Did anyone see that trading show on Channel 9?

Life as a trader is certainly fun at the moment. It seems everywhere I turn people are talking about their share portfolio, how well the market is doing and arguing over what stock will be the next to double this month.  More and more I am noticing:

  • People are always talking about their share club and that I should join it
  • In order to ‘be someone’ I have to be investing in shares
  • That TV show about shares, options M&A activity and LBO’s was a massive ratings hit for channel nine
  • The hosts of lifestyle shows about how to add more value to your share portfolio  through options are households names now
  • How everyone from business owners, banks, politicians and my next door neighbour are telling me how good shares are for a long term investment and that I can’t lose on shares, not like that risky / dodgy / fixed property market
  • The finance shows like Bloomberg, CNBC etc are breaking out the party hats as the S&P500 breaks to record highs…

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Hang on... Wait. I was confused sorry. None of that actually is happening!

No one is involved in shares clubs, people look at you like you are a leper (or patronizingly as they tell you how their property investment is so much safer) if you tell them you invest in equities, no one makes TV shows about equities because they are ratings flop. Cooking, talent, and renovation shows are all the buzz.

I can’t see Scott Cam wanting to tarnish his lovable reputation by daring to be associated with shares, or worse… options. And if that isn’t enough, every man and his dog (who has probably lost money lately on their property if they were honest) is telling me to stick with property and shares are a suckers game!

The news has been negative and pessimistic for the last 4 years, all while the market continues to move up (with periodic clean outs) and while the press and sentiment stays negative it will continue to go higher.

For most people, especially mums and pops it is hard to remember or imagine what it is like to have broad based optimism in the market let alone euphoria and mania. There will come a time though when we have that situation. My guess is – equity markets will be significantly higher than they are now!

When sentiment shifts then I might consider off-loading positions. Until then, markets will continue to rise (and piss most people off!)

Contrary Signs in the World's Tallest Building

 

Last week China announced their plans to build of all things now, the world’s tallest building. The Sky City Tower when completed will stand 838 glorious meters high as a showcase and testament to the unstoppable economic power that is China. Or so we are lead to believe…

There are a number of contrary signs I take from this proposed building.

1.     It is measuring in at 838mtrs. The current world’s tallest building in Dubai the Burj Khalifa stands at 830mtrs. One has to wonder if the actual needs of the building’s owners necessitate that is being 8 metres taller. Would a building of 829mtrs not suffice?? Would two less stories have meant the building would not have been worthwhile building? One has to wonder then if the motivation of this building is meeting consumer demand or grandstanding. (When men with money and the need to grandstand collide, you can be sure money will rapidly change hands!)

2.     Planning to pile $1.5Billion into a single project requires a good degree of confidence of a positive outcome. This level of confidence is typically only achieved when the great majority of investors see nothing but blue skies (pardon the pun). OR from government officials who have motives that are not based on Return on Equity but pushing the facade of all is well. Frankly, I don’t know which is more concerning, wide eyed investors or inept politicians…

3.     History has taught us that ‘world’s tallest building’ type projects tend to coincide with overheated property and credit bubbles. Nothing better to pop a bubble then an 838mtr pointy needle!

4.     As with so many investors the philosophy ‘a little is good, so a lot much be great!’ is often their undoing. Having made easy money from China’s property boom, many investors are no doubt feeling bulletproof. Believing that the$150Million project made $30million in profit so obviously the $1.5Billion project will make $300million in profit! Silly us… why didn’t we think of just doing bigger projects earlier??

 

This is sort of behaviour tends to mark tops in a market. Signs like this are what make me as a contrarian look for ways to position myself asymmetrically for material downside from markets like this breaking down!

When the hardest thing to do is, well… hard

Trading and investing are counterintuitive activities. So much of what we know instinctively and rationally that helps in everyday life that, when applied to trading can lead to disaster. What makes it even harder is most of the time, what feels like the right thing in our gut can well be the exact wrong choice to make from a trading perspective!

Our psychological wiring as humans evolved to help us survive and thrive in what are often harsh and threatening physical environments. A key attribute which has evolved with particular strength and influence on our thinking is ‘Safety in Numbers’

The psychological phenomena of ‘Safety in Numbers’ for the most part serves us well, if we see a crowd of people screaming and running out of a building then odds are the smart thing to for us is run in the same direction.  There is a good chance there is real and legitimate danger in the building. “Run away!’ is the immediate response our survival instincts arrive at. Thousands of years of evolution have crafted this response to be fast, immediate and not requiring much thought or deliberation.

This same thought and action process however is what kills traders in financial markets. When markets are euphoric and ecstatic our instinctive wiring means that our emotional desire to buy is at its highest. After all, look around everyone is feeling good, everyone feels safe and comfortable, prices are up and the horizon looks perfect…

This is usually the worst time to buy as prices are at excessive, unrealistic nor sustainable levels. This however is often easier said than done. Our psychological wiring makes the allure of buying when stocks are loved and adored by the masses very hard to resist. Thousands of years of evolution are pushing you to join the crowd because the programming – ‘Safety in numbers’ is running on overdrive!

Equally this applies to when markets are crashing and equities are hated and despised by the masses, this paradoxically is when prices are often at their lowest. When equities are universally hated they are also usually universally underowned.

Times like this are usually accompanied by a bombardment of news articles and programs shouting from the rooftops how terrible equities are, how toxic they are and they will continue to slide into hell. The only thing they are certain of is things will get worse!

When the environment is like this a traders psychological wiring can wreak havoc on their account. The internal pull to stay in the ‘safety of the crowd’ can be huge. For many this pull is too strong and they liquidate and move to the sidelines.  Telling themselves they will ‘move back in when things settle down more’.

The trouble with this, they get locked into a cycle of selling low and buying, repeating until they are broke or their wife forbids them from losing any more money!

And this happens all because of that powerful wiring of ‘Safety in numbers’.  Knowing this, in order to be successful one needs to simply do what is opposite of what the vast majority do. I say simply, however it is perhaps one of the most challenging things to do. Buying when the masses are throwing their portfolios out at any price in a scramble to get out is sometimes easier said than done. Equally, selling when people are hocking their first born to raise cash to buy equities can be equally challenging.

For those who can develop this discipline and emotional mastery and not send themselves crazy in the process, the possibility to outperform and succeed is much more real…

Could you be wrong 30 times in a row?

I was speaking with a Mentor member recently. This member had been fortunate enough to have put a bearish position on the Aussie dollar by way of Deep out of the Money Puts on FXA(the ETF that tracks the AUD). At the time he entered the trade FXA was trading around the $101 level. He bought puts for the $94 strike.

In hindsight site this turned out to be a very lucky and profitable trade, at the time though it was significantly contrarian to say the least. However because of this member was able to buy the puts for just $5 each – essentially the lowest practical price options on equities trade at.

As luck / fate / chance would have it, Mr Market started taking serious notice of the complacency in the Aussie Dollar market. It shouldn’t be breaking news to DTR members to know that through June the Aussie took a good beating from Mr Market (and by extension FXA).

The mentor member was able to close out some of their puts at $150 per contract. In effect producing a 3000% return. (Events like this are what I am talking about when I say ‘being an option writer’s worst nightmare!).

Now consider if this mentor has put $100 on this trade, which would have bought them 20 Put options. Closing out at $150 per contract would have seen their original $100 turn into $3,000.

Yes, of course making a return like this is nice and something most traders seek, but my discussion with the mentor focused on now deploying that capital effectively rather than getting all happy clapping and big noting one’s self, this is the type of behavior Mr Market is always searching for to punish!

Rather, the mentor and I discussed having a focus on finding 30 trade ideas over the coming weeks / months that $100 could be deployed into each. The conclusion we drew from our discussion is it would indeed be a very tall order successfully find 30 consecutive trades that are 100% complete total losses. By default then it is likely a few or some of these 30 trades could possibly be runaway winners in their own right, setting this mentor up to repeat the process.

And that is what making your capital go viral is all about – letting winners get away from you and redeploying the new capital in ways that make it harder for Mr Market to get you!

Thinking Contrary & Asymmetrical Payoffs: The Key to success... In more ways than one!

A fundamental tenet of a successful contrarian trader is the ability to read the sentiment and positioning of the majority of the market. Being able to decipher where the majority (and thus ‘weak hands’) are positioned is critical in helping the contrarian to have an edge to position accordingly with.

A great focus that is often in the contrarian’s repertoire to help assess sentiment is observing how the market responds to data releases. Now in a purely logical and rational market (surely an oxymoronic statement if there ever was one!) data releases that exceed / miss the consensus expectations should be cause for symmetrical movements. That is, if a key piece of data is released and misses by 1% and the resulting market action is down 80 points then in a rational view, an equivalent data release exceeding by 1% should move the market up 80 points.

Now of course there nuances and other factors that will influence the price action however the underlying principle here is that good / bad news of equal magnitude should move markets in a symmetrical manner.

Yet this rarely if ever happens….

As a contrarian this is excellent! This type of behaviour is like having the proverbial x-ray machine that allows the contrarian to peer into the pervading mood of the market and the majority of its participants thinking. When the contrarian sees outsized responses to one type of data release relative to its counterpart, he catches a glimpse as to the undercurrent mood and psychology.

Cynics will argue that any piece of data can be used to prove a point – the same piece of data can be used by the bulls as ‘why’ the market should go up and the bears for ‘why’ the market should go down. And this is exactly the point – the data is absolute, the response is relative.

In 2007 data was starting to miss expectations, yet the market continued upward. The underlying mood was one of almost blindly bullish – blue skies were ahead and any pesky data miss was just a trivial bump in the road that the powerful bull was steam roll over.

The market now appears to be stuck in a psychological stasis that floats between pessimism and scepticism.

Look out!

If the Fed tapers equities will crash! The party will be over and markets will plummet!

If the Fed doesn’t taper the market will crash!

They will only not taper because the economy is deteriorating so it will all end in a depressed crumpled heap! Get out now while you can!

The pervading view (at least pushed by the press of popular opinion) seems to be that no matter what the Fed does equities will suffer. The point that the Fed has clearly said they will only taper if data supports the thesis the economy is improving and will likely do so on its own is lost on most.

Will the Fed taper or not? Who cares says the contrarian.

When doomsday prophesies are circulating in the media as being the outcome of both courses of action, the contrarian forms the view that irrespective of what the Fed does, the path of least resistance for equities is up.

Why? Because the majority of weak hands have already cut and run from equities in anticipation of this alleged market calamity. The contrarian believes that those who are likely to sell in the event of the Fed tapering / not tapering have already done so. As such the pool of marginal sellers had been well drained. If a great majority cannot be marginal sellers then they can only become marginal buyers!

Think about it…

 

Thinking Contrary

Train Wreck in the Dow as it falls 1000 points in May!

Eye catching heading isn’t it? Except for one thing – it hasn’t actually happened (for the record the Dow is up some 700 points). If the Dow had been down 1000 points in May it would have represented a fall of about 7%. This is almost the exact percentage size drop the 30 Year US Treasury Bond has fallen in May.

Think about that for a moment and let it sink in…

Imagine for a moment if the Dow had actually fallen by 1000 points this month -  all hell would have broken loose in the media, the VIX would have spiked up over 30. Newspapers would have lead with stories about the world coming to a depression crushing end.

But none of that happened, there were no headlines, no average man in the street talking about how much bad an investment stocks are and how it’s just a con game there to rip off honest hard workers.  Nope the 30 Year had a decline that would be identical to a 1000 point fall in the Dow and there was barely a mention of it.

Refusal to throw in the towel by bulls is often what marks the peak of the Bull Run.

To me this highlights just how crowded and slanted investor sentiment still is towards Bonds / negative towards equities. Falls of 6-7% aren’t enough to dislodge the stupid notion that Bonds are the ultimate ‘Safe-Haven’. Yet just last week the Dow was off a percent or so and we were flooded with headlines that ‘That’s it, its all over! / The Bull Run in stocks is over’

Yet again the majority of investors are too quick to throw in the towel on equities at a mere hint of a pullback and simultaneously unwilling to throw it in on Bonds – even when the price action AND data flow supports a downward price movement…

Long Short Trading

Give a man a Hammer and all he will see is nails

Long Short Trading is a strategy that can be used be used to alter one’s risk profile. When assessing a trading strategy it is important to do so relative to the market environment one is in.

Over the last 18 months we have been (as I have said on many occasions) in the ‘pessimism’ phase of Templeton’s Bull Market cycle.  During that time the strategy of buying OTM long dated calls was ideal – Vol was low, demand for calls was virtually nonexistent, fundamentals were turning up and improving yet market sentiment was toxic. These conditions formed the proverbial ‘perfect storm’ for capitalising on long term Calls.

That being said, as a trader it is important to not fall into the trap of “If you have a hammer you see everything as a nail.” Buying long dated calls is an effective strategy in the right environment.

My view is this current Bull Market has a great deal to run and that markets will move significantly higher. And as I always say – it is the application of the view, not the view that counts.

As the market moves from Templeton’s Pessimism into Scepticism (and brief forays into Optimism) it is important to evaluate how one deploys new capital. This is why I am beginning to introduce Long/Short trades.

What Long/Short trades do is help to lessen the directional risk to a portfolio. With a healthy allocation to Jan-15 Calls I am looking to alternative ways to profit but to do so in a way that is differently to my Jan-15 Call exposure.

Relative Performance of Citigroup and Wells Fargo

Long/Shorts allow me to profit (assuming I am right) from continued bullish moves in stocks I think are undervalued and at the same time, hedge to a degree my position by shorting stocks in a similar industry that are extremely overvalued.

Long/Short means I no longer am concerned with the direction of the market. All I am focused on is the (extreme) valuations of two stocks reverting back to more reasonable levels.

If the Bull Market continues, then my long- the significantly undervalued stock is likely to appreciate more so relative to my short which is looking stretched in it valuations.

Likewise if the Bull Market ends prematurely or the market experiences significant pull backs the greater value in the Long position is likely to go down less than the fully priced short – Overall a profitable position.

Long/Short trades are not a replacement or a superseding of my Jan-15 calls. It is simply a way to get exposure to upside potential through a risk profile that is not correlated to my current positions. And that is what trading is all about – exposing yourself to gains in a variety of positions in such a way that the risk of being wrong in all of the positions is uncorrelated and unrelated as possible.

Profiting from Smart People Who do Stupid Things

I recently came across this article from The Motley Fool. The author spoke about seemingly smart investor mistaking situations with low volatility and smooth, stable returns as being safe investment opportunities.

If a stock has grown by profits steadily and consistently year after year then surely it is a ‘safe’ investment… Perhaps you might want to ask the good folks who believed this when they bought Citigroup in 2007 (at over $500/share).

Citigroup like most other stocks at the time was booming! Profits were flying the market was giddy with greed and euphoria. And for most people, why wouldn’t it be? Citigroup’s profits had been steadily and consistently growing for ten years. Surely this honey pot would keep producing sweet gold forever… wouldn’t it??

Take a look here at Citigroup’s profit.  If you cover the 07&08 columns, the profit trend looks nice and stable. To a contrarian cynic like me though, it looks a little ‘too stable’. Anytime a pattern becomes glaringly obvious Mr Market has a habit of coming and smacking those who have become complacent.

The article I mentioned earlier spoke about investors doing stupid things and assuming that because the profits had been rising steadily that it was foolish to assume they would continue forever. This is a good point, however I don’t think the author took it far enough.

The premise of the authors article is still based on stock picking as the main ‘edge’  for investors and that they need to be smarter than the average person when it comes to picking specific stocks.  This is where I think the argument becomes floored.

The average person vastly over estimates their stock picking ability. And hindsight is 20/20 – yes of course we can all see now that Citigroup at $500 was a stupid buy. Very few (particularly those poor sods who paid $500) considered the degree to which they could be wrong on their bullish call on Citigroup- remember it ended up bottoming at $10 (that’s 98% of their capital wiped out).

It is for this reason that I constantly harp on about it is ‘your application of your view that counts not the view itself’.

The author’s response to these types of situations is to warn investors that avoiding volatility leads to underperformance and can lead to your portfolio being blown up.  My thoughts would be recognise that if trying to avoid volatility likely leads to underperformance and decimation of portfolios then by default, seeking volatility will likely lead to outperformance and longevity of your portfolio.

Following the author’s approach an investor might well have missed out on getting creamed by not having invested in Citigroup in 2007 which is ok. But consider for a moment if the investor had applied their ‘be wary of low volatility’ thesis in a different way. What if the investor looked at Citigroup and thought:

“You know what, Citigroup seems bullet proof, year after year profits and the share price keep climbing, volatility is so low on this thing, it just seems to me that is heading towards that too good to be true realm.”

If this was the investor’s approach then Long term puts would have begun to look attractive, with share prices at record highs, investor sentiment at record euphoric highs and vol on Puts at record lows, it would have been a very cheap position to enter into.

Of course I can bring up any historical event to proof a point. My point is not ‘I could have made a bundle on puts on Citigroup in 07-09’. My point is how one applies their view is what is most impactful to their portfolio. The first investor may have avoided getting creamed, the second investor may well have been sitting on Puts that returned 100-1000’s of percent as Citigroup plummeted.

Same view – different application. This is where you find your edge in trading!