Sunday, April 18, 2010

Review of Richard Wyckoff’s “The Day Trader’s Bible”

Richard Wyckoff (November 2, 1883 – March 19, 1934) was a trader and educator in financial market. I happened to get hold of two books written by him: “The Day Trader’s Bible” and “How I trade in stocks and bonds”. Both books are well worth the reading time and deserve their places in investment classics. The following are general reflections on the first book “The Day Trader’s Bible”.

You may be wondering that Day Trading and Value Investing are two completely difference approach to investment. Day Trading is short term and concentrates on market movement or tape reading. Value Investing is long term and focuses on fundamental value of underlying investment. However I found that there are masters in both trades and more importantly two disciplines share some common principles, in other words, the importance of the human element in the game. I still believe you have to choose (or naturally fall into) one discipline based on how your brain is wired. However it is always beneficial to be able to appreciate the approach of another school of investors.

Day Trading is a Profession

Richard first asserted that day trading “… is a pursuit that is profitable… but it’s not for the slow minded or weak hearted. You must be resolute… strength of will is an absolute requirement as is discipline, concentration, study and a calm disposition.” Like many other things in life, success in trading is only for the few who really enjoy the work and not just want the glory.

Rebutting a common criticism of day trading that the average man or woman can never makes a success of day trading by reading moment by moment transactions of the market, Richard emphatically pointed out that “…The average man or woman seldom makes a success of anything! That is true of trading stocks, business endeavours or even hobbies! Success in day trading usually results from years of painstaking effort and absolute concentration upon the subject…”

Richard clearly differentiated day trading from mechanistic chart reading, where investors trade the market based on chart analysis alone. As factors influencing the market are infinite in their number and character, trading can never be an exact science where successful formulas exist. The author confidently offered the following bet:

“Let anyone, who thinks he can make money following any kind of a chart have a friend prepare it, keeping secret the name of the stock and the period covered. Then put down on paper a positive set of rules which are to be strictly adhered to, so that there can be no guesswork. Each situation will then call for a certain play and no deviation is to be allowed. Cover up with a sheet of paper all but the beginning of the chart, gradually sliding the paper to the right as you progress. Record each order and execution just as if actually trading… Put my name down as covering the opposite side of every trade and when done send me a check for what you have lost.”

Successful day traders have a broad knowledge base accumulated through years of intense study. Richard quoted the advice from a professional singer to a young aspirant: “One must become a ‘personality” – that is, an intelligence developed by the study of many things besides music”.

Comparison between Day Trading and Value Investing

Day trading is largely driven by momentum or the change of supply and demand. Hence day traders always play the market with a close stop so as to avoid any large loss. Day traders only increase the bet if the initial positions are confirmed to be right.

Value investors focus on the “intrinsic value” of the business and buy when the price is significantly lower then the value and sell when the price is close to the value. It is common practice for value investors to double down because if a stock is good value at $10, it should be more attractive at $5. As value investors generally don’t use stops, large losses can occur if the investment thesis is wrong.

There are a few common themes for success in both day trading and value investing:

1. Proper mental attitude is the key. Practitioners in both fields should train their mind and aim to develop themselves into a “objective trading or investing machine” which takes note of a situation, weights it, decides upon a course and gives an order. There is no acceleration of the pulse, no nervousness, no hopes or fears concerning his actions. The result produces neither elation nor depression.

2. Every player need to work out his own way of investing or trading as it is very likely what is one man’s meat is another’s poison. There is no secret of trading, as everyone has to pay his/her dues to become the expert.

3. It is important to know what kind of situation to avoid. Value investing guru Warren Buffett prefers to wait for the fat pitch. Successful day traders wait for the defined sign of a big market movement to justify the cost of trading (brokerage, tax etc).

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