Shorts got burned

I’m seeing this note on the wall everywhere today!

Today is the jobs report day and the market responded to the super strong jobs report with a roaring rally. Regardless you like or not, if you are at least reasonable, you have to agree that the US economy is really strong with a very healthy and strong employment market. Of course Trump’s haters have laughably argued that the strong US economy is due to Obama’s economic policies. In reality, anyone with a sane mind has to agree that it is due to Trump’s very business-friendly economic policies and deregulations with the historical tax-cut. I digress a bit.

No need to say, such a strong rebound and rally in the past two weeks or so is certainly a pain for anyone betting in the wrong direction in general. Since I’m often telegraphing publically about my view of the market, I cannot hide that I’m totally wrong till now about the overall market direction for the past two weeks. No need to sugarcoating! But does that mean those with a wrong betting must get burned? Not at all if you ask me and here is why.

I think the trading master Soros once said “It’s not whether you’re right or wrong, but how much money you make when you’re right and how much you lose when you’re wrong.” I think this is exactly the key every trader should learn and understand. No one can be always right, not even Buffett (the value investing master) or Soros (the trading master). So no need to feel bad if you are wrong, which is just part of investing and trading. The critically important for every one of us to learn is how to control our risk so that if we are wrong, we won’t lose much but if we are right we can win bigger. That’s really the key to differentiate between winners and losers, not the winning/losing rate. This is the principle I’m trying to follow to avoid being truly burned when I’m wrong. There are few more specific advices I can share based on my experience:

• Don’t ever use margin, which can truly kill you. I personally never use margin to trade regardless how much I’m convinced for a trade! It’s just not worth it for the potentially fatal risk involved.
• Never short anything naked, i.e. directly short stocks or sell call options without hedging. This is in essence using margin with unlimited risk that can potentially fatal. I personally always use hedging to short or use put options to bet for the short side. This way, my total downside risk is always predefined and I know upfront how much max I can lose if I’m wrong. As long as it is within my acceptable limit, there won’t be an excruciating burning moment for me even if I’m completely wrong.
• Bet small, especially for short term speculation, and try to go with a high reward/risk ratio for each trade. This is the key in order to be able to win bigger but lose small. For example, I was shorting IWM (Russell 2000) for this week with the weekly puts. Given the very short duration, my position size is quite small relatively speaking as I was prepared to lose all while betting for a quick double. Well I got it wrong and indeed has lost all. But my loss has been more than enough compensated by another short betting (see below).
• Try to diversify if possible. Even in this roaring bullish market, not everything is bullish. We are still seeing many cracks, especially among those that have been chased up fiercely already. A couple of weeks ago, I told my friends that I started to short NKE after it moonshot following a very strong earnings report. See what has happened for it. After it topped around $97, it has declined all the way down to slightly below $90 as of today. Since I’m using a longer term bearish call spread, my bet is relatively big as the risk reward is something like 3:1 in my favor. It has been a luckily great short in the past two weeks. After such a fast decline, some sort of bouncing is very likely. So I’ve adjusted my short spread to make it more neutral. But I think we will get another chance to short it again if it indeed shoot up with a dead cat bounce. In addition, I’m also holding some puts for MRK and VZ and I think they will turn out to be great shorts as well, given the overall market has been in such an overbought condition and the TA for the two are quite bearish.

No one likes being wrong but it is unavoidable in trading. However, you don’t need to  be burned when wrong! As long as you can manage your risk appropriately, you don’t need to be the burning victim even when you bet on the wrong side. Hope this helps!