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Lesson 9: Playing the Odds

So you want to know how I am trading and profitable after 30 years and many are not? Learning that sometimes thing work in the markets and that sometimes they don't but that's has NOTHING to do with good and bad trading. What counts is executing the high probability action.

Take a moment and contemplate this:
There is a sign in a collection agency it says;  
"Winning is a just a matter of luck, ask any loser".

You see this in poker, sometimes you do the odds and realize you are probably up against a better hand and you fold. Sometimes it turns out you were bluffed and that hurts, but in the long run if you played correctly over many games you will overall win.  The poker hand pictured above is 7 2 off suit, general thought to be the worst hand in poker. However if per chance the community cards come up as 7 7 7 2 2 you have one of the most unbeatable hands possible.  Just because you won once playing 7 2 does not make it a good hand to play. In fact play it long enough and you will loose a lot of money.  In other words, just because you have one win does not make it wise. A single win is anecdotal evidence and should not be the basis of rational decisions.

What would you say if a young man told you that he has a time saving driving trick, it works like this: if he wants to go left and he is first at a red light, he watches the other light to see it turn yellow and just before he gets a green light, then he hits the gas and burns across the intersection to complete a left turn before the oncoming traffic can hit him. He tells you he has done this a few times and it works! Your advice to this young driver? The odds will catch up with you and will not be pretty when it does. It is irrelevant that the young driver argues that it HAS worked, the point is it will not always work and when it does not work, it will be horrible.

So in driving, poker, trading we use rules, common sense and the odds to control our actions. You see that the first graph in my weekly charts is the Bull Bear lines. When dark green is over red this is a U.S. bull market, the odds are the U.S. market will go higher. So you hear me say NEVER SHORT A BULL MARKET. That would be a counter trend move and those are dangerous.

I was at a meeting of traders in London, many were new to trading and bought me beers and ran trading ideas past me, often to be met by me frowning and saying don't do that. One lad thought he had a great idea, buy one S&P futures contract at open and wait all day until it was up 4 pips, then sell. In his logic, everyday the market goes up SOMETIME during the day higher than 4 pips over the open. Just wait and collect a fast $100. Unfortunately there are two flaws in this plan, first even if it works, how can you handle the emotions of a common 160 pip down move before it recovers. You would be under water over $4,000 to make $100 could you handle that (would your broker allow that)? But the real killer is the one day (and they happen like 2008 or on 9/11) where the market slides limit-down for days. Assuming your broker gives you infinite margin, you could be under to the tune of $100,000, with no hope for at least a year for recovery.

Every trader has watched a fellow trader caught in a bad trade, they pray "oh god please let me just get back to even". I don't want to break even, I want to win. Never bet the farm on a single trade and when you screw up (we all do), cut your losses now and move on.
Playing the odds means being realistic. For example, my family taught me a rule,  stay clear of companies with big draw downs. If you get caught in a loss cut your loss and run. Once you are out stay-out for a long while. No matter what my emotions say about the stock I only buy solid up-trends and if I get burned I run.

An example: Enron
In 1999 I was stopped out of most of my tech stock positions and had decided the tech bubble was just that, a bubble. I had no trouble accepting that since most of my huge technology stock gains were in the world of "to good to be true". I had made a fortune, but I know this:
"Trees don't grow to the sky"

I used stock screening tools to find a non-technology based stock in a solid uptrend. Boy did I find one, it was called Enron. Soon after I bought it I was down 7% and I dumped it. But I was surprised soon after my exit, an analyst on TV said it was a good buy, and sure enough up it went the next week. I convinced myself that I was shaken out from a minor pull back in sympathy with the tech sell off.  I felt stupid, but I also realized that outside of Enron, almost  every stock was down and that to be long at that moment was counter trend, even though clearly (in my mind) Enron was a great company, it said so almost every day in the newspapers.

Soon after the stock plunged again and once again experts touted the time to get in. In fact all the way to zero they said ... get in.

It is always a bad idea to listen to "experts" (yes my advice included). Five dozen experts tracked by CXO Advisory Group LLC of Manassas, Va., over the past two years were right only about 48 per cent of the time in calling the broad direction of the U.S. stock market. Even a coin is right 50%. CNBC's Mad Money host Jim Cramer saw the future with 47-per-cent accuracy, while bond king Bill Gross’s public forecasts were on the money only 46 per cent of the time. In fact Jim Cramer is one of the worst at this, I recall him recommending his viewers buying Goldman Sachs about a year before the financial crisis. Here are a few more:

  • Bear Stearns. Cramer recommended buying this stock on 8/17/07 at $118.20 per share. He lost 95 percent on this one - selling at just under $6 per share on 3/20/08. Watch this one minute video when viewer asked if he should sell out and keep his life savings, his answer, don't be silly:
  • Morgan Stanley. Cramer recommended buying this stock on 9/15/06 at $70.95 per share. Its recently been trading around $25.
  • Lehman Brothers. Cramer recommended this stock on 10/17/05 at $55.18 per share. On 9/5/08 with the stock trading at $16 per share, on CNBC, Cramer selected Lehman as a "screaming buy" and said things couldn't get any worse for the company. The firm went bankrupt and the stock trades for pennies per share for more than a 99 percent loss for Cramer.
  • Merrill Lynch. Cramer recommended buying this stock on 9/19/05 at $60.17 per share and sold it on 9/12/08 for $17.05 per share for a 72 percent loss.
  • In the 12/30/07 issue of New York Magazine, Cramer made investing in Goldman Sachs his #1 recommendation for the year. He said looking ahead through the end of 2008, "Goldman Sachs makes more money than every other brokerage firm in New York combined and finishes the year at $300 a share. Not a prediction-an inevitability."

In short stay clear of expert advice, But in the case of Enron even the employees were buying on the way down.

Playing the Odds

So how can you be smarter than a bunch of, TV pundits, Internet bloggers, wall street analysts and often the firms own employees?  

Play the odds. 

In the time of the Enron mess, look at the data. Here is the Bull Bear lines for the S&P500 in 1999 to 2001. If you had paid attention, you would understand that the overall market was "broken" after October 2000, and you would not even play a "great company" like Enron.  Look at the negative slope line on the bottom chart after October 1 2000 and the green nearly crossing red at November 1 2000.

But also if you had bought in early 2000 and you saw that the stock was in a sideways moving funk, you would be happy to raise your stops, then jump out after a 7% draw-down and perhaps get in at a better time, but as the rule goes, not right away. This is exactly what I did.

Even if you missed all that ... there were many warning signs in 2001, including layoffs and executives quitting and SEC investigations. Wall Street should have know the end was near.  Never, never plays a stock, country, bond that has any whiff of impropriety or trouble (like in the funny etrade ad).  I recall a super star gold stock called Bre-X, their star  geologist Michael de Guzman died in a very suspicious helicopter accident where he fell out the doors of an Alouette III helicopter high above the Borneo jungle. Baby that's a sell signal!

When the gold market was peaking near 1700 I wrote an article called After the Gold Rush. Gold peeked at 1850 and went down for weeks. I found myself on a  gold discussion board asking a guy why he want to buy gold and so I sent him a graph of the price of gold, it was going nothing but downward. I said why would you invest in THIS. He rattled off a pile of crap about support and resistance, blah blah. He sent me a note a few weeks later, it said that I was right, as gold kept dropping.

Internet networking titan Cisco Systems was one of the best-performing stocks of all time, thanks to a monster run during the tech boom of the 1990s. People were in love with this stock. When Cisco topped in March 2000 and started falling, it may have been tempting to grab shares. But the stock plunged more than 90% over the next 2 1/2 years, marking a series of lower lows along the way.

A good friend of mine bought Canada's flagship company, NORTEL. He placed several orders as it crashed from $100 a share to zero. Each time he was convinced that this was the bottom. His love of Nortel blinded him, he could not convince himself the trend was his friend.

Hey it happens to me too. I bought at what I thought was the bottom of the big crash of 2008, only to be stopped out. Lets ride along with me back in 2008 you can feel my pain as I looked for a market bottom. My rational mind knew at some price the market bottom would be in. My floor trader friends said the final capitulation would be "like thunder".  I never heard any thunder, but it sure was raining hard. Look at me: I bought at the green arrow, stopped out at red arrow, went in to total despair at the blue arrow.  .  .

A Foolish Game. 
But what is it in people that makes them want to buy on the way down? In my case in the crash, the wall street analysts in Enron or my friend with Nortel, what we were looking for was to be proven right. We wanted to see the magic point of turn around call the bottom and win. What we were doing is called catching a falling knife. Most people just can't resist a good bargain. But the stock market works in a different way. Stocks that seem high in price tend to go even higher. Stocks that fall usually go lower. Buying a falling stock can have the same effect as trying to catch a falling knife: You'll get hurt, almost every time. Market pundits often will recommend buying after a big drop. They tell investors to get in on this supposed once-in-a-lifetime opportunity before the stock takes off again.

As a stock drops it often has a small and temporary recovery in a financial market following a large fall. When a financial market suffers a consistent fall traders attempt to detect when prices are at their lowest and then buy stocks hoping for a bargain. If they buy too soon prices may rise temporarily but then decline again. Floor traders coined a term for this, the "dead cat bounce". The morbid idea being that even a dead cat will bounce if you drop it from a great height. Catching dead cat bounces and falling knives only makes you broke.

Even thought I predicted a market correction in January 2007, no one expected this. In 2008 during the crash, I felt like some evil market maker named "Chicky" was trying to outdo me, every time I bought, he pushed the market down. In my mind he sneered at me. Every time I bought Chicky was in my head, he said in a Brooklyn accent "hey trader boy, check da quotes your down an eighth ya wana buy some more?" I wanted to be right and I was fighting the market.

I had forgotten in the market:
"It's not whether you're right or wrong that's important, but how much money you make when you're right and how much you lose when you're wrong."

You can only master the markets if you play the odds and stop trying to prove you are smart. Here is 30 seconds of advice from Homer. This what "lucky traders" look like:

You Have the Tools
In my weekly market comment I give you many fine tools, like the bull bear lines or the NYSE high Low chart to tell you if you are on the right side of the market. I don't go through that exercise because I care if you read them, I do it because I need those charts for my own account. If you happen to read them so much the better, but honestly it is my own self discipline than makes me put that data together.

You should also remember that markets are correlated, for example the U.S. dollar and the price of gold. So if the Bull Bear lines say it is a good time to be in US dollars it is probably a bad time to be in gold.

For the last few years the bull bear lines have been bullish on equities (stocks) and treasuries (US Bonds). So the rule was if you want to play these you must only be long. Recently that changed for Bonds, so now the odds might be with you to short bonds. However, the U.S. markets right this moment are in a pull back so odds are, short term, bonds will rally. Just because right now YOU CAN short bonds does not mean you SHOULD short bonds.

Look for Steady Freddy
Another key taught to me by my family -- look for a steady progresses from right to left. Not just overall gain but a smooth trajectory. For example here are two stocks, Progress a big insurance company, and Canfor a Canadian lumber company that moves based on the price of lumber and the housing market in two countries.



You might be temped to buy the lumber company if you got a tip or saw news about the price of lumber, but from from the look of the chart, rumors come and go for this range bound stock.

An Example of What Not to Do
In a recent market message I showed how the VIX was rising, I showed that to explain the unstable current situation. A Canadian reader asked if he should buy an ETF that profits from the U.S. VIX rising. In fact it is a leveraged or juiced ETF so it moves very strongly in a move in the VIX. First off Juiced or leveraged ETFs are dangerous, but that is not all.  I told him, no not unless there is an apocalypse. Here is the chart the arrow is where he asked:

A rising VIX is correlated to falling U.S. equity prices. In other words a big market sell off. But in fact the current bull bear lines are green over red and the U.S. markets are within 60 days of an all time high. That is a BULL MARKET in U.S. equities. Buying HVU.TO is a counter-trend move, a very risky move. In fact it is a low odds play.  The instability in question was coming from mostly China, now the Chinese market bull bear lines were another mater. Also the fundamentals in China were total different than the USA with a wildly out of control market and crazy speculation. At a time like that, if you want to short anything short China.

Understand this, even if a trader out there bucks the trend, and goes out and buys HVU.TO in a bull market and let say he wins, that is not skill, that is luck. No more than, putting your money on the roulette wheel on red and winning once, it does not show you have mastered anything.

Winning is:
  • not luck, 
  • not going to happen every time, 
  • it is not about being right

To win:
  • do your home work 
  • look for long slow trends
  • never catch a falling knife
  • cut losses early 
  • diversify your portfolio
  • stay with the trend
  • don't be greedy

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