Why Does Magic Work?

To put simply: a good magician provides a scenario where the viewer can project his/her own frame of reality onto what has occurred. Magicians don’t blatantly infer things, they let the audience do that. They know how the human mind works; we are wired to make connections where none may exist. This is a “bug” in our natural operating system--we are efficient at filling in mental gaps of information. Here is a video link to a Penn and Teller clip emphasizing our predisposition to “fill the gaps”--just amazing entertainers.

Notice this comic strip from Scott Adams, creator of Dilbert.

Scott Adams is openly methodical about his opaque cartooning techniques in his book, How to Fail at Almost Everything and Still Win Big. He creates the image of the lead character to be simple. This allows the reader to project him/herself as Dilbert. He also makes the backgrounds to his comics a plain gradient to provide optimal “imagination”. As a trained hypnotist in his early years, Adams learned that humans have the natural propensity to project.

It's important for us to not project in the often opaque markets, especially the stock market. One should have a procedure for risk management to prevent unnecessary loss of capital based on a false premise. If you have a $10,000 account, does it make sense to put $5K into Apple because it's Apple and the other $5K into Google because it's Google? It’s easy to draw market conclusions that pan out to be worthless--it's in our nature. It's ok to use intuition to enter the market. Many traders have great success using their own discretion, but the true edge is in the risk management system; the way you enter the market is far less important than when you exit. And your initial position sizing based on your risk parameters and assessment of your market should be well thought out.  

Clinging to an unchallenged belief is the downfall for most investors. One may get absurdly, freakishly lucky with a buy-and-hold strategy that finishes at a massive market peak right before he/she retires, but what if the market corrects 90% the year before retirement?

Instead of accepting magic as magic, realize that magicians dedicate an unbelievable amount of time into exploiting people's natural psychological deficiencies. 

Instead of confusing Warren Buffett's strategy as buy-and-hold, pop the hood of the car and see whats really happening inside.     

Ultimately, you can only win in the markets if someone else loses on the other end. When you're a buyer, you must find a seller, when you're a seller, you must find a buyer. This transcends all markets and all timeframes. Markets are a zero-sum game.

The Good News + the Bad News

“He who thinks he knows, doesn’t know. He who knows he doesn’t know, knows”

-Lao Tse

Embracing uncertainty is essential in trading. A trend-following trading process systematically makes trades that are centered around uncertainty--calculated uncertainty.

One never knows when a big move will happen, but a portfolio of diversified futures positions, betting on both the long and short side, combined with a well-defined strategy for cutting losing trades short, will undoubtedly capture any and every massively large trend.

Big trends are inevitable. The philosophy is to simply wait for the wave to come, then surf it as long as it permits you to. It can take 5 months, it could take 5 years, but when the statistical “once-in-a-lifetime” event occurs(which happens far more often than the market prices in), it will yield so much return that it will make up for every little losing trade along the way, and return huge profit on top of that.  

The nature of this system is that it relies on skewed returns: ~90% of the returns come from ~10% of the trades. There are a lot of little failures en route to a big win.

Here is an WTI Oil chart. Look how persistent and patient a trader has to be to capture a big win:    

A trend-following system got short oil toward the end 2014. (each +/- $1 move in oil=+/-$1000 in futures contracts. If a trader got short oil at $100, he/she would have a profit of ~$70,000 per contract).

But in early 2010, mid-2011, and mid-2012, trend followers had to endure sizeable losses betting on a drop in oil. A discouraged trader would have gotten sick of being “whipsawed” out of their positions and would have missed the trade of the year if they did not place that same exact bet toward the end of 2014.  

I’m not making any commentary on oil, or any commodity/asset. Markets move because people participate in them. People get drunk with euphoria and deflated with pessimism. Ultimately, trend-following takes advantage of that--it rides euphoria to the moon and makes sure to not miss the last bus to pessimism-ville.

The bad news: It takes well over 1 million dollars to properly deploy a diversified futures trend-following system. *you can improperly deploy a futures trend-following system with $50K, but the results will likely end in a loss of $50K .

The good news: There are plenty of CTAs that have a pooled futures account and will allow individual investors to buy a piece of their business. I have a portion of my portfolio allocated in a vetted and regulated CTA fund(until I start my own futures fund). I believe if one has a 401K, it would be prudent to allocate some funds to a vetted CTA as well.   

Not that this should affect your strategy, but my CTA has been short US stock market futures since August and still holds that same view.

CNBC is Not Your Friend, But I Am

“Most of the misinformation is not deliberate. People want to be led astray. They constantly ask the wrong questions, and those selling information get rewarded by giving them the answers they want.”

-Van K. Tharp, Trade Your Way to Financial Freedom.

If given the choice to deliver what’s best for the investor or what will get eyes on the screen, CNBC will choose the latter EVERY SINGLE TIME. Their only agenda is to make money via commercial advertising--more viewers, more money; that's the media business model. If they don't profit, they become extinct.

CNBC mostly caters to those who ask the wrong questions. When you start asking better, more thoughtful questions, you will realize how unnecessary an outlet like CNBC is and how vital a good trading book is. I have to admit that CNBC it is a great channel for entertainment, as they have a decent offering of shows after 7 PM, and sometimes they bring on a smart guest, but most of the time it's a really bad place for investment advice.

Questions worth asking:

How has the stock market been moving? How is it moving now? Are we in the midst of some serious range-bound price action, where the price will ultimately revert back up to ~18,000+? Or is the market headed much lower?

There are no clear answers, but these are good questions to ask before placing trades in the stock market.

Questions that are even more important to ask:

What's my investment philosophy? What’s my strategy? How much of a downdraw am I willing to experience in my account? Why am I in the markets in the first place?  

Market movement is important, but we all get dealt from the same deck. You should know what you are going to do far before the market presents that reality. A confused trader is a losing trader.  

PS: If you buy the book in the link, Amazon pays me ~¼ of a penny per purchase :)

All proceeds will be ultimately donated back to Amazon somehow.  

Don't Throw Money Away

Below is a WMB Put contract I own. The “spread” between the bid-ask is wide--$2.10 and $5.60, a $350 price spread. If I were to sell the contract with a “market order,” I would receive $210.

But if I were to sell with a “limit order,” I could name my own price. This doesn't guarantee I will get the price I want, but it's better than taking the default market price.

I would set my limit price at $5.60, or $560 per contract and see if I could get a buyer at the “ask price”. Sometimes this works, sometime you have to settle for less.

*each contract represents 100 shares of a company, so there is a 100X multiplier to get at the $ exposure.

When you sell a contract and don’t receive maximum amount on the deal, the unobtained $ amount is called “slippage.”       

It is best to make slippage as small as possible to make compounding growth as large as possible; this is done through “limit orders.”