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.


20 Replies to “The Fair Coin”

  1. I have never done trading but based on my experience in poker I think only two things are required:

    1) independent thinking – stay away from herd mentality
    2) discipline – when you decide to play a hand you play hard otherwise you fold and leave when the Whiskey is over and you have enough cash ..


    1. amit ji, i appreciate your thoughts expressed here. Remarkably well said, these comments reflect your experience and depth of thought you have given to it. What you say here or if I may generalize here, what are considered good practices for “fair value games” are more often than not very handy in financial markets as well. However the point emphasized here is there is an additional layer of uncertainty involved in the markets. Just imagine playing poker with a deck containing 26 aces or 40 same suited cards ! all said and done, very solid observations


  2. awesome dude…. very good indeed…. i actually thought like that when my brother lost during the crash of the BSE… but u have put it very concretely n given words to my hunch…. good job.. keep it up..


    1. Thanks Manoj Kumar Mishra for these words. Always feels good to connect to a reader and I am glad I was able to articulate your thoughts here. Although this is my last blog for the year, I continue to look forward to your responses in any future blogs.


  3. Gauaa ji, your intellectual stimulation has reached orgasmic levels. I concur with you thoroughly.

    Only certainty is uncertainty. We endeavour to build complex models to quantify risk/uncertainty, arrive at fair value but end of the day our model is as good as its assumptions. After all predicting future is not an easy task :P

    There is a lot of science involved in forming a view and arriving at “fair price” but the market forces me to believe that money making is more of an Art than Science. So, fair value is a myth.

    I totally agree when you say, nothing is too expensive to sell in a bull market and nothing is too cheap to buy in a bear market but you have to be smart as a brain surgeon to know when to buy/sell.

    Loosing mental capital is the worst case – our dear Vinod Kambli is an excellent example.

    Gauaa ji, isnt a trader just an educated gambler?


    1. thanks laluji. you know i am a simple man and try to express what i feel in simple words. being fortunate to have been in the company of the scholars like yourself, it has always been a pleasure to initiate and engage in a discussion. after all the purpose is not to convince others to subscribe to one’s own views, the purpose is to start a meaningful conversation. thanks again for your wonderful response. ciao.


    1. putra, i can say many things to this. i can be modest and say that probably my intellectual capital is not worth enough to be invested in some other meaningful business, or i can say that i ain’t in the business of gambling and we ain’t any gamblers. i can also lay the blame elsewhere saying entire life i have been guided, first by my parents and then by social norms etc etc. but the real thing my dear friend is, everything has a price ! all dollars are green and green is my favorite color !


  4. Hi
    Nice lesson Gauaji …. everyday I try to remind myself these (and a few other ground rules) and everyday I end up as sucker ! But reading the basics again does help.
    BTW it was a very well written piece!

    Hope you throw more light on different aspects of trading (and life!).



  5. Good analysis, as these are exactly the kind of thoughts that go through every traders mind based on their own experiences. The pitfall here is that people tend to learn wrong lessons by this method. I believe the beauty of the market is that you can make money in many different ways provided you really understand your strategy and always stick it.
    I did not go through all the messages but I don’t fully agree with message #1 [only if it was that easy to know whether it’s a bull market or a bear market, I thought even Warren Buffet couldn’t crack this problem :).. as they say a bull/bear market is a bull/bear market until it isn’t] , #2[I agree that you need to understand what went wrong with the unsuccessful trades, however its hardly a wise idea to play into the hands of the market in the long run] and #5 [how does it matter whether the stock is at 52 weeks high or low, it’s the underlying fundamental that matter the most]. I have made many-many successful trades doing exactly opposite of these messages. Of course it doesn’t mean market wont behave the way you described in your examples.
    I think market does funny things in the short term and not everything is a ‘good’ lesson. Just my humble opinion.


    1. dhanyawad surya jee. aap jaison ka sahara hi to mujhe prerit karta hai. bahut dinon se koi topic nahi mil raha tha.. but recently mujhe inspiration aaya hai…. on theory of black money… i thought i had perfected this theory but then a discussion with a friend made me realize a loophole in it. i am still working on it and will be back soon. it will be a hard core theoretical economics blog.


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