The "Not So Simple" Rules of Trading


129 ratings



John Mauldin

17 Jul, 2006

in Money Management and 1 more

The rules that should be 'Utterley Simple Rules of Trading' but which we all seems to find 'Utterley Difficult!'

The world of investing/treading, even at the very highest levels, where we are supposed to believe that wisdom prevails and profits abound, is littered with the wreckage of wealth that has hit the various myriad rocks that exist just beneath the tranquil surface of the global economy. It matters not what level of supposed wisdom, or education, that the money managers or individuals in question have. We can make a list of wondrously large financial failures that have come to flounder upon these rocks for the very same reasons. Let us, for a bit, have a moment of collective silence for Long Term Capital Management; for Baring's Brothers; for Sumitomo Copper... and for the tens of thousands of individuals each year who follow their lead into financial oblivion.

 I've been in the business of trading since the early 1970s as a bank trader, as a member of the Chicago Board of Trade, as a private investor, and as the writer of The Gartman Letter, a daily newsletter I've been producing for primarily institutional clientele since the middle 1980s. I've survived, but often just barely. I've made preposterous errors of judgment. I've made wondrously insightful "plays." I've understood, from time to time, basis economic fundamentals that should drive prices--and then don't. I've misunderstood other economic fundamentals that, in retrospect, were 180 degrees out of logic and yet prevailed profitably. I've prospered; I've almost failed utterly. I've won, I've lost, and I've broken even. 

As I get older, and in my mid-50s, having seen so much of the game--for a game it is, with bad players who get lucky; great players who get unlucky; mediocre players who find their slot in the lineup and produce nice, steady results over long periods of time; "streak-y" players who score big for a while and lose big at other times--I have distilled what it is that we do to survive into a series of "Not-So-Simple" Rules of Trading that I try my best to live by every day ... every week ... every month. When I do stand by my rules, I prosper; when I don't, I don't. I am convinced that had Long Term Capital Management not listened to its myriad Nobel Laureates in Economics and had instead followed these rules, it would not only still be extant, it would be enormously larger, preposterously profitable and an example to everyone. I am convinced that had Nick Leeson and Barings Brothers adhered to these rules, Barings too would be alive and functioning. Perhaps the same might even be said for Mr. Hamanaka and Sumitomo Copper.

Now, onto the Rules:

R U L E  1

Never, ever, under any circumstance, should one add to a losing position ... not EVER!

Averaging down into a losing trade is the only thing that will assuredly take you out of the investment business. This is what took LTCM out. This is what took Barings Brothers out; this is what took Sumitomo Copper out, and this is what takes most losing investors out. The only thing that can happen to you when you average down into a long position (or up into a short position) is that your net worth must decline. Oh, it may turn around eventually and your decision to average down may be proven fortuitous, but for every example of fortune shining we can give an example of fortune turning bleak and deadly.

By contrast, if you buy a stock or a commodity or a currency at progressively higher prices, the only thing that can happen to your net worth is that it shall rise. Eventually, all prices tumble. Eventually, the last position you buy, at progressively higher prices, shall prove to be a loser, and it is at that point that you will have to exit your position. However, as long as you buy at higher prices, the market is telling you that you are correct in your analysis and you should continue to trade accordingly.

R U L E  2

Never, ever, under any circumstance, should one add to a losing position ... not EVER!

We trust our point is made. If "location, location, location" are the first three rules of investing in real estate, then the first two rules of trading equities, debt, commodities, currencies, and so on are these: never add to a losing position.

R U L E  3

Learn to trade like a mercenary guerrilla. 

The great Jesse Livermore once said that it is not our duty to trade upon the bullish side, nor the bearish side, but upon the winning side. This is brilliance of the first order. We must indeed learn to fight/invest on the winning side, and we must be willing to change sides immediately when one side has gained the upper hand.

Once, when Lord Keynes was appearing at a conference he had spoken to the year previous, at which he had suggested an investment in a particular stock that he was now suggesting should be shorted, a gentleman in the audience took him to task for having changed his view. This gentleman wondered how it was possible that Lord Keynes could shift in this manner and thought that Keynes was a charlatan for having changed his opinion. Lord Keynes responded in a wonderfully prescient manner when he said, "Sir, the facts have changed regarding this company, and when the facts change, I change. What do you do, Sir?" Lord Keynes understood the rationality of trading as a mercenary guerrilla, choosing to invest/fight upon the winning side. When the facts change, we must change. It is illogical to do otherwise.

R U L E  4

Capital is in two varieties: Mental and Real, and, of the two, the mental capital is the most important.

Holding on to losing positions costs real capital as one's account balance is depleted, but it can exhaust one's mental capital even more seriously as one holds to the losing trade, becoming more and more fearful with each passing minute, day and week, avoiding potentially profitable trades while one nurtures the losing position.

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Re: The "Not So Simple" Rules of Trading

excellent - 10/10

well done john............having been involved in the Family gambling business since the 1960's and later Trading since the 1980's it all rings so true .......


Feb 18, 2013

Member (26445 posts)

Re: The "Not So Simple" Rules of Trading

Brilliantly 'Not So Simple', thank you. I shall endeavour to follow these every day.

Feb 17, 2013

Member (2 posts)

Re: The "Not So Simple" Rules of Trading

I wouldn't say it was 'common' sense, or less people would continue to add to losses and cut winners etc.

Some very good points, I also suspect the author would rather be a poet. :)

Aug 31, 2011

Member (62 posts)