The Fine Art of Doing Nothing

It has been a long time since I wrote about Traderman and his Diary. To those who are new to this note I have to explain that Traderman is a fictional trader who keeps a diary that I, somehow inexplicably, have complete access to.

Traderman has developed over a period of time from trading for fun to trading for a living. As a result, his diary often has jottings which can be relevant to traders.  So without much ado, here is what he had to write on Monday evening.

Dear Diary: The rally of Friday caught everybody off guard. Oh, the pleasure of seeing the short sellers getting cut. Every time they tried to re-enter the short position and at every new high they had to cut it. There is great pleasure, dear diary, in being right and seeing others getting killed.

But today was another story. A dull day if there ever was one. It was one of the more boring days in recent times. Nothing happened through the day. It required a great amount of will power (which I have in spades!!!) to be able to sit through yesterday without putting on a trade.

Talking about willpower, people fail to see the incredible expenditure of effort and the iron will required--- to appear to do nothing. To the lay observer it might look like I am wasting my time but only I know the effort required to make it appear so!!!. 

I know, dear diary, you are thinking that I am making a virtue out of a weakness or a fault. So I will try and think of one example where doing nothing is a virtue. Ok got it. Have all of us not seen how easy it is to book profits in a winning trade? It takes great effort to do nothing and let the profits run. 

Ok I got another one. Do you know how easy it is to try and tinker with your trading rules? Especially after you have a string of losing trades? How easy it is to try and see how those recent losses could have been avoided? How easy it is to think of a filter that could have avoided those trades? Do we, dear diary, not know the disastrous consequences of curve fitting our system to only recent trades?  A lesser person or trader would be tempted to attempt those changes. Only a seasoned trader with iron will can DO NOTHING!

Dear Diary, Now that I am getting into the groove, let me say that “Doing Nothing” is also good in other spheres of life. When your customer shouts at you it is best to--- do nothing. Do not justify your position... just say sorry and do nothing. When your boss shouts? What are you going to do dear diary? Yes you got it... do nothing. When your girlfriend gets angry.... Yes dear diary... You are right... Do nothing. Doing nothing is an art form Dear Diary. It saves you from a lot of trouble. It saves you from unnecessary action because often enough if you keep doing nothing for long enough then whatever it is that is troubling you or people will go away on its own. Problems get resolved, solutions come and all good things happen to the person who has learnt the difficult art of ....You are right... Doing Nothing.

Traderman must have written this in the evening yesterday after the market closed. He clearly was happy with his trading in the last few days. But late in the night he made another jotting in his Diary.

Dear Diary: Another live example of the benefits of Doing Nothing! I had not called Sonia in days. Just now I received a call from her asking me whether I was fine. Man she misses me! I am so happy! Do Nothing is a better mantra than even Hakuna Matata! Even better than “Dont worry Be Happy”

This is the reason why I choose to Do Nothing and just Ctrl C Ctrl V from Traderman Diaries. It saves a lot of effort and I do get to send off a decent piece to my friends. Before I sign off, let me say that I am long and will continue to be long until 5170 is broken.

Expect the Unexpected

It is the thirteenth day of the great eighteen day War of Mahabharata. In an attempt to capture the eldest Pandava Yudhistira, the Kaurava commander Dronacharya has laid out his best formation, the Chakravyuha, the unbreacheable spiral within spiral kind of formation. In the meanwhile, Arjuna, who alone knows how to breach the formation, has been cleverly drawn away from the main battle by a select brand of mercenary warriors. The well laid out plan is thus in place. Nobody among the Pandavas knows how to break the Chakravyuha. The one person who knew it i.e. Arjuna is away from the battle. Yudhistira is therefore ripe for the picking. The Great War is set to end on the thirteenth day by his capture or death.

Unknown to the Kauravas, Abhimanyu, the son of Arjuna, has knowledge of how to break into the Chakravyuha. Arjuna had described this to his mother while he was still in her womb. But by a quirk of fate, his mother Subhadra had fallen asleep(she hardly would have been interested in this detailed description of a War formation!) before Arjuna could describe how to get out of the formation. Kauravas had not planned for this unknown unknown.

Abhimanyu, though a great hero, is worried that once he gets in, he will not be able to get out of the mess. His uncles Yudhistira, Bhima and others assure him that they will be close behind him. Once he breaches through the formation with his knowledge, they will drive in through the breach and protect him all the way. The idea is that once they are in, they can wreak havoc.

So begins the fateful day of the War. Abhimanyu makes the breach with a well laid out plan of defense. Unfortunately, before others can drive in through the breach, Jayadrata a Kaurava warrior effectively seals the breach and Abhimanyu is left to fight the battle all alone.

What follows is something that can only be described as epic. He destroys warriors after warriors as he plans his way out of the formation. He realises quickly that is only hope of survival is to drive all the way through and breach the formation on the other side. With this in mind, he drives deep down right to the centre. He fights epic battles and kills thousands. He even manages to fight one with Duryodhana, the Kaurava prince, who he bloodies but spares because his uncle Bhima has sworn to kill him. He kills his son and several other warriors leading to increasing consternation among the Kaurava ranks. There is now a very real chance that Abhimanyu will succeed in single handedly destroying this well thought out plan.

Finally as the day begins to end, Dronacharya realises that this great warrior cannot be killed by fair means. So begins the passage of time in the war which ends all rules of fair play with which the war was fought until then. Against all prevailing rules, the Kauravas gang together to fight Abhimanyu and kill his charioteer and his horses. They destroy his chariot and attack him simultaneously. His bow is cut from behind. Abhimanyu continues to fight with his sword. His sword is cut so he continues to fight with the broken chariot's wheel. Like a pack of hyenas, they surround the lion. Finally the incessant sniping and cutting is too much for the lion. A tired and weak Abhimanyu succumbs and the Kauravas manage to kill him.

A day which began as a day when the Kauravas would emerge victorious, ended as a day of unimaginable losses for them. One single warrior had slayed hundreds and thousands of their men. Instead of capturing Yudhistira they had only managed to kill one individual and that too through unfair means. The loss of morale in that one day was immense. They had planned for everything. Arjuna had been drawn away. The best formation had been laid. All that was left to do was to go in and pick up Yudhistira. Unfortunately their best plans were put to rest because of an Unknown unknown.

On the other hand, Abhimanyu, the great warrior was aware of his shortcomings. The fact that he did not know how to return back was a known unknown. Despite this, the plans of the Pandavas to mitigate the risk of the known unknown failed miserably.

So, on the thirteenth day of the Great War, both sides suffered because of the Unknowns. Kauravas due to the unknown unknown and Pandavas due to the known unknown. Similarly the investor/trader faces needs to be aware and wary of both these situations. The point is that while Unknown unknowns cannot be mitigated at all, the known unknowns can also lead to ruin if the plans to mitigate them do not succeed. For eg, if a trader tries to reduce risk and exposure to the market by shorting a set of stocks against his long position on another set of stocks, he could still be destroyed if the stocks he shorted went up and the long stocks went down. His risk mitigation efforts could only end up increasing risk.

The only way to reduce risk therefore is to not take it on in the first place. What is the point of going for so called low risk long-short portfolio strategies and then leveraging to ensure returns are decent? What is the point of doing a LTCM? If one indeed wants to take risk, then the best bet is to make it explicit. That is if one has both long and short positions in the portfolio then instead of netting out the positions to calculate exposure it is best to gross it out so that one is aware of ones real exposure to the market and to risk. It is one thing to fool the investor in a fund. It is disastrous to fool oneself!

If you notice, in my trading, I am either long or short. Never both long and short a set of stocks. I am currently long and will cut my long positions and go short below 5170.

Zombie Dance

The Zombie War continues. I had written a note earlier on this subject in my note titled  "Nightmare on Wall Street". In that note I had said that our Zombie market story is in an infinite loop. It starts with the market grinding down down slowly as the market participants start worrying about some European nations ability to pay off its creditors. Notice it does not fall sharply because already there are rumors that some bailout will be stitched in place. As the weeks draw out, the market continues to fall, but slowly. Then a meeting is scheduled. By the end of that meeting a bailout is announced or it is announced that the Govts will do "whatever it takes" to calm the markets. The markets react joyfully, killing all the shorts. After that has happened, suddenly, almost on cue, the market again starts worrying that the bailout will not be sufficient to prevent a default in the future.... leading us back to the situation where the market starts grinding down slowly as the market participants start worrying about some European nation's ability to pay off its creditors....and so on in an agonising slow Zombie dance.

I truly hope for my own sake that this "whatever it takes" will, just this once, lead to some truly radical measures. If the Europe problem can be somehow consigned to the backburner, then we can get back to worrying about country specific issues like the slowdown in China, the lack of governance in India, the fiscal indiscipline of the US, the Iran problem etc. There is no dearth of problems.

But we have learned to handle these problems because we lived through them in the past and we can expect them to be papered over in the same manner it has been done in the past. What is key for the market is that this Zombie menace in Europe is resolved or at least contained at the earliest so that we can get on with our lives and start making some money in the market!

As of now, the Nifty has rallied substantially and has moved above my buy level of 5203 in a huge gap up. I bought when the first 5 min high was crossed at 5250. Fingers crossed now and hoping that the markets will not react down as it usually does after forcing me into a long position!

The selection conundrum

I am sure you have heard this often enough. The right path is the tough path to take. The road is strewn with difficulties. The wrong path is the easier path to take. However, though the wrong path seems easier, as you travel down that road, it can lead to ruin. The right path on the other hand, though the more difficult one, leads to your personal growth and happiness.

Isn't it nice to read? A nice easy way to determine what is the right decision to make? The unsaid assumption in the earlier statements is that if you keep choosing the more difficult options, you would be choosing correctly. The problem in this assumption is this. While all right paths might be difficult, all difficult paths are not necessarily the right paths. So while exercising regularly is both difficult and right, running away from home to become an actor is difficult but not necessarily right! Therefore using difficulty as a criteria for choosing between paths is therefore not necessarily the optimum solution.

The parallel in the world of investing can be seen very often. Specially in the world of advisors, sellers of infallible methods and ..... daily note writers! For eg look at the attached chart of S&P. It is made to look like a simple trendline break would have ensured huge profits over the last 12 years. Similarly, one can show that 80% of the trend reversals are accompanied by a positive or negative RSI divergence. Thus either trendlines or RSI divergences can be made to look like the Holy Grail of trading/investing.

The reason however, that things are not as simple as they seem is because while 80% of the reversals are accompanied by divergence in RSI, 80% of the divergences do not necessarily lead to reversals. Divergences occur more often than just at reversals. Mathematically it can be put as P(Div/Reversal) (probability of divergence given that there is a reversal) is 0.8 but P(Reversal/Div) is not 0.8.... it can be much lesser. And, really we are not interested in P(div/reversal), we are interested in P(Reversal/div).

This same inaccuracy can be seen in most methodologies that are touted including so called Candlestick Reversal Patterns like Hammer or Hanging Man. Lest you think that I am only going after technical analysis, the same problem is seen in fundamental analysis. It can be shown that before a large move a lot of stocks were available at low Price to Historical Earnings. Therefore low P/E can be touted as a method to buy stocks. The problem with that is the same as the one with technical indicators and patterns. While, given that there is a large move one can see that stocks had low P/Es, not necessarily all low P/E stocks made large moves. Therefore using P/E as a criteria for picking stocks need not be useful.

Saying all this has resulted in one understanding. In the world of trading and investment at least there are lots of easy paths out there like looking for divergences or trendline breaks or low P/E stocks or any such simple one size fits all kind of solutions. The more difficult path and perhaps the right one would involve lots more work and analysis to determine stock selection and direction. So in this world at least, perhaps, the more difficult path is the right one!

Having used up a lot of your time, I have to state that I remain out of the market. I will buy nifty above 5203 and will sell short below 5090.

One Fallacy Trumps Another?

You know I love this movie Sholay. If you are not yet aware of this then you really have been lazy and not been reading my dailies! Well, the point is that there are lots of things that I love about this movie. The slow unfolding of the story. The intermittent high voltage action which can hold its own even after 37 years of improvements in technology. The vast landscape. The classic cops vs bandits, the revenge drama and guy camaraderie mixed together into a heady cocktail. Nevertheless, in all this excellence, one thing never fails to baffle me. Why does Dharmendra never call Heads?

I mean he thinks that the coin is fair. The coin always comes up Heads in his experience. Why does he never call Head in at least one of the several times the coin is tossed in the film? Why does he keep agreeing to "Tail" unless he believes that after so many Heads this time it will definitely be "Tails"?

This same question was asked in a study conducted even among so called highly qualified finance professionals. They were asked to bet in multiples of one dollar on the toss of a fair coin. If they were right they would get the amount they bet. The way the game is structured, if it is played often enough then the player would end with the same amount he started out with. What the researchers were interested in seeing was the players reaction after a run of Heads or Tails was encountered.

The result was interesting. After say four Heads, players were willing to bet higher amounts on Tails and vice versa after a run of Tails. They were succumbing to the classic gamblers fallacy of assuming that what holds true for large numbers affects the individual try. That is to say that over a period of large number of attempts, a fair coin should throw up roughly 50% Heads. But that does not have to effect the result of the individual throw of the coin. After 4 heads the 5th throw can also land Heads with a 50% probability. The chances of a Tail does not increase.

This classic mistake is also seen in investing. While growth, returns or even prices of the entire class of stocks will show a mean reverting trend i.e periods of above average returns as a whole could see periods of below average returns as a whole, this principle cannot be used to create a mean reverting strategy for the individual stock. Just because a stock showed a large growth one month does not necessarily make it ripe for slower growth the next month. This strategy can only be used over the entire class in general i.e. for maybe a portfolio and not for a stock in particular. So using Mean Reversion for an individual stock or index could be a losing proposition.

I on the other hand, do not succumb to this gamblers fallacy. Never. I, if anything, succumb to the (probable) fallacy of believing in Trends. If I see a run of 3 Heads, then I might start assuming that there is a Trend somewhere and start betting more on Heads until a reverse trend of Tails is seen. If the coin is truly fair ( or in the case of my trading, if the market is truly random) then I should lose money using this strategy.

The fact that I have not might just mean one thing...No.. not that the market is not random and that it trends. I am under no illusions that my trading proves Trend following works. The fact that my trading has been profitable might just mean that I am lucky to have more people succumbing to the gamblers fallacy and betting on mean reversion than on Trends and until that remains the case, I might continue to make money believing in Trends.

I continue to be out of the market. I will go long above 5203 and sell short below 5030.

Action Men

The sport pages in India are full of the England Italy Euro football quarter finals which England in their inimitable style, lost on penalties. They are also full of "Pirlo's" magical penalty kick which so completely flummoxed the English goal keeper that he was left sprawling on his right hand side when the ball floated in at the center, exactly at the spot where he had stood moments before. This apparently turned the penalties Italy's way which the they were losing until then.

In any case, magical or not, trust statistics to turn something magical to the mundane. In his interesting book "Value Investing" James Montier highlights a study where experts studied the penalty shots taken and the goalkeepers reaction over an extended period of time. They found that strikers of penalties shoot to their left, right or at the center roughly equally that is 33% of the times. That means there is really no particular direction that they favor. The goalkeepers however tended to dive to their left or right roughly 94% of the time, hardly ever standing their ground. It was also found that even the times that they were right i.e. they dived to the correct side(only 33% chance of being correct) they could save only 33% of the shots. So roughly they would save 1/9 of the penalties if they dived. However when they stood the ground and the shot was hit at the center (remember 33% of the shots) they saved 66% of the time. That means they would save 2/9 of the penalties if they just stood the ground- an increase of 100% over the saves when they dived.

Therefore from the goalkeepers perspective it made complete sense to stand the ground. Surprisingly even from the strikers perspective (if he knew that goalkeepers tended to dive on either side 94% of the time) it made eminent sense to shoot at the center. When you look at it this way, you realise that Pirlo's shot was nothing magical.

The key question however, is why did the goalkeepers dive despite knowing that their chance of a save REDUCED by 50% just by diving? The answer apparently was in the human bias towards action. It was better to have done something and failed than to be seen to be doing nothing (standing their ground at the center) and failing. The coaches and bosses are likely to pardon somebody who is seen to be "trying" than somebody who did not even make an effort (standing the ground) even if not making the effort was actually the correct thing to do!

In all instances where a person is likely to be judged by the outcome than the process, there will be this incredible attraction for action over inaction even if inaction is the right thing to do. For eg. it is better for a Fund Manager to have invested in the Facebook IPO and lost 30% than to not invest and be questioned for inaction if by some crowd induced madness Facebook surged after the IPO.

In any case, I again suffered a loss yesterday in the madness induced by RBI expectations. I went long at 5192 which I squared off late in the day. Now I will sell short below 5030 or go long above 5202.

Precis

A police office catches a dreaded dacoit. The dacoit escapes from jail and exacts terrible vengeance. He kills almost his entire family but lets him live after cutting his hands. The police officer hires two petty thieves to catch the dacoit so that he can have his revenge. The thieves catch the dacoit and in the process one of them is killed.

Another short story: Two thieves are hired by an ex police officer to catch a dacoit. As they strive to do that, they find a new purpose and meaning in their otherwise nomadic life. They manage to catch the dacoit but at a terrible cost as one of them dies in the final shootout.

Any Indian would have realised that both the stories are simplistic versions of the same complex story of the movie Sholay. In their simplified form both stories lose some of the nuances of the entire movie. They necessarily have to focus on only one aspect of the larger story. Also the side stories and the moments which drove the original story forward are lost in this simplification.

The equity market is a far more complex story than even Sholay. So complex that it cannot be written in any one single form. When one sits down to write the market story, one will necessarily have to simplify and in the process lose some of its nuances and some important parts of the story. But this simplification is necessary in order to understand and trade/invest in it.

So one story can go like this. "Markets consist of companies and various stages in their life cycle. The best investment strategies involve looking for companies which have shown a 5yr track record of high return on capital, a steady positive earning number, cash flows which are a significantly positive and a P/E which is in the lower end of its range" The moment one writes a story like this, one can convert that story into a quantifiable screen and reduce the number of investible companies from the thousands listed to a hand few.

Or one could write another story and say " Markets consist of companies which are listed and participants who invest and trade them. The human nature being what it is, it will make people want to buy companies that others are buying into and sell what others are selling into. This results in trends and therefore a stock that goes up continues to go up and one that goes down continues to go down" If your simplified story of the market reads like this then you can create a trading system based on trend following.

I guess each participant comes to his own simplified version of the market story over a period of time. The faster the better. In the process he could lose out on other versions of the same story. But sticking to his personal version and method gives him the highest chance of success in his endeavor to make money in the market.

The problem starts when intelligence comes in the way of simplification and the human mind rebels. When it starts saying that the market is a complex structure and therefore it feels compelled to make its market story as complex as possible. It is then that a consistent investment or trading approach becomes impossible. The trader jumps from one version of the story to another and makes his own life completely miserable in the process.

Needless to say, I have never had to deal with the rebellion of the mind. I have gone by the simplest version of the market story that is possible which states the the markets trend enough to make money over a period of time. Now I am living on the hope that simple stories do work.

I went long yesterday which was a mistake in my calculations. I have shorted again at 5143 and will cut my short positions and go long only above 5192