One Raving Lunatic

  • Posted by
  • on November 24th, 2010

This week has shown us once again how the crazed actions of one person can impact our investments.  Reed Hastings at Netflix again risked a profitable business model…not only did he plow ahead with unlimited TV and movie streaming, but also raised prices on his current happy customers.  One trick pony, huh?  Kim Jong-Il and his freak show decided to shell his neighbor and rival…a different act of madness but one that caused ripples throughout global markets.  How can we plan for such lunacy?

As traders, all we can do is tap our imagination when constructing our plans.  Expect(and accept) outrageous outcomes.  Size our positions not on some miniscule distance to yesterday’s high or low, but on the reality of the real risk that may exist.  Consider long options instead of common stock for shorts and even longs.  Build portfolios for a 100 year flood, since they seem to come along every 5 years or so.  Examples I use include the following:

1) Expect outsized outcomes- each night I plan for 5 AM scenarios…Way Up, Up, Flat, Down, Way Down.  If you don’t think any of these can occur on a given day, then you haven’t been around very long.  No matter the chart pattern or news we see, we have no idea which scenario will happen tomorrow, so plan for all of them.

2) Accept the market’s news reaction- much of the time the market does what appears logical in absorbing news, but we’d better be open to the message when it appears irrational.  After the opening range sets up, I re-plan my day for the way in which the market absorbed the news of the day.

3) Size using longer timeframes- it makes perfect sense to use the point of validity as a stop price, but using it to size a position exposes us to extra risk.  This doesn’t matter for daytraders planning to exit immediately on an intraday stop, but once we hold overnight we have the risk profile of an investor whether we plan it or not.

4) Consider long options- I can’t say how well I’d sleep if my portfolios were full of common longs and shorts, but I know how well I sleep with the risk profile of an option.  No matter the event, I can only lose my premium…now that is a hard stop.

Look at J Crew this week.  The only reason I didn’t short it in August is because its short interest exceeded my threshold of 10% of the float.  That’s a hard rule I’ve put in place only in the last year to protect myself against joining a crowded trade.  What if I didn’t have this rule, and/or the private equity folks did their math a little faster?  Only the use of puts instead of short stock would have been my savior.

In our quiet planning, remember that we trade these pieces of paper based on our perception of value, or the presence of buying/selling pressure, or some other process we are proud to call our own.  Our selection process may improve, but it will always have blind spots…as Charles Kirk said on AbnormalReturns TV “if you think your system doesn’t have a weakness, you just haven’t found it yet.”  To plan using only the current and obvious backdrop puts us at risk of even the black ducks like NFLX, JCG, and Korean-inspired selloffs.  Reading the crowd is one thing, but it only takes one committed person with a whiteboard to crush our brilliant interpretation.  To sustain success in market operations, we need to be just as committed to radical thinking as are the leading actors.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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