2/2/13 Defense

Trading is a defensive game, and 95% of my confidence in trading stems solely from knowing I will take losses immediately. The same principle applies to all interactive activities:

(i) 80% of driving is defensive (slowing, braking, mirrors).

(ii) 80% of martial arts is learning to block or fall to the mat.

I added an MBA in Finance in the late eighties (if not for the 1987 Crash which decimated brokerages, I might have ended up near Broad and Wall). Back then it was all about the Capital Assets Pricing Model (CAPM), the underlying theory behind terms like 'beta' (a measure of a stock's volatility relative to that of the entire market). I had started trading in the mid-eighties, playing stocks (like any amateur) based on articles in the Wall Street Journal. Armed now with the secrets of CAPM, I was about to make a killing, not! As we all know by now, short-term price movements have little to do with fundamentals, and everything to do with crowd psychology. So I can honestly say that a BA in Psych + two years in the School of Hard Knocks (hitch-hiking around the country in '73-'74, during which I learned a great deal about myself [and human nature]) were more useful. 

The most valuable part of Business School? Probably the 'inside' knowledge that Wall Street brokers (which include many of my former classmates) are no smarter than you and me.

The second most valuable lesson arrived in 1998 with the implosion of Long-Term Capital Management (LTCM). I spent an entire semester at Michigan researching a presentation on the Black-Scholes Options Pricing Model. LTCM was a hedge fund founded in 1993, one which included Myron Scholes and Robert Merton as directors. This was the equivalent of Crosby, Stills, Nash and Young. Naturally, I read everything i could about their arbitrage strategies. In hindsight, with not just one, but two future Nobel laureates on the board, the fund was doomed from the start (although it was longer-lived than CSNY). 

As with all lessons in life, we don't really understand something until we've been through it. I shorted Dell Computer in the mid-nineties, when its stock price began climbing to unsustainable heights. The price in fact began to drop shortly after, but hubris kicked in and I waited patiently for it to fall further. Instead, traders began running prices higher almost on a daily basis. I finally exited with a painful loss (yet one which imparted an invaluable lesson in the power of a short-squeeze, which I use to full effect when trading).

Trading in 2013 is an entirely different game. 

(a) The Fed (and more recently, the Central Banks of Europe, Japan, and China) have artificially depressed interest rates in order to support failing economies and/or price exports competitively. This makes it very difficult to make historical comparisons (in my opinion), and may be one reason John Hussman is not doing well. 

(b) Short-term trading no longer involves just fading crowd psychology. Traders must now also compete with high-frequency black boxes (HFTs) - I have no idea how they're programmed, but odds are they are designed to play on the emotions associated with crowd psychology. As Craig suggests, we can move to the small pond for now.  Let the whales kill each other off, and we can then return to our usual hunting grounds.  Defense, bro.

Super Bowl Sunday.  The one day of the year I can pretend to be a football fan.  Violent sport?  Nah.  Trading's more deadly.