After my frightening experience with jones & laughlin, and my more fortunate experience with Texas gulf producing, I sat down to assess my position. By now I had been scared and beaten by the market enough to appreciate that I should not regard the stock market as a mysterious machine from which, if I were lucky, fortunes could be extracted like the jackpot in a slot machine. I realized that although there is an element of chance in every field in life, I could not base my operations on luck. I could be lucky once, maybe twice—but not constantly.
No, this was not for me. I must rely on knowledge. I must learn how to operate in the market. Could I win at bridge without knowing the rules? Or in a chess game without knowing how to answer my opponent's moves? In the same way, how could I expect to succeed in the market without learning how to trade? I was playing for money, and the game in the market was against the keenest experts. I could not play against them and expect to win without learning the fundamentals of the game.
And so I started. First I examined my past experiences. On one hand, using the fundamental approach, I was wrong. On the other hand, using the technical approach, I was right. Obviously the best method was to try to repeat the successful approach I had used with texas gulf producing.
It was not easy. I sat with my stock tables for hours each evening, trying to find another stock like it. Then one day I noticed a stock called m & m wood working. None of the financial information services could tell me anything much about it. My broker had never heard of it. Yet I remained obstinately interested because its daily action reminded me of Texas gulf producing. I started to watch it carefully.
In December 1955 the stock rose from about 15 to 23⅝ at the year end. After a five-week lull, its trading volume increased and its price resumed its advance. I decided to buy 500 shares at 26⅝. It continued to rise and I held on, watching its movement intently. It kept moving upward and its volume of trading was consistently high. When it reached 33,1 sold it and took a profit of $2,866.62.
I was happy and excited—not so much because of the money but simply because I had bought m & m wood working, as I had bought Texas gulf producing, purely on the basis of its action in the market. I knew nothing about it nor could I find out very much. Yet I assumed from its continuing rise and high volume that some people knew a lot more about it than I did.
This proved to be correct. After I had sold it, I found out from the newspaper that the steady rise had been due to a merger, which was being secretly negotiated. It was eventually revealed that another company planned to take over M & M wood working for $35 a share, and this offer was accepted. This also meant that although I was in complete ignorance about the behind-the-scene deal, I had only sold out 2 points under the high. I was fascinated to realize that my buying, based purely on the stock's behavior, enabled me to profit from a proposed merger without knowing anything about it. I was an insider without actually being one.
This experience did more than anything to convince me that the purely technical approach to the market was sound. It meant that if I studied price action and volume, discarding all other factors, I could get positive results.
I now began to try to work from this point of view. I concentrated on a close study of price and volume and tried to ignore all rumors, tips or fundamental information. I decided not to concern myself with the reasons behind a rise. I figured that if some fundamental change for the better takes place in the life of a company, this soon shows up in the rising price and volume of its stock, because many people are anxious to buy it. If I could train my eyes to spot this upward change in its early stages, as in the case of m & M wood working, I could participate in the stock's rise without knowing the reason for it.
The problem was: How to detect this change? After much thinking I found one criterion—that was to compare stocks with people.
This is how I began to work it out: If a tempestuous beauty were to jump on a table and do a wild dance, no one would be particularly astonished. That is the sort of characteristic behavior people have come to expect from her. But if a dignified matron were suddenly to do the same, this would be unusual and people would immediately say, "There is something strange here— something has happened. *'
In the same way, I decided that if a usually inactive stock suddenly became active I would consider this unusual, and if it also advanced in price I would buy it. I would assume that somewhere behind the out-of-the-ordinary movement there was a group who had some good information. By buying the stock I would become their silent partner.
I tried this approach. Sometimes I was successful, sometimes not. What I did not realize was that my eyes were not sufficiently trained yet, and exactly when I started to feel confident I could operate on my theory, I was in for a rude awakening.
In May 19561 noticed a stock called Pittsburgh metallurgical, which at that time was quoted at 67, It was a fast-moving, dynamic stock and I thought it would continue to move up rapidly. When I saw its increased activity, I bought 200 shares for a total cost of $13,483.40.
I was so sure of my judgment that I threw all caution overboard and when the stock—contrary to my expectation—began to weaken, I thought this was just a small reaction. I was sure that after the slight drop it was set for another big upward move. The move was there all right—but it was in the wrong direction. Ten days later Pittsburgh metallurgical stood at 57¾. I sold it. My loss was $2,023.32.
Something was obviously wrong. Everything clearly pointed to the stock as the best in the market at that time and still, no sooner had I bought it, than it dropped. And what was more disillusioning, no sooner did I sell it than it started to move up.
Trying to find an explanation, I examined the stock's previous movements and discovered that I had bought it at the top of an 18-point rise. This was as much as the stock could contain for the time being. Almost at the very point that I put money in it, it started to drift downward. It was evident that I had bought the right stock at the wrong time.
Looking back I could see this very clearly. I could see exactly why the stock had performed the way it did—afterwards. The question, however, was: How to judge a movement at the time it happens?
It was a simple, straightforward problem, but it was complex in its enormity. I already knew that book systems did not help, balance sheets were useless information was suspect and wrong.
Clutching at a straw, I decided to make an extensive study of individual stock movements. How do they act? What are the characteristics of their behavior? Is there any pattern in their fluctuations?
I read books, I examined stock tables, I inspected hundreds of charts. As I studied them I began to learn things about stock movements which I had not seen before. I started to realize that stock movements were not completely haphazard. Stocks did not fly like balloons in any direction. As if attracted by a magnet, they had a defined upward or downward trend, which, once established, tended to continue. Within this trend stocks moved in a series of frames, or what I began to call "boxes".
They would oscillate fairly consistently between a low and a high point. The area, which enclosed this up-and-down movement, represented the box or frame. These boxes began to exist very clearly for me.
This was the beginning of my box theory, which was to lead to a fortune.
This is how I applied my theory: When the boxes of a stock in which I was interested stood, like a pyramid, on top of each other, and my stock was in the highest box, I started to watch it. It could bounce between the top and the bottom of the box and I was perfectly satisfied. Once I had decided on the dimensions of the box, the stock could do what it liked, but only within that frame. In fact, if it did not bounce up and down inside that box I was worried.
No bouncing, no movement, meant it was not a lively stock. And if it were not a lively stock I was not interested in it because that meant it would probably not rise dynamically.
Take a stock, which was within the 45/50 box. It could bounce between those figures as often as it liked and I would still consider buying it. If, however, it fell to 44½, I eliminated it as a possibility.
Why? Because anything below 45 meant it was falling back into a lower box and this was all wrong—I wanted it only if it was moving into a higher box.
I found that a stock sometimes stayed for weeks in one box.
I did not care how long it stayed in its box as long as it did and did not fall below the lower frame figure.
I observed, for instance, that when a stock was in the 45/50 box it might read like this:
45. 47 - 49. 50 - 45 - 47
This meant that, after reaching a high at 50, it could react to a low at 45 then close every day at 46 or 47 and I was quite happy. It was still within its box. But, of course, the movement I was constantly watching for was an upward thrust toward the next box. If this occurred I bought the stock.
I did not find any fixed rule as to how this takes place. It just has to be observed and instantly acted upon. Some volatile, eager stocks moved into another box within hours. Others took days. If the stock acted right, it started to push from its 45/50 box into another, upper box. Then its movement began to read something like this:
48 - 52 - 50 - 55 - 51 - 50 - 53 - 52
It was now quite clearly establishing itself in its next box—the 50/55 box.
Do not misunderstand me on this. These are only examples. What I had to decide was the range of the box. This, of course, varied with different stocks. For instance, some stocks moved in a very small frame, perhaps not more than 10% each way. Other wide-swinging stocks moved in a frame between 15% and 20%. The task was to define the frame exactly and be sure the stock did not move decisively below the lower edge of the box. If it did, I sold it at once, because it was not acting right.
While it stayed within its box, I considered a reaction from 55 to 50 as quite normal. It did not mean to me that the stock was going to fall back. Just the contrary.
Before a dancer leaps into the air he goes into a crouch to set himself for the spring. I found it was the same with stocks. They usually did not suddenly shoot up from 50 to 70. In other words, I considered that a stock in upward trend that reacted to 45 after reaching 50 was like a dancer crouching, ready for the spring-up.
Later when I had more experience I also learned that this 45 position in a stock after a 50 high point has another important benefit. It shakes out the weak and frightened stockholders who mistake this reaction for a drop, and enables the stock to advance more rapidly.
I came to see that when a stock was on a definite upward trend there was a feeling of proportion about its advance. If it was on its way, rising from, let us say, 50 to 70 but occasionally dropping back that was all part of the right rhythm.
It might have gone like this:
50 - 52 - 57 - 58 - 60 - 55 - 52 – 56
That meant it was in the 52/60 box.
After this, on an upward swing, it might have gone:
58- 61 - 66 - 70 - 66 - 63 - 66
This meant it was well inside the 63/70 box. I also considered that it was still edging towards higher spheres.
The major problem still remained; what was the right time to buy into it? Logically, it was the moment when it entered a new higher box. This seemed quite simple, until the case of Louisiana land & exploration proved it was not.
For weeks I watched the behavior of this stock and saw it form its pyramiding boxes. When the upper frame of its last box was 59¾I felt I had assessed it correctly. I told the broker to telephone me when it reached 61, which I considered the door of its new box. He did, but I was not in my hotel room when the call came. It took him two hours to reach me. By the time he did, the stock was quoted at 63. I was disappointed. I felt I had been deprived of a great opportunity.
I was angry at the way it had passed me at 61 and when it went to 63 in such a short time I was certain I had missed a very good thing. Good reason deserted me in my excitement. I would have paid any price for this stock in my enthusiasm. I just had to get into a stock, which I thought was going up to a fabulous price.
Up it went—63½—64½—65. I was right. I had judged it correctly and I had missed it! I could not wait any longer. I bought 100 shares at 65—at the top of its new box—because I had missed it at the bottom.
Although I was improving in my selection and method, I was still somewhat of a baby in the mechanics of Wall Street, so I placed my problem before the broker. We discussed the 61-point telephone call, which had unfortunately missed me. He told me I should have put in an automatic "on stop" buy order. This meant the stock would have been bought when it rose to 61. He suggested that whenever I made a decision about a stock I should put in a buy order at a named figure. Then the stock would be bought for me without further consultation if the market reached this figure. This I agreed to do.
My problem of buying automatically at what I thought was the right time was settled.
By this time my box theory and its form of application were firmly planted in my mind and on three consecutive occasions I used it successfully.
I bought Allegheny ludlum steel when it appeared to me to be going into the 45/50 box. I bought 200 shares at 45¾ and sold them three weeks later at 51.
I also bought 300 shares of dresser industries when it seemed to be entering the 84/92 box. I bought at 84, but as it did not seem to be making the right progress through the box, I sold at 86½.
Then I bought 300 shares of cooper-bessemer at the bottom edge of the 40/45 box at 40¾ and sold at 45½•
My profit on these three transactions was $2,442.36.
This gave me a great deal of confidence, but then I received a slap in the face, which proved to me that I needed more than a theory alone. In August I bought 500 shares of north American aviation at 94⅜ because I was sure it was about to establish itself in a new box over 100. It did not. Almost immediately it turned around and started to fall back. I could have sold it when it gave up a point. I could have done the same when it lost another point. But I decided against it and stubbornly held on. My pride did not let me act. The prestige of my theory was at stake. I just kept saying this stock cannot go down any further. I did not know what I learned later, that there is no such thing as cannot in the market. Any stock can do anything. By the end of the next week, the profit from my three previous operations was gone. I was back where I had started.
This experience, as I see it, was an important turning point of my stock-market career.
It was at this point that I finally realized that
There is no sure thing in the market - I was bound to be wrong half of the time.
I must accept this fact and readjust myself accordingly - my pride and ego would have to be subdued.
I must become an impartial diagnostician, who does not identify himself with any theory or stock.
I cannot merely take chances. First, I have to reduce my risks as far as humanly possible.
The first step I took in that direction was to adopt what I called my quick-loss weapon. I already knew that I would be wrong half of the time. Why not accept my mistakes realistically and sell immediately at a small loss? If I bought a stock at 25, why not at the same time order the stock to be sold if it returned below 24?
I decided to give "on-stop" orders to buy at a certain figure with an automatic "stop-loss" order on them in case the stock went down. This way, I figured, I would never sleep with a loss. If any of my stocks went below the price I thought they should, I would not own them when I went to bed that night. I knew that many times I would be "stopped out" for the sake of a point just to see my stock climb up immediately after. But I realized that this was not so important as stopping the big losses. Besides, I could always buy back the stock—by paying a higher price.
Then I took the second equally important step.
I knew that being right half of the time was not the answer to success. I began to understand how I could break even and still go broke. If I invested about $10,000 and I operated in a medium-priced stock, each operation would cost me approximately $125 in commission every time I bought a stock, and another $125 every time I sold it.
Let us suppose I was right half of the time. At $250 a deal, I had only to trade 40 times without taking a real loss and I had lost my capital. It would be completely eroded by commissions. This is how the commission-mice would nibble away at each operation and would finally eat up my money:
500 shares at $20
PAID (including commission)
500 shares at $20
RECEIVED (deducting commission)
40 transactions at $250 = $10,000
There was only one answer to this danger: My profits had to be bigger than my losses.
I had learned from experience that my most difficult problem was to discipline myself not to sell a rising stock too quickly. I always sold too quickly because I am a coward. Whenever I bought a stock at 25 and it rose to 30, I became so worried it might go back that I sold it. I knew the right thing to do but I invariably did the opposite.
I decided that since I could not train myself not to get scared every time, it was better to adopt another method. This was to hold on to a rising stock but, at the same time, keep raising my stop-loss order parallel with its rise. I would keep it at such a distance that a meaningless swing in the price would not touch it off. If, however, the stock really turned around and began to drop, I would be sold out immediately. This way the market would never be able to get more than a fraction of my profits away.
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:
I examined my weapons:
Price and volume
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.