The Black Swan

Contrary to popular belief, black swans don’t have to be bad. They can also be good. Most people think of panics and crashes when they think of black swans, but really a black swan refers to any improbable event that could not be foreseen. The Nasdaq up 13 days in a row? I’d call that a highly improbable event.

I’ve seen some technical/sentiment stuff on this rally in the last few days. Really, the only other time in history we’ve had a rally to all-time highs of this magnitude, with the index meeting certain breadth criteria, was in March 2000. Dum dum da. You can’t extrapolate too much from this, but it sure is interesting. Goldman Sachs put out some research before the rip, talking about how short CTAs were and how much they had to cover in the event of a squeeze: $38 billion. And then the squeeze happened. I saw that research and discounted it because I don’t put too much stock in Goldman research, and I’ve also never seen CTA positioning have a large effect on the market. Well, it did.

But I’m not here to talk about the stock market. I’m here to talk about being wrong (because I sure was wrong). I thought the SPX had some downside to 6,100 or so, and maybe in an alternative universe, it would have gotten down there. Maybe it still will. The war is over, but we still have private credit to deal with, along with some other stuff. Also, sentiment flipped to bullish relatively quickly.

So, what do you do when you are wrong on a trade? Cover! Close out the position! Cut risk, get to flat, and start over.

I don’t have a clear thesis right now, but the dollar rallied a lot during the war, so I think the dollar should be lower. Bonds sold off a lot during the war, so I think bonds should be higher. Aside from that, I don’t have a clear macro thesis at the moment. The sell-off in risk was my macro thesis. There are already some people talking about SPX 8,000, which seems a little premature. There is a trade for that, too—1x2 call spreads on the upside. But I am skeptical.

We All Get to Be Wrong

If you invest long enough, you are going to be wrong a bunch of times. I first started trading in 1998. Funny enough, my first few trades were winners. I would say that the first time I was really wrong about something was when I shorted some dot-com stocks in January 2000. The Fed cut rates, the stocks ripped, and I was stopped out. They all eventually went to zero. Stan Druckenmiller had the same experience, although my losses were a little more manageable. I could have added to the short, but that would have been irresponsible, so I remorselessly cut the position.

A lot of people think this is discipline, but I don’t really see it that way. Discipline is getting up at 3:30 in the morning to lift weights in your basement. Cutting losing positions isn’t discipline. In trading, you want to do more of what works and less of what doesn’t. If a trade isn’t working, do less of that and more of something else that is working. 

Trading is actually pretty simple. If something is causing you psychic pain, then take action to stop the pain, and do it sooner rather than later. Sometimes people don’t do this because they think they will stop themselves out at the worst possible time, and as soon as they do, the stock will go in the right direction. Do not trade off fear of future regret. Likely, if you have a losing position, it is eating up a bunch of mental capital. You sit there and stare at your screen, at the stupid stock all day long, wishing and hoping that it will come back. Imagine how much better you will feel when you cut that position. And it will also free up actual capital to allocate to winning trades. I cut a trade recently that wasn’t working, and four days later, the company was investigated for antitrust violations. There was something in the price action that I just didn’t like, so I cut the position without remorse.

I’m working on a new book (the one after THE AWESOME PORTFOLIO) called SUPERINVESTORS, which is about the 20 traits of successful investors. Discipline is one of them, but I haven’t gotten to that chapter yet. And there is such a thing as having too much discipline—it is good to have small losses, but if you are too disciplined, you need perfect entry points to have winning trades, which is dang near impossible. But yes, what you think of as discipline is not actually discipline—it’s just good trading. Trading doesn’t have to be hard. You do more of what works and less of what doesn’t, which is also true in all of life.

Sometimes, when the market is moving against you, you freeze, not knowing what to do. This is common. You should have a bias to action. Of course, there is not much you can do when the market is up 13 days in a row, with no pullbacks, other than cover shorts aggressively. It feels terrible to do it, but you have to do it. Most people like to cover shorts on a pullback, but sometimes we don’t get the pullback.

If you got this wrong, don’t worry. Pretty much everyone did, and if you meet someone who didn’t, they are probably lying. Nobody predicted a short squeeze of this magnitude; this is one for the history books. Like I always say, in trading, you either make money or you learn something—there are no bad outcomes.

Jared Dillian, MFA