45 Years in Wall Street – A Life Time of Experience

(Part Two)

Neil A Costa

In Part 1One of this series of articles (ATAA Journal, Jan/Feb 2003), it was concluded "W. D. Gann’s twenty-four 24 never-failing rules today represent the core of his massive contribution to the accumulated knowledge of trading and investing. These rules are not optional extras, but rules that must be rigorously applied if a trader or investor is to be successful." In that article his first six rules were examined.

In Part Two2 of the series, Rules 7 to 10 12 will be discussed:

 

Rule 7 – Trade only in active stocks. Keep out of slow, dead ones.

If there is a secret to making quick trading profits, the secret is to trade strongly trending markets. Active stocks are also usually more liquid, reducing slippage and making the process of entering and exiting trades easier.

The following chart Chart 1 shows a stock that illustrates the characteristics of a strongly trending market. A kagi chart (similar to a Gann Swing chart) can be a very effective method of removing the noise from the market and revealing, in the case of Bristile Ltd, a powerful underlying move.

1.      A strongly trending market, illustrated by a kagi chart.

Rule 8 – Equal distribution of risk. Trade only 4 or 5 stocks, if possible. Avoid tying up all of your capital in any one stock.

Mr. Gann’s Rule 8 raises the important issue of diversification. There is an old Wall Street saying which says "don’t put all of your eggs in the one basket", which Mr. Gann clearly agrees with.

On the other hand, there are many traders and investors who take this to the extreme and who accumulate 30 or more stocks. Such a large number of stocks can also be hazardous to the wealth creation process, as diversification over such a large number of stocks will make it impossible to focus on the strongest stocks, thus diluting the proportion of very strong stocks in the portfolio.

W.D. Gann advocated limited diversification in an interview:

I could go over the history of Scales, Livermore, Durant, Ryan and the balance of the great men of Wall Street, and in analyzing their trading, the one weak point would be found in all of them, they diversified too much. Did not speculate in one commodity or a few special stocks, but spread all over the board. The result was that they had too many irons in the fire and when one thing started to go wrong and begin to lose money, they would invariably get out of stocks and commodities in which they were making money and keep those that were going against them.

He also stated:

Tape reading requires patience, and the essence and value of it is concentration. There is no such thing as a man being born with a mind that can concentrate on 10 things at one time, much less 700. Then success depends upon selecting a few stocks and concentrating upon them.

(Gann, W.D., Truth of the Stock Tape, Lambert-Gann Publishing, Pomeroy, 1923, page 4.)

Warren Buffett also cautions traders against over-diversification:

Buffett - describes traditional diversification as the "Noah’s Ark approach"… Buy two of everything in sight and end up with a zoo instead of a portfolio. .

(Train, J., The Money Masters, Publisher unknown, 1994, page 2.)

After many years of wrestling with the issue of the optimal number of stocks to own, the author has concluded that Mr. Gann’s suggestion of four or five stocks is very sound. Owning more stocks is permissible, but returns will be lowered towards that of the index as the number increases.

 

Rule 9 – Never limit your orders or fix a buying or selling price. Trade at the market.

Too many traders have missed excellent trades in strongly trending stocks, or have bought or sold at ridiculous prices, because they were inflexible about their buying or selling price. Strongly trending stocks, by definition, are moving quickly. Therefore, to limit a buying or selling price in such stocks can mean accepting a very poor trade entry or exit price after one has had to ‘chase’ the market.

This rule applies more and more as the average length of one’s trade increases. Limit’s can be of useful to very short-term traders, particularly those who exit their trades when targets are hit.

W. D. Gann illustrates this rule when selling, in the following statement:

There is another type of investor who always gets out of the market too late, because when the big advance comes, he holds on and hopes that the stock will go higher than it ever does. It never reaches the price at which he wishes to sell. The first quick break comes, and he decides that if the stock advances again to its former high level, he will sell out. The stock does advance but fails to get as high, then declines still lower, and he again fixes a price in his mind at which he will sell, but this is only a "hope" price, and he sees the stock drift lower and lower until finally, in disgust, he sells out after the stock has had a big decline from the top.

(Gann, W.D., 45 Years in Wall Street, Lambert-Gann Publishing, Pomeroy, 1949, pages 20-21.)

Mr. Gann used to describe this first lower top as the safest place to sell.. (Similarly, Mr Gann describes the first higher bottom as the safest place to buy.)

The following chart Chart 2 shows a stock that has made its first lower top. The once dominant buyers can no longer overcome the sellers and push the stock to new highs. The sellers have taken control..

2.      The first lower top, illustrated by a kagi chart.

Rule 10 – Don’t close your trades without a good reason. Follow up with a stop loss order to protect your profits.

The best trader in a group will always be the trader who is the most skilled at exiting his or her trades. Amateur traders tend to let their losses run and cut their profits short. Clearly this is the opposite of what they should be doing.

It is the trades where we let our profits run which gives us our biggest profits. If one only trades in strongly trending markets, the trader’s aim should be to look for reasons to stay in the trade for as long as it continues to trend strongly. Sadly, too many traders search for, and inevitably find, many reasons why a market will stop at a particular price or on a particular day. They then over-tighten their stops or exit at these points, only to see the market power on to much greater heights.

 

Rule 11 – Accumulate a surplus. After you have made a series of successful trades, put some money into surplus account to be used only in emergency or in times of panic.

Mr. Gann’s Rule 11, instructing traders to accumulate a surplus, is one rarely followed by traders. Instead, they prefer to trade or spend this money.

In is often said that if you trade for long enough, everything will happen to you. Certainly, you will experience times when the markets go from the extremes of ‘booms’ to the undervaluations of ‘busts’. You will also experience extremes in the volatility of some markets that can be caused by the extreme gluts and the extreme scarcity of some commodities.

It is at these times that extraordinary trading opportunities can occur. Those with surplus funds can capitalise on these opportunities. Those with no funds, or funds tied up elsewhere, often spend the rest of their lives talking about the great trade that "could have been".

 

Rule 12 – Never buy just to get a dividend.

Buying a stock to collect a soon-to-be-paid dividend can be very tempting. At first glance it seems a way to generate a quick, sure, profit. Of course, you are not the only person to realise that this opportunity exists, and so the price of the stock will tend to rise in anticipation of the payment of the dividend and fall by the amount of the dividend when the stock goes ex. dividend, thus negating any advantages.

Some people buy a stock purely because it pays a good, regular dividend. These people are investors, not traders.

Mr. Gann’s advice is applicable to investors as well as traders. The fact that a stock pays a good, regular dividend is not a good enough reason, alone, to purchase the stock. The stock company could be about to reduce the size of the dividend or eliminate the dividend entirely. Stocks should only be purchased which Only stocks that are strong from a technical perspective should be purchased.

 

Chart 3 illustrates that a company that pays consistent dividends can still be a very poor trade or investment. In just over three years this the Telstra stock’s price has halved and there is little sign of recovery at the time of writing.

3.      Telstra. Buying a stock for its dividend is risky.

 

Conclusion

As we continue our discussion of Mr. Gann’s twenty-four 24 never-failing rules, it can be seen that Mr. Gann was a great analyst. Many of his rules are based on important technical analysis considerations, and that is why they are the rules that are of as much value in 2003 as they were when he wrote 45 Years in Wall Street in 1949.

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