Back in 2008, in one of the more active chat rooms that I often frequented, I came across an interesting character that went by the username of “Trader1”.  Despite having perhaps the most unoriginal name in the chat room, he seemed to be a nice guy, who was always chatting about the markets and the trades he was making.

His philosophy basically boiled down to “buy on the dips.”  This was something he would call out from time to time, saying things such as, “I am buying more XYZ on this dip”, or “this dip is a great place to buy more XYZ.”  He bought a lot of stocks on the dip like CFC, LEH, and BSC.  Don’t try and look these symbols up, because the companies don’t exist anymore.  Trader1 eventually disappeared from the chat room and I suspect that the call out he makes most now is, “would you like fries with that?”

The reason Trader1 didn’t make it as a trader was that he did not have a sound methodology in his trading.  He may have thought that “buy on the dip” was a sound method based upon his success in the past, but he made the same mistake that many others traders make; he used outcome to validate his method.  Now that your eyes are rolling back in your head, let me tell you what I mean.

Say you go to Las Vegas, and you and your buddies go out and get shitty-drunk. Maybe you drink one of those margaritas in giant plastic Eiffel Tower mug or maybe you split a brewzooka, it really doesn’t matter. Now that you are fully lit, you take everything you own; your car, your house, your life savings, your autographed picture of Patrick Swayze from Roadhouse, everything, and put it all on “red” on the roulette wheel.

If you in fact hit “red”, it was still a bad decision.  The reason is, even though you won, the methodology you were using, “everything on red”, was flawed.  Eventually it would not work (actually 50% of the time), and the one time it didn’t work, the downside is so large that it would wipe you out and you would not be able to play in the game anymore.

He’s Dalton. He’s the Cooler DAMMIT….!!!

Trader1 was fooled into thinking that his method worked, because in the two years that he had been trading, the market had in fact rebounded after every dip.  The problem was that Trader1’s method did not have any contingency in case the market didn’t rebound after each dip.  It was basically based on a consistent “one-sided” outcome, something that never happens in the world of trading.

The most obvious way that Trader1 could have improved his methodology would have been to incorporate a stop-loss rule.  In addition, he could have had a “target” rule, where he would take some or all of his profit when a position hit a certain level.  But perhaps the best way he could have improved his trading was to create a rules based methodology.  If his trading was not initially profitable, he could then refine his rules until he found a method that was consistently profitable, and then evaluated the “success “ of his trading not by the outcome of his trades, but by the adherence to his trading rules.

You can read more about flawed methodology and fooling yourself into thinking your “system” works by reading Fooled by Randomness and The Black Swan by Nassim Taleb.

Buy the dips working…..

Now…..not so much!

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Over the last few months, whenever I am asked at a social function what I do I respond “I trade stocks”, which usually prompts a “look” that ranges from pity to Schadenfreude.  This is usually followed by something akin to them saying “things must be pretty tough, huh?”  I of course respond that I am doing fine, because I can make money when the market moves down by……………

SHORTING…..!!!! (insert glazed look in conversationalist’s eyes).

My mother actually thinks that I am doing something illegal when I tell her I can make money if a stock goes down.  Personally I’ve never had an issue with the concept of shorting, which is probably why I trade.  But for others who don’t quite understand the concept I have developed a simple way to explain it.  It goes like this…..

A share of stock is a standardized instrument just like a book or a DVD, meaning each share of IBM is the same, just like every copy of “Harry Potter and the Deathly Hallows” on the shelf at the local bookstore is the same.

So let’s say your best friend just bought a brand new copy of “Harry Potter” and the moment he brings it home you ask him to borrow it.  Now that you have borrowed it from him, you owe him back one copy.

You then take the copy he loaned you and sell it.  Maybe you sell it on Ebay, maybe at a garage sale, maybe to an individual, it doesn’t really matter.  You get $25.00 for the book when you sell it.  You still owe your friend one copy of Harry Potter, so you order a copy on-line from a discount book wholesaler.  That copy only costs you $19.95.

The book arrives and you return it to your friend, keeping the difference between what you sold it for ($25.00), and what you bought it back for ($19.95).  You have thus made money by selling something you did not own and then buying it back (and replacing it) for less that you sold it for.

Short selling is the same concept, you just replace a share of stock in XYZ company for the copy of the Harry Potter book.

In the above example the venue you sell the book in could be various, but with the stock it is the open market.  If you were unable to buy the book back for the $25.00 or less that you sold it for you would have had to cover the difference out of your own pocket and thus lose money.  The same would go for the stock example as well.

If someone doesn’t understand the concept of short selling after this explanation, then they never will.

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I bought my first stock one week after I turned eighteen.  I walked into a Dean Whitter office at my local Sears, and bought 300 shares of Altos Corporation.  They did something with computers, I think.  I knew their stock was going to go crazy because some guy on the local cable access show said it would.

Over the next 20 years I continued to trade stocks, while at the same time building a successful business in a non-financial related field.  In 2004 I decided to sell my company and trade full time.   I loved trading, and had been consistently profitable in the previous two decades, so the transition would be easy I figured.  I was wrong.

One day I was on my way to my mother-in-law’s house to drop off my then infant daughter.  My mother-in-law would watch her during the day while my wife was at work, and I built my trading empire.  I was winking at my daughter, listening to the radio, and smugly thinking about how good I had it.  I was a “trader”, and was enjoying everything that came with that regal title.

You know what I mean.  Roll out of bed a few minutes before the open, if you wanted.  Trade for a couple hours, if you wanted.  Take off in the middle of the day, if you wanted.  What freedom!  Woe unto those chained to a desk, working their 9 to 5 Dilbert-esque jobs.  I had it made.

Unfortunately I had no idea what was about to happen to my perfect world.

I had been building a very large position in CELL, some company that did something with old cell phones in Latin America, I think.  This stock was ready to explode.  I knew that because some guy on the Yahoo Message boards had been telling everybody for a few weeks now.  Now when I say a “very large” position, what I mean is outsized, as in double the size of my trading account.  I mean that is what margin is for, right?

CELL was going to announce their stellar earnings after the bell, and I was giddy with thoughts of the things I was going to buy with my profits.  As I drove I used my cell phone to check up on the current price.  It was still early morning so I didn’t expect to see much movement.   Every minute or two I would hit “refresh” to see what was happening (this was pre-smart phones).  It went like this;

Refresh:   CELL 31.79 +.15  +.50%                                                                       

Refresh:  CELL 31.82 +.18  +.53%

Refresh:  CELL 31.75 +.11 +.47%

Refresh:  CELL 28.79 -2.85  -9.33%                             

What….???

Refresh:  CELL 27.84 -3.80  -12.18%

Bad tick right…???

Refresh:  CELL  26.98 -4.68  -14.83%

This is not funny..!!!

“Wow I am killing it with this modern technology…!”

The mother of all douche chills hit me as I realized I was exactly equidistant between my house and my mother-in-law’s, and had no way to find out what was going on, let alone get out of the trade.

You see,  the large, well known retail broker I was checking prices from with my phone was “un-cool”.  I had opened an account there with a token $100 so I could have access to mobile data.  My trading account was with another “cooler” broker.  They were too cool to have mobile access.  And I was too cool to have their phone number or my account number programmed into my phone.

Hell, my mother-in-law didn’t even have a computer, so there was no relief when I got to her house.

The upshot is that for some reason, CELL’s earnings came out 4 hours too early.  Were they leaked or was it a mistake, really at that point it just didn’t matter, as my account was already down 30%.  Fortunately, I held my position for the inevitable bounce that never came, and peeled off another 10% in the next couple days.

“We want the right to buy crappy used cell phones. Viva Che’….!”

The most disturbing thing about this whole incident was not the money I lost.  It was the shattering of the illusion that I had any idea of what I was doing.  In my head I was still trading part-time, like I had all those years that I owned my business.  Only now I no longer had that business (income) to fall back on.  This was it.  I had gone out on the high-wire with no safety net, and took a near fatal fall.  Would I be able to pick myself up and recover?  Could I make it trading? Because, for some reason that thought had never entered my mind, as I assumed that I would be profitable from day one forward.  It was a scary place to be, and one I was not comfortable being in.

Anyway, I think they sold used cell phones in Latin America.

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