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Know When To Walk Away


Occasionally (and this seems like an excellent occasion) it is worthwhile to step back and, rather than considering the investing attributes of the market, ask whether it is necessary to act on any decision today.

Reading various columns and periodicals (Barron’s, Bloomberg, etc) today, something struck me. Every one of them asks a question along the lines of “Is the market in a correction that should be bought, or is it starting a new bearish leg that should be sold?” In some sense this is not different from the discourse during any other week. CNBC, especially, makes it a habit to ask its guests what they would be buying right now (and occasionally, what they would be selling right now).

But shouldn’t the discourse be a bit different at the moment? Isn’t the market acting somewhat…er…unusually?

I had a rhetorical writing professor once who would respond (to almost assertion), “So what?” Her point was that the rhetorician is responsible for persuading the audience that the points raised are not just germane to the argument but develop it inexorably, so that conclusion B necessarily follows from premise A.

And so my question is, as a trader’s/investor’s question always should be: “So what?” Maybe the market is merely correcting, and perhaps it is finished doing so. The VIX, volumes, interest rates, and other measures of market stress such as interbank lending spreads have rapidly expanded to the levels we were accustomed to seeing in the crisis, and maybe that means the correction is over or nearly over. Maybe the market is beginning a new down leg in a secular bear market. After all, just because it would have been profitable to sell the VIX the last time it was at 45% doesn’t mean that it is profitable to do so now. Let’s assume that I have reached a conclusion, either that this is a correction or that it is the end of a bear-market rally and another leg down is unfolding. The question really is, “so what?”

In thinking about (and explaining) trading decisions, I often find a card-playing analogy to be illuminating. A game like Texas Hold-Em is a simple game that, as they say, takes a lifetime to master…but the parameters are constrained. That is, there is always the same number of cards, the rank of hands is unambiguous, and the order of play is defined and immutable. You always know what your hand holds. And the decisions required are always the same: bet or raise? How many chips to put into the pot? Or instead, should I check or fold? And that’s it. The analogy to investing is probably obvious: at a macro level, before any security analysis, the question is buy or sell, and how much?

And that is, of course, what all the commentators focus on: determining whether we should be buying, or selling (maybe Omaha Hi-Lo is a better card playing analogy; you can win by getting the best high hand, or the best low hand). But what about sitting out this hand? A key question facing any card player who doesn’t have the absolute best possible hand (“the nuts,” in poker lingo) is whether the return offered by the pot in the event of a win (the “pot odds”) make it worthwhile to remain in the hand, or if it is better to discard the hand and wait for better cards. But market commentators seem often to neglect this question. Maybe it’s better to sit this one out?

All observers can agree that right now, market prospects are extremely uncertain. What the elevated level of the VIX is saying is that many participants are concerned about the prospects of a severe move. While it is admittedly true that the more that investors buy protection, the less likely it is that they feel pressured to sell when the market trades lower – which is one reason high levels of implied volatility tend to be associated with, and may even be causal of, near-term market bottoms – the question of whether we are at a local minimum in the market and “due for a bounce” may be moot. Why do I need to catch the bottom? Why not wait until the picture becomes clearer?

True, the market is 10% cheaper than it was a month ago. But the prospects are also a lot more near-term uncertain than they were a month ago. It isn’t clear to me that I need to be putting chips into the pot right now. (And by the way, the toughest lesson I ever had to learn as a trader was that doing nothing is often the right thing.) And the risks are not symmetrical – there may be only a small chance of a -10% day or a -20% week, but there is a vanishingly-small chance of an up 10% day or up 20% week. Stocks go “up on the staircase and down on the escalator,” and this means that uncertain situations deserve special respect. I think we are in this sort of situation right now.

One clear difference between cards and the markets: in cards, you can win with a bad hand by bluffing your opponent into folding. In the markets, you can only win by being in the market when the odds are good, and out when the odds are not in your favor. It is okay to choose not to play.

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