Trading Rule – “It is not necessary to be always right in the market”

THE NEXT TIME YOUR FELLOW TRADER BOASTS HOW OFTEN HE IS RIGHT IN THE MARKET, ASK HIM WHAT HE DID WITH HIS VIEW. BEING RIGHT TOO OFTEN HARDLY MATTERS. WHAT YOU DO WHEN YOU ARE RIGHT IS MORE IMPORTANT THAN BEING RIGHT. THE MARKET IS A COMPLEX GAME AND MOST PEOPLE ARE LIKELY TO BE WRONG AT TIMES. THAT IS NOT MATERIAL. WHAT MATTERS IS WHAT YOU DID WHEN YOU WERE RIGHT. IF YOU COULD PREDICT THE MARKET TO PERFECTION BUT DID NOT HAVE THE GUMPTION TO TAKE A POSITION IN THE MARKET, IT IS ABSOLUTELY POINTLESS. FOCUS ON RESULTS!

BEING RIGHT VERSUS BEING WRONG IN THE MARKET?

Take the case of two traders in the market. Trader-A was of the view that markets could crack and therefore he bought put options. When markets moved against him, he booked small losses on the puts and closed his position. Trader-B, on the other hand, perfectly predicted a 10% rise in the market, which was achieved over the next 3 days. Had he acted on this view, he would have surely made a killing. Sadly, he did not take any position and missed acting on the rally. The point is that there is really no difference between the two traders. One got his call wrong and lost a bit of money, while the other got his call right and yet did not money because he could not put his money where his mouth was. Being right hardly matters if you cannot leverage on it.

DOES IT MATTER HOW OFTEN YOU ARE RIGHT?

Frankly, it does not matter. What really matters is what you do when you are right. What really matters is how much conviction you show when you are absolutely right. Take the case of Warren Buffett. Over an investment career spanning 55 years, Warren Buffett made most of his money by focusing on a handful of stocks. A few names like Coca-Cola, GEICO, and American Express have generated most of the returns for Warren Buffett. In between, he has had many wrong calls including the notorious position that he took in IBM. However, that is immaterial in the larger scheme of things. What matters is that when he got his call right, he made the best of the situation. That is what has, perhaps, distinguished Buffett from the other creed of investors. Paul Tudor Jones may have made many wrong calls in his career but sticking his neck and buying on Black Monday 1987 was the moment when he literally staked everything on his view. Same is the case with Paul Johnson when he shorted sub-prime mortgages in 2006 and made $15 billion in the trade.

“What you do when you are right is more important and meaningful than how often you are right or how often you are wrong” – Jesse Livermore

6 THINGS TO DO WHEN YOU BELIEVE THAT YOU ARE RIGHT…

  1. Double your bets and if required leverage. When John Paulson had a conviction on his subprime short position, he literally staked the entire firm. The trade may have tested his patience but eventually, he proved to be right. When you have that absolute conviction, double your bets on the position.
  2. Conviction does not come easily. Rigorously back-test your assumptions and the market data from time to time. You need to be absolutely convinced each day that you are on the right track. That is the kind of conviction that a trader like Stanley Druckenmiller brought to the table when he bet against the UK Pound in 1992. That is the kind of conviction that pays off when you are right…
  3. There is a counter-side to being right and that is being wrong. So if you need to show absolute conviction when you are right, you must also display the ability to cut your positions rapidly when you are wrong. That will ensure that your money is not locked up in losing positions where you have low conviction. That is important when you need to constantly fund your conviction trades.
  4. The big risk when you are right is exiting too early. There are two common mistakes that you make when you are right. Firstly, you do not have the gumption to take a position and secondly, you exit your position too early. If required you hedge when your position is in profit or even you can keep shifting your trailing losses upward. Some risk management is called for if it eventually helps you to make the best when you are right.
  5. Have a Plan-B in place. That is very important even when you believe that you are correct. That is what happened in case of Long Term Capital Management (LTCM). The Nobel Laureates who ran the fund believed in mean reversion. What they did not bet was that markets could be irrational much longer than they could remain solvent. Always keep a Plan-B in place.
  6. Maintain a mental ratio of wrong to right commitments. Decide how much you are willing to lose wrong bets versus how much you will wait for right bets. Similarly, decide how much capital you will stake in wrong bets versus how much capital you will stake in right bets. The relative ratio should be comfortable enough to make money even when you only get half the calls correct.

NEVER STAY TOO LONG IN A WRONG TRADE…

Let us come back to our basic premise that we all trade with finite capital. That means we need to get out of wrong positions as soon as possible. Wrong positions may turn after you exit but that is immaterial. Your conviction is more important. As well put your bets on the position where you have conviction. After all, how much you extract out of your right calls is what will eventually make you a successful investor.

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