Category Archives: Trading

Watch Out for Bottomless Pits

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A shareholder-friendly management?

Forget about it.

Very difficult to find, nowadays.

Gone are the days where you’d see an Azim Premji driving his 800, or a Narayana Murthy travelling economy class.

These legends believed in increasing the shareholder’s pie. And this they did, big time. Ask any Wipro or Infosys shareholder. These legends were very clear about one thing: there was no question of pumping in useless expenditure into their public limited company at the cost of the shareholder.

The norm, btw, is totally opposite. Public limited company managements live it up at the cost of the shareholder. Very few promoters are actually bothered about their shareholders. It is the norm to put medical bills, day to day living / wining / dining / entertainment costs, personal property purchases etc. into the company. Why should the promoter bear such costs when there is the public limited company to put these and such costs into? Logical?

Don’t expect too much from your average promoter. He’s not in the game for you.

Where does all this leave you, by the way?

Firstly, you need to look out for, and avoid bottomless pits. These are companies that bear huge amounts of expenditure emanating from the whims and fancies of the promoter. For example, the total sports sponsorship bill for Kingfisher Airlines is staggering. Then there’s this huge red flag in their balance sheet – the company is in under a mountain of debt. On top of that, this company just reported almost a 100 million USD Q2 loss. Math doesn’t add up for you to be investing in such bottomless pits, does it?

In your search for idealistic and shareholder-friendly managements, you might come up with a handful of names. Next you’ll find that it’s no secret. If there’s an idealistic and shareholder-friendly promoter around, people can see this in his or her deeds and of course in the balance sheet of his or her company. Savvy early investors make a beeline for such companies, with the result that by the time you get there, the concerned share-price is already quite inflated. You’ve identified a good investment, but you are not going to enter at an expensive price. If you do, you’ll not be able to sit on your investment for the long-term. Even slight volatility will shake you out of it.

Instead, you choose to wait for the right price to arrive, and then you enter. Well played.

The deal is, that more than 90% – 95% of managements don’t play it like an Azim Premji, or a Narayana Murthy, or an Anu Aga for that matter. However, shareholder-unfriendly promoters sometimes own companies that are lucrative investments. This can be due to niche, cycles, technology, crowd mentality, whatever. When do you buy into such companies?

As a long-term investor, you wanna be buying such companies at a deep discount to real value. My thumb-rule is a single-digit price to earnings ratio. You can have your own thumb-rule. You might have to wait a long time to get this kind of a price, but that’s what long-term investing is about.

As a trader, you buy into such a company with the momentum. You can buy after a resistance is broken. Or after a high is taken out. Or upon a substantial dip after the first burst of momentum. As a trader, what is far more important for you is to know when to let such a company go. Know the level by heart below which or at which you will exit such a company. In trading, exits are far more important than entries.

The mistake you don’t want to be making is to invest in a bottomless-pit, no matter how cheap the share price is.

As Ponzi as it Gets

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Charles Ponzi didn’t dream that he’d become one of the most copied villains in the History of mankind.

Ponzi was a financial villain. His ideology was so simple, that it was brilliant.

Lure the first set of investors with promises of huge returns. Transfer the first few return payouts. Lure more and more investors as the news spreads about the scheme with great returns. Transfer few more return payouts to old investors from the investment principal of new investors. Lure a peak level of investors ultimately. Then vanish with all the collections.

As Ponzi as it gets.

I hardly read the financial newspapers. Technical trading finds news to be more of a burden. Earlier, I used to gauge sentiment from the news. Now, my Twitter-feed is an excellent gauge for sentiment. Also, with time, one starts to gauge sentiment in the technicals. Candlesticks are a great help here.

Yesterday, in a loose moment, I picked up the Economic Times. Normally, it’s not delivered to our house. Yesterday, a supplement of the ET was included in our normal newspaper. Probably a sales gimmick. Anyways, I glanced through it. Was shocked to find that 25 recent Ponzi schemes had been unearthed in India alone.

What is it about us? Can we not understand what greed means?

The sad fact was that all the investors who were trapped were retail small timers.

Education, people, education. Are you financially literate? If not, please don’t enter the markets. No amount of regulation can save you from being duped if you are financially illiterate.

When you’re putting your money on the line for the long term, you’re looking for quality of management. A track record is something you want to see. Average returns are great returns if they promise safety of the principal.

Where there’s promise of huge rewards, there are also proportionate risks. If you really want the thrill of very high returns, all right, fine, go ahead and risk a miniscule percentage of your portfolio size in a risky, high yielding scheme. Tell yourself that the principal might or might not come back, and for heavens sake, don’t bet the farm here.

These financial times are as Ponzi as it gets, people, so TREAD CAREFULLY.

What U Gonna Do When They Come For U?

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“Bad Boys Bad Boys, what u gonna do…

what u gonna do…

… when they come for you?”

Lots of bad boys floating around.

They make a beeline for an underlying, for example Gold. Hike up its price. Entice you to enter at a peak. They cash out. You, the slow poke, are left high and dry.

Then the bad boys gang up and short the underlying simultaneously. Price tanks. From one day to the next, you are sitting on a large loss. You get out, disgusted.

Don’t make yourself vulnerable to such bad boys. Get your strategy right.

Buy at strategic points. If you are buying at dips, do so at pinpointed levels, like Fibonacci ones. You can also buy when a resistance is broken. Or, you can buy when a high is taken out with volume. Don’t buy above that. Meaning to say, that’s the vulnerability cut off. After that, you expose yourself to the bad boys, because you don’t have any margin of safety after that point. Through your actions, you activate bad boy zone.

On the short side, go short at strategic points in a rally. That’s where margin of safety is maximum. You can also short when a support is broken. Or, you may go short when a low is taken out with volume. Below that is bad boy zone.

At times, the human being likes the thrill of being in bad boy zone. Got me there, I like it too. Only sometimes. In bad boy territory, you need to be light. Don’t carry too much cash in your pockets when they come for you. In bad boy territory, do options. Options are your best friends here.

The advantage of operating in bad boy territory is that every now and then, there’s a jackpot for the taking. There’s no telling how far bad boys take an underlying in a particular direction. Where there’s risk, there’s reward. Out of ten option trades you put on, at least two or three should hit the pot if your research is good. That’s all you need.

In bad boy territory, the only position you want to be in is about showing the jackpot in the one hand and the finger from the other. By default, your losses must be small here, and they are, because you are doing options. Period. With that, you’ve shown the necessary aggression that is required in this territory, and you’ve also shown proper backfoot (defence) strategy. That is winning behaviour in bad boy territory. That’s the language understood by bad boys, telling them to lay off. Now, even if they try to come for you, they’ll not get you. Ever.

An Elliott-Wave Cross-Section through a Crowd Build-Up

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At first, there’s smart money.

Behind this white-collared term are pioneering investors who believe in thorough research, and who are willing to take risks.

Smart money goes into an underlying, and the price of this underlying moves up. Wave 1.

At the sidelines, there are those who have been stuck in this underlying. As the price moves above their entry level, they begin to off-load. There’s a small correction. Wave 2.

By now, news of the smart money has perforated through the markets. Where is it moving? What did it pick up? Who is behind it? Thus, more investors following news or fundamentals (or both) enter. The price moves past the very recent short-term high of Wave 1, accompanied by a surge in volume.

This is picked up on the charts by those following technicals, who enter too. By now, there are analysts speaking in the media about the turn-around in company so and so, and a large chunk of people following the media do the honours by entering. Wave 3 is under way.

Technical trend-followers latch on, and soon, we are at the meat of Wave 3, i.e. the middle off the trend.

Analysts on the media then speak about buying on dips. All dips are cut short by a surge of entrants seeking to be part of the crowd.

The first feelings of missing the bus register. The pangs of these cause more people to enter.

Meanwhile, the short community has been getting active. Large short positions have been in place for a while, and they are bleeding. Eventually, the short community throws in the towel, and there’s massive short-covering, causing a further surge in price.

Short-covering is sensed by gauging buying pressure despite very high price levels. It is the ideal time for smart money to exit. That’s exactly what it does, without any dip in the price of the underlying whatsoever.

Short-covering is over. Smart money starts boasting about its returns of X% in Y days, openly, at parties, in the media, everywhere. This causes pangs of jealousy and intense feelings of missing the bus in those still left out. Some enter, throwing caution to the wind.

The price has reached a level at which no one has the guts to enter. Demand dries up. With no buying pressure, the price dips automatically. Bargain hunters emerge, and so do shorters. The shorters sell to the bargain hunters right through a sizable dip. This dip happens so fast, that most of the crowd still remains trapped. Wave 3 has ended, and we are now looking at the correcting Wave 4 in progress.

At this stage, technical analysts start advising reentry upon Fibonacci correction levels. Position traders buying upon dips with margin of safety enter, and so does the second-last chunk of those feeling they’d missed the bus. The price edges up to the peak of Wave 3 and past it. That’s the trigger for technical traders to enter.

We now see a mini-repeat of Wave 3. This is called Wave 5. Once Wave 5 crosses its meat, the last chunk of those still feeling they’d missed the bus makes a grand entry with a sharp spike in the price. These are your Uncle Georges, Aunt Marthas and Mr. Cools who know nothing about the underlying. They cannot discern a price to earnings ratio from an orangutan. They desperately want to be a part of the action, since everyone is, at whatever the price. And these are the very people that traders sell to as they exit. With that, the crowd is at its peak, and so is the price. There are no more buyers.

What’s now required is a pin-prick to burst the bubble. It can be bad news in the media, the emergence of a scandal, a negative earnings report, anything.

The rest, they say, is History.

Dealing with Distraction

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I’m a huge Sherlock Holmes fan.

The stand-out quality I admire about Holmes, apart from his mastery in observation and deduction, is his ability to switch off.

In the midst of the most engrossing case, Holmes will switch off for half a day or more, and will visit the museum, or will play the violin. While having switched off, there will not be a single thought on his mind concerning the ongoing investigation. He will be fully and totally involved in the recreational activity. Of course he switches off at a juncture where he knows that nothing of consequence is happening for the next so many hours, but that’s not the point.

The ability to switch off is a huge asset to the trader. It allows the trader’s mind and body to recuperate. Also, it does away with overtrading. If a position is showing good profit, the trader who installs a trailing stop, and then switches off, opens the window for still larger profits.

At many times, one is distracted. It is potentially dangerous to trade while distracted, just as it is dangerous to drive while communicating on the cellphone. While distracted, the trader needs to switch off. As long as it takes. Till the source of distraction is nullified, at least in the trader’s mind.

Just a minute, forget about the trader. Investors need to be experts at switching off too, after having entered into an investment. If they don’t have this ability, they’ll be thinking about their investment day in, night out, for years at a stretch. The investment will eat into their life. If we’re looking at the average investor with 10 to 20 investments and without the ability to switch off, we’re also looking at a mental and emotional wreck.

Traders and investors both need to learn how to switch off from Sherlock Holmes.

Taking Compulsion Out of One’s Trading Equation

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Mr. Cool’s next trading cameo starts a few months after his last blow-up. He keeps coming back, you’ve gotta give him that.

This time around, his girl-friend wants a fur coat. Cool is determined to buy a fur coat for her from his trading profits.

Thus, Mr. Cool has put himself in a position where he is compelled to trade. Compulsion adds pressure. A trader under pressure commits basic blunders. There’s no question of getting into the Zone while pressure mounts.

Sure enough, Cool overtrades. Apart from that, he fails to cut his position-size after the first run of losses. These are two basic mistakes. They are being caused by compulsion. Mrs. Market is ruthless with players who commit basic blunders. As usual, Cool blows up, yet again. The fur coat is not happening. In fact, there’s no girl-friend anymore.

Meanwhile, Mr. System Addict has been evolving. He’s achieved a large-sized fixed income by ploughing previous profits into safe fixed-income products. He’s under no compulsion to trade. His fixed income allows him to live well, even without trading. He has a lot of time to think. Often, he gets into the Zone, where he’s moving in tandem with the market, and is able to swing with the market’s turn. What makes him get into the Zone so often?

It’s the lack of pressure. He’s comfortable. A free mind performs uniquely. There’s no question of making basic mistakes, because full focus is there. Addict is a human being who is aware. He knows when he is in the Zone. That’s when he doubles up his position-size and logs his trade. His win : loss ratio is 70:30 by now. His trading income surpasses his fixed income for the year.

Is Commodity Equity Equal to Commodity?

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Rohit likes Aarti, but has no access to her.

Priya wants to be friends with Rohit. Priya looks a bit like Aarti and behaves like her too, at times.

Rohit and Priya become friends.

Is Priya = Aarti?

Can this question be answered with a resounding yes or no?

Of course Priya is not equal to Aarti. Priya is Priya and Aarti is Aarti. Ask Rohit about it during one of Priya’s temper tantrums.

And, at other times, Priya is just like Aarti. At still other times, Priya is as calm as the Pacific Ocean. Even calmer than Aarti. At those times, Rohit feels he is even better off with Priya than he would have been with Aarti.

After this short diversion into human relationships, let’s study the correlation between commodities and commodity equity.

The average working individual does not have access to commodities as an asset class. He or she is not a farmer, and doesn’t have the time or the nerve to play futures and options, in an effort to put some money in commodities.

Is there any avenue such a person can access, to invest a piece of his or her pie in commodities.

It’s time to study the world of commodity equity.

For example, we are talking about agriculture stocks, precious and non-precious metal mining stocks, oil and natural gas stocks etc. etc.

Do such stocks always behave as their underlying commodity?

Can one put one’s money in commodity equity, and then feel as if one has put the money in commodities?

These questions can be answered in terms of correlation.

There are times when Gold moves x%, and Gold equity also moves x%, in the same direction. At such times, the correlation between Gold and Gold equity is 1:1.

At other times, the levels of movement can be mismatched. For example, the correlation can be 0.8:1, or 1.2:1. Sometimes, there is even a negative correlation, when Gold moves in one direction, and Gold equity in the other. At still other times, one moves, and the other doesn’t move at all, i.e. there is no correlation.

You see, Gold equity first falls under the asset class of equity. It is linked to the mass psychology of equity. When this mass psychology coincides with the mass psychology towards commodities, here specifically Gold, there is correlation. When there is no overlap between these psychologies, there is no correlation. When the public just dumps equity in general and embraces commodities, or vice-versa, there is negative correlation. These relationships can be used for all commodities versus their corresponding commodity equity.

What does this mean for us?

Over the long-term, fundamentals have a chance to shine through, and if there is steady and rising demand for a commodity, this will reflect in the corresponding commodity equity. Over the long term, the discussed correlation is good, since truth shines forth with time. That’s good news for long-term investors.

Over the medium-term, you’ll see correlation at times. Then you’ll see no correlation. You’ll also see negative correlation. Position traders can utilize this information to their benefit, both in the long and the short direction.

Over the short-term, things get very hap-hazard and confusing. It would be wrong to look for and talk in terms of correlation here. In the short-term, for trading purposes, it is better to treat commodity as commodity and commodity equity as equity. If you are trading equity, a gold mining stock or any other commodity equity stock might or might not come up in your trade scan. When such a stock does get singled out for a trade as per your scan, well, then, take the trade. Don’t be surprised if at the same time your friend the commodities trader is trading oil futures instead, or is just sitting out. That’s him or her responding to his or her scan. You respond to your scan. In the world of short-term trading, it is hazardous to mix and correlate commodities with commodity equity.

Phew, that’s it for now. It’s taken me a long time to understand commodity equity, and I thought that I’d share whatever I understood with you.

Options 1.0.3

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Has your stop ever been jumped over?

Yes?

Did it make you angry?

Yes?

It might make you angrier to know that Mrs. Market couldn’t care less about you on a personal level. It’s you who has to adapt, not Mrs. Market.

So, next time you see Mrs. Market moving many points in one shot, you have a choice. Either you can choose to take the chance of having your stop jumped over in the hope of huge rewards, or you can use options as an instrument to trade.

In general, a stop getting jumped over is a non-issue with options, because you are pre-defining your maximum loss here. Your option-premium is the maximum loss you will incur on the trade. Once you’ve mentally aligned yourself with this potential maximum loss, you are actually then asking Mrs. Market to do all the jumping she wishes to do. It just doesn’t bother you anymore. You travel, do other stuff, and then take a sneak-peak at your position.

Once your position starts making money, you might decide to fine-tune your trade-management after achieving your target. If you then make sure that your trailing stop is wide-gapped, you can still relax and do other stuff. Maybe one time out of twenty, Mrs. Market will jump even your wide-gapped trailing stop. Even if she does, you are well in the money, and you do not forget to install a new stop. Also, a little while ago, you were mentally prepared to forgo your whole option-premium, so giving back a part of your profits seems a piece of cake to you.

Welcome to the world of options. We have plunged right in. I believe that the best way to learn something is to plunge right in. Gone are the days of bookish learning.

The options market in India is just about coming into its own. At any given time, there will be at least 20 scrips on the National Stock Exchange showing very high options volume for long trades, and at least 10 scrips showing heavy volume for short trades. Bottomline: you can get into a liquid trade on either side, anytime you want. The number of scrips showing this kind of liquidity is picking up. We are still very, very far away from the mature options market in the US. What can be said is that the Indian options market will offer you liquid trades, anytime, both on the long and the short side. Frankly, that’s all one needs.

On the flip side, options on commodities have yet to come to India. Also, only the current month options are adequately liquid in India. Regarding options, the Indian market is getting there. Well, as long as you get a liquid trade anytime you want, who cares if we’re not as mature as the US options market? I don’t.

Over the last few months, options have been the instruments of choice, with unfathomable volatility abounding. I was dying to have a go, but have been caught up in so much other distracting stuff, that I’ve not traded for two months now. I like sticking to my trading rules. One of them is to not trade if I’m distracted. I really stick to this one.

Those who did trade the options market over this period would have done exceptionally well, because ideal conditions persisted. Big and quick moves, like a see-saw. The scenario would look like this: Long options give quick profits, short options simultaneously becoming very cheap, especially the out of the money ones. One sells the now expensive long options (which were picked up cheap), and stocks up on the now cheap out of the money short options. The market turns around and leaps to the downside, giving quick and large profits on the short options. One sells the short options and picks up now cheap out of the money long options, again. The repeat trades according to this pattern can continue till they stop working. When they stop working, what have you lost? Just your premium on some out of the money options.

Wish I’d had the frame of mind to trade options over the last two months. But then, one can’t have everything!

Jumping Jackstops

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Recently, Mr. Cool and Mr. System Addict decide to get into a trade.

Yeah, surprise surprise, Mr. Cool is liquid again!

They’ve decided to trade Gold, and are pretty much in the money already. Their trades have come good first up. Both are leveraged 25:1, which is common with Gold derivatives. Mr. Addict has bet 5% of his networth on the trade, and Mr. Cool, true to his name, has matched Mr. Addict’s amount.

Gold prices jump, and Mr. Addict’s target is hit. He exits without thinking twice, and is pretty pleased upon doubling his trade amount within a week. He pickles 90% of the booty in fixed income schemes, and is planning a holiday for his girl-friend with the remaining amount. Instead of trading further, he decides to recuperate for a while.

Meanwhile, Mr. Cool rubs his hands in glee as the price of Gold shoots up further. His notional-profits now far exceed the actually booked profits of Mr. Addict. When’s he planning to exit? Not soon. He wants to make a killing, and once and for all prove to Mr. Addict and to the world, that he rules. He wants to bury Mr. Addict’s trade results below the mountain of his own king-sized profits. Gold soars further.

Mr Cool has trebled his money, and is still not booking any profits. He picks up his cell to call Mr. Addict. Wants to rub it in, you know.

Mr. Addict puts down his daiquiri by the poolside in his hotel in Ibiza. His girl-friend has at last started admiring him. They’ve been swimming all morning. “All right, all right, he’ll take this one call. Oh, it’s Mr. Cool, wonder what he’s up to?” Mr. Addict is one of the few people in the world who are able to switch off. He’s totally forgotten about Gold and his winning trade, and is really enjoying his holiday.

Mr. Cool tries to rub it in, but receives some unperturbed advice from the other end of the line. He’s being asked to be satisfied and to book profits right now. Of course he’s not going to do that. All right, fine, if he wants to play it by “let’s see how high this can go”, he needs to have a wide-gapped trailing stop in place, says Mr. Addict. Of course he’s got a wide-gapped trailing stop in place, says Mr. Cool. Mr. Addict wishes him luck, cuts the call, and forgets about the existence of Mr. Cool, dozing off into a well-deserved snooze.

As Gold moves higher, Cool starts to think about that wide-gapped trailing stop. Let alone having one in place, he doesn’t even know what it means. A quick call to the broker follows. The broker is ordered to install a trailing stop into Mr. Cool’s trade. Since Cool doesn’t know what “wide-gapped” means, he forgets to mention it. The broker doesn’t like Cool’s attitude and his proud tone. He installs a narrow-gapped trailing stop.

Circumstances change, and Gold starts to drop. It’s making big moves on the downside, falling a few percentage points in one shot. Cool’s narrow-gapped trailing stop gets fully jumped over; it doesn’t get a chance to become activated in the first place, because it is narrow-gapped and not wide-gapped. The price of the underlying just leaps over the narrow gap between trigger price and limit price. Happens. Cool does not install a new stop. Stupid.

Next morning, Cool’s jaw drops when he sees Gold down 15% overnight. On a 25:1 leverage, he’s just about to lose his margin. The phone rings. It’s the margin call. Cool panics. He answers the margin call. His next call is to Mr. Addict, asking what he should do. Mr. Addict is shocked to learn that Cool has answered the margin call. He asks him to cut the trade immediately.

Cool’s gone numb. Gold drops another 4%. Phone rings. Second margin call. Cool doesn’t have the money to answer it. In fact , he didn’t have the money to answer the first one. In the broker’s next statement, that amount will show up as a debit, growing at the rate of 18% per annum.

Mr. Cool’s not liquid anymore. Actually, he’s broke. No, worse that that. He’s in debt. Greed got him.

A Fall to Remember (Part 2)

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Part 1 was when Silver fell almost 20 $ an ounce within a week. Like, 40%. Swoosh. Remember? Happened very recently.

And now, Gold does a Silver, and falls 20 % in a few days. These are the signs of the times. “Quick volatility” is the new “rangebound move”. Put that in your pipe and smoke it.

The wrong question here is “What’s a good entry level in general?” Why is this question wrong?

When something new becomes the norm, there is too little precedence to adhere to. It becomes dangerous to use entry rules which were established using older conditions as a standard.

I believe there is one way to go here. The correct question for me, were I seeking entry into Gold or Silver, would be “Is this entry level good enough FOR ME?” or perhaps “What’s a good enough entry level FOR ME?”

Let’s define “good” for ourselves. Here, “good” is a level at which entry doesn’t bother YOU. It doesn’t bother you, because you are comfortable with the level and with the amount you are entering. You don’t need this sum for a while. It is a small percentage of what you’ve got pickled in debt, yielding very decent returns. If the underlying slides further after your entry, your “good” level of entry still remains “good” till it starts bothering you. You can widen the gap between “not-bothering” and “bothering” by going ahead with a small entry at your “good” level, and postponing further entry for an “even better” level which might or might not come.

If the”even better” level arrives, you go ahead as planned, and enter with a little more. If, however, your “good” level was the bottom, and prices zoom after that, you stick to your plan and do not enter after that. This would be an investment entry strategy, which sigularly looks for a margin of safety. Entry is all-important while investing, as opposed to when one is trading (while trading, trade-management and exit are more important than entry).

Trading entry strategies are totally different. Here, one looks to latch on after the bottom is made and the underlying is on the rise. Small entries can be made as each resistance is broken. It’s called pyramiding. Trading strategies are mostly the complete opposite of investing strategies. Please DO NOT mix the two.

Sort yourself out. What do you want to do? Do you want to invest in Gold and Silver, or do you want to trade in them? ANSWER this question for yourself. Once you have the answer, formulate your strategy accordingly. U – good level – how much here? U – even better level – how much there? U – no more entry – after which level?

Life is so much simpler when one has sorted oneself out and then treads the path.

Blowing up Big

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Derivatives are to be traded with stops. Period.

Stops allow you to get out when the loss is small.

Common sense?

Apparently not.

Who has common sense these days?

Also, the human being has embraced leverage as if it were like taking the daily shower. Bankers and high-profile brokers have free flowing and uncontrolled access to humongous amounts of leverage.

Apart from that, the human being is greedy. There’s nothing as tempting as making quick and big bucks.

Combine humongous amounts of leverage with large amounts of greed and brew this mix together with lack of common sense. That’s the recipe for blowing up big.

Every now and then, a banker or a high-profile broker blows up big, and in the process, at times, brings down the brokerage or the bank in question. In the current case at hand, UBS won’t be going bust, but its credibility has taken a sizable hit.

Bankers are to finance what doctors are to medicine. Where doctors manage physical and perhaps mental health, bankers are supposed to manage financial health. Bankers are taught how to manage risk. Something’s going wrong. Either the teaching is faulty, or the world’s banking systems are faulty. I think both are faulty. There exists a huge lack of awareness about the definition of risk, let alone its management.

Trained professionals lose respect when one of them blows up big. Such an event brings dark disrepute to the whole industry. Most or all of the good work to restore faith in the banking industry thus gets nullified to zilch.

A doctor or an engineer is expected to adhere to basics. I mean, the basics must be guaranteed before one allows a surgeon to perform surgery upon oneself. A surgeon must wash hands, and not leave surgical instruments in the body before stitching up. Similarly, an construction engineer must guarantee the water-tightness or perfection of a foundation before proceeding further with the project.

Similarly, a banker who trades is expected to apply stops. He or she is expected to manage risk by the implementation of position-sizing and by controlling levels of leverage and greed. Responsibility towards society must reflect in his or her actions. A banker needs to realize that he or she is a role model.

All this doesn’t seem to be happening, because every few years, someone from the financial industry blows up big, causing havoc and collateral damage.

Where does that leave you?

I believe that should make your position very clear. You need to manage your assets ON YOUR OWN. Getting a banker into the picture to manage them for you exposes your assets to additional and unnecessary stress cum risk.

In today’s day and age, the face of the financial industry has changed. If you want to manage your own assets, nothing can stop you. There exist wide-spread systems to manage your assets, right from your laptop. All you need to do is plunge in and put in about one hour a day to study this area. Then, with time, you can create your own management network, fully on your laptop.

Your assets are yours. You are extra careful with them. You minimize their risk. That’s an automatic given. Not the case when a third party manages them for you. Commissions and kick-backs blind the third party. Your interests become secondary. Second- or third-rate investments are proposed and implemented, because of your lack of interest, or lack of time, or both.

Do you really want all that? No, right?

So come one, take the plunge. Manage your stuff on your own. I’m sure you’ll enjoy it, and it will definitely teach you a lot, simultaneously building up confidence inside of you. Go ahead, you can do it.

The Power of Leverage

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Apart from the D-word, the Street’s got the L-word too.

This L stands for L-E-V-E-R-A-G-E.

So, how much leverage do you enjoy from your spouse?

Or, do you have any leverage on politician so-and-so?

Or, bank so-and-so or brokerage so-and-so is offering a 10:1 or a 16:1 leverage on derivatives.

Just racking up the various uses of the L-word.

In colloquial terms, the amount of leeway your spouse allows you in your marriage is called leverage. Also, the amount of dirt you have on a politician to coerce him into following your wishes – that’s called leverage too. But for now, let’s get back to the Street.

On the Street, The L-word gives the D-word its power to destroy big.

Do you remember what the D-word was? D-E-R-I-V-A-T-I-V-E-S.

A derivative is a stink normal trade without the power of leverage. When brokerages start offering you leverage like 16:1, the stink normal derivative becomes lethal. Then, small amounts of volatility can wipe out the principal put up by you. If a down-turn continues, your loss can become many times your principal. People can go bankrupt like this.

You see, for every market move, your profit or loss is the move times the leverage. On a 5% move, a 16:1 leverage can result in 80% profit or loss. Leverage works on the upside as well as the downside.

The problem arises when the player doesn’t know how to play either side. Most players don’t know.

Leverage can be used to one’s advantage only when the down-side is protected with a stop. Most people don’t use a stop while deploying leverage. That’s why they lose, and lose big.

This singular characteristic of the average market player of not knowing how to use stops results in a spiralling bomb during market down-turns. As losses pile up, selling pressure increases due to dejection or the like as the market heads even lower. What if they’d taken a 2% or a 5% or even an 8% hit when a stop was hit? They’d be out and the market could stabilize near the stop level because of lack of further selling pressure.

Leverage is something that must not be used if one doesn’t fully understand how to use it. Unfortunately, almost everyone consumes leverage as if it were a bar of Snickers. Leverage is served to customers on a platter. Even a loan, or debt on the credit card is leverage.

Leverage is the driving force of consumerism and the modern industrialized world.

Just 40 $ Away…

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The first signs of greed can be sensed.

We’re talking about Gold.

A few months ago, serious players in Gold had identified Rs. 28,000 / 10 grams as their target for Gold.

This target has been achieved for a while now. Nobody’s booked their Gold.

Instead, the target has been revised to Rs. 30,000 / 10 grams, which is just another 40 $ an ounce away.

Please don’t tell me that nobody is going to book (meaning sell, as in booking profits) their Gold @ Rs. 30,000 / 10 grams. I’ve got this nagging feeling that they’re not.

Hmmm, greed is setting in. Nothing unusual. That’s how a bubble progresses.

Yesterday, an update from Reliance alerted me to the hypothesis that Rs. 40,000 / 10 grams was a real possibility in Gold.

Maybe, maybe not. As of now, Reliance is sounding like that fellow who predicted a Dow level of 36,000 some years ago. Today, 36k on the Dow seems impossible, even in one’s dreams.

Does it matter to you how high Gold can go? Or is your target more important? Both are valid questions.

If your target has been achieved, here’s one scenario. Book the Gold and put the released funds into debt. Debt in India is safe, and is giving excellent returns, especially to the retail investor.

If your stomach is full, do you dream about more food?

Seriously people, playing this by targets is a serious option.

It’s also ok if you wanna play it in a “let’s see how high this can go” manner. That’s just another way of playing it. Fine. In this case, you need to set trailing stops, and you need to stick to these if they get hit.

Either way, identify a booking strategy for Gold and stick to it.

Take greed out of the equation. There’s no room for greed in the career of a market player. There’s no room for fear either.

We’ll talk about taking fear out of the equation some other day, if and when unprecedented gloom and doom abounds.

What are We, Really?

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One bout of torrential rainfall and our infrastructure comes to a stand-still.

What are we, really?

Is India a golden investment?

Not with the current state of governance.

Is India an investment?

Yes, but only at single-digit price to earnings ratios.

Why?

Because while investing in India, one needs to factor in very bad governance, terrorism, and fragile infrastructure. That’s why the margin of safety required is huge.

Is India a good trade?

Yes.

Why?

Because of the pull and push between the shining private sector versus the apathetic government sector. This contrast causes big moves, both up and down. Ideal for trading.

So how should one play India?

Again, up to you. Invest in it at single digit PEs. Cash out when PEs hit the early 20s. Or, just sheer trade it. Suit yourself.

Crowds Eventually Start Behaving in a Deluded Manner

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We’re human beings.

The majority of us likes forming a crowd.

Our crowd-behaviour eventually goes warped. History has shown this time and again.

In the market-place, I make it a point to identify crowds. The biggest money is to be made by capitalizing upon the folly of a crowd. That’s why.

So first let’s gauge very broadly, what the main aspects of market-study are, and then let’s see where crowd-behaviour fits in.

Market-study encompasses three broad areas. These are:

1). Fundamentals,
2). Technicals and
3). Sentiment.

You guessed it, crowd behaviour falls under “Sentiment”. Well, sentiment can knock the living daylights out of the best of “Fundamentals”. And, sentiment makes “Technicals”. Thus, for me, the most important factor while understanding market moves is sentiment.

A stock can exhibit the choiciest of fundamentals. Yet, if a crowd goes delusional, it can drive down the price of even such a stock for longer than we can remain solvent. Let’s write this across our foreheads: Delusional Crowds can Maraude Fundamentals.

Since we are now writing on our foreheads, let’s write another thing: Delusional Crowds can cause Over-Bought or Over-Sold conditions to Exist for longer than we can remain Solvent. There go the technicals.

A crowd thinks in a collective. All that’s required is a virus to infect the collective. A virus doesn’t have to be something physical. It can even be an idea. The space that we exist in is laden with disease-causing energies. Once a crowd latches on to a virus-like idea, its behaviour goes delusional.

Here are some examples of such behaviour. At the peak of the dot-com boom, in March 2000, a crowd of rich farmers from the surrounding villages walks into a friend’s office. They are carrying bags of cash. They tell my friend that they want to buy something called “shares”. They ask where these can be purchased, and if they are heavy (!). Since they are carrying their life-savings with them in cash, and plan to spend everything on this purchase of “shares”, they want to also effetively organize the transport of the “shares” to their homes in the villages. Thus they want to know if “shares” are heavy to transport!

In the aftermath of the dot-com bust, Pentasoft is down more than 90% from its peak. I think this legend is from 2001. A crowd of rich businessmen collects the equivalent of 20 million USD and buys the down-trodden shares with all of the money. The scrip goes down to zilch and today, one’s not even able to find a quote for it.

In the 17th century, people actually spend more than the price of a house for the purchase of one TULIP, for God’s sake.

You get the drift.

The current crowd is building around Gold. It’s behaviour as of now is still rational. In due course, it has high chances of going irrational.

Whenever that happens, we’ll definitely be able to see the signs, because both our eyes are OPEN.

And what was Mr. Fibonacci thinking?

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0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, 233, 377… , … , …

What’s this?

A random set of numbers?

Nope.

It’s the Fibonacci series.

How is it derived?

Start with 0 and 1, and just keep adding a number to the one on its right to get the next number, and so on and so forth.

What’s so peculiar about this series?

As we keep moving from left to right, the result of dividing any number by the one on it’s immediate right starts converging towards 0.62.

Also, as we keep moving from left to right, the result of dividing any number by the second number on its right starts converging towards 0.38.

The series starts with a 0.

Another number to note is 0.5.

So, in a nutshell, these are the important figures to note, which this series generates: 0, 0.38, 0.5, 0.62. There are more, but these are the most important ones.

I’ve always wondered why the 0.5 is important. Actually, “half-way” is big with mankind.

What’s the significance of this series?

In any activity involving a large number of units, these Fibonacci ratios are said to be observed.

It is said that crowds behave as per these ratios.

It is said, that for example when many leaves fall from a tree over a long period of time, a Fibonacci pattern can be determined in their falling.

It is said that these ratios are ingrained in nature.

True or false?

Don’t know.

What I do know is that the trading fraternity has taken these numbers to heart, and looks for Fibonacci levels in anything and everything. Most commonly, entry into a sizzling stock is planned after the stock has corrected past a Fibonacci level and has once again started to rise.

In simpler terms, aggressive traders who buy on dips will look for a 38% correction of pivot to peak before entering.

Less aggressive traders will wait for a 50% correction and then enter upon the rise of the underlying.

Traders who like to value-buy will wait for a 62% correction, which might or might not come.

If the underlying goes on correcting past 62%, it is best left alone, because the correction can well continue beyond 0, the starting point of the prior rise.

A current example where you’ll most definitely see Fibonacci ratios in action is with Gold.

The million dollar question I have been hearing around me today is when to enter Gold now, especially because it is correcting heavily.

The immediate answer for me would be to enter at a Fibonacci level of correction.

Which level?

That depends upon your risk profile.

Face-Off

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Markets are about returns.

Just as many roads lead to Rome, so do multiple paths lead to returns.

The two basic approaches in this game are investing and trading. We are keeping things basic, and are not even going to talk about scalping, arbitrage etc. We are looking at paths taken by most players.

So who has got it better, the investor or the trader?

Markets have this characteristic of collapsing. Unless the investor has bought with a decent margin of safety, he or she can be sitting on a huge loss. This can lead to irritability, sleepless nights, ill-health and family problems. An investor needs to slay these demons before-hand. Allowed to grow, these demons can wreck havoc.

The nimble trader on the other hand treads lightly. Technicals alert him or her well before a collapse, and when the collapse comes, the trader is ideally already fully in cash. Such a trader has no professional reason for a sleepless night.

However, when the bulls roar, the investor’s entire portfolio adds to the roar, and very soon the investor is sitting on huge gains. The trader on the other hands builds up positions slowly, and might miss a large portion of the up-move during the staggered entry process. To be fair, the investor’s exposure (risk) has been large in comparison to the trader, and thus the reward in good times will be proportionately large too. Given a choice, I’d personally take the comfortable nights throughout the year.

Then there’s active and passive playing. Investing is a passive play. One doesn’t need to man one’s portfolio on a daily basis, and can focus on other things instead. Trading, on the other hand, is very much an active play, and needs to be attended to on a daily basis.

So, unless the investor likes action, this is a favourable scenario. Unfortunately, the majority of long-term investors mess up their long-term portfolios owing to the need for action.

Trading can lead to action overload. A bad day’s result can cause mood swings. The trader needs to be in control of emotional machinery and ready to withstand a pre-determined level of loss. Unfortunately, most traders fail badly in the emotional and stop-loss department. On the whole, I feel this particular round is won the by the investor. So, it’s 1 round each.

The last round in today’s discussion is about life-style. The bored investor can either use the spare time for constructive activities, which is a great scenario, or for useless ones, like surfing adult sites. The point I’m trying to make is that a bored investor is a prime candidate for sowing wild oats.

The sensible trader uses non-market hours to finish research for the next day and then to give the mind and body relaxation and rest. However, all the action makes most traders less sensible and more flambuoyant, and equally likely candidates for sowing wild-oats during non-market hours. I think this round is a tie.

So who’s got it better, the trader or the investor?

This is actually a trick question.

What’s the proper answer?

The answer is that YOU have got it better if you fit into the profile of a sensible trader or a balanced investor, and that YOU have got it bad if you fit into the profile of a reckless / flambuoyant trader or a bored and thus trigger-happy investor.

Both investing and trading are about YOU.

You need to see how good or bad YOU have it, and forget about the rest.

Street’s got the D-word

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There seems to be an X-word in every avenue of life.

The Street has its own – the D-word.

It spells D-e-r-i-v-a-t-i-v-e-s.

Whatever reasons there are for a crisis to develop become secondary at the peak of the crisis, because derivatives take over. The crisis is driven to the nth level because of massive institutional leveraging in derivatives in the direction the crisis is unfolding. Recipe for disaster.

The human instinct is to maximize profit, irrespective of any consequences. When masses start shorting the stock of a company that’s already in trouble, its stock price can well go down to zero (and lead to bankruptcy), even if the company’s mistakes are not deserving of such a price / destiny.

Similarly, when masses start going long the futures of a company’s stock, the resulting stock price overshoots fair-value in a major way. Then come along some fools and buy the scrip at an extreme over-valuation. They are the ones that get hammered.

That’s the way this game has unfolded, time and again.

Does it need to be this way for you?

No.

Firstly, as a long-term investor, don’t buy into over-valuation. Make this a thumb rule. Control your animal instinct that wants a piece of the action. Leave the action to the traders. You need to buy into under-valuation. Period.

Unfortunately, most long-term investors (myself included) miss action. Then they fool around with their long-term holdings to get some, and in the process mess up their big game.

The animal instinct in the long-term investor can be channelized and thus harnessed. One way to get action is to play the D-game. Of course with rules. The benefit can be huge. Action focuses elsewhere and doesn’t mess up your big game.

So, play the D-game if you wish, but play it small.

Secondly, be aware that you’re only doing this to take care of the action-instinct. Any profits are a bonus.

Thirdly, keep the D-game cordoned off from long-term investment strategies. No mixing, even on a sub-conscious level.

Then, take stop-losses. DO NOT ignore them.

Also, when anything is disturbing you, DO NOT play the D-game. It DOES NOT matter if you are out of the D-game for months. Remember, this is your small game. What matters is your big game.

Categorically DO NOT listen to tips.

If you are down a pre-defined level within a month, press STOP for the rest of the month.

Make your own rules for yourself. To give you some kind of a guide-line, I’ve listed some of mine above.

A D-game played with proper rules can even yield bombastic profits. 95% lose the D-game. 5% win. Derivatives are a zero-sum play-out. 5% of all players cash in on the losings of the other 95%.

So, play in a manner that you belong to the winning 5%.

Financial Academia and the Street – A Comprehensive Disconnect

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1994 AD.

My friends in the Physics Department of the University of Konstanz, Germany, were busy trying to increase the number of holes on a silicon strip.

This was nanotech research in its advanced stage.

Nanotech saw successful implementation in the real world, though the explosion is yet to come. Nevertheless, the key words here are successful implementation.

Successful implementation on the street is only possible when a research model is practical.

Financial academia time and again delivers impractical models and is then surprised when they meet with failure on the street.

Let’s take the case of the Long Term Capital Management hedge fund. Nobel laureates ran it. They did not incorporate the possibility of a sovereign debt default in their model. So sure were they of themselves, that they went on to buy billions of dollars worth of derivatives, leveraging themselves to the hilt. Their total leverage in the end stood at 250:1. The sovereign debt default by the Russian government in 1998 triggered the LTCM fund to go belly up, and with it disappeared the life-savings of thousands of trusting investors. The ripple effects of this disaster almost knocked the world’s financial system off its platform. Talk about disconnect.

Currently, we are seeing the effects of another disconnect in action.

The Euro was conceived on the basis of hundreds of PhD theses and tons of post-doctoral research. What the researchers couldn’t possibly incorporate in their models were some basic human and emotional facts.

For starters, let’s try the Greeks. They like to retire early and work lesser than their Eurozone colleagues. Their bankers are gullible and not too street-smart, and have made some really bad bets.

Italians like to take short-cuts. They like to over-price and under-cut.

Germans like to go the whole hog. They are punctual and more environment-conscious. They do not like subsidizing those who don’t work for it.

French farmers want to sell their milk for its proper price. They and the majority of their nation dislikes subsidizing others who might not deserve subsidy.

One could go on. The list is endless.

How does one incorporate such realistic “human” stuff in mathematical models?

One can’t.

Mathematics doesn’t possess the language to reflect such human and emotional factors.

So what do these theses contain, upon which the Euro has been built. Other, disconnected stuff, no realistic, street-related emotional / human factors of value.

What we’re seeing is real disconnect in action. Financial academia is way out of its depth on the European street or for that matter on any other street. It should lay off from the street so that further disasters are prevented.

Let’s hope and pray that the Euro-chapter does not meet with a harmful end.

Is the Middle-person History?

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Motivations…

are the propellors of life.

One can’t be an expert at everything. So one hires others to do stuff for one.

Of course one has to make it worth the other person’s while.

And the person you’ve hired needs to do the best possible job for you.

This used to be the pattern in the business of money. After the turn of the century, things started going haywire.

The middle-person in the business of money used to be a long-term wealth enhancer. His or her primary motivation was the creation and appreciation of your wealth.

Now, his or her focus is on the commissions generated by maximal short-term churning of your portfolio. This is dangerous for you.

I don’t know any wealth-manager who will share your loss with you. If earlier the loss would be felt only emotionally / morally by your wealth manager, even that is gone. So now, there’s nothing that’s stopping investment advice from becoming a function of the commission offered to the wealth manager. If a product offers more commission, that’s the product being recommended.

Where does that leave you?

Frankly, I feel that one is better off without an investment advisor. The web offers enough information on any and every investment product in existence. All you need to do is invest your time.

No time, you say? Who’s money is it? Yours, right? Then you need to jolly well take out the time. Only you can do justice to the proper, balanced and judicious investment of your funds.

So come on, snap out of any laziness. One hour a day to carve out a trajectory for your hard-earned money is all that’s required. If for nothing else, do it for your kids.