Sunday, July 14, 2013

Perception v Reality Ch

In any serious financial speculation one must be aware of reality and perception and more importantly, be able to objectively distinguish between the two. For example, every time you take a with-the-trend position, you should premise that you are in for a mega—move. By so
doing, you will be encouraged to hold the position and not look for short-term trades. Here is perception versus reality. Your perception tells you to hold every with-trend position, looking for the big move. Your sense of reality tells you that most trades are not destined for the big move. But, since you don't know in advance which trade will be wildly successful and since you know that some of them will be, the strategy of choice is to assume each with-the-trend trade can be the ‘big one’; and let your stops take you out of those trades which fizzle. This strategy can be illustrated with an example.
Situation ‘A’ occurs in the World Trade Center building, in New York. Imagine you
are in a lift with two other men, one of whom you recognize as a leading money manager of equities. You and he have never met, but his reputation as a dynamic and usually-right money manager is legendary. The LMM (Legendary Money Manager) is talking to his companion: ‘Charlie, I want you to buy 100,000 shares of XYZ this afternoon; it's trading around US$40.00.’ Charlie, whom you surmise to be one of his dealers replies: ‘Sure thing, boss. But what’s up? What are you looking for in the stock?‘ The LMM replies: ‘Looks like there's a little technical squeeze about to happen. I'm not looking for much of a move, so if you see,
say, ten points in it, grab the profit.’ End of conversation, as the two men get of at the 43rd floor, and you continue up to your office on the 46th.

When you reach your oflice, you sit down for a minute to consider the situation. You think about the ‘tip' you just heard, and make an assessment of whether the conversation was genuine or whether they staged it just to draw you into the market. You conclude that it was a
genuine conversation. So, you call your stockbroker. ‘Pete, what's going on in XYZ? you inquire. ‘Strange  I should ask,‘ replies the broker, ‘there's some good buying coming in, and the stock just jumped from 39 1/2 to 41 on big volume; no one seems to know why.’ ‘Very interesting,‘ you respond. ‘Pete, please buy 500 shares for me, at the market. Call me back with the fill.’

In a few minutes, you get a return call from the broker confirrning that you’ve just bought 500 shares of XYZ, 300 at 41'/4 and the remaining 200 at 41'/2. The stock is now 41 1/2 bid oflered at 42.

You then start to follow the stock,, which closes that day at 44, again on heavy volume; and opens the following morning at 45 1/4 on a large block. The stock continues strong for a few days but, on Friday, it seems to be running out of steam, opening at 52 for a new high, but closing down at 49, the first day in the week that it opened on a high and then closed down at the low.

On Monday, it opened on a downside gap, at 48 1/4. It is important to digress and discuss the strategy here. What would you do, if you were the investor in the story, sitting with the 500 shares? Recapping the situation: you bought XYZ because of an overheard conversation between a legendary money manager, who said he was looking for just ten points, and his dealer. You could easily expect that the dealer may be bailing out with his anticipated ten-point
profit and that if you held the position, you could find the stock back at the original US$42 price wondering why you never sold the stock to grab the easy profit. So, what would you do?
Well, I don't know what ‘you’ would do, but if it were me, I'd dump the 500 shares at the market. The stock did what you expected of it, so get ofi” the ‘train’ and look for another ride.
End of Situation 'A.'

However, that wasn't what really happened — it was just a story. The actual story follows and it's considerably more interesting.

This story begins exactly the same way. The money manager and his dealer are in the same lift with you and you do overhear a conversation, although not the exact same conversation:
The LMM is talking to his dealer: ‘Charlie, I want you to buy 100,000 shares of XYZ this afternoon; it's trading atound.US$40.00.' Charlie replies: ‘Sure thing, boss. But, what's up. What are you looking for in the stock?’

As you can see, until now, both conversations have been identical, but here they diverge.

Back to the LMM: ‘I think there’s a big move in the ofling. l’m looking for the stock to double by the end of the year. And, if you get the first 100,000 shares around US$40.00, pick up an additional 50,000 shares if it gets to US$55.00.‘

End of conversation, as the two men get of at the 43rd floor and
you continue lfilfw your ofi-ice on the 46th.
Let's review now: this part of the story is the same. You assess whether the conversation you just overheard was genuine and assuming that it was, you call your stockbroker and ask him to buy 500 shares. From here, the story continues just as before, except for the part about what you would do with the stock. Well, what would you do?

It is a pity this isn't some form of interactive TV. But since it isn't, I can’t hear your response. So, permit me to tell you what I would do. I would hold the stock and not even consider selling shares on the minor reaction back to 48 1/2. Matter of fact, I would consider buying more shares on, say, a 50% to 60% reaction from the recent trading high.

Well, there you have it. The actual market action is identical in both instances. Yet, in situation ‘A,’ you (I) would look to dump the 500 shares on the reaction to 48 1/2. But, in situation ‘B,’ you (I) hold the stock and would in fact, probably buy more shares on any further extension of the price reaction. You must be ready to ask, why am I telling these stories and what are the significant clifierences between actions we would take in situations ‘A’ and ‘B?’ What has all this to do with investment strategy and, ultimately, is there a lesson to be learned

Let's start by answering the last question: it has everything to do with investment strategy and if you learn this lesson well and practise it consistently, your speculative results should be greatly improved. The significant difierence between the two scenarios has more to do with
perception than reality. The actual facts of the two scenarios are essentially similar. You overheard a conversation in which a money manager told his dealer to buy 100,000 shares of a particular stock. The difi"erence between the two situations is that, in the first instance,
you were anticipating a small, short-term advance and you quickly dumped the stock based on that perception. In the second situation, your expectation, based solely on an overheard conversation, was that the stock could experience a very substantial up-move, possibly
doubling in price. Accordingly, your tactical conclusion was to hold the position despite the price reaction and to even buy more on further reaction. This conclusion was based entirely on your perception of an anticipated major price move.

Your initial action to buy 500 shares were identical. But your subsequent actions were entirely different, based solely on your expectation or perception that the stock could have a major move, rather than merely a short-term rally.

In reality the significance of this is that every time you assume a market position in the direction of the major trend (and having a with-the-trend-position is the critical factor), you should premise that the market could have major profit potential and you should play your
strategy accordingly, as you did in situation ‘B.’ Now, before you rush forward to inform me that most market situations, in reality, are not destined for the big move, I will certainly concede that point. But, who can predict in advance, which situation does and which does not have major profit potential (remember, we are restricting this discussion solely to markets in line with the major market trend)?

The annals of financial markets are replete with real time examples of markets that started most unimpressively, but then developed into full scale mega-moves. Meanwhile, most of the original participants who may have climbed on board at the very inception of the move, got out at the first profit opportunity and then watched as the market continue to move very substantially, but certainly without them.

A good case in point was the cotton market in 1993 and 1994. Cotton futures commenced an advance from around the 60.00 level in October 1995 and I had a good-sized long position. There was substantial long-term resistance around 70.00 and l took profits on half of my position, thinking I would hold the other half for the long pull. Well, despite the best of intentions, something in the market distracted me and I sold out the balance of the long position, still around 70.00. As you can see from the chart (Figure 9.1), the market
wasn't much impressed by my liquidation because prices roared past me, right up to the 77.00 level and I watched on without any position in the market.

Some of my biggest profits in futures have been in copper and wheat, where I held long positions for eight to ten months. My winnings on these with-the-trend positions were substantially more than US$1 million each. But, my longest holding period and I would like to hear from any reader who has been able to continuously hold a position for longer, was in world sugar, back in the 1970s. I got long of sugar around the 2.00 level back in 1969 and held it (kept rolling) the positions forward and at times got stopped out, but re-entered) for
some five years till 1974, ultimately liquidating near the 60.00 level.

Jesse Livermore tells a story about a famous old speculator, Partridge, who was a long-term stock holder. At times, other traders would give him tips and then ask him what he thought they should do. Hc always listened intently and finally he would say, ‘you know, it's a bull market,’ or ‘you know, it's a bear market,‘ as though he was giving them a precious piece of wisdom. Once a fellow trader went up

to Partridge and told him that he was selling his position in Climax Motors because he heard it was heading lower and he could then buy back his stock at a lower price. He advised Partridge to do the same.

‘My dear boy,’ said old Partridge, in great distress, ‘if I sold that stock now I'd lose my position, and then where would I be?’ Partridge was holding 500 shares with a 7 point profit, for a total profit of US$3,500. The tipster was nonplussed. ‘Can you beat that?‘ he said. ‘He bought 500 shares and now he has a US$47.00 profit; I tell him to sell out and rebuy after the decline, and he tells me he can't do it because he would lose his job.‘ ‘I beg your pardon, Mr Harwood’ responded Partridge. ‘I didn’t say I would lose my job. I said that I would lose my position . . .  y
stock position in Climax Motors; and I don't want to do that.‘

Livermore then went on to say, that what Partridge meant was that in a bull market, he didn't want to take the risk of not being able to buy back his stock. Livermore then pointed out, that a long-term holder speculating with the trend, should not try to capture small counter-trend profits by trying to get in and get out, because ultimately, the market would run away with the trader just sitting there on the sidelines. Livermote's final admonition should be a good warning to all traders:

‘I know that if I tried to trade against my position by taking the counter-trend moves, I might lose my position and with it the certainty of making a big killing with the big move. It is the big
swing that makes the big money for you.’



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"There is the plain fool who does the wrong thing at all times anywhere, but there is the Wall Street fool who thinks he must trade all the time."J Livermore Manchester City FCl Crude Palm Oil


From Dragons and Bulls by Stanley Kroll
Intro and Foreword
The Importance of an Investment Strategy
5 The Art of War, by Sun Tau (circa 506 BC) and The Art of Trading Success (circa AD 1994)
That's the way you want to bet/a>
Long-term v Short term trading
Technicals v Fundamentals
Perception v Reality
Part 1: Winners and Losers
Part 2: Winners and Losers
Sun Tzu: The Art of War
Those who tell don't know, those who know don't tell
Why there is no such thing as a "bad market"
The Secret to Trading Success
The Experts, do they know better?
Risk control and money management
Good advice
The 'good bets' business by Larry Hite
Don't lose your shirt
Ed Sykota's secret trend trading system