Trade Like An O'Neil Disciple - Part I

To be perfectly honest, I've always been a believer of stock Fundamentals and kind of felt little uncomfortable trading on pure Technicals - I'm always afraid that I'll get into a stock that skyrockets on public Euphoria and then once people realize it has weak fundamentals, decides to try bungee jumping.

Having read Darvas's work - which was obviously Techno-Fundamental in nature, but with lack-lusture guidance in terms of implementation - I was looking for a knowledge source that'll help me replicate Darvas's style of trading/investing. Finally after a lot of research, William O'Neil seemed to be a great candidate. I just found a copy of Trade Like An O'Neil Disciple in Safari Books and started reading it.

Here's the first lesson:

a key but obvious point that ensures that you will not fall in love with your stock and hold it past its prime. Buy based on both fundamentals and technicals, but sell purely on technicals. Technical action should always be the final judge when selling a stock.

Stop Loss orders can be indicative of a bear market!

Darvas's box system had been working well for him for a while when suddenly in 1957, he found that he was stopped out of most of his positions upto the point where he did not have a single position left. Perplexed, he started to wonder if his system is failing. But as it turns out, a Bear market was just around the corner !

Darvas writes:

"
But no opportunity seemed to appear. What I did not know was that we were at the end of one phase of the great bull market. It was several months before this became evident and it was declared a bear market. Half the Wall Street analysts still discuss it. They say it was merely an intermediate reaction —a temporary halt in the rising market. They all agree, however, that prices collapsed.

Of course all these opinions are expressed by hindsight— when it is too late. The advice to get out of the market was not available when one needed it.

I recall the case of Hitler when he decided to invade Stalin­grad. To him it was just another Russian town to be conquered and occupied. Nobody knew while the battle of Stalingrad was being fought that it was the turning point in the war. For a very long time, few people realized it.

Even when the German armies were halfway back, it was still talked about as strategic withdrawal. It was, in fact, the end of Hitler. The Nazi war bull market ended the day Hitler attacked Stalingrad.
In the same way, I realized that it was impossible for me to assess great historical turning points in the market when they began to happen. What fascinated me, as Wall Street prices continued to fall, was the gradual realization that my system of ducking out quickly with my stop-losses made such an assess­ment unnecessary.
I made the joyful discovery that my method had worked much better than I had dreamed. It had automatically released me well before the bad times came. The market had changed - but I was already out of it.

The most important aspect to me was that I had absolutely no hint whatsoever that the market would slide. How could I have had any information? I was too far away all the time. I had listened to no predictions, studied no fundamentals, and heard no rumors. I had simply gotten out on the basis of the behavior of my stocks.

Later when I studied the stocks I had sold automatically, I found that they subsequently slid down very low indeed in the recession period.

Look at the following table:

	1957 I sold at	1958 Lowes price	1956 Highest price
BALTIMORE & OHIO	55	22⅝	45¼
DAYSTROM	42¼	30	39¾
FOSTER WHEELER	59½	25⅛	39⅛
AEROQUIP	27½	16⅞	25¾
ALLIED CONTROL	48¼	33½	46½
DRESSER INDUSTRIES	54½	33	46⅝
JOY MANUFACTURING	68	38	54½
ALLEGHENY LUDLUM	56½	30⅛	49⅜

When I looked at this table, I thought this: If my stop-losses had not taken me out of the market I could have lost about 50% of my investment. I would have been like a man in a cage, locked in with my holdings and missing my opportunity to make a fortune. The only way I could have escaped would have been by smashing out, taking a 50% loss, possibly ruining my­self, and gravely impairing my confidence for future deals.

I could, of course, have bought these stocks and "put them away.'* This is a classic solution among people who call them­selves conservative investors. But by now I regarded them as pure gamblers. How can they be non-gamblers when they stay with a stock even if it continues to drop? A non-gambler must get out when his stocks fall. They stay in with the gambler's eternal hope of the turn of a lucky card.

I thought of the people who paid 250 for new york central in 1929. If they were still holding it today it was worth about 27. Yet they would be indignant if you called them gamblers! "

Nicholas Darvas's Objectives and Weapons for milking money out of the stock market !

Darvas, after a series of random losses discovers his famous box trend following method but the question of when to get in and when to get out still haunts him - he writes :

And how to determine when to take profits?

I realized that I would not be able to sell at the top. Anyone who claims he can consistently do this is lying. If I sold while the stock was rising, it would be a pure guess, because I could not know how far an advance might carry. This would be no cleverer a guess than anticipating that "My Fair Lady" would end its run after 200 performances. You could also guess it would go off after 300 or 400 performances. Why did it not go off at any of these figures? Because the producer would be a fool to close the show when he sees the theater full every night. It is only when he starts to notice empty seats that he considers closing the show.
I carried the Broadway comparison through to the problem of selling. I would be a fool to sell a stock as long as it keeps advancing. When to sell then? Why, when the boxes started to go into reverse! When the pyramids started to tumble down­wards, that was the time to close the show and sell out. My trailing stop-loss, which I moved up behind the rising price of the stock, should take care of this automatically.
Having made these decisions, I then sat back and re-defined my objectives in the stock market:

1. Right stocks
2. Right timing
3. Small losses
4. Big profits

I examined my weapons:

1. Price and volume
2. Box theory
3. Automatic buy-order
4. Stop-loss sell-order

As to my basic strategy, I decided I would always do this: I would just jog along with an upward trend, trailing my stop-loss insurance behind me. As the trend continued, I would buy more. When the trend reversed? I would run like a thief.

I realized that there were a great many snags. There was bound to be a lot of guesswork in the operation. My estimate that I would be right half of the time could be optimistic. But at last I saw my problem more clearly than ever. I knew that I had to adopt a cold, unemotional attitude toward stocks; that I must not fall in love with them when they rose and I must not get angry when they fell; that there are no such animals as good or bad stocks. There are only rising and falling stocks—and I should hold the rising ones and sell those that fall.

I knew that to do this I had to achieve something much more difficult than anything before. I had to bring my emotions— fear, hope and greed—under complete control. I had no doubt that this would require a great amount of self-discipline, but I felt like a man who knew a room could be lit up and was fumbling for the switches.

Dravas's rules - he learnt them the hard way !

So, finally after two weeks of breaking my head over design issues , I finally had some more time to dedicate to my latest hobby, i.e., trading. Just started reading the book by Nicholas Dravas - How I Made $2,000,000 in the Stock Market.

Here's a set of rules he learnt the hard way after loosing a fair bit of his equity in the market:

"

1. I should not follow advisory services. They are not infallible, either in Canada or on Wall Street.
2. I should be cautious with brokers' advice. They can be wrong.
3. I should ignore Wall Street sayings, no matter how ancient and revered.
4. I should not trade "over the counter"—only in listed stocks where there is always a buyer when I want to sell.
5. I should not listen to rumors, no matter how well founded they may appear.
6. The fundamental approach worked better for me than gambling. I should study it. 
7. I should rather hold on to one rising stock for a longer period than juggle with a dozen stocks for a short period at a time.

"