Mania and Depression in Markets

Severe market crashes happen. I believe they are a natural byproduct of markets; absolutely inseparable from the markets themselves.

The human condition of optimistic euphoria fueled by greed has resulted in countless booms and busts.

Throughout history, many economies have experienced tremendous bouts of euphoria which lead to unrealistic asset valuations. The euphoria never lasts and the subsequent crashes prove to be cautionary tales.

From 1985-1990, Japan’s economy went through a memorable boom-bust cycle.

It all started In 1985, when America, on behalf of automobile producers, grain exporters, and engineering companies, convinced the world’s major economic powers to devalue the $USD to reduce their trade deficit. In theory, devaluing the $USD would spur US exports because it would be cheaper for other countries to buy US goods.

Japan gave into America’s proposal and their increasingly stronger Yen caused a massive wave of consumerism in Japan; they had immense buying power.

The Japanese government felt it had to react to the strong Yen. In an effort to compensate for a potential decline in exports, Japan lowered interest rates to spur the country’s growth. Thier intent was to encourage corporations and individuals to speculate with a cheap money supply.    

“The strong yen, low interest rates, zaitech(financial speculation) and the willingness of banks to lend, led to a speculative boom in real estate and the domestic stock market.”  

-The Pit and The Pendulum,  David Harding and James Holmes.  

At the height of the boom, the Japanese Nikkei hit about 40,000, ~+500% on the decade.   

The bubble popped when the Bank of Japan began to raise interest rates in hopes of deflating property prices. As Japanese stocks and real estate were in the midst of a large downturn in 1990, the Japanese government reversed its rising interest rate policy and lowered rates into negative territory to blow air back into the bubble. But the Japanese government was too late; investor sentiment was already dead. The people’s fear of loss outweighed their desire to speculate. Japanese citizens prefered to keep money in a bank account with negative interest rates and lose a bit each year than to risk it in the markets again. Ever since, Japan has been quite risk averse.

Lessons to take away:

1: It's never one single thing that causes a bubble, it's a combination of complex events.

2: Bubbles do not occur in isolation. When economies inflate, many jobs and services are built upon the bubble, so when the impending bubble bursts, the reverberation is widespread.

Avoiding Disaster

Trading isn't about targeting gigantic wins as much as it's about avoiding catastrophic losses.

My job is in disaster avoidance--I’m a manager of risk. The good times(trending markets) will come, they always do, they always will. The trick is in surviving the instances when the markets can crush you.

Ultimately, trends are what bring in the outsized wins. And you cannot participate in the trend if you can’t afford to place the bet. So my line of logic stands: cut losing trades off at the point of the predetermined exit/trailing stop so you have the chance to capitalize on future trends. In short--don't let losers become huge losers.

When you allow price to do the talking, you can ignore your inner biased narrative and shun a fundamental belief about an asset/instrument. “It has to go up in the future” is not a strategy, it's a recipe for disaster.

I entered into 2 Valient Pharmaceutical trades over the past year. I got hurt for sure, but I could have gotten killed without my system.

What could have killed me?

If instead of selling on the way down, I could have bought on the way down to average my dollar cost. This would have DECIMATED my portfolio. I ended up taking a few small losses on my VRX trades. If I allowed my losers slip further or bought on the way down, I could have easily had a double digit % drop in my entire portfolio.

What saved me from getting killed?

I Determined hard exits before I entered into the trades, which in turn lead to appropriate position sizing based on my risk parameters. I never know if I will win or lose when I enter a trade. But if I do lose, I always know how much.

Chart 1: My initial entry

Chart 2: My exit point

Chart 3: My second shot at Valeant. I entered into another small position here.

Chart 4: My partial exit. I sold 2/3rds of my shares here.

Chart 5: My complete exit from the trade.

Chart 6: Current price. No position held.

“The public ought to grasp firmly this one point: that the real reason for a protracted decline is never bear raiding. When a stock keeps on going down, you can bet that there is something wrong with it, either with the market for it or with the company.”

-Edwin Lefevre, Reminiscences of a Stock Operator

All this being said, something is rotten in the biotech sector. The prices are giving the hints. With volatility getting super low again, I’ve purchased inexpensive Put contracts on big name biotechs as a portfolio hedge/alpha generator in the upcoming months. Once volatility gets high again, premiums will get fluffy, and it will get expensive to bet on a drop in biotech.

Worst Case Scenario

Calculating the “worst case scenario” answers: “What would happen if every position I currently hold goes against me and triggers an exit?”

I used to trade without knowing my WCS, but it's like walking through a messy room with the lights turned off.  

The question I came to was, “how could I run a profitable trading system without quantifying my total portfolio risk? If the shit hits the fan, where will I stand?”

The necessary prerequisite to calculating the WCS is establishing a hard exit before you enter a trade and using a trailing stop on winning positions. While I know many investors don’t have hard exits in positions, it is in my opinion that reading this article will do you little good without having that foundational knowledge.

If you do want to build the necessary knowledge on how position sizing, timeframe, initial exits, and trailing stops interact with each other, all of this info is archived here.

Trading may seem confusing and overwhelming, but good trading needs to be treated like any other business if it's going to be successful. Given enough time and effort, the murkiness becomes crystal clear.   

Essentially, the “worst case scenario” is losing all of the Total Open Risk in your account. Once Total Open Risk is calculated, you can determine how bad the worst case scenario could be.

1: Before finding Total Open Risk, you must determine Individual Position Open Risk.

2: The Excel cell formula for Individual Position Open Risk is “=(Price of Asset - Exit price) x number of shares.

3: After finding each Individual Position Open Risk, you can then find the Total Open Risk, which is just the net sum of every Individual Position Open Risk.

4: In Excel, the cell formula for Total Open Risk is “=SUM(column containing Individual Open Risks)”

*To remember: open risk is always changing because asset prices and exit prices are always changing. If you set up an Excel(or GoogleSheets) spreadsheet the right way, as you update asset prices and exit prices, the Individual Position Open Risk and the Total Open Risk will automatically adjust to the changes.

Below is a small sample of some trades I’m in. Hopefully the visual adds clarity.

As you can see, I have my assets listed in column A, current price in B, current stop price in C, # of shares in D, and Individual Position Open Risk in E.

So for ARTNA shares, I’ll go into Cell E4 and type, “=(B4-C4)*D4” and hit enter. GoogleSheets does the calculations for me. As long as I have columns B, C, and D filled out, I can just drag the bottom right corner of Cell E4 and it will do all the calculations for all of my assets.

In a separate Cell to the right, I will write the formula for Total Open Risk, which is “SUM(E4:E8)” for this sample.

Now that you can determine Total Open Risk, you can know how bad the worst can be. Right now in this account, my maximum estimated WCS downdraw is 10.5%. I’m comfortable with that number, but if it was at 60%, I may want to sell off some assets to pare back my risk.   

It took me about 8 months to get to this point in my trading system, so do not feel discouraged if it all seems like a different language.

The Best Trade Idea of the Decade

*You can give a man a fish……..  

OR...

You can tell him which waters are best for fishing.  

You can offer a fishing rod.

Advise on which baits work well.

You can even suggest a recipe for cooking the fish.  

*You can give a man a stock/trade idea……..

OR...

You get the point; it's better to teach someone a process than to provide a tip.

I recently read an incredibly well thought-out article by NYC Hedge Fund manager Brian Shapiro. It would a disservice on my part to not share his article.

Titled, “It's Time,” is about the next big investment of the decade--gold. Its profound, informative, and an overall elegant argument for why gold could be a great trade over the next ten years.    

But beware of trading on other people’s beliefs. While using other people’s trading ideas, one may neglect to recognize that there is an entire system behind a trade.

A trade idea is worthless without the system to support it.

Questions to ask yourself:

Can I assume gold will rise over the next ten years?

Do I just “buy-and-hold,” and hope for the best?

How big of a position do I take?

When do I sell?

Do I buy physical gold, gold futures, an ETF, a gold mining company, etc.?

If you cannot specifically answer these questions, it will do you more harm than good to participate in markets.

In the long run, a reliable process will outperform unstructured individual trade ideas.  

Here's the water, a fishing rod, bait, and a recipe. All the answers are there if you’re willing to look and ask the right questions.

Here's the fish: an amazing nugget of knowledge, but worthless without a trading plan.