The Fair Coin

Lets assume I give you a fair coin and ask you to toss it 100 times. Anybody’s guess that the fair value of number of heads in these 100 tosses is 50. That’s because the probability of a heads on tossing a fair coin is 1/2, similarly the probability of rolling 3 or less in a fair dice is 1/2 and so on. No, no… this blog is not a lecture on probabilities. Its just to share a very simple and yet powerful observation I have made this year. So simple it is, that one may easily call it “obvious” but it is equally overlooked by most people I have come across who deal in the financial markets – professionals  / mum and pop alike.

 

I think the world where we live in holds no concept of “fair value”. There is nobody in this world who can tell me that the fair value of stock X is Y dollars. I have read many research reports and heard many experts who forecast that by year end oil will trade at 99.89 dollars or sensex will reach 25,240 by next Deepawali (an Indian festival). And believe me, nothing amuses me more. Because I don’t think anybody can tell us what the fair value of oil or sensex is i.e at what point it is too cheap and at what point it is too expensive. (so whats the point in predicting to the last decimal anyways!)

 

Please don’t get me wrong in saying that financial markets are all random and the only way one can make money is by being lucky which over a long enough period will zero out and hence by definition nobody can make money in the long run in the financial markets. I know people (or heard about) who have consistently made loads of money over a very long horizon (and I am in no way claiming that I know their secrets). On the contrary, I am saying that markets are not all random. There are bull markets (prices tend to go up) and there are bear markets (prices tend to go down) and there are sideways markets. All I am saying here is in a bull market nothing is too expensive to sell and in a bear market no stock is cheap enough to buy at any price.

 

I read a book in the beginning of this year (“Reminiscences of a Stock Operator”) and after an year I now realize the its power. In a small incident mentioned in the book, the narrator and protagonist Larry Livingstone (a US stock trader in early 1900s) met an old man at a broker’s shop who would come there everyday, just watch the stock prices and not sell any stock he holds (it was during a bull run) even though at times the stock prices would run up too far and too quickly. All the other traders would advise him to sell his stocks here at higher prices (since stock prices went up too far and fast) and to buy them back later at a lower price after a correction. But he would just smile to them and say,”Thanks. But its a bull market you know.” All the fellow traders would smirk at him and call him an idiot for missing so wonderful opportunities but later it turned out that eventually he made more money than the traders who tried to be smart and sold their stocks at the “higher prices” looking to buy them back at lower prices because mostly prices never came down after they sold it and then they hesitated to buy them at a higher price thinking if it was too expensive to hold 10 points lower, it is definitely a sell at current levels  – so why buy it now. And then they would see it going 20 points up, 30 points up…. long live the bull market.

 

Message # 1. The most important message of the story is – my friend, in a bull market nothing is too expensive to sell and in a bear market no stock is cheap enough to buy. So this simplifies our lives a bit doesnt it? Instead of spending our precious time and piece of mind in running complicated quantitative models (with thousand assumptions) and finding the fair value, all we have to do is to determine whether its a bull market or a bear market. If it is a bull market, we just buy stuff and sell it only when we think its no longer a bull market. If it is a bear market, we just sell stuff and buy it only when we think its no longer a bear market.

 

Message # 2. Always “Respect the tape” i.e. respect the market. If we lose money on a trade, become very critical of it and question if we were wrong in our belief in the first place i.e. its a bull/bear market. I know a person who was bearish on Korean bonds, so he sold them at 108.00. Up they went to 109.00 i.e. 100 ticks. He painfully hung on to the trade. Went to 109.50. Got stopped out. Higher they go to 110. He sold again. Then higher to 110.50. Fortunately, this time bonds sold off 50 ticks to 110.00 and he “took profit”. Then up went the bonds to 110.50, he sold again, got stopped out at 111.00, sold again at 111.25, stopped out at 111.75, sold at 111.50, stopped out at 112.50 and finally 113 and stopped at 113.50. He lost millions in this trade, but more importantly lost his confidence and precious time which he could have devoted elsewhere and made money. As Gartman rightly puts it, mental capital is much more precious than physical capital. During recent November Euro crisis (led by Ireland), entire world was puking but US equities were not going down. Naturally we were all bearish on US equities and I sold at 1193. I thought that given the state of the world these f**king equities should be at 1150 not 90s. US equities sold off  to 1172 but absolutely absolutely refused to go lower. I sold more at 1183 and when they very strongly refused to break lower and started climbing up I started to have second doubts and promptly covered my shorts at 89. Today they trade at 1250. The way US equities rejected Ireland crisis gave me a lot of confidence. It is a sin not to be long if one is bullish and here was an asset class which had shown greatest strength in the crisis. So we bought equities at 1210 and still like them. All I want to say through these 2 examples is – dude, no matter what or how strong your view is, whatever research you may have done, at some point of time you have to respect the market. If the market is bullish, you must buy and if the market is bearish you must sell. The moment market tells you otherwise, you have got no business to stay in the trade. I paid the price of ignoring the markets back in February when I was long Indonesian Rupiah and held on to it despite it falling, doubling up in the process and grandly losing half a million in the trade. That was a devastating experience, it shook me completely and it took nearly 3 months and the market rout led by Greece to bring me back up and running.

 

Message # 3. One thing which we should absolutely avoid at any cost is to think we are smarter than others and try to capture the short terms bounces/falls! OK, some people may be good at it, but with all due respect I don’t know many such people. During September/October I was very bullish on Philippines Peso denominated government bonds. (In very simplistic terms bonds are like loans). I thought their prices are going to go up (reasons not relevant here). So I bought them (say at 100) and also sent it out as a trade view to the whole world. Up they went, and higher and higher in the coming week. You bet, I felt like a f**king rock star. Then I felt prices have come up too fast, too quickly and I have already made handsome money. So I should lock in profits and buy them back in a correction. So I sold at 125 thinking I would buy it back at 110/115. Two weeks later prices went up to 175 and I was feeling  like a complete idiot ! Good thing, I bought them back at 175 and only sold them in December (at 200) when I turned bearish on Philippines Bonds. God knows how much these bonds are actually worth (and frankly I don’t care). All I know is I don’t think they are going to go up anymore. A similar case is when you like something but don’t buy it just because you think it may fall a bit from here and then you would buy. Losing money always hurts. What hurts more is not to make money on something which you were so confident about ! I was very bullish on Taiwan dollar (i.e. I thought it will appreciate or USD/TWD will go lower). It was trading at 30 figure against the USD. But I was worried a bit that it may fall to 30.26 where I would buy it. So I didn’t buy TWD. Today it trades at 29.45 and I just helplessly stare at it.(Agree, I am being a sucker here!) I someone asks me I just can’t say that market may go up or down to this level. All I can say with any reasonable confidence is whether the market is going to go up or go down or don’t know.

 

Message # 4. Never sell something which is making fresh highs and never buy something which is making fresh lows – because you simply don’t know where the hell it may go before it turns. Remember – there is no such thing as the fair value. One of my friend started selling Australian Dollar at 0.93 since it was going up to its yearly highs. Up it went to 94, he sold more, 96 more, 97-98 he was even more convinced since AUD was hitting some 20 year highs. Finally AUD crossed parity (100) went up to 101 and he stopped shorting AUD. I had learnt this lesson earlier this year very painfully in a stock which I bought at 300, it hit 250 which was yearly low, I bought more, it went to 220, I bought more, it went to 190 before I stopped out. Today it trades at 100 and the reason I still have my job is fortunately I had bought it in small size. So when it came to AUD later in the year, we promtly bought it at 95 and sold at 101 – when European debt concerns worried me.

 

Message # 5  If only we had the concept of the fair coin in the financial markets, life would have been so much simpler. If in the first 30 tosses, say there are 20 tails when I had bet on “heads”, in most likelihood I am going to lose and I would pull out and ask him to stop tossing i.e. pull out of the trade. If on the other hand, I had 30 heads then I would stay in the trade. I know I would be right 50 pct of the times and given the flexibility of being able to chose when to pull out of the trade, I would only have to ensure when I have a losing trade on, I lose less money and when I have a winning trade on, I win more. Then net net I would make money. But in the financial markets there is no concept of fair value. Maybe the coin I was tossing had heads to tails probability of only 0.2 (and ofcourse, I don’t know)! So all we can do it, when we are “reasonably sure” of a bullish trend, we buy and sell if bearish. Very often we cannot be sure of the trend / timing during the first 15 and last 15 percent of the moves and more often than not I have seen people losing money (inculding myself) trying to capture these tops and the bottoms. During August/September, I was bullish on Korean Won. However it was going up. 1170 was a good technical level, so I sold dollars and bought KRW at 1168 (I would make money if USD/KRW goes to 1150 and lost if it goes to 1180). I thought I was picking a top here. I got stopped out at 1180.  Soon, it went to 1200 came down to 1190, went up to 1200, came down to 1192, went up to 1200 and came down to 1198 where I sold dollars again (this time 1200 looked like a good resistance and I was still bullish on KRW). However from my previous experience at 1168, I was a bit shaky and when it went up to 1205, I could not hold it any more and stopped out. Finally, it started coming down. This time I waited. Waited, waited and waited. 1197, 1192, 1185, 1180 before I pulled the trigger. Now I was sure the market is in my direction. Went to 1170, I promptly sold more, back to 1175, then 65, then 1150.  Finally I took it off at 1145 even though it settled around 1135-40. The reason I took it off was I was no longer sure of the move now. This is no fair world and we ain’t in the business of gambling.