses
Cut your losses short and let your profits run.
This is only common sense applied to your trading.
The answer is in theory simple: Cut shares that hit your stop loss. In practice, traders panic and hope that the situation will turn and the share will bounce.
Axiom 16: Being Reckless
Do not plunge recklessly after one or more successful trades.
Again, psychology enters the mind of the trader: Repeatedly making profits may give you then sense that you can do no wrong. This sense ultimately proves fatal.
Axiom 17: Diversify
Diversify your holdings.
The best portfolio structure is to be invested in at least three different sectors and across the market cap spectrum.
Unless in a position to protect a trade against extreme possibilities, it is a good rule not to trade at all.
In other words, always protect yourself with “stop-loss” orders, so as not to be caught by a sudden reversal in the market. A better stop-loss strategy is to have a training stop loss and always stick to that strategy. If you avoid selling a share that falls to that stop loss, you only have yourself to blame.
Axiom 19: Bulls, Bears, and Hogs
Bulls win. Bears win. Hogs get slaughtered.
I believe that this is one of the soundest rules on Wall Street. Greed has caused too many traders to fail in the market, simply because too many wait too long to buy or sell. Waiting for the right time doesn’t mean waiting till the price has moved into a new trend, rather it is getting in or out before everyone else does.
Axiom 20: Being Repetitive
The market seldom does the same thing more than three times in succession.
It seldom makes the same “high” or same “low” more than three times in succession. Therefore, be constantly on the alert for “triple tops” and “triple bottoms.”
Axiom 21: Stops
After a long rise, place stops close to, but under the previous week’s low.
This rule is especially true in strong bull trends. Whenever a stock declined under the previous week’s low, it was usually the forerunner of a sharp decline and often indicated the end of the advance. This rule was excellent “safety insurance.”
Axiom 22: Being Wrong
Don’t stay wrong long.
Sooner or later, all traders make their share of mistakes in the market. But you can always rectify your error. If you’re mistakenly bullish, turn bearish. Conversely, if you’re a bear and are wrong, adjust yourself to the trend. Don’t let pride, stubbornness, or prejudice blind you if you have planned wrong. Learn how to change with the tide.
Axiom 23: Desire and Money
The mere desire to make money should never be the mainspring for speculative actions, but only when an opportunity exists.
This takes a great deal of discipline, but it is sound advice. No matter how much cash you have ready for investment, don’t invest unless a clear opportunity exists. Opportunities are not long in developing in the market.
Axiom 24: Price
Buy only when the outlook warrants, price being secondary.
Even a “low-priced” stock is not “cheap” if it won’t go up. By the same token, even a “high-priced” stock is a buy if it is forecast to climb.
Axiom 25: Timing
The market always does what it should do, but not always when.
Sometimes the market can be frustratingly slow in its reaction to fundamental and technical triggers. But ultimately it does return to fair value. Patience in the sphere of trading is easier when you have a predetermined strategy.
Axiom 26: Be Logical
Be bullish in a bull market; be bearish in a bear market. Do not be either a bull or a bear all the time.
Many traders are either bulls or bears, and tend to crowbar reasons for being continuously such a trader. Ultimately, this becomes expensive until you learn to be more analytical, understanding when to go long and when to go short.
Learn to recognize the bull and bear signals and have a strategy for both.
Myths
Time to point out and correct a few of the popular myths about share trading. There are many myths about trading, and we can’t outline all in this chapter, so here are some of the more dangerous myths which to traders should be aware of. My intension is to replace these with more realistic concepts to build a foundation to knowledge.
Myth 1: Casinos
In recent years, some of these myths have been countered by a 7-year bull run, particularly when compared to the volatility of the 1980s and 1990s. In 1994 to 1995, as columnist for the Mail & Guardian, I wrote about the casino comparisons many traders used when buying and selling shares. After numerous interviews, I became astutely aware that some traders saw the stock market as nothing more than an opportunity to make money from volatility. I asked a number of traders how they took advantage of the market? Their reply was at times surprising.
One trader told me that the market was there to take advantage off by moving market sentiment. “When markets are radically volatile, it is only a matter of time before we see a crash!”
We did see a market crash in 1998, but it was not restricted to any specific country. Markets around the world fell, but an interesting issue became highlighted during the subsequent rebound. The world had turned its focus on emerging markets and the future would never be the same. Globalization means that markets, whether in South Africa, China, or Brazil, are the focus of traders from around the world and cannot be totally influenced by secular sentiment.
This has been proven since 1995 by phenomenal growth in stock markets, on the back of, among other, rising oil prices, war on terrorism, the rising economic influences of Mainland China and the European Community.
In the stock market, analysts are continually forecasting future share prices by taking into account environmental influences of global and local markets. This is why stock prices fluctuate—because the outlook for business conditions are continually and rapidly changing, and consequently, so do share prices.
So, ordinary shareholders expect their returns to be volatile, but they also expect them to be positive in the long run and higher than the return on bonds, treasury bills, or other less risky investments. Despite volatility and stock market crashes, stocks have trended steadily higher in value over the years; see appendixes.
It is this continuous uptrend in the value of markets around the world that sets the stock market apart from gambling. In addition, if a trader is reckless in his or her purchasing of stocks, remember that the trader will still own the stock even if the share price falls. In gambling, you either win or lose.
It is thus critical that you know from the start that investing and gambling are two completely different pursuits. When you understand this, your trading strategy will become more focused and less affected by fear and greed.
Myth 2: Why Research?
Some traders believe that, in order to be successful, you must be able to predict general stock market movement and a company’s trading range. These traders say that if you can determine a company’s trading range, then you can buy when it reaches the lower price range and sell when its gets to the top of the range.
And they do this by only using a set of technical indicators or triggers. Stated differently, they use buying patterns and historic trends to forecast price movements. In addition, they believe that technical analysis encompasses all factors that could influence a share price. In other words, you can ignore research or any fundamental analysis on the company, its financials or corporate deals.
There is a reason why nearly every large retail brokerage firm has a chief economist or market strategist and a team of analysts, whose main responsibilities are to predict the climate for stocks.
If results are any indication, the conclusion must be that trading without thorough research is prone to failure. One of the purposes of these three volumes is to free you from the compulsion we all seem to have to trade without a plan.
The key is to develop a plan that has a long-term focus, with a short-term safety net. Such a method would place a limit on potential losses, while riding the upward movement. This should ensure that your returns are better than general market trends.
This method looks at and concentrates on how shares are actually doing, compared to how they could do in the future.
Example:
• Share C is trading at $30.
• It reached a high of $37 in the past 12 months and a low of $33.
• According to your long-term analysis, the share could reach $45 in the next 18 months, due to a host of fundamental factors, that is, restructuring, management change, new merger, and so on.
• In the short term, however, factors (cyclical nature) could see the share fall by an unknown amount.
• To protect this investment, the independent stockbroker places a 5-percent stop loss on the share. This means that if the share falls by 5 percent, the share gets sold.
• However, to secure future (long-term) profits, the stop loss is made a “Trailing” one. This means that if the share rises to $35, the stop loss becomes $33.
This way, the trader has a plan to keep the share for 18 months, while securing his or her short-term profits. In the long run, a good investment strategy that does not rely on forecasts and analysis will fail.
Myth 3: Stocks and Gravity
The obvious statement “what goes up must come down” may be true under the laws of gravity, but these do not rule in the world of finance and stockbroking. I have repeatedly heard traders say that a specific share has “climbed so high that it must come down.”
Why? If the company has performed well and is better off financially this year when compared to last year, why would the share price come down? If the company gets bigger next year and improves sales and cost efficiencies, why should it not have a share price that is better next year than this year?
The answer lies in the influence of sentiment on company share prices. People buy and sell shares and when a share has climbed rapidly, they tend to panic and sell. Under the guise of “taking profits” traders sell. When the share hits a level that is acceptable in the minds of these traders—and in view of the future financial prospects of this company—the share tends to rise again.
The important thing to remember is that at some point, these shares advance to where they will never again return to their previous levels. As we have noted previously, stock investors demand a permanent return on their investments, just as investors in other types of assets demand a permanent return on theirs.
Some individual stocks do go up rapidly, and then give back the entire gain just as rapidly. All experienced investors and traders have had this disappointing experience. However disappointing it may be to have a good profit going and then see it evaporate, do not let this bitter experience lead you to believe in taking profits too quickly. If you do, it will cost you the really big gains, in the long run.
Of course, the grain of truth in this myth is the fact that any share trend consists of a series of advances and retreats, resulting in a net increase over time. If you are going to believe the statement “what goes up must come down,” then keep in mind that it often happens that a stock moves much higher than the fall that happens during profit taking. Think of it this way: If a share increases tenfold in value and then undergoes a 20-percent correction, you are still ahead by eightfold.
Another expression is to buy good stocks when there is profit taking. Note that many of the best-performing stocks do not have significant pullbacks, while they are increasing in value. By waiting for a good stock to pull back, you will most likely doom yourself to sitting on the sidelines while a stock makes a tremendous move upward, without you. When it finally does have the pullback you’ve been waiting for, that could be the beginning of the stock’s demise.
Myth 4: Buy Low, Sell High
This myth is propagated by so many, from novice to top professional traders. The issue that is seldom stated is what is the low price and when has the share reached its high level?
Not knowing these basic variables leads many traders to commit major trading errors.
For instance, how do you know that a share that has fallen will not continue to fall? One of the most common investor mistakes is to buy stocks that have fallen. The issue is really to understand and be able to calculate the fair value of a share. That way, when a share falls below that fair value, then you can buy, depending on your personal set of entry levels.
If you are to succeed in the stock market, you must remove from your mind the theory that a share that has fallen offers value. It is your trading strategy that will determine whether or not you reap the benefits of the winners you find.
Chapter 6 pinpoints mistakes and pitfalls which traders face every day.