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Anatomy of a Losing Trade


Remember: Investing is an emotional as well as an intellectual discipline.

It's my belief that trading and investing is, more than an intellectual discipline, an emotional discipline.

Therefore, I'm going to share the following self-analysis in the spirit of affecting positive change through financial understanding.

Description of the Trade that Failed

After having correctly picked the bottom and having gotten fully invested on the long side in early March while the S&P was between 680 and 700, on April 15, I announced on Buzz & Banter that I'd decided to take profits on my entire long position. I did so with the S&P between 840 and 845.

I explained that I was expecting a dramatic increase in volatility accompanied by a correction of around 10% sometime between April 15 and May 15.

I developed a 4-part rationale for a correction:

1. Given that it was highly likely there'd be disappointments at some point during earning season, the probabilities of a correction were high. And given that companies that had recently exceeded expectations were being sold after their earnings announcements, probabilities of such a correction had increased.

2. The prospect for speculation surrounding the stress tests was a looming threat to the market.

3. I developed a somewhat esoteric theory that drew an inverse parallel between the extreme volatility between mid-October and mid-November of 2008 after a steep and steady fall, and what might be a similar explosion of volatility after a similarly steep and steady rise leading up to mid-April of 2009.

4. Some proprietary indicators of mine that had a very good recent track record were flashing sell signals.

Notwithstanding all of these rationales, on the very day I sold all of my long exposure, I expressed a strong doubt regarding my correction thesis: "I do have one major concern: Everybody and their grandmother is expecting a correction. So I very much doubt that it will occur in the manner that people expect."

On Friday, April 17, I actually decided to establish a put position in XLF and SPX in anticipation of a sharp 1- to 2-day correction the following week. At the time I established these put positions, the S&P was at around 875.

The timing seemed perfect. The following Monday, April 20, the market corrected significantly to about the 832 level. As announced on the Buzz & Banter, I closed the put position Tuesday morning, April 21, when the market was in the 835 range. So far so good.

I announced in Buzz & Banter that I was expecting another assault on the highs and possibly a false break of the 875 level before the market finally made a 10% correction. The former was spot on. However, at this point, things started to go bad for this trade.

Beginning on April 23, I began to focus on risks related to the stress tests, and wrote an article on April 27 (Op-Ed: Back-Door Nationalization?) highlighting the severe dangers inherent in SCAP. I began accumulating some put positions in XLF on April 24 and continued through April 30, adding a VIX call position.
No positions in stocks mentioned.
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