Monday 28 January 2008

W. D. Gann 's 24 rules


Rule 1 Amount of capital to use: Divide your capital into equal parts and never risk more than one-tenth of your capital on any one trade.

Trading can be exciting. Money management is intrinsically boring. As a consequence, many traders ignore basic money management rules to their peril. It is no coincidence that Mr. Gann's first rules are survival rules. As Mr. Gann stated:

Your first thought must be to protect your capital and make your trading as safe as possible. There is one safe, sure rule, and the man who will follow it and never deviate from it will always keep his money and come out ahead at the end of every year. This rule is divide your capital into 10 equal parts and never risk more than one-tenth or 10 per cent of your capital on any one trade. You can always find new opportunities to make profits, so long as you have capital to operate with. Taking heavy risks in the beginning endangers your capital and impairs your judgment. Trade in such a way that you not be disturbed mentally by a loss or two, if it comes.

(Gann, W. D., 45 Years in Wall Street, Lambert-Gann Publishing Co., Pomeroy, WA, 1949, p. 17.)

It must be stated that risking 10 per cent of capital should be considered to be the absolute maximum percentage and only for those with smaller trading accounts. Two to five per cent would be a more appropriate percentage to risk for the majority of traders.

Rule 2 Use stop loss orders. Always protect a trade when you make it with a stop loss order 3 to 5 points away.

Stop loss orders are not 100 per cent guarantees of trading safety just as seat belts are not 100 per cent guarantees that one will not sustain injury in a road accident. This is hardly an argument against stop-loss orders or seat belts, however. The evidence supporting the use of both stop loss orders and seat belts is overwhelming!

Mr. Gann was adamant that stop-loss orders should be an integral part of a traders reason for taking a trade. He left no doubt about his views on this subject by saying:

I feel that I cannot repeat too many times the value of using stop loss orders because it is the only safety valve to protect the investor and trader. An investor or trader will place a stop loss order and one time out of ten the stop will be caught at the exact top or bottom. After this he always remembers this and says, "If I place a stop loss order, they will just go down and catch it, or just go up and catch it and then the market will go the other way." So he does not use the stop loss order the next time. The trader forgets the nine times out of ten the stop loss order was right and would have prevented big losses by getting him out at a time when the market was going against him.

Mr. Gann adds:

PLACE A STOP LOSS ORDER AT THE TIME YOU MAKE A TRADE AND DO NOT CANCEL IT.

(Gann, W. D., 45 Years in Wall Street, Lambert-Gann Publishing Co., Pomeroy, WA, 1949, pp. 18-19.)

It should be noted that Mr. Gann advised traders to "place" the stop-loss order, in other words to give the order to their broker. Some traders say that they do not need to do this as they use mental stop-loss orders.

There are two real problems with the use of mental stops. The first is that it leads to a delay in the execution of the order. An order placed with a broker can be executed the moment the market has traded at the nominated price. Even if a trader is aware of a stop price being hit, he or she has to contact the broker before the order can be executed.

The second problem with the use of mental stops is the fact that it gives the trader the opportunity to second-guess his or her trading plan. It is very tempting to rationalize that "my stop may have been hit, but it has been a good trade so I will wait just one more day". Many a trader or investor has waited "just one more day", day after day, until a profit has become a loss.

One of the most effective pieces of advice I give traders who are having trouble with discipline is to tell them to always place a stop-loss order with their broker. The temptation to override it is then out of their hands.

Rule 3 Never overtrade. This would be violating your capital rule.

There are two forms of overtrading. The first is when Rule 1 is violated that is, when more than 10 per cent of your trading capital is placed at risk in the market.

The second form of overtrading involves taking too many trades in a relatively short period of time. This form of overtrading can:

  • Expose too much of one's account to the market;
  • Result in excessive transaction costs;
  • Result in the stress associated with making numerous decisions under pressure;
  • Lead to excessive work for a reduced reward.

Rule 4 “ Never let a profit run into a loss. After you once have a profit of 3 points or more, raise your stop loss order so that you will have no loss of capital.

Most experienced traders or investors have suffered the disbelief involved in realizing that they have let a profit run into a loss. As Mr. Gann states:

It is just as important to protect your profits as it is to protect your capital. Once you have a profit on a trade, you should never let it run into a loss. There are exceptions to this rule, and the amount of the profits should determine where stop loss orders should be placed. The following is about the safest rule that I can give you to use under average conditions. When a stock has moved 3 points in your favor, place a stop loss order where you will be even if it is caught. In very active high-priced stocks, it will even pay you to wait until the stock shows a profit of 4 to 5 points; then move your stop loss order up to where you will have no loss should the market reverse. In this way, you will have reduced your risk to a minimum and the possibility of profits will be unlimited. As the stock moves in your favour, continue to follow up with a stop loss order, thus protecting and increasing your profits.

(Gann, W. D., 45 Years in Wall Street, Lambert-Gann Publishing Co., Pomeroy, WA, 1949, p. 19.)

Clearly, some common sense needs to be used when applying this rule. Active, higher-priced stocks need to be given more room to move than less volatile, lower-priced stocks.

Rule 5 “ Do not buck the trend. Never buy or sell if you are not sure of the trend according to your charts.

One of Wall Streets most famous sayings is "the trend is your friend". The trend is certainly your friend and trading with the trend is clearly a profitable way to trade. The key is therefore to have a definition of trend and to apply it consistently.

Mr. Gann defined an up trend as a market making higher swing tops and higher swing bottoms on a swing chart. Similarly, he defined a downtrend as a market making lower swing tops and lower swing bottoms.

Rule 6 “ When in doubt, get out, and don't get in when in doubt.

Professional traders trade when their proven system gives them a clear buy or sell signal. In other words, they trade when the odds are stacked in their favour.

Just as it makes sense to trade only when a clear signal has been given, it also makes sense to get out when in doubt. A trend cannot be progressing well if there is real doubt.

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.

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. Ganns Rule 8 raises the important issue of diversification. There is an old Wall Street saying which says "dont 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 "Noahs 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. Ganns 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 ones trade increases. Limits 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.)

Rule 10“ Dont 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 traders 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. Ganns 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".

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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. Ganns 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.

W. D. Ganns 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 stocks 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.

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.

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!

ule 16“ Never cancel a stop loss order after you have placed it at the time you made a trade.

W. D. Ganns extensive experience as a trader is obvious when we examine the wisdom of this short rule. In this rule he instructs us to:

  • Place a stop-loss order at the time the trade is placed.
  • Place the stop-loss order with a broker. It should not be aœmental” stop.
  • Never cancel a stop-loss order.

Good trading rules, such as those devised by Mr. Gann more than 50 years ago, take into account the all-important psychological aspects of trading. Placing a stop-loss order with a broker, as opposed to having aœmental stop”, is a good example of this. Not only does the broker execute the order the moment the market trades at the nominated price, but it also eliminates the possibility of the trader saying those fateful wordsœIll just give the trade one more day to come good”.

Rule 17“ Avoid getting in and out of the market too often.

Many amateurs trade for excitement. Professionals, on the other hand, trade with the objective of implementing their proven system to the letter“ and enjoying the resulting profits. Entering and exiting the market too often makes trading more exciting for amateurs, but the professionals soon learn to take transaction costs into account.

When traders open a trade, they commit themselves to oneœround trip” of transaction costs. These costs are a real cost of trading and can make a significant difference to the profitability of different trading systems. A system with an average trade length of three days will have transaction costs which could be up to twenty times higher, in total, than one with an average trade length of three months.

Medium-term stock market trading systems are generally more profitable than short-term systems due to the lower transaction costs. They are also less stressful to trade, require less work, and allow traders to make their trading decisions in the calm after the market has closed.

Rule 18“ Be just as willing to sell short as you are to buy. Let your object be to keep with the trend and make money.

Short selling is foreign to many traders. Few beginners can understand how one can make money in a falling market, and indeed very few people engage in short selling.

Short selling is unpopular for a number of reasons. These include:

  • Most traders are conditioned to, and experienced in, trading stocks in a rising market.
  • Short selling appears to be unethical, as uninformed people believe that in the stock market, it is the trading equivalent of stealing.

The short selling of stocks did, in fact, become illegal in Australia in 1980. It was reintroduced in the mid-1980s, but with conditions attached.

Professional traders, particularly in the United States, have made considerable sums of money trading the short side of the market, despite the fact that the average American investor also has a clear preference to only trade the long side.

Short selling is a practice that is good for all markets, as it helps to prevent extremes in price movements. If a short seller believes a market is at a top, regardless of whether he or she is correct, and the person sells stocks short, this adds selling pressure to the market, taking some of the˜heat out of the buying frenzy. Similarly, the short seller must buy the stocks back at some point, thus applying buying pressure that will help to prevent excessively low prices. Also, the short seller contributes badly needed liquidity in a bear market.

Traders who are experienced in trading on the long side and who have an adequate amount of trading capital are in the best position to undertake short selling. It is also best undertaken in a sustained bear market.

Rule 19“ Never buy just because the price of a stock is low or sell short just because the price is high.

One of the most common mistakes made by amateurs is to buy a stock simply because the price of the stock is low. This can be a very expensive mistake, indeed.

There are many reasons why a stocks price could be low. These include:

  • The market is a sustained bear market and the prices of the majority of stocks are falling.
  • The stock has experienced a normal correction.
  • A negative rumour concerning the stock has been circulated.
  • One or more of the large funds is unloading the stock.
  • The company is in severe financial trouble and may not survive.

Clearly, it is dangerous to buy a stock purely because its price is low“ particularly if we do not know why it is low. Even if we do know the real reason that the stocks price is low, the stocks price could soon be much lower if the trend is down. Indeed, a stock with a low price could still be an excellent candidate to short sell!

As Edwin Lefevre stated in Reminiscences of a Stock Operator:

“…stocks are never too high to buy or too low to sell. The price, per se, has nothing to do with establishing my line of least resistance.”

(Lefevre, E., Reminiscences of a Stock Operator, Traders Press, Inc., Greenville, S.C., page 122.)

Rule 20“ Be careful about pyramiding at the wrong time. Wait until the stock is very active and has crossed Resistance Levels before buying more and until it has broken out of the zone of distribution before selling more.

Rule 21“ Select the stocks with small volume of shares outstanding to pyramid on the buying side and the ones with the larger volume of stock outstanding to sell short.

Mr. Gann is reminding us that a given buying force will move the price of a stock more if that stock does not have an excessive number of shares outstanding. He is also advising us to only short sell highly liquid stocks, as liquidity will be needed to ensure we can cover our shorts with ease.

Rule 22“ Never hedge. If you are long of one stock and it starts to go down, do not sell another stock short to hedge it. Get out of the market; take your loss and wait for another opportunity.

Hedging a stock in order to avoid taking a loss is much like failing to exit the market when a stop has been hit, or averaging down. In both cases, the trader is not willing to face the fact that the trade has failed. As Mr. Gann advises, it is best to exit the market with a small loss and to prepare for the next trading opportunity.

Rule 23“ Never change your position in the market without a good reason. When you make a trade, let it be for some good reason or according to some definite plan; then do not get out without a definite indication of a change in trend.

Consistently profitable traders plan their trade and trade their plan. To deviate from a proven plan is to not have a plan.

A good trading plan incorporates strategies that allow a trader to trade with the trend and to have a positive expectation of success. It should also give the trader an exit signal when the market has negated the reason for being in the trade“ usually when the trend has changed direction.

Rule 24“ Avoid increasing your trading after a long period of success or a period of profitable trades.

Mr. Gann was not only a great trader and analyst“ he also had a well-above-average understanding of human nature. He understood only too well that human beings, after a particularly profitable period in the market, feel compelled to increase their trading by a large amount. They mentally project their trading profits and realise how much they would have made if they had been trading with the larger stake throughout that period.

W. D. Gann understood that above average success in the market is usually associated with a strongly trending market. He also understood that when the market stopped trending strongly, sideways or choppy market action was a possibility. Such action is more difficult to trade and would be a particularly poor time to increase the size or frequency of ones trading.