THE BIGGEST MISTAKE I EVER MADE TRADING

It was October of 2007 and the bull market in Asia was rip snorting mad.   I was having a spectacular year sitting on 25%+ gains and probably letting my hubris get the best of me.  I had begun to dabble in overseas trading that year as I expanded my strategies and tried to add another weapon to the arsenal.  The 6 1/2 hour trading day in New York wasn’t cutting it any longer.  In essence, I had become a market junky.  What resulted was one of the worst months of my life.

I have always been a bit of a contrarian investor, but like Warren Buffett, I have also always waited for fat pitches – grape fruit size pitches.  China’s bull market in 2007 was the contrarian fat pitch that just kept getting fatter.  In the middle of October 2007 I took a cut – a pretty big cut for me.  I shorted a number of Hong Kong traded equities.  Primarily large cap stocks traded in Hong Kong and Shanghai.  It just so happened that I had shorted the market to the very day of the peak in Shanghai.  I had nailed it.  Almost to the minute.  But a funny thing was going on in Hong Kong.  Regulators were talking about a way to reduce the price discrepancy between the Hong Kong market and the Shanghai market.

In case you don’t know, China has three large stock exchanges – Shanghai, Hong Kong and Shenzhen.  Many of the same Chinese companies trade on multiple exchanges.  But the exchanges have different rules.  For instance, only citizens of mainland China can own the Shanghai A shares.  In Hong Kong, however, foreigners can purchase stocks (as I was doing).  The problem with this format is that you can have the same company trading on two exchanges at very different prices.  Many experts say that the rules in Shanghai create liquidity restraints and make for a less efficient market.  They say this is why the Hong Kong shares often trade at more reasonable valuations.  It’s long, detailed and complex, but you get the basics.  There was an arbitrage to be had and I wasn’t familiar with it.

The Shanghai market began to immediately tank after I sold the HK shares short.  I had top ticked the market – I was going to make a fortune, right?  No.  See, traders in Hong Kong were buying shares while shorting shares in Shanghai.  It was a gimme arbitrage opportunity for those who understood it.  Being right had never felt so wrong.  Being someone who had never traded HK stocks before – I didn’t understand what was going on.  Over the course of the next 3 weeks the HK shares I was short rallied 20% on average.  I spent 3 sleepless weeks staring at the computer screens trying to understand the mistake I made.  I was too smart and too good at trading to make such an error, right?  Wrong.   Those three weeks were spent endlessly learning and stressing over the mounting losses as the stupidity of my error became evident….

I knew I was right.  My analysis was not wrong by 20%.  I knew the market was about to roll over hard, but I hadn’t understood the intricacies of the market before I placed the trade.  In a stress induced frenzy I added to the position.  Mind you it was a fairly small portion of my portfolio (less than 25%), but for me that was too much volatility in one position.  I had broken one of my cardinal rules of letting 20% of my portfolio dictate 80% of my daily performance.  Even worse, I had let my emotions get the best of me.  I was unraveling.  I experienced a 10%+ total draw-down that month.  For a supreme hedger like myself, this was a huge move.   I was floating in the market’s wind like a feather as opposed to hedging and controlling price as I had grown accustomed to. I felt as though all of my years of hard work were suddenly flawed.  Then it all reversed.

The first 15 days of November 2007 were nothing short of spectacular.  The Hang Seng folded like a lawn chair.  I made another classic psychological error and cut out at break-even.  The stress had been too much.  This was not exactly what I had in mind when I placed the trades just a few weeks earlier.  My thesis at the time was about an enormous global housing and stock bubble that was similar to the Nasdaq and on the verge of leading the global economy into a spectacular recession.  You know, kind of like what happened over the following 18 months.  But I made not one penny on the trade.  The next two weeks were spent revamping a clearly flawed investment approach.

In retrospect it turned out to be the best learning experience of my entire career.    I’ve had bigger losses.  Much bigger, but none was so educational.  The result is much of what you read here at TPC on a daily basis.  I learned that psychology is the most important driver of price.  Never let prices control your psychology and never let your psychology dictate your trading. I learned not to over trade.  6 1/2 hours is plenty of stress for one day. I learned never to trade something you don’t completely understand.  I learned to follow rules systematically.  And perhaps most importantly, I learned that trading is not the most important thing in life.  When I was stressed to the max the people around me were the supporters I needed most.   I learned that you trade to live, not live to trade.  It sounds cheesy I know, but it’s true.  Mistakes are valuable in life.  As long as you learn from them.  We all make them.  Own them and learn from them….Trading is no different.

Hopefully my mistake helps someone else out there avoid one of their own.

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Paul

    Great article and thanks for sharing this insight!

  • Henry

    “The first 15 days of November 2007 were nothing short of spectacular. The Hang Seng folded like a lawn chair. I made another classic psychological error and cut out at break-even. The stress had been too much. This was not exactly what I had in mind when I placed the trades just a few weeks earlier. My thesis at the time was about an enormous global housing and stock bubble that was similar to the Nasdaq and on the verge of leading the global economy into a spectacular recession. You know, kind of like what happened over the following 18 months. But I made not one penny on the trade.”
    -It is such a tremendous stress on your psyche when the trade goes against you. That is when the trade break even, you are so tempted to jump out. Then you missed the big move in your direction. I experience this more often :( Live and learn.

  • van

    great article, been there, got the t-shirt

  • van

    PS

    Have you gone short from neutral, I may have missed it.

  • JTodd

    Great article, thanks for sharing!

  • http://www.pragcap.com TPC

    I am only short about 15% via actual equity. The rest of my portfolio is positioned in what I call an anti-beta trade. Effectively shorting the equity markets via low beta instruments such as the dollar….

  • Robert in Chicago

    This is hilarious. Of the time my partner and I spend analyzing individual stocks, more than half goes to Chinese companies; our long exposure also tends to be one-half Chinese. In October 2007 we were the “smart guys” on the other side of TPC’s trade. We were long the Hang Seng index because we knew it was being driven by anticipated convergence with Shanghai A-shares, and we got off the boat in time. We were trying to short the Hong-Kong-listed A-share ETFs (but couldn’t get the borrow). We were short Petro China because it was ridiculous for it to be the world’s most valuable company and be worth twice Exxon Mobil with far less oil reserves; we covered 50% lower.

    Yet in the end, we got burned and learned exactly the same big-picture lesson as TPC: psychology rules all. Our _primary_ China exposure was long U.S.-listed Chinese small-caps. While the big Chinese stocks were trading at 30-50x earnings, our small-caps were at 5-8x. We knew there was a China bubble, but we thought our stocks’ valuations would protect them. And in early October, they were rising 10% per day every day; our fund was making 5-6% per day some days.

    Then one day in mid-October, at approximately noon: whoosh! I watched my trading screens as the air started leaving the bubble. The reversal took only minutes. Stocks that had been up 10% on the day ended down 10%. Had we known what we know now, we would have started selling and waited to re-buy. Instead we told each other, “this stock is at 5x earnings; what is it going to do, go to 2x?” Indeed, a year later at the bottom, the entire universe of such stocks was at 1.5-3.5x earnings. We started adding to positions far too early and aggressively and had a horrible 1Q08 as a result. In a bubble burst and mass market panic, under-owned and under-traded stocks get hit _worse_ than the big favorites, despite their valuations.

    All ended well: we stuck with those stocks as most of them quintupled or better off their bottoms and are up over 200% for 2008-09 while the developed-market indexes are down 30-40%. But the lesson remains.

  • http://www.pragcap.com TPC

    Good stuff Robert. Those were crazy days. The entire trade reversed in a matter of days. It was really incredible. It was almost as spectacular as the volatility of last October and November….

  • Bill

    Awesome post, TPC, thanks so much.

  • James

    Hey…at least you aren’t someone who bought UNG at a 16% premium and are losing all of your money due to scam artist ETFs…….

  • http://www.pragcap.com TPC

    James,

    The lawsuits are coming. The time decay in the leverage funds and the rollover inefficiency in the futures funds has misled millions of investors….Sorry to hear you got caught up in that debacle.

  • Onlooker

    TPC

    When did you get short equities? I missed that.

  • http://www.pragcap.com TPC

    I have been effectively short for over a month. Long vix, dollar, etc. My actual equity shorts are very small.

  • Henry

    all the EFT like FAZ, FAS are a bunch of scam product. If you hold for longer than a day then there is pretty good chance it goes down. Maybe it’s better to short BOTH of those EFTs. If you plot the two charts, you would see that they both trend down. I was looking at USO today..watch the time on these headlines
    Headlines
    Filter Headlines

    * Futures Movers: Crude unchanged; gasoline rises on higher demand at MarketWatch(Wed 3:16pm)
    * Futures Movers: Crude edges lower after inventories report at MarketWatch(Wed 1:29pm)
    * Futures Movers: Crude turns higher on rising demand at MarketWatch(Wed 1:16pm)
    * Futures Movers: Crude turns higher as EIA data show rising demand at MarketWatch(Wed 12:04pm)
    * Futures Movers: Oil erases losses as data show rising demand at MarketWatch(Wed 11:25am)
    * Futures Movers: Oil falls for third session after jobs data at MarketWatch(Wed 10:15am)

  • James

    James,

    The lawsuits are coming. The time decay in the leverage funds and the rollover inefficiency in the futures funds has misled millions of investors….Sorry to hear you got caught up in that debacle.

    ———————————————————————————–

    Oh, I NEVER got involved in these commodity etfs (well I did short USO a few times but that is it). But I talk to a lot of people who have lost a whole bunch in UNG due to its roll over costs and premium that continuously eats away at their money. Also…what really put the nail in the coffin for me was that oil is still over 100% up from its 52 week low while USO is up like what…35-40%??? No, not me sir. I am not in those things. If I want to buy for a natural gas rebound, I will buy some sturdy, small cap producers like GMXR (GMX Resources) or EP (El Paso)that have their production hedged…

  • Balinvadasz

    Actually, selling ATM or slightly ITM calls on the leveraged ETFs (as a directional position) has been working quite well for me. This way, the time decay and higher volatility both work in your favour. Example: if you thought financials were overvalued, then selling calls against FAS or UYG would make you money even in a sideways, choppy market as long as the underlying doesn’t go up significantly.

  • James

    Actually, selling ATM or slightly ITM calls on the leveraged ETFs (as a directional position) has been working quite well for me. This way, the time decay and higher volatility both work in your favour. Example: if you thought financials were overvalued, then selling calls against FAS or UYG would make you money even in a sideways, choppy market as long as the underlying doesn’t go up significantly.

    —————————————————————————–

    What does SELLING calls have to do with buying the underlying stock? Selling calls for anything with high implied volatility in a side ways market will make you money…

  • Onlooker

    TPC

    I knew about your other derivative and non-correlated type assets that are a proxy for being short, but the 15% equity short position was a surprise as you hadn’t mentioned that at all to my knowledge. Last I knew you had pulled off your longs just under 1000. That’s why I asked. Once again, you don’t owe us any accounting of your positions, but if you’re going to tout market calls, well, you know…

    Plus I value your guidance as you’ve made some good calls.

  • http://www.pragcap.com TPC

    Onlooker,

    I haven’t done a formal update in the last week (though some emailers can attest to my short positions as they’ve asked me for advice on specific positions such as my housing short – which I believe I mentioned in a comment section a few weeks back) so they were never mentioned. Besides, they are so small that it hasn’t really been worth mentioning.

    Trust me, I would never take credit for something that wasn’t mentioned on the site. Nonetheless, the derivatives shorts have performed really well in the last month. I am working on a model portfolio that will represent my ideas so my personal accounting will improve in the coming months.

    TPC

  • JTodd

    Short both the 3X long and short funds was the best trade for the least risk in the last year.

    Too bad for me by the time I realized this you could no longer short them and they had already lost most of their value.

    The larger 2X funds (QLD/QID SSO/SDS) aren’t as bad but I’d still rather short them then buy them long.

  • prescient11

    Btw, is this America or isn’t it. Are we a nation of fools.

    Double and triple levered etfs function as theya re meant to. Anyone saying those are buy and hold vehicle are ridiculous.

    Although I will point out that the decay factor would seem to necessitate some kind of rule against shorting them, because if you can take near infinite drawdowns, shorting both sso and sds makes a lot of sense.

  • prescient11

    And if my point wasn’t clear enough I apologize, we should be able to buy and sell whatever trading vehicles we want, and this comes from a guy who lost several ten thousands on srs.

  • chase m

    thank you for the shared anecdote

    i would agree that over extension really splays you on the yardarm

    not having followed your threads of 17 july, i remained short and you were indeed dead on; it has been tortuous slowly extricating myself from that

    i can dca (dollar cost average) my way out of anything but a bankruptcy, but hubris of thinking one “knows” coupled with overextension makes for a potent and unpleasant experience