@Quora: In trading, how can I stop getting emotional?

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Answer by Laurent Bernut: @Quora: In trading, how can I stop getting emotional?

Excellent answer from @Nate Anderson. Viktor Frankl (Man’s search for a meaning) survived both Auschwitz and Dachau. One of his most profound lessons was that: “between stimulus and response, there is a space called freedom”. You cannot control what is happening to You, but You can control your response.

The paradox of systematic traders and psychology

Every systematic trader who writes about building trading system devotes a lengthy chapter on psychology. Meanwhile fundamentalist hardly ever talk about psychology. You would think that mechanical traders would care less about psychology and people who rely on their judgement talk more about it.
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My theory is that systematic traders experienced mentally devastating losses which prompted them to develop systems so as to remove emotions. Along the way, they managed to quantify their systems and realised that after all is said and done: 90% of trading is mental, the other half is good maths.
Bottom line: Your emotional hijack means You do not have system yet

The counter-intuitive trick about system development

Most people who develop systems fail to execute. There are two reasons: they focus on the wrong thing and they don’t have faith in their system.

Wrong focus: the only soldiers who do not have exit strategy are kamikaze

People focus exclusively on entry and consider exits as an after thought. They have it completely backward. Entry is a choice, exit is a necessity. Emotions kick in once a position is in the portfolio, not before.
Real life example: Long IAU strike 11 April 2016 options at 0.20 on entry date. Actually, I had my eye on the 12 strike but a fat fingered Viognier Zibibbo called Abraxas (how can You not surrender to that deadly combination ?) got in the way of trading. I felt bad for a couple of days and then moved on, c’est la vie.
Now, let’s say i would have bought in the chrematocoulrophony (financial jesters) and sold the same option on that day. Current value is 1.20 with 2 months time value left. That is -500%. This thing would have drilled a hole in my portfolio through the center of the earth and pop out somewhere in Antarctica. It would have drilled a hole in my brain. I would feel trapped without a way out.
Bottom line: system development starts with the exit in mind.

Corollary: Peace of mind

Before: no clear exit strategy. I used to read every single news, check prices 2-3-5-10 times a day. I was always torn between running positions a bit longer (greed) and taking money off the table (fear).
After: exit strategy for every contingency: It brought immense peace of mind. There were three booby traps: stop loss, profit target and on the time axis trend reversal. I knew that unless an exit condition was tripped, positions would run their course. I had harnessed volatility. I checked price once a day, the rest of the time, I was one of the heaviest users of  YouTube on earth. This lead to surreal conversations with my boss:
– “What ! Are You watching another Shaolin flick ?”, he laughed
– “Why ? You are not ?”, I replied vaguely outraged by his lack of cultural curiosity “Time for some off-site (code word for plundering the Roppongi Enoteca wine shop) ?”
– “it’s only 4:00 pm”, he said looking for a feeble excuse
– “Yeah, I know late start, let’s get into position for the happy hour”, with high conviction for the day

Systematic execution and pregnancy

Developing a system that works is the hard part. And then executing it day in day out is the hard part. This is where a lot of guys trip in the carpet. They spend considerable time developing a strategy that they run until it stops working. Then, it is back to the drawing board, tweaking endlessly, waterboarding it until it confesses. Two reasons:
  1. Complexity is a form of laziness: I have seen a lot of systematic strategies. The most fragile ones are always the most complex ones. Optimisation is the poor brain solution
  2. Faith: We trade our beliefs. The best example is Markowitz, the father of the half century old modern portfolio theory (MPT). At the end of his career, a journalist asked him the composition of his portfolio. The inventor of the efficient frontier candidly replied: 50% stocks, 50% bonds. I rest my case
Bottom line: systematic trading is like pregnancy. Either You are pregnant, either You are not. Sorry, but You can’t be un-pregnant on ladies night.

Trading is 90% mental, the other half is good math

Mindfulness:

Ray Dalio meditates, twice a day. I rest my case. I meditate every day, sometimes twice during rough markets. Before trading, I seat in silence 2 to 5 minutes until presence.
Check Rande Howell at Trader State of Mind. His work is unique and transformative. He works on the Pearson Marr or Jungian archetypes. I cannot recommend his work highly enough.
I would highly recommend the App called Calm.com. It is reasonably priced and has excellent guided meditation.

Journal your journey:

Journal your journey through the markets. Journal your emotions, when You are making money and when You aren’t. Pay particular attention to your fears when losing money.
I am working on a format that could be useful and meaningful using Google sheets and Evernote. There are some elements of Nathaniel Branden’s stem sentence completion exercise. Mr Branden is famous for his work on self-esteem and deep belief elicitation. There are also elements of Byron Katie’s work. Finally, it is brought together in a quantitative format using Google Sheets.

Trade with fear

Some charlatans recommend to trade without fear. That is not how the brain works, at all. Tell the antelope that a lion is just a confused cat. Fear is a signal. Fear is an evolutionary mechanism that has kept You alive to this day. Ignore it, it grows and soon enough it infiltrates your trading, it cripples your action.
Fear exists in the shadow. Name it, face it, and then physically walk through it. This is why it important to journal your experience.
Fear is vastly underrated. It keeps You sharp. Size your positions as though You expected them to fail.

Visualisation

Athletes train to visualize their performance. There are clinical studies that show that athletes who visualize their performance have more muscle mass than those who don’t. Surprisingly enough, those who simply visualise without physical effort have higher muscle density than those who neither train nor visualise.

Visualisation does not mean seeing oneself on the podium with a gold medal, laughing under the cameras. That is wishful thinking. Visualisation is rehearsing procedures to overcome obstacles, feeling fear arousal and bringing calm response. It is about setting anchors that will trigger neuro-physiological responses.

At elite level, athletes are in similar physical shape. The difference that makes the difference is mental preparation. Best example is Conor Mc Gregor versus Chad Mendes. He won the fight mentally before he won it physically. He was on the ground, pummeled by some severe elbows to the head. Meanwhile, he was laughing: “is that all You got ?”

 

THE POWER OF CHECKLISTS

Airplane pilots have checklists. Firefighters have checklists. Surgeons have checklists (read Atul Gawande’s “Checklist manifesto”). Bottom line: these are highly skilled, highly trained professionals who have responsibility for human lives. They swear by checklists.
Meanwhile, finance people believe it is beneath them. Investing is supposedly an art. Checklists free up some precious bandwidth that can be used for thinking. In this ultra competitive sport called trading, every extra bit of mental bandwidth spared is a competitive advantage over emotional traders.
Great investors are not smarter, they have smarter habits. Break all your tasks in small specific checklists.
Example: my short sell checklist
  1. Check risk per trade and lots: if position small (i-e too volatile), then reject
  2. Check exposures & balances: if trade exceed risk, then reject
  3. Check borrow cost and availability: if expensive, then reject
  4. Set Stop Loss on platform GTC
  5. Sell Shares at Limit validity 1 day
  6. Take break, do something else: cool down and refresh (2-5 mn)
  7. Verify one last time and send
My entire workflow is broken down into small checklists: Buy to Cover, Buy Long, Sell Long, trade reconciliations, trading signals, portfolio management system update, etc. This helps a lot during stressful times.

 Conclusion

When we are on the bus in a new city, we check every stop, every building. We are afraid of missing our stop. Before getting on the bus, our stress hormones are mildly activated. Once in, stress hormones go up. Bottom line, exit matters. Think about them before entry

Success is habit. Unfortunately, so is failure. They have the best habits.

Trading is mental: profits are a side effect of inner alignment between deep seated beliefs all the way to daily routines.

In trading, how can I stop getting emotional?

Quora.com: What-do-the-fund-managers-that-consistently-beat-the-market-do-differently-when-picking-stocks-than-those-who-cant-beat-the-market

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https://www.quora.com/What-do-the-fund-managers-that-consistently-beat-the-market-do-differently-when-picking-stocks-than-those-who-cant-beat-the-market
Great fund managers are not smarter, they have smarter portfolio management habits. Making money is not about trying to be right, it is about accepting to be wrong and move on. That is much easier for married men…

Portfolio Manager serenity prayer

No manager consistently beats the markets. Every style has its peaks and valleys. The difference is how managers weather those periods. Profits look big only to the extent losses are kept small. If You know when your style is out of favour, then fold, take less risk. Making money is about accepting to be wrong and move on.

Risk and trading edges are not stories, they are numbers

Finance is the only industry where science fiction is smack in the middle of the marketing pitch and nobody calls the bluff. Ask any manager what their trading edge is and they will weave some positive science fiction story that would put LafayetteRon Hubbard to shame.
Read Jack Schwager’s and Mike Covel’s books and the common thing between all market wizards is their understanding of risk. Risk management is not part of the business. It is the business.
You just cannot meditate enough on this formula
Stop Loss is the 2nd most important variable
Look at the above formula. Stop has a direct impact on the following variables in your system :
  1. Win%: the tighter the stop loss, the lower the win rate
  2. Loss% (1 -Win%): and vice versa from above
  3. Avg Loss %: stop losses cap your losses. BTW
  4.  You can’t buy if You are fully invested
  5. Position sizing: anchor your stop loss and limit prices for position size
Many books were written about cutting losses short and running winners. Very few were written about riding losers and cutting winners.

90% of trading is mental, the other 50% is good math

Making money in the markets is like diet: simple but not easy: eat less, exercise more. Simple, yet the number of obese people continues to go up, not easy. Making money in the market is simple: buy stuff that goes up and short stuff that goes down.
The difficult part is the inner chatter, the beliefs we hold. Great managers have exceptional inner alignment from deep subconscious beliefs to daily routines and habits. Setting a stop loss and honoring it is not a debate: it is a habit.
Some people have subconscious beliefs that they are not worthy of the money they make. So, they sabotage. Some people have fairness as a core value, so stocks should revert because they are too expensive or too cheap. Well, life is unfair and so are markets. Fairness is hardwired in us, It is also a destructive belief.
I have an exercise about eliciting deep habits, but it is a daily struggle.

Complexity is a form of laziness

Long term performing managers have worked hard to simplify their process. Complexity is fragile.
Stress is designed to de-activate the thinking brain. It is an evolutionary built-in feature. If You start thinking that the lion chasing You is in fact a confused cat with some unresolved oedipian complex, then You are lunch.
Markets are stressful. So, it is impossible to execute complex sequences under heavy stress. This is why people make stupid (referred to as sub-optimal) decisions under stress.
Fear makes anyone piss their pants. Fortitude is the ability to work with wet pants.

Grandmother’s advice on advises

Only take advises from people You want to look like. That just took care of 95% of glorified journalists otherwise referred to as experts and market gurus.
You are 100% responsible for your own decisions.
The attitude towards mistakes is fundamentally different. I worked with one fund manager who one day called me to his office to talk about a stock he had some loss. This stock was literally the best performer that year (pure veteran’s luck). After being told that I should have insisted, I finally answered: “R…, if we are here having this conversation, it is because 1) i told You to buy 2) You did not and thought it was a stupid idea 3) You watched it go up 4) You felt frustrated 5) You bought at the peak 6) Now You nurse a loss, feel frustrated and want to blame somebody.”
There is an interesting book called mindset about fixed versus growth mindsets. Finger pointing is a classic fixed mindset attribute, quite destructive in trading

What are your best short selling ideas right now?

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Answer by Laurent Bernut:

This is answer to a question on Quora.com

Lifeisunfair

Life is unfair, so are markets, get used to it

This is a novice question that lead to two unprofitable biases: fairness bias and confirmation bias

When new to the fascinating short world, we want to short overvalued stocks. They believe that this has gone too far and that it “should” go down (same grammatical “should” as there “should” be peace on earth BTW).
We are hard wired for fairness. Even before speaking toddlers understand fairness. One of the subconscious beliefs behind this reversion to the mean is fairness.
Well, life is unfair, markets are unfair, let’s just get used to it. Overvalued stuff  often becomes ridiculously overvalued. Remember this please: pioneers are the ones with arrows in their backs

2nd stage, when we have lost enough money playing vigilante, we often turn ultraconsetvative. We want every box to be ticked, every fact confirmed. Every bit of information has a price tag in the markets. So stocks drop like stone, waiting for confirmation is an expensive habits.

If you want to be consistently profitable in the short selling world, change your mindset from outcome (need to be right bias) to process (probabilities). Probabilities are calculated risk assuming <50% hit ratio.
Short selling is a psychological & probabilistic game

What are your best short selling ideas right now?

Why do 100% of economists say that it’s hard to predict stock prices?

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amygdalaAnswer by Laurent Bernut:

“Forecasting is a difficult business, particularly when it is about the future”, Yogi Berra, modern American philosopher
Economists are extraordinarily helpful at predicting … the past. They will give today a savant explanation as to why their predictions for last week did not pan out. Economists gather some attention during bear markets when all predictions turned out be wrong anyways and investors want to gauge the “real economy”. Now, not only economists are wrong. Analysts are appalling and strategists are laughable. We, as a species, are biologically incapable of forecasting anything.
Experts cannot predict
In early 2008, before the GFC, my friend Marco Dion, quants guru at JP Morgan, wrote a piece about analysts earnings forecast accuracy 1 year out.
The probability of being spot on is a whooping 2%. The correct terminology for such low percentage is statistical error: “oops, I got it right”…
The probability of being +/-10% was 25%. That is half a coin-toss.
I used to compile strategists’ predictions published in Barrons and measure forecast accuracy twice a year. Fasten your seatbelt. If You thought analysts were bad, You haven’t seen anything yet. Forecast accuracy of Barrons roundtable was 17%. That is simply a few notches below useless, that is laughable.
(The primary reason why strategists were so low is primarily the broad range of questions from interest rates to currency, S&P levels. Within their domain of competence (fixed income, equities or currencies), they were relatively OK  but were tragic everywhere else)
Why we can’t predict 
Our “ability to predict” is located in the prefrontal cortex. It is the siege of our thinking brain. Now, within that brain, there are several regions invoked every time we make a prediction.
“High conviction” predictions trigger a zone called the ventro-median prefrontal cortex. The interesting part is the dorsolateral cortex, where our ego and identity gets activated. Hal Hershfield has observed through fMRI dual activation in those regions when subjects asked to make projections about their financial well being claimed to have good financial literacy. In other words, people who claimed they knew something about the subject were also more prone to overconfidence. Our forecasts are contextual.
A third thing that makes it even more interesting is something called recency bias. We extrapolate tomorrow based on what we know today. Have You ever wondered why analysts earnings prediction go in straight line up through the next 20 years ? It does not even dawn upon them there could be a dip.
Maybe we asked the wrong question in the first place
Back in the 60s, there were a series of studies conducted at Yale University where subjects were asked to send electric shocks to test subjects if they answered wrong (Milgram experiment )Milgram_Experiment_advertising. Of course, test subjects were actors and no shocks were sent, but the interesting part was that few people rebelled. The objective was to measure compliance to authority, specifically how could people obey nazi orders and send victims to a certain death. We are conditioned to respect figures of authority and experts.
Yet, in finance, we still avidly seek the opinions of experts who continue to prove time and again that they are hopeless at it: they are still several standard deviations below a coin-toss. So, why do we still rely on them ?
Rather than running an ugly contest on who’s worse at forecasting, maybe we should ask ourselves a better question: despite overwhelming evidence that we are hopeless at forecasting, why do we keep doing it ?
Our fear receptor is a region in our brain called the amygdala. These are two glands in the center or our brain. They are our fear receptors. The amygdala has helped our ancestors survive saber tooth tigers. It has not evolved for thousands of years. In the Jungian and later Pearson Marr archetypes, amygdala could be compared to the orphan.
Now, our primitive brain does not know the difference between a saber tooth in the bush and a news headline. Uncertainty triggers fear. This fear activates the amygdala.
So, we rely on “experts” who know better and can reassure us and soothe our uncertainty. In other words, we delegate our fear management to experts.
Is there a better way then ?
Uncertainty is not going away anytime soon. Uncertainty and risk are part of life. Rather than delegating fear management, maybe we should learn to live with it, to make peace with it. Fear exists in the shadow and evaporates when brought to light.
  1. Mindful meditation: There are several techniques designed to reduce fear, one of the best being “mindfulness meditation”. I would also recommend the work of my trading coach Rande Howell (trader’s state of mind).
  2. Risk is a number: The second way is to quantify risk and stop loss. Risk is not a paragraph at the end of a dissertation called investment thesis. Risk is a number: know how much you are willing to risk and can afford to lose before entering any trade.
Conclusion
“Forecasting is a difficult business, particularly when it is about the future”, Yogi Berra, modern American philosopher
We are hopeless at forecasting. Forecasts have been wrong and no matter how technology evolves, they are likely to be wrong in the future as well. (I had this conversation with Nate Silver in Hong Kong actually). Even if forecasts accuracy doubled, it would still be below a coin toss. So rather than trying to improve them, how about learning to live without them ? How about growing comfortable without discomfort ?
If You are interested in how “Greed and Fear” tricks our brain: Amygdala and the neurophysiology of Greed and Fear. and, don’t forget to sign-up if You want to receive free bonus material

Why do 100% of economists say that it’s hard to predict stock prices?

What the great Chinese philosopher Bruce Lee can teach Fund managers about mastery

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Answer by Laurent Bernut: This was originally a question on QUORA: which investment method is the best ?

As the Great Chinese philosopher Bruce Lee said: “have the style of no style, be water my friend”Game of death

There are two games of trading: outer and inner game of trading

Stage 0: Dunning Kruger effect
The Dunning Kruger effect is a cognitive bias where unskilled individuals believe in their illusory superiority. It is often found in senior management of old listed companies such as Volkswagen, Kodak, Sony etc. When Bruce Lees did not know anything about Wing Tsun, he thought a punch was merely a punch. After he had internalised his craft, a punch became just a punch.
In the beginning, anyone thinks the stock market is easy. Then they lose

Stage 1: Exploration
Bruce Lee not only explored Wing Tsun, but also English boxing, karate.
At this stage, market students embark on an exploratory phase to build a syncretism of what they think is best.

Stage 2: Perfection
This is the most common mistake of all outer game centered practice. Students perfect their craft and believe their style beats any other style out there. MMA is better than Brazilian Jiu Jitsu. Kyokushinkai is more resilient among karate etc.
Still, students myopically concentrate on their microscopic universe and fail to embrace diversity. They may be outwardly good, but they are still trapped in the outer game.

Stage 3: Acceptance
Responding to a challenge from other Kung Fu teachers, Bruce Lee defeated his opponent in a  whooping 3 minutes. In doing so, he injured himself and pestered about how long it took. He then proceeded to enrich his repertoire.
This is the first stage of inner game. This is where internalization and deep learning starts.
This is the essence of the “10,000 hours”. This is where “flow state” happens. Students redefine their identity. They free themselves from the confine of the style they used to practice.

Stage 4: Mastery “Be water my friend”
At this stage, students redefine the game. They bend reality. It becomes effortless. Master traders and investors have redefined their game. They have a congruent universe governed by a simple set of rules.

So, in conclusion, there is no superior method: fundamental, quantitative, technical, HFT, etc. There is a better method for You that suits your personality. It is incumbent upon You to find your path on the markets. Believing that fundamental or technical analysis is the way to succeed, just because everyone else around is doing it, will not work. They are also struggling. A long journey on the markets begins in stillness

Which investment method is the best?

Amygdala and the neurophysiology of Greed and Fear

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Going into a combat mission without an exit plan is suicide. In fact, the only soldiers who nevamyg400er bother with exit plans are kamikaze. On the other hand, market participants routinely enter positions without a clear exit plan. The problem is that as soon as we enter a position, our emotions impair our ability to make rational decisions. Greed and fear have a chemical signature. This is the first article of a series of four about exits and emotional mastery.

Dopamine and cortisol: the chemical brothers of Greed and Fear
When there is no exit plan, there is uncertainty about what to do next. A mild level of uncertainty can be exciting. A region of the brain Nucleus Accumbens (NAc) gets activated. This triggers the mesolimbic reward circuitry, often referred to as the dopamine reward circuitry. Dopamine is released. People take on more risk. By the way, cocaine, opiates and nicotine activate dopamine transmission. This is why just watching the portfolio feels a bit addictive sometimes. As Kuhnen and Knutson showed, risk seeking behaviors are often associated with NAc activation and high level of dopamine. In other words, Dopamine is the chemical signature of greed.
When a few positions “go against us”, uncertainty turns from thrill to mild discomfort. We are more vigilant and come back to reality. When performance starts to suffer, uncertainty morphs into stress. Stress triggers the amygdala, located in a primitive part of the brain called the limbic brain. Its primary function is to keep us alive at all times at any cost.  It is always on. The problem with the amygdala is that it cannot discern between real danger and an imagined threat, between a saber tooth tiger and a -1% dent in the portfolio. At higher levels of stress, the amygdala activates the pituitary gland that releases cortisol. When cortisol is released, the neo-cortex or thinking brain is hijacked, game over.
In his latest research, Daniel Goleman, author of Emotional Intelligence and focus, goes one step further. He describes a state of prolonged high stress as neurobiological frazzle: the thinking brain shuts down and physical health deteriorates. This is what we call burn-out. Bottom line, uncertainty has a destructive physiological signature.
Uncertainty: get comfortable with discomfort
Uncertainty cannot be eliminated whether in life or in the markets. We can learn to 1) manage it and 2) reduce it.
1) Getting comfortable with discomfort literally determines the quality of our lives. This is the subject of a future article
2) Reducing uncertainty simply comes down to  having plans and rituals or habits. One of the most important plans is the exit plan.
The three questions that will notably reduce stress:
When everyone else is stressed out, every bit of clarity counts. Unfortunately, every decision is an additional stressor. Every bit of stress reduces the mental bandwidth. This depletes the thinking rain of its capacity to make good decisions. This is called decision fatigue. Willpower is a muscle.
An interesting study was done in Israel about parole decisions made by judges. Convicts examined before lunch were 2/3 more likely to be denied parole than after lunch break.
Bottom line: if we do not want to look like deers in the headlights, we must plan our exits before entry. Experienced traders often say that the best time to put on a stop loss is 5 minutes before entry.
There are only three possibilities after entry: either a stock goes up, down or nowhere. So, an exit strategy must answer those three questions
  1. Price goes down, there is a loss: at what price do we reduce risk ? How much do we need to exit ?
  2. Profit goes up, there is profit: At what price do we take risk/money off the table ?  How much do we need to exit ?
  3. Price goes nowhere: how many days after entry ? How much do we need to exit ?
Note also that exits do not have to be binary 0-100%. This is the subject of the next two articles.
Note that there is no room for interpretation. This is not the time for abstract debates on valuations, long-term prospects, or any other rationalization that our amygdala fueled inner idiot will throw at us. It has to be an unambiguous IF…THEN sequence.
The good news is that unless any stock triggers any of those landmines, there is no need for action. It helps achieve three things:
  1. It reduces the need for constant monitoring: market participants often stay glued in front of their monitors expecting the markets to telegraph a compelling call to action
  2. It helps navigate volatility. Volatility often tempts us into action. Having a plan and sticking to it helps reduce the urge
  3. It frees up mental space that can be used for higher cognitive functions: research and planning.
Everyone knows that the key to success is to cut losers and ride winners. The problem is that no-one has ever come up with a formula. If You want a clear method to accomplish this, while maintaining your conviction, then the game of two halves is for you.
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The view from the short-side: how we process emotions and the market signature of the 5 stages of grief

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Market participants are constantly asked to defend their conviction. The moment they have to justify their positions is the moment they lose impartiality. They become attached to whatever they have to defend. Being right is no longer about the process (taking calculated risks), but about the outcome (making money). A losing position is an attack on the ego. For this reason, market participants process emotions through a 5 stage cycle defined by Elizabeth Kubler Ross as the psychology of grief. Each phase has a distinctive market signature and even a specific language.

Summary:
  • Short sellers have a unique perspective on how market participants process emotions
  • The 5 phases described: market regime, market signature, language and profitable course of action

 I have been a professional short seller for almost a decade. For 8 years, my mandate was to under-perform the longest bear market in modern history: Japan equities. I have always searched for a way to identify the signature of human emotions across markets. Many respected market gurus have come up with charts plotted with emotions ranging from euphoria to despondency. Yet, they never really resonated with the short seller in me. Those were written by market participants with a natural Long bias. The short side offers a unique perspective on how investors process emotions. We, short sellers, never sell against buyers. We ride the tails of those who were once holders and now have to “accept” losses and “let go” of attachment.
There are three market regimes: bull, bear and sideways. Each regime can be subdivided into two categories: quiet or choppy. Bear markets usually start in sideways choppy markets: an epic battle between bears and bulls. They usually end in indifference: sideways quiet or bull quiet. Everyone has thrown the towel and no-one cares anymore.
The psychology of grief has five phases: denial, anger, bargaining, depression and acceptance. We will examine each phase looking at the market regime, the market signature, the language and a profitable course of action.
Phase 1: Denial
  • Market regime is usually sideways choppy. Stocks stop making new highs. They are trapped in a volatile range. Short interest is low. Bulls fight bears.
  • Market signature is the compression of estimates. Optimistic and pessimistic analysts have fairly close estimates. All available information has been “baked in” the estimates. The decisive factor is a sudden penetration through support level.
At this stage, analysts jump in and say two things:
  1. This is a “one-off”, “inventory adjustment”, “seasonal adjustment” etc
  2. This is a “Buy on Weakness opportunity”: Analysts are usually quite vocal as they appeal to market participants who were waiting for a pullback to enter a position
If a stop loss was not triggered, it is best to wait until the ensuing rebound is over to make a decision. If the new peak is below the previous high, then start trimming. When in doubt, reduce position size.
Phase 2: Anger
  • Market regime has morphed into a choppy bear. Stocks make lower highs and lower lows. Volatility remains elevated. Short interest start to tick up. Professional short sellers, such as myself, put a chip on the table just to see. Fast money, those who bought the dips and lost money, turn around and engage in some revenge short selling.
  • Market signature is characterized by institutional reducing their weight. Initial sellers are Long Onlys trimming their weights. Mutual funds may well keep their bets over the index, but they still trim their weights so as to reflect under-performance.
At this stage, analysts express their frustration:
  1. “…But the market does not understand …”: that is always an interesting argument, particularly after years of out-performance, institutional participation. Market probably knows something analysts refuse to accept yet
  2. “Short-sellers and speculators are taking the stocks down…”: ignorant analysts and market commentators blame us for stocks tanking, yet facts are stubborn: short interest is low. Secondly, in order to sell short, we need to locate borrow. Borrow availability represents a tiny fraction of the free float. Simply said, we just do not have the might to take anything down.
At this stage, it is prudent to aggressively reduce bet size for two reasons: 1) Volatility remains high and 2) performance does not justify a big position anyway. For market participants with a Long/Short mandate, this is a good time to anchor a small short bet. Position sizing is crucial as volatility remains elevated. Those anchors become invaluable when stocks move into the next phase as they embed substantial profits.
Phase 3: Bargaining
Me: “Doctor, if I eat my vegetables, stop drinking, smoking, eating poorly and exercise more, will I live longer ?”
Doctor: “I don’t know, but it will feel much longer anyway”
  • Market regime shifts from bear choppy to bear quiet. Bears have won the battle.
  • Market signature is a softening of a leading indicator that triggers a downgrade of estimates. Negative earnings momentum attracts short-sellers. Short interest start to rise.
At this stage analysts bargain with their conviction:
  1. “We take our estimates down, we revise our target price, we extend our investment horizon, but…”: Since analysts were ardent supporters, they believe they cannot change their mind at once
  2. “… We keep our Buy rating, because the long-term story is still intact”: the softening is not perceived as the symptom of a disease but a temporary setback
Analysts devote their existence to a few stocks. They know something is wrong but they cannot publicly admit that it is time to let go, but market participants can read through the lines and sell. Price action has already shown some weakness, but quantitative short sellers see negative earnings momentum as the sign to build positions. Short interest rises and so does the cost of borrow. This is when anchoring a small position in the previous phase becomes invaluable: borrow was secured at a cheap cost.
 
Phase 4: Depression
  • Market regime is bear quiet to bear volatile because of short squeezes
  • Market signature is 1) deterioration of newsflow , 2) radio-silence from the analyst community and 3) rapid increase in short interest
At this stage analysts:
  • crawl under their desks: they hardly contact companies or market participants
  • “this is a stock for long-term investors”: to which there is only one retort: “then it should be matched by long-term commissions”. If they frown, sell short…
Short interest rises quickly. The quality of borrow deteriorates (callable stocks, usury borrowing rate etc). It becomes costly and difficult to sell short. As a rule of thumb, do not sell short when short utilization (shares borrowed/shares available) rises above 51%. Volume is thin so any tiny event can trigger a short squeeze. Amateur short sellers are forced to cover, which trigger a cascade of short cover.
Phase 5: Acceptance
When the inexorability of reality sets in, there is a sort of euphoric relief.
  • Market regime is either quiet bull (small higher highs, higher lows) or sideways quiet
  • Market signature is terrible news-flow, massive downgrade from the analyst community, elevated short interest (crowded short). It is also muted price action: stocks do not react to a torrent of bad news anymore
At this stage, analysts are frustrated and no longer afraid to tarnish their standing with companies. They downgrade ratings, estimates and publish some vitriolic content such as:
  1. “Structural short”, “flawed business model…”, “…mismanaged”: it sometimes becomes personal, because analysts had a rough inner journey being champions of a lost cause
When all the negativity, particularly the words “structural words”, does not move share price anymore, it is a sign that the worse is over. There is one logical thing left to do: cover the short and go long.
Discussion
Markets are the ultimate mental sports. As much as we would like to think we are rational, the moment we are asked to defend our opinions is the moment we lose impartiality. The irony is that we intuitively know when something is not quite right. Still, we feel obligated to defend our stance. We refuse to admit reality, so we go through a painful process that eventually leads to acceptance. Pain is inevitable, suffering is optional. Making money in the markets is not about trying to be right, it is about accepting to be wrong and move on. Would You like to learn simple powerful techniques designed to reconcile the need for conviction and the reality of losses ?
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