Monday, July 27, 2015

Marty Schwartz and the sunspot theory

Every so often you come across a post from a trader talking about a specific stock along the lines of "Is there a reason NOT to own XYZ plc?"

Whenever I see a question like that, it immediately sets off alarm bells, which more often than not are confirmed when you go and look at a price chart of the stock in question.

To me it sounds like a loaded question - one where someone is now in an irrational mode. Chances are they have opened a position in a particular stock only for price to go against them. It is like they are looking for something - anything -  which justifies them holding on to their position, to avoid taking the loss and gives them hope that price will go back in their favour.

This type of situation can be magnified where they have bought into a stock just ahead of earnings, only for price to dive.

I've seen people fall into this trap a number of times - people who supposedly simply follow price and its trends now suddenly become converted to using overbought or oversold indicators. Or possibly while basing their buying and selling decisions on what charts say, now start swatting up on price/earnings ratios and other fundamental information.

This is a disaster waiting to happen.

Take responsibility for your own decisions - You bought the stock. No-one forced you. If price has violently moved due to earnings, were you aware that they were due to be released?

Get your risk under control - You determined the risk per trade and position size. Successful traders always attempt to fully quantify the potential downside or loss on every position. If that metric is too great, they pass on the trade. Every trader has losses. The simplest way to keep losses small is to only risk a small element of your equity on each position.

Never enter a trade unless you know where you are getting out - If you have a complete trading plan, then you will have clear rules about what to do regarding exits, either when closing a winning trade, or bailing out of a losing one. You created those rules, presumably when you thinking clearly and objectively. Why are you avoiding following those rules? If you don't have such a plan, then you need to consider whether you should even be trading in the first place.

Park your ego at the door - Were you solely concentrating on the potential gains you could make on a trade? Did you have £'s or $'s flashing in front of your eyes, believing you were 'nailing' the top or bottom of a price move? The market can make complete fools of people. Listening to your ego for your buying and selling decisions could be the death knell for your trading career. Quite often, this can happen where people get confident about picking a top in the market - one only has to look at charts of stocks like Google and Amazon this week to visualise the potential damage to people who were looking to short prior to earnings.

If you ever find yourself a situation where you are scouting around for some reason to stay in your trade - STOP. You have to swallow your pride, admit you are wrong on the trade and get out. Even if it means taking a big loss. That loss could get even bigger. You have to honour your exit rules, whatever they may be.

The absolute worst thing you can do is start averaging down on your losses, going against a trend, in the hope that you can make back some or all of those losses. Think Nick Leeson, the Japanese Nikkei, and the subsequent collapse of Barings Bank.

Other ultra-successful traders have talked about similar scenarios where all rationality went out of their trading decisions and led to big losses.

In Market Wizards, Mark Weinstein talked about a trade on soybeans that went against him, where price went limit down against him for several days. He avoided his broker, and went to see a grains analyst at another firm, trying to find a justification to satisfy his original trade.

"I was looking for someone to hold my hand. He told me I would be OK, because the fundamentals were still strong and there would be tremendous demand for soybeans if the market went down another day. Of course, on the fourth day the market locked limit-down again."

He also stated that his profit target on the trade was motivated by making enough profit to purchase a French chateau he had found.

"The biggest mistake I made was having a specific target of what I wanted out of the trade.

I didn't consider the risk and took on too large a position. I was not using any type of rational judgement. I was being guided by my material desires."

On a shorter-term scale, Marty Schwartz talked about something similar in Pit Bull, in the chapter 'Never Short a Republican'. He was consistently shorting the S&P on US Election day, when the market was only going in one direction - up. It so happened that his wife, Audrey, who worked with him, was not there that day.

"I'd lost it. If Audrey had been there, she would have been slapping me on the side of the head telling me to stop because selling contracts at the lock limit was more than stupid, it was just completely, totally, undeniably, and unbelievably self-destructive. Why didn't she call? Didn't she care that I was getting killed? Why wasn't she there to say, "Buzzy, just listen to yourself. What are you doing? Stop selling and cover those positions, NOW!" 

"I have what I call my sunspot theory, which says that 2 percent of the time, you become uncontrollably irrational. This was one of those times. I had the facts on the screen in front of me, but I refused to believe them."

That night, Schwartz went to see fellow trader Bob Zoellner. This is what he hold him:

"Marty, you're not thinking straight. It's like we always say, you can't shift to first gear from reverse without going through neutral. You've gotta change direction, you've gotta stop the losses. Cover your position, get back to neutral. Once you're out, things will look better.

You can't outsmart the market. Your indicators are wrong. You've gotta clean out your position. Believe me, take the loss. Remember, your winners are ahead of you, not in back of you."

The next day, he dumped his whole position for an $800,000 loss in the first hour of trading.

"Zoellner was right, as soon as I was out, I started to feel better. I started to breathe again. I even got some color in my cheeks, all four of them."

In all these instances, rational thought has gone out of the window. Be it excessive risk, looking to someone else for a crutch to keep the trade open, or plain ego. Just one such occurrence lasting only a few minutes or hours, can wipe out months, if not years, of hard-earned gains. Don't let that happen to you. Avoid your sunspot.

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