This Part really starts to get into the ‘Nuts & Bolts’ of how he does things and once again a huge THANK YOU to Michael for providing this excellent text.
Everyone is obsessed with entry, but it should be the other way around. Obsess about your exits.
Many traders focus on entry but this is only 50% of the trade. An entry gets one into a trade but it is the exits and their cumulative profits and losses which will decide your success as a trader. It’s been proven that with a random entry and managed exits one can make money net of fees (Van Tharp). High probability entries are great, but if you are constantly selling for a 30% loss and taking your profits at 20%, those same high probability entries are worthless. I believe exits are much more important than entries as not entering can’t lose you money.
"Investing is not a points scoring game – you win by limiting your mistakes as much as possible... A pilot does not score points by getting to the airport quicker but by doing all of his checks, not making mistakes, and landing at the destination safely" – Free Capital
You need to play to win to consistently churn money into your account, but you need a stake to play. Therefore, capital preservation is key. By focussing on the downside and knowing your maximum drawdown before entering (and sticking to it) the risk is then to the upside. Focus on not making mistakes – the market offers ample opportunities to increase wealth and you don’t need to be on every stock to reach your destination.
"The kind [of stock] that makes an investor of you against your will by the simple expedient of falling into a trance the moment you go long of it. The chap who is compelled to lug a corpse for a year or two always loses more than the original cost of the deceased; he is sure to find himself tied up with it when some really good things come his way" – Jesse Livermore
If, like me, you have ever made the mistake of becoming a long term trader from a short term investment, then falling into this hypnosis can be detrimental to your success and your returns. Opportunity cost is real, which is why I often sell a stock that is rising in order to buy something which I think will go up even faster. There is logic in my method for doing so: my goal is to take trades where the risk/reward is skewed in my favour. By thinking objectively about your positions on a nightly basis after the market has closed, it helps one to see positions where the risk has now increased substantially and the reward is now not so slim. Think of risk as constantly evolving and not a static concept. The notion of ‘house money’ too is nothing more than a gambling fallacy. The money is real – but it’s not yours until you’ve banked it. If you wouldn’t now enter the trade at its current level, should you really be holding all of it? Or should you be taking some risk off the table?
Beware: the cheap trap!
Another gains goblin you should try to avoid on your journey is Mr Cheap. He cunningly tries to tell you that a stock is now cheaper because the price has fallen or the PE is low. What a ludicrous proposition! A stock that has a falling PE could be because its profits have fallen but its share price has fallen further. Is that the sort of stock you really want to own? Furthermore, if you are buying a stock that is not yet profitable, what happens when the cash runs out? A stock that goes down does not necessarily go back up. Those who were buying cheap shares like Carillion and Conviviality Retail because the share price couldn’t go any lower were sadly surprised. They did go lower. They all went to £0 and everyone lost all of their money.
If you ‘invest’ in a stock that is not making money then they will inevitably need to raise more at a discount. Don’t think for a second that the directors will work for free – they still need paying and they’ll use your money for it.
Believing directors blindly is another mistake I have had the misfortune to make. I suspect I am not the only one, and I certainly won’t be the last, but allowing a director’s comments on a rampcast to prevent you from selling when you know you really ought to and then be done by a deeply discounted placing leaves a sour taste in the mouth.
Sometimes speaking to management can be helpful in that they can help to explain parts of the business and answer some of your questions, but trying to gain an inside line is a sucker play (and we all know what pay a sucker play gets). If what the directors say sounds good it would be in an RNS if it were material. If it is material and it is not in an RNS, then they are breaking the law by disclosing market sensitive information and you should be extra careful of everything else they say. Be aware of confirmation bias and the fact that management and especially CEOs are salesmen. They want you to buy more stock because they want the share price to go up.
Lifestyle directors are no different to salesmen peddling snake oil
Some directors actually specialise in this spiel; their companies never achieve anything yet they continue to rake in hefty six figure salaries paid for by shareholder money. Lifestyle directors whip out the begging bowl every few months to boost the coffers, usually with a story about how they’re doing to drill or mine a hole in the ground, which often ends in tears when the music stops. You can make good money trading these stocks, as where these directors fail in the operational capabilities they more than make up for in ramps. A good example of these types of trading plays is UK Oil & Gas, which at one point last year was worth more than top quality oil & gas companies SDX Energy and Serica Energy, despite not having produced a single drop of oil (1p to 10p!). Some ramps are so powerful they are almost evergreen – the "Gatwick Gusher" pump has multi-bagged UK Oil & Gas many a time. I’ve already set my alarm for the 2019 ramp where they promise a lot, achieve nothing, and make me a load of money.
"The speculator’s chief enemies are always boring from within. It is inseparable from human nature to hope and to fear" – Jesse Livermore
Stock trading is incredibly different to stock investing. They require completely different mindsets and skillsets. An investor who sees a fall in price with no underlying reason for the movement senses an opportunity to acquire more of the company for a cheaper price. A trader who impulsively averages down is a schmuck. Commit to what you are, and do not be a short term trader who then switches into long term investment. Decide what the position is and stick to it. Trading and investing at the same time is possible but only if you realise that they are two separate concepts and treat them as such.
"The cotton showed me a loss and I kept it. The wheat showed me a profit and I sold it out… Of all speculative blunders there are few greater than trying to average a losing game" – Jesse Livermore
Be aware of the disposition effect. This has cost many a stock market speculator money in terms of both opportunity cost and bigger losses, as they sell what goes up and keep what goes down. If your gardener pulled out your plants and watered the weeds – you’d fire him! Apply the same logic to yourself.
This does not mean that averaging down is always a bad idea, but if your entries are correct then you should not be frequently selling for a loss at support, only to see the stock bounce back and have you kicking yourself. There should be a clear objective reason for doing so and you need to be extra careful of managing the trade. If you always cut your losses instead of averaging down, you’ll never be in the position where you take a big loss because you kept buying more and more. Remember, the market can stay irrational longer than you can stay solvent.
"Markets are never wrong – opinions often are" – Jesse Livermore
A trader needs to constantly monitor their emotions and how they feel in order to protect against themselves. Lose your opinions, not your money. Every day, you’re only ever one trade away from doing serious damage to your portfolio and to yourself. Trading on tilt (poker term for frustration or emotional breakdown) or where you are no longer capable of making objective decisions can not only set you back months but completely wipe you out. To protect against on this, I like to look at my positions nightly and imagine what could happen, and know where I’m getting out. If you don’t plan and you end up in a pressured environment, can you really trust yourself to make the optimal decision in the heat of battle? I have found out that I can’t, and so I created checklists. I don’t trust myself. But I trust a process and try to stick to it.
"Nowhere does history indulge in repetitions so often or so uniformly as in Wall Street. When you read contemporary accounts of booms or panics the one thing that strikes you most forcibly is how little either stock speculation or stock speculators today differ from yesterday. The game doesn’t change and neither does human nature" – Reminiscences of a Stock Operator
Greed. Fear. Hope. Regret. These four emotions repeat themselves in every market participant without fail (unless you’re reading this and are not actually human but in fact a high frequency trading algorithm). Greed has people overexpose their positions. Fear of missing out has people chasing spikes. Hope has people grimly holding onto losses when their stock collapses through support and is in freefall. Regret causes self-inflicted damage for not selling out when they still could’ve. Whenever you feel one of these emotions – remember this: Mr Market is testing you and trying to see if you will do something stupid. Emotions have no place in the high stakes trading arena.
"They say you never grow poor taking profits. No, you don't. But neither do you grow rich taking a four-point profit in a bull market" – Jesse Livermore
You need to run winners to provide the fat tail on your bell curve but at the same time not taking some risk off the table as the stock moves up in your favour distorting the risk/reward against you is silly. Holding all of your position that is 200% up in a few days – who is the risk/reward favouring? It’s certainly not you.
"Fear and hope remain the same; therefore the study of the psychology of speculators is as valuable as it ever was. Weapons change, but strategy remains strategy, on the New York Stock Exchange as on the battlefield" – Reminiscences of a Stock Operator
Nowhere is this psychology more pronounced than on the bulletin boards. I have found these to be a useful indicator of the general sentiment of a stock – though definitely not to be relied upon – but if there are 500 posts and several posters are talking about a 30p party when the stock price is 3p, you can bet there’ll be some volume. And where there is volume there is volatility, and so there exists a trading opportunity. Ultimately, it’s volume that pushes stocks higher, and I have found this to be a brilliant indicator. Stocks that have a high chance of amounting to nothing and a low chance of striking the jackpot attract punters like a moth to the flame; the reason being that humans prefer the small chance of winning big than the high chance of winning little. Ed Croft from Stockopedia has done a quality video which can be found in the bibliography at the bottom of Part 3.
These are the stocks where the multibaggers exist – often a small market capitalised stock with a new exciting strategy or asset. They are almost always unprofitable but could become the next big thing if they do something. ‘If’ being the key word here.
"By a judicious investment of a temporary character." – Reminiscences of a Stock Operator
It rarely pays to stick around in these stocks. Stocks that rise quickly can fall just as quick. When a trader crosses the line and becomes a believer in the story, their money can be considered as good as gone. For no matter how high the stock goes he truly believes in the merits of the company and considers himself an ‘investor’, and so he rationalises himself into holding for a higher gain but does not create an exit plan. And regardless of how low it goes he seeks out confirmation bias from bulletin boards, vague news stories that provide a tenuous speculative link, and refuses to hear any rational logic which may suggest he is wrong. The believer may even end up throwing good money after bad.
Block your eyes with wax lest you hear the siren’s song
Never fall in love with a story. One of my biggest winners was CloudTag, and once it became clear CloudTag didn’t actually have a working product I realised I had to get out and started selling on the way up. I rode the stock from ca. 2.75p to a high of 15p – it ended up reaching 24p at its peak! Whilst this stock put money in the pockets of many punters (both long and short), others lost thousands and I even heard one story of a poor chap who put his money he’d saved up for a house deposit into the stock only to watch it delist.
"One of the most helpful things that anybody can learn is to give up trying to catch the last eighth – or the first. These two are the most expensive eighths in the world" – Jesse Livermore
Picking bottoms and calling tops is a fool’s game, and working out how much you ‘could’ have made is unnecessary self-inflicted pain. I bought the gap on PYC and traded this from 1.4p to 5p – but that same stock carried on going to 30p. Was I annoyed? A little. But Harry Hindsight only ever appears to tell you so after the event, and I made the best objective decision based on the facts at the time. It was a great trade. These stratospheric rises happen rarely but enough to keep people holding on to the next one – the best anyone can do is to plan their trades, and then do their absolute best to trade their plans.
"I never buy at the bottom and I always sell too soon" – Baron Nathan Rothschild
Punters buy and sell in herds. They say greed climbs a wall of worry but fear takes the express elevator down. When everyone is buying and the price is rapidly rising, it’s probably not a bad idea to think about selling some. If you’re unsure – sell half. That way, you have banked a gain and can still benefit from the upside. When the fear strikes it’ll be a crowded exit.
Always put downside first and know how much you are willing to lose maximum, and keep the risk to the upside. Take some off the table as the stock moves up. We’re not here to catch the top – we’re here to make money. No matter how high the stock is, or how many times it’s bagged, there’ll always be someone there to tell you it’s going higher. Always.
".. like a real philanthropist of the type that is so abundant in Wall Street – the sort who loves to put millions into the pockets of friends, acquaintances and utter strangers alike" – Reminiscences of a Stock Operator
You can find these tipsters everywhere. Some of them are good, and some of them are bad. It can pay to listen to the good ones, as they can be helpful in providing leads for you to do your own research. Never buy anything that you have not done your own research on, because no matter who the tipster is, you do not know their risk profile, their position size, their portfolio, their entry, their exit. Tips can be useful leads only – if you treat them as anything more then you are the one to blame if it goes wrong.
Tips can come from many places: paid for tip sheets, well known investors, stock market columns in the newspapers. Very often they can move prices and so it is well worth being aware of the major players. Sometimes there are trades just by jumping on tips, and selling out. First in, first out! Some people mock others who buy tips, yet those are the ones making the money. I know who I’d rather be.
In the microcap world, literally anything can move a stock. Recently, Ross Group moved 200% because someone posted on a bulletin board that there was a sentence in the annual report that the board expected the number of employees to increase in the next financial year, suggesting that the board might do something compared to the previous nine where they did nothing. It doesn’t make any sense, and it doesn’t have to either.
There are some Twitter accounts that are capable of moving stocks. Last summer, almost everything one account tweeted about rocketed. They had the golden touch, blessed was any share that they cared to mention. It didn’t matter whether the stock in question was fundamentally solid or absolute junk. To profit from this, I set up a column in Tweetdeck to follow all of their tweets, and for a period I was entering every stock they posted about within 30 seconds. This was brilliant as I could silently sell into the liquidity coming in to make a quick scalp (it is illegal to promote a stock whilst selling your position – not that this stops anyone, of course). Obviously, once this stopped working, I stopped doing it.
Twitter and bulletin boards can be helpful to find trades. A stock that is up 100% because it’s been pumped on hot air via the bulletin boards is not a high risk trade to short if volume is thinning. Knowing which stocks are the ramp du jour means you can let the rampers do the hard yards and meet them at the finish line to collect your profits.
A low price for a man to pay for not having the courage of his own convictions! It was a cheap lesson
The other side of stock market tipsters are those that want you to sell. I find it incredibly hard to believe people actually bother to try and convince others to sell so they can then buy in cheaper, but they exist. It would be less effort learning to trade but they don’t seem to ever grasp that. You can find some of these dopes on bulletin boards where they keep coming back weekly for years on end, where they pretend they are altruistically trying to stop other private investors losing money. Perhaps they lost money once and are now bitter. Perhaps they are short. Perhaps they developed a weird fetish for the stock and keep coming back. Some of these can be credible and convincing, and some of them may even have a modicum of truth to them – but do not let them get into your head without good reason. If you do, they are robbing you of a learning opportunity. You will only learn by making your mistakes. It’s OK (and encouraged) to hear the bear case, but do not let someone else sway your mind unless it is fully your decision. Many of the people who frequent bulletin boards to talk stocks down continuously are losing traders who, quite literally, have nothing better to do, and so most can be dismissed without a further thought.