Monday, August 24, 2009

Watts, Speculation as a Fine Art, part 2

In Speculation as a Fine Art Dickson G. Watts sets forth six conditional trading rules. It is these rules that I will summarize in today’s post. Even though I don’t personally advocate or follow all of them, I consider Watts’s case for them intellectually challenging.

1. “It is better to ‘average up’ than to ‘average down.’” Although, Watts admits, probably four times out of five averaging down works because the trader can exit profitably on a retracement, “the fifth time, meeting with a permanently declining market, the operator loses his head and closes out, making a heavy loss—a loss so great as to bring complete demoralization, often ruin.” The better course, though one still fraught with danger, is to average up. “Buying at first moderately, and, as the market advances, adding slowly and cautiously to the ‘line’—this is a way of speculating that requires great care and watchfulness, for the market will often (probably four times out of five) react to the point of ‘average.’ Here lies the danger. Failure to close out at the point of average destroys the safety of the whole operation. Occasionally a permanently advancing market is met with and a big profit secured.” Watts here is saying that the market is mean reverting about 80% of the time and trending about 20% of the time.

2. For the speculator “buying down” is not advisable. It “requires a long purse and a strong nerve, and ruin often overtakes those who have both nerve and money.” But those “men of good judgment, who buy in times of depression to hold for a general revival of business” can be very successful investors.

3. In what I suspect is not an original rule (though I have no idea who coined it), Watts urges the speculator to stop losses and let profits run. “Not to have the courage to accept a loss, and to be too eager to take a profit, is fatal. It is the ruin of many.”

4. The fourth rule addresses when to go with the trend and when to be a contrarian. “The rule is, to act cautiously with public opinion; against it, boldly. To go with the market, even when the basis is a good one, is dangerous. It may at any time turn and rend you. Every speculator knows the danger of too much ‘company.’” However, Watts does not advocate rash contrarianism. “The market has a pulse on which the hand of the operator should be placed as that of the physician on the wrist of the patient. This pulse-beat must be the guide when and how to act.”

5. Contrary to the commonly accepted rule today that one should never short a dull market, Watts claims that “quiet, weak markets are good markets to sell.” They normally break to the downside. But once markets start to decline and then move parabolically to the downside, they should be bought. Similarly, an advancing market that moves from strength to excitement should be sold “with great confidence.” (He wrote of course more than a century before the dotcom bubble, initially at least, mercilessly punished those who bemoaned irrational exuberance.)

6. Since speculation involves chance, “calculation must measure the incalculable.” In this calculation it is better to have a broad perspective. “Those who confine themselves too closely to statistics are poor guides.”

In conclusion, Watts points to the fundamental principle that lies at the base of all speculation: “Act so as to keep the mind clear, its judgment trustworthy. A reserve force should therefore be maintained and kept for supreme movements, when the full strength of the whole man should be put on the stroke delivered.”

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