EQUITY RUN UPDATE: $10,909.
Switching views isn’t easy and it should be done with caution. Flip-flopping at every piece of news or at the turn of a candle is no view at all, it’s just blowing with the wind. Additionally, some of the greatest trades in history were made by people who held contrarian views for a long time, even years at times, before the traders’ views were validated and a windfall rewarded their resilience and insights.
However, many times the markets are speaking clearly, yet we hold on to a view that we feel so strongly about that can drive us straight to the precipice of total failure (or simply to a huge missed opportunity).
When is it ok to switch views?
You should/can switch view when you have reached the end of your view’s timeframe and/or the limit of capital you set out to risk for the potential reward and/or the fundamental core of your thesis has changed. Ok, it’s a mouthful. I’ll break it down, because this is critical to your success.
Timeframe. Whatever view you develop on a particular markets, regardless of input factors (Technical? Fundamental? Global macro? Arb? Whatever..), you should establish a timeframe within which you expect your view to evolve. In other words, to say that soybeans’ price will double, without a giving a timeframe, it’s completely useless. Of course, price can double in the next 30 years. You may not be alive to enjoy those benefits… And even if it happened, by then the value of your trade would be insignificant because time has eroded much of the gain. However, if you can say bean prices could double within the next 3 months, you have created a thesis that can be traded, assuming proper sizing. And speaking of sizing…
Sizing risk. The second thing you have to determine in advance of the trade is the amount you are willing to risk for the sake of the return you expected, within that particular timeframe. Again using the soybeans example, if you think prices could double, are you willing to endure a drawdown of 99% of your trading capital to wait for your thesis to play out? Probably not. Determine what your view, your thesis is worth. This is the combination of adverse price action, combined with the size of your position. You should never, ever bet 100% of your capital on a thesis. Just the 1% probability that you are wrong (and trust me, the probably is higher than that), plus the time that it takes for your view to prove to be correct, are sufficient to effectively guarantee that you will go bust if you bet 100% of capital. A good rule of thumb for sizing is to use the trading range of the corresponding thesis timeframe to determine where to put stops on your trades.
Let me write and example:
Thesis: Soybeans to go from $9.00 to $18.00.
Timeframe: 30 days.
Risk: 1% of capital.
Trading range or Average Trading Trade: How high or low did soybeans move in the last 30 days (or at least an average of 30-day periods)? Given that that range has already occurred in the previous 30 days, you can reasonably project that it might happen again. You can be more conservative and think it could be wider, but to think it would be tighter is equivalent to adding risk to your trade.
Once you have the entry price and the stop price (derived from the range), you can determine how many contracts of beans you can trade and not loose more than 1% if all went wrong. If within 30 days what you expected to see happen hasn’t happened and you haven’t been stopped out already, then it’s time to reconsider your thesis.
Fundamental change. In your thesis you should have a dominant factor that drives your idea. Maybe a second idea to support it, but the dominant one is the driver. In the case of soybeans, a jump of that size would probably be based on a significant weather issue developing in the US or in Brazil. If the drought were to change to rain, it’s time to change thesis. Don’t wait 30 days to do so…
Side observation: I don’t know if the data actually supports a perception that I have, but I’ll express it anyway. It seems to me that the bigger the timeframe one uses, the bigger the bet the trader will have on hand, therefore the bigger the reward or the loss. Recently, this is most evident in those who made billions during the 2008 financial crisis, who held contrarian views for years, went against anyone and everyone. They continue to look for the next big short, but without a timeframe (that I know of) and can’t seem to change the tune of their thesis. A rare exception, probably delayed by a couple of years, was the recent closure of Electica by Hugh Hendry. The market rewarded their contrarian resilience handsomely and they are continuing to be contrarians, despite very different markets (yes, over-leveraged, but also firmly in the hands of central bankers and packed with other skeptics, not the 2007 optimists). Besides their losses, we also have to listen to the paternalistic pontifications that flow out of their pride from the once-successful venture…
Well, markets are also here to teach humility, as Hendry’s own testimony reminds us.