"Investment students need only two well-taught courses - How to Value a Business and How to Think About Market Prices" - Warren Buffett
Thursday, 11 June 2020
7 Samurai Principles for Successful Traders
By Frank Ivancic
I happened to be re-reading an excellent book this morning, Budo Secrets by John Stevens, which describes various teachings of Japanese martial arts masters and I was struck by one section that I felt translated very well into what a successful trading philosophy should be.
The two words that make up Budo (‘Bu’ and ‘Do”) translate into English as “The way of brave and enlightened activity” and I think that this is a good motto to have when trading. The famous Japanese swordsman, Yagyu Renya (1625-1694) listed seven principles of enlightened samurai and I have shown them here, only modified to fit the trading world.
1. Stay in the Centre
This is about staying centred in body and mind. Professional traders see what they do as a business, not a fun hobby. If you want fun and excitement, go to Las Vegas. If you want to make money in the markets, get serious about it.
Nearly all the traders who were covered in Jack Schwager’s brilliant Market Wizards series mentioned the importance of remaining emotionally neutral during gains and losses. This is an essential trait that any trader must master before they can be consistently successful.
A good trader has a system which they follow. When you win, your system gets validated. When you lose money, you need to check to make sure that your system is still relevant for the market. If it is, then you must remain confident and keep to your system until it starts to bear fruit. Flip-flopping due to emotional swings is a sure path to the poor house.
Emotional control is your shield against Mr. Market’s manic-depressive mood swings.
2. Empty Sword
This principle is about learning to make the far come near. No one can make the market do anything. The market is the boss. Sure, some manipulators can drive a particular stock or commodity up or down in price, but they can only do it when the price momentum allows for it. If a stock is weak and there are few buyers, then a speculator can be the catalyst for selling pressure. But that same speculator can’t do that if the stock is shooting higher as a flood of buyers pour money into it. You can only take what the market gives.
One successful trader said that only one out of 20 of his ideas were clear winners. The secret is to cut losses quickly on losing trades to keep enough capital available for that one big success, as can be seen though George Soros’ philosophy to build long-term capital through preservation of capital and via home runs. Stanley Druckenmiller has stated that it’s not whether you are right or wrong that counts, but it’s how much you make when you are right and how much you lose when you are wrong that matters. Jesse Livermore repeatedly stressed how you need to ride winning stocks and cut losers quickly.
Expect that you will lose money on many of your trades and wait for those big, winning trades to come along. Have confidence in your system (and your risk management principles) that your winners will more than cover for any losing trades that you make.
Preserve your cash as best you can when you are wrong, and swing for the fences when you have a winning position. That is the way to build great long term returns.
3. Cut-off Self
This is about not trying to beat the market. Stay with a system and let that tell you whether you should enter or exit a position. When you are just going with gut feelings or on other people’s opinions, you will lose far more than you win.
Ed Seykota and others have said that they make money when they trust their systems. They lose money when they think they are smarter and try to do things on their own. Commodities trader, Richard Dennis, said that he could publish his trading rules in the newspaper and that almost no one would use them, because most people get caught up in the excitement of trading. He also said that people could come up with trading systems that were 80% as good as the ones that he used, but it wouldn't matter because people would have trouble sticking with them.
If you have developed a proven, tested way to make money in the markets, then stick with it and get out of the way. Your job is to help create rules for risk management and to constantly test the validity of your system in an ever-changing market.
Don’t be a gunslinger. Discipline is the key.
4. Harmonize the Hara and the Senaka
This states that the martial artist should use their body in a unified and rhythmic way. When it comes to trading, this means that you should not rely on any one indicator when making a decision on buying or selling. There are a multitude of tools that can be used to create a far more accurate and clearer picture of what is going on with a stock or in the market as a whole.
If the RSI on a stock seems oversold, check the MACD and Money flow Indices. Is volume confirming the move? Did the price breakthrough a major moving average? Where are the support and resistance levels? What has the stock done on previous occasions at similar inflection points? Has there been any major news on the company or commodity? Are insiders buying or selling?
There are so many things that can be taken into consideration and the more things that you can find that are pointing in the same direction, the clearer to outlook for the security will be. Take the time and do the work.
There is no easy way to (legally) make money in the markets. Roll up your sleeves, do the work, and increase the odds that you are right.
5. Forget Your Body
This is about not rigidly sticking to a particular stance or position. It is about being flexible and not having any problem with exiting a position when it turns sour. Too many traders become emotionally attached or enamoured with a stock, commodity or an outcome. When this happens they become blinded to important changes are unable to adapt when the market changes and they lose money.
Even Warren Buffett, who says his time horizon for keeping a good stock is forever, dumps that same stock when the fundamentals change. Be nimble and know when the time comes for cutting a position. It all depends on your time horizon and your risk tolerance.
When all the indicators were screaming higher inflation and stock market turbulence in the 1970s, it was a great time to buy gold. When things went parabolic and Volcker came in and raised interest rates, it was a clear sign to get out. Trading is a business, and traders do their best when the trades they make are emotionless and boring. If things start to get exciting for you, then it could be a sign that something is wrong with your trading philosophy.
If you think Bernake is evil and destroying the economy, that's fine. Just don’t make trades based on your anger. Call your representative in Congress and vent instead. Being cool, level-headed, and trading on facts are much better than trading based on trying to be ideologically right. The facts will set you free.
Don't get married to your positions and always be ready to change your mind. Remember, hope is a terrible investment strategy.
6. Greet Your Opponent
Risk management is probably the most important aspect of trading. Know when to fight and when to run. Even before you implement a trade you should have a price point in mind that will invalidate your hypothesis. If that price (your stop) is reached, just get out and move on even if you have a loss.
Livermore always said that whenever he got into a winning trade, it usually made money for him from the start. He also spoke about how every up trend has its natural reactions (when a stock would consolidate in price and move down) and this was to be expected. He was always on the lookout for abnormal down drafts, though. When the market gives you a warning sign, get out a look for reasons later. Remember: the market will often make moves before the facts come out and are known.
Always have tight stops on your trades and only risk an amount that you are comfortable with on any single trade. One trader once said that if you have trouble sleeping at night due to a position that you own, you are in too deep and you should scale it down to a ‘sleep level’.
Set your stops either as a percentage trailing stop or have a set price that, if the stock falls below that level, sell it. Be cold and ruthless about it. If the price bounces back and things look good again, you can always buy back later. Some traders say that you should never risk more than 5% of your equity on any single trade. Others cut their losses if they end up being down 10% in one month. You need to find what you are comfortable with and stick to it.
When you see an opportunity, take it. When you see a threat, know when to retreat.
7. Practice by Yourself
A serious trader needs to follow these guidelines every day without fail. They need to practice and improve themselves and not just rest on their laurels, so to speak. Good traders adapt and are constantly learning. Keep a trading journal on all of your trades. Why did you think that this was a good trade? Why did you decide to get out? What happened after you bought it? This will help you find patterns and shed light on where your strengths and weaknesses lie. Maybe you habitually make the same mistake over and over, but can't see it? Maybe you have missed many opportunities at riding a winner because you fear losing your 5% gain? Never assume that your logic and reasoning is perfect. If you are losing money, you are doing something wrong.
Bad traders keep making the same mistakes over and over again. Only Good traders learn from their mistakes and strive to become better. There is no place for ego if you want to make money on your trades. The best traders are humble.
The two words that make up Budo (‘Bu’ and ‘Do”) translate into English as “The way of brave and enlightened activity” and I think that this is a good motto to have when trading. The famous Japanese swordsman, Yagyu Renya (1625-1694) listed seven principles of enlightened samurai and I have shown them here, only modified to fit the trading world.
1. Stay in the Centre
This is about staying centred in body and mind. Professional traders see what they do as a business, not a fun hobby. If you want fun and excitement, go to Las Vegas. If you want to make money in the markets, get serious about it.
Nearly all the traders who were covered in Jack Schwager’s brilliant Market Wizards series mentioned the importance of remaining emotionally neutral during gains and losses. This is an essential trait that any trader must master before they can be consistently successful.
A good trader has a system which they follow. When you win, your system gets validated. When you lose money, you need to check to make sure that your system is still relevant for the market. If it is, then you must remain confident and keep to your system until it starts to bear fruit. Flip-flopping due to emotional swings is a sure path to the poor house.
Emotional control is your shield against Mr. Market’s manic-depressive mood swings.
2. Empty Sword
This principle is about learning to make the far come near. No one can make the market do anything. The market is the boss. Sure, some manipulators can drive a particular stock or commodity up or down in price, but they can only do it when the price momentum allows for it. If a stock is weak and there are few buyers, then a speculator can be the catalyst for selling pressure. But that same speculator can’t do that if the stock is shooting higher as a flood of buyers pour money into it. You can only take what the market gives.
One successful trader said that only one out of 20 of his ideas were clear winners. The secret is to cut losses quickly on losing trades to keep enough capital available for that one big success, as can be seen though George Soros’ philosophy to build long-term capital through preservation of capital and via home runs. Stanley Druckenmiller has stated that it’s not whether you are right or wrong that counts, but it’s how much you make when you are right and how much you lose when you are wrong that matters. Jesse Livermore repeatedly stressed how you need to ride winning stocks and cut losers quickly.
Expect that you will lose money on many of your trades and wait for those big, winning trades to come along. Have confidence in your system (and your risk management principles) that your winners will more than cover for any losing trades that you make.
Preserve your cash as best you can when you are wrong, and swing for the fences when you have a winning position. That is the way to build great long term returns.
3. Cut-off Self
This is about not trying to beat the market. Stay with a system and let that tell you whether you should enter or exit a position. When you are just going with gut feelings or on other people’s opinions, you will lose far more than you win.
Ed Seykota and others have said that they make money when they trust their systems. They lose money when they think they are smarter and try to do things on their own. Commodities trader, Richard Dennis, said that he could publish his trading rules in the newspaper and that almost no one would use them, because most people get caught up in the excitement of trading. He also said that people could come up with trading systems that were 80% as good as the ones that he used, but it wouldn't matter because people would have trouble sticking with them.
If you have developed a proven, tested way to make money in the markets, then stick with it and get out of the way. Your job is to help create rules for risk management and to constantly test the validity of your system in an ever-changing market.
Don’t be a gunslinger. Discipline is the key.
4. Harmonize the Hara and the Senaka
This states that the martial artist should use their body in a unified and rhythmic way. When it comes to trading, this means that you should not rely on any one indicator when making a decision on buying or selling. There are a multitude of tools that can be used to create a far more accurate and clearer picture of what is going on with a stock or in the market as a whole.
If the RSI on a stock seems oversold, check the MACD and Money flow Indices. Is volume confirming the move? Did the price breakthrough a major moving average? Where are the support and resistance levels? What has the stock done on previous occasions at similar inflection points? Has there been any major news on the company or commodity? Are insiders buying or selling?
There are so many things that can be taken into consideration and the more things that you can find that are pointing in the same direction, the clearer to outlook for the security will be. Take the time and do the work.
There is no easy way to (legally) make money in the markets. Roll up your sleeves, do the work, and increase the odds that you are right.
5. Forget Your Body
This is about not rigidly sticking to a particular stance or position. It is about being flexible and not having any problem with exiting a position when it turns sour. Too many traders become emotionally attached or enamoured with a stock, commodity or an outcome. When this happens they become blinded to important changes are unable to adapt when the market changes and they lose money.
Even Warren Buffett, who says his time horizon for keeping a good stock is forever, dumps that same stock when the fundamentals change. Be nimble and know when the time comes for cutting a position. It all depends on your time horizon and your risk tolerance.
When all the indicators were screaming higher inflation and stock market turbulence in the 1970s, it was a great time to buy gold. When things went parabolic and Volcker came in and raised interest rates, it was a clear sign to get out. Trading is a business, and traders do their best when the trades they make are emotionless and boring. If things start to get exciting for you, then it could be a sign that something is wrong with your trading philosophy.
If you think Bernake is evil and destroying the economy, that's fine. Just don’t make trades based on your anger. Call your representative in Congress and vent instead. Being cool, level-headed, and trading on facts are much better than trading based on trying to be ideologically right. The facts will set you free.
Don't get married to your positions and always be ready to change your mind. Remember, hope is a terrible investment strategy.
6. Greet Your Opponent
Risk management is probably the most important aspect of trading. Know when to fight and when to run. Even before you implement a trade you should have a price point in mind that will invalidate your hypothesis. If that price (your stop) is reached, just get out and move on even if you have a loss.
Livermore always said that whenever he got into a winning trade, it usually made money for him from the start. He also spoke about how every up trend has its natural reactions (when a stock would consolidate in price and move down) and this was to be expected. He was always on the lookout for abnormal down drafts, though. When the market gives you a warning sign, get out a look for reasons later. Remember: the market will often make moves before the facts come out and are known.
Always have tight stops on your trades and only risk an amount that you are comfortable with on any single trade. One trader once said that if you have trouble sleeping at night due to a position that you own, you are in too deep and you should scale it down to a ‘sleep level’.
Set your stops either as a percentage trailing stop or have a set price that, if the stock falls below that level, sell it. Be cold and ruthless about it. If the price bounces back and things look good again, you can always buy back later. Some traders say that you should never risk more than 5% of your equity on any single trade. Others cut their losses if they end up being down 10% in one month. You need to find what you are comfortable with and stick to it.
When you see an opportunity, take it. When you see a threat, know when to retreat.
7. Practice by Yourself
A serious trader needs to follow these guidelines every day without fail. They need to practice and improve themselves and not just rest on their laurels, so to speak. Good traders adapt and are constantly learning. Keep a trading journal on all of your trades. Why did you think that this was a good trade? Why did you decide to get out? What happened after you bought it? This will help you find patterns and shed light on where your strengths and weaknesses lie. Maybe you habitually make the same mistake over and over, but can't see it? Maybe you have missed many opportunities at riding a winner because you fear losing your 5% gain? Never assume that your logic and reasoning is perfect. If you are losing money, you are doing something wrong.
Bad traders keep making the same mistakes over and over again. Only Good traders learn from their mistakes and strive to become better. There is no place for ego if you want to make money on your trades. The best traders are humble.
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