Thursday, November 02, 2006

Dave Landry vs. Phantom of the Pits

I've only started reading The Phantom of the Pits recently. In Chapter 5, he states his first rule of trading:
"Reduce or close out a position altogether if it has not been proven correct. "

Closing a position because the market has not proven you correct is NOT the same as closing a position because the market proved you wrong. In other words, let the market prove you correct, but do NOT give the market a chance to prove you wrong.
IF I've interpreted and understand this rule correctly, what the Phantom is saying is that once a position has been opened, you are like threading a maze in the sense that there are only one or two scenarios where the position should be continued to be held, but there are very many, many "dead-ends" - scenarios where a position should be closed out. The rationale here is that the approach to the market should be from a position of pessimism, and that this the most essential way to keep losses small.

Now, If anyone has been following any of Dave Landry's webcasts, you'll know that he repeatedly advocates NOT micromanaging a position. I tried to describe in my own words what Dave Landry means when by micromanaging. Essentially, Landry advocates letting the market decide whether to take out your stops as a part of avoiding micromanaging your trade. Anyone who has closed out a position before their stops were hit, only to see the stock run-up dramatically right after exiting the trade will understand that micromanaging a trade will greatly increase the probability of missing out on such profitable run-ups.

How interesting.

So now I am looking at two trading rules that both make sense, but are in direct conflict with each other. The main conflict that I see here is that one is advocating quickly closing a position before it has a chance to hit your stop, whereas the other is advocating letting the market decide when to take out your stop.
So how can this be reconciled? I'm not sure that it can, because these two rules, I believe, address different styles of trading. Landry's style is to try to catch onto the multi-month run-ups like AKAM back in this past summer, or AAPL for most of the latter half of 2005. So, his rule of letting the markets decide whether to take out your stops is geared towards catching those multi-month, trending, momentum winners (with the occasional pullback here and there).
I haven't read enough of the Phantom of the Pits (POP) to understand what trading style he is describing with his rule. However, his rule#1 seems to suggest a trading style where winners are discovered by a continual process of quickly and ruthlessly eliminating the losers. This also suggests a capital preservation attitude governing the trade, as opposed to the capital appreciation attitude behind Dave Landry's stop rule.
At first glance, it may seem like the POP's rule seems to be more important than Landry's stop rule - after all, capital preservation is more important than capital appreciation. However, it should also be understood that these two different rules address different market situations. This is consistent with the fact that there is no one trading strategy which is applicable to all market situations. There will be certain situations and conditions whereby it is better to NOT micromanage, and there will be certain situations whereby it is better to close your position before your stop is hit. MAYBE in a trending market (which is not what we have this week), letting the market decide when to take out your stops MIGHT make more sense, and in a sideways, choppy market (which is what we do have this week), the POP's rule might make more sense.

Regardless of whether one rule is more correct or better or not, the bottom line is that it is actually good that we have two contrasting rules to study and digest - that's what makes a market! That way, we can use our own critical thinking ability to discern for ourselves when, whether and how to incorporate these rules into our own trading styles.

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