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45 Years in Wall Street – A Life Time of Experience
(Part Three)
W. D. Gann’s twenty-four never-failing rules represent the core of his massive contribution to the accumulated knowledge of trading and investing. In this article, Part Three of the series, Rules 13 to 15 will be discussed:
Rule 13 Never average a loss. This is one of the worst mistakes a trader can make.
Professional traders and investors have a clearly defined point of no return. When they place a trade or make an investment, they also place a stop-loss order that automatically removes them from the market when their reasons for taking the trade fail to materialise. This limits their loss and preserves their capital.
People who average a loss choose to buy more and more stock as the price of the stock falls. Their reason for doing this is that each time they purchase more stock at a lower price, they lower their average purchase price over the total amount of stock purchased. For example, a trader purchased shares as follows (ignoring transaction costs):
Initial purchase 1000 shares @ $6.00 per share. Total cost of first purchase is $6000.00.
The share price falls to $3.00. The trader averages their loss by purchasing another 1000 shares.
Second purchase 1000 shares @ $3.00 per share. Total cost of second purchase is $3000.00.
Overall, 2000 shares have been purchased for $9000.00, or for an average price of $4.50. This is considerably less than the initial purchase price of $6.00 per share.
For some, averaging a loss has great appeal. In theory, it allows these people to be wrong about a stock’s immediate prospects and yet allows them to progressively lower the average purchase price per share, in readiness for its recovery.
In reality, what they are doing is making a trade or investment, realising that the trade was going to fail, and instead of immediately taking a small loss using a predetermined rule, they choose to throw more and more good money after bad. Sometimes, they will eventually make a profit from the trade often many years later. Of course, there can be a large opportunity cost associated with tying up trading or investment capital for such a long period when the money, minus a small loss, could have been reinvested in another strong stock.
Sometimes the stock never recovers. The trader or investor then loses all of their capital. The final, very low average price becomes meaningless as the stock is worthless.
Jesse Livermore was one of the greatest traders of all time. He said the following about holding and hoping and taking losses in his book, ‘How to Trade in Stocks’, (original publisher unknown, copyrighted in 1940):
On the best trades:
Experience has proved to me that real money made in speculating has been in commitments in a stock or commodity showing a profit right from the start. (Page 19)
On taking losses:
Profits always take care of themselves but losses never do. The speculator has to insure himself against considerable losses by taking their first small loss. (Page 21)
On holding and hoping:
If my stock does not act as I anticipated, I immediately determine that the time is not yet ripe - so I close out my commitment. (Page 22)
On so-called 'blue chips' (Livermore was pointing out the danger in the commonly held market belief, at the time he wrote the book, that it was safer to invest in railroad stocks than to have the money in the bank):
New York, New Haven and Hartford Railroad
Price on April 28, 1902 - $255. Price in January 2, 1940 - $0.50.
Chicago, Milwaukee & St. Paul Railroad
Price in December 1906 - $199.62. Price January 5, 1940 - $0.25.
Chicago Northwestern
Price in January 1906 - $240. Price January 2, 1940 - $0.31.
Great Northern Railway
Price in February 9, 1906 - $348. Price on January 2, 1940 - $26.63.
(Page 24)
On 'buy and hold' investing:
Speculators in stock markets have lost money. But I believe that it is a safe statement that the money lost by speculators alone is small compared with the gigantic sums lost by so-called investors who have let their investments ride. (Page 25)
From my point of view, the investors are the big gamblers. They make a bet, stay with it, and if all goes wrong, they lose it all. (Page 25)
A modern cousin of averaging a loss is a process known as dollar cost averaging. Dollar cost averaging involves purchasing a fixed value of stock at regular intervals.
For example, a trader or investor may choose to purchase $5000 worth of a particular stock every three months. With dollar cost averaging, as the price of the stock rises and falls over time, your $5000 purchases a smaller number of shares when they are trading at higher prices, while purchasing a larger number of shares when they are trading at lower prices. This process allows you to average a lower price than you would have if you had purchased all of your shares near the top of the market.
Again, dollar cost averaging has the same fatal flaw as averaging a loss if the stock price goes to zero; the entire stock holding becomes worthless.
Above is a weekly candlestick chart of Pan Pharmaceuticals. The Pan Pharmaceutical collapse caught many by surprise. Would you, as a technical analyst, have been surprised if you had been following the chart? How would you be feeling during the final week knowing that you had averaged a loss, or applied dollar cost averaging, to this stock?
Rule 14 Never get out of the market just because you have lost patience or get into the market because you are anxious from waiting.
Good traders and investors have learned to be patient. Amateurs love ‘action’. However, prematurely exiting a trade often prevents the big profits from being accumulated and prematurely entering a trade is to take a trade that has not given a clear entry signal. Professional traders wait patiently for an exit or entry signal, or they do nothing.
A News Corporation weekly chart covering the period when the price rose from $5.70, to $11.35, in approximately 10 months. Always look for reasons to stay with a strong stock.
Rule 15 Avoid taking small profits and big losses.
As mentioned earlier, traders should be looking to cut their losses short and to let their profits run. Sadly, many traders end up doing the exact opposite. They take small profits, as they fear that the profit will become a loss if they do not take it. They accumulate big losses because they do not want to admit to themselves that the trade had failed. Ego and trading do not mix very well at all!
Conclusion
The three trading rules discussed in this article are rules that can result in a trader making large profits from their trading and investing activities. Of course, it is one thing to read and understand the rules. What is of greater importance is their consistent and disciplined application.
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