Shorting has made it back into the headlines because a number of directors and financial commentators are seeking to blame it for the fall of civilization, or at the very least the fact that bank shares have taken a beating.

I wrote just over a year ago about how powerful forces will do whatever they can to skew the market to favor long positions. And so it has come to pass that restrictions have been introduced on short selling, first in the UK and then the US.

I can sympathize with the need for restrictions to some extent. If banks such as HBOS in the UK were allowed to go bust, the lost deposits and the need for tax-payers to refund people’s savings would drive economies into depression. There was also the suspicion that traders on the short side were spreading rumors to undermine the stocks they were shorting.

Financial commentators need to get things in perspective though. Short selling hasn’t destroyed the banks’ balance sheets and reputations. Bad management alone has done that. Short selling can merely accelerate the discovery process and bring to light the fundamentally poor risk management practiced by people who – given their enormous remuneration levels – should have known better.

It looks, though, that shorting didn’t actually have much to do with the situation. Take HBOS again. During the three-day price slump culminating in its takeover, 990 million HBOS shares were traded – that’s almost 19 percent of the stock. Yet figures from dataexplorers.com show only 3 percent of HBOS stock was on loan. (Fannie Mae and Freddie Mac at some stages peaked at 40 percent loaned.) So for UK authorities to blame shorting for HBOS’s predicament and then use this as the basis for trading restrictions seems a bit like blaming a mouse because a dog ate your supper.

I enjoyed the quote at the end of the week from SEC chairman Christopher Cox:

“The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets.”

In a rational world, we would of course apply the same high-minded approach during bull markets, when stocks are talked up rather than down and companies are able to fund takeovers of other companies using the value of their own hyped stock as capital. We don’t though. We allow these bull-market frauds to continue. They only seem to be exposed finally by falling stock prices. (These evil short sellers again!) Still, I shouldn’t complain too much; bull markets that continue for too long are easy to profit from, because you can simply sit on the trend for as long as it runs.

The week’s happy/sad events bring Jesse Livermore’s short-selling career to mind. Here’s what he had to say in Reminiscences of a Stock Operator about how he and others brought the market to its knees through short selling, and why he stopped selling and went long before he caused a country wide (not Countrywide!) catastrophe:

Things got worse and worse. Finally there came the awful day of reckoning for the bulls and the optimists and the wishful thinkers and those vast hordes that, dreading the pain of a small loss at the beginning, were now about to suffer total amputation without anaesthetics.

My friend’s partner was as bearish as I was. The firm therefore did not have to borrow, but my friend, the broker I told you about, fresh from seeing the haggard faces around the Money Post, came to me. He knew I was heavily short of the entire market.

I had seen a smash coming, but not, I admit, the worst panic in our history. It might not be profitable to anybody if it went much further. Finally it became plain that there was no use in waiting at the Post for money. There wasn’t going to be any. Then hell broke loose.
The president of the Stock Exchange, Mr. R. H. Thomas, so I heard later in the day, knowing that every house in the Street was headed for disaster, went out in search of succor. He called on James Stillman, president of the National City Bank, the richest bank in the United States. Its boast was that it never loaned money at a higher rate than 6
per cent. Stillman heard what the president of the New York Stock Exchange had to say. Then he said, “Mr. Thomas, we’ll have to go and see Mr. Morgan about this.”

The two men, hoping to stave off the most disastrous panic in our financial history, went together to the office of J. P. Morgan & Co. and saw Mr. Morgan. Mr. Thomas laid the case before him. The moment he got through speaking Mr. Morgan said, “Go back to the Exchange and tell them that there will be money for them.”

“Where?”

“At the banks!”

So strong was the faith of all men in Mr. Morgan in those critical times that Thomas didn’t wait for further details but rushed back to the floor of the Exchange to announce the reprieve to his death-sentenced fellow members.

Then, before half past two in the afternoon, J. P. Morgan sent John T. Atterbury, of Van Emburgh & Atterbury, who was known to have close relations with J. P. Morgan & Co., into the money crowd. My friend said that the old broker walked quickly to the Money Post. He raised his hand like an exhorter at a revival meeting. The crowd, that at first had been calmed down somewhat by President Thomas’ announcement, was beginning to fear that the relief plans had miscarried and the worst was still to come.

I heard a day or two later that Mr. Morgan simply sent word to the frightened bankers of New York that they must provide the money the Stock Exchange needed.

“But we haven’t got any. We’re loaned up to the hilt,” the banks protested.
“You’ve got your reserves,” snapped J. P. “But we’re already below the legal limit,” they howled

“Use them! That’s what reserves are for!” And the banks obeyed and invaded the reserves to the extent of about twenty million dollars. It saved the stock market. The bank panic didn’t come until the following week. He was a man, J. P. Morgan was. They don’t come much bigger.

That was the day I remember most vividly of all the days of my life as a stock operator.

That morning a broker who had done a lot of business for my brokers and knew that I had been plunging on the bear side rode down in the company of one of the partners of the foremost banking house in the Street. My friend told the banker how heavily I had been trading, for I certainly pushed my luck to the limit. What is the use of being right unless you get all the good possible out of it?

Perhaps the broker exaggerated to make his story sound important. Perhaps I had more of a following than I knew. Perhaps the banker knew far better than I how critical the situation was. At all events, my friend said to me: “He listened with great interest to what I told him you said the market was going to do when the real selling began, after another push or two. When I got through he said he might have something for me to do later in the day.

“When the commission houses found out there was not a cent to be had at any price I knew the time had come. I sent brokers into the various crowds. Why, at one time there wasn’t a single bid for Union Pacific. Not at any price! Think of it! And in other stocks the same thing. No money to hold stocks and nobody to buy them.

I had enormous paper profits and the certainty that all that I had to do to smash prices still more was to send in orders to sell ten thousand shares each of Union Pacific and of a half dozen other good dividend-paying stocks and what would follow would be simply hell. It seemed to me that the panic that would be precipitated would be of such an intensity and character that the board of governors would deem it advisable to close the Exchange, as was done in August, 1914, when the World War broke out.

It would mean greatly increased profits on paper. It might also mean an inability to convert those profits into actual cash. But there were other things to consider, and one was that a further break would retard the recovery that I was beginning to figure on, the compensating improvement after all that bloodletting. Such a panic would do much harm to the country generally.

I made up my mind that since it was unwise and unpleasant to continue actively bearish it was illogical for me to stay short. So I turned and began to buy. It wasn’t long after my brokers began to buy in for me and, by the way, I got bottom prices that the banker sent for my friend.

“I have sent for you,” he said, “because I want you to go instantly to your friend Livingston and say to him that we hope he will not sell any more stocks to-day. The market can’t stand much more pressure. As it is, it will be an immensely difficult task to avert a devastating panic. Appeal to your friend’s patriotism. This is a case where a man has to work for the benefit of all. Let me know at once what he says.”

My friend came right over and told me. He was very tactful. I suppose he thought that having planned to smash the market I would consider his request as equivalent to throwing away the chance to make about ten million dollars. He knew I was sore on some of the big guns for the way they had acted trying to land the public with a lot of stock when they knew as well as I did what was coming.

As a matter of fact, the big men were big sufferers and lots of the stocks I bought at the very bottom were in famous financial names. I didn’t know it at the time, but it did not matter. I had practically covered all my shorts and it seemed to me there was a chance to buy stocks cheap and help the needed recovery in prices at the same time if nobody hammered the market.

So I told my friend, “Go back and tell Mr. Blank that I agree with them and that I fully realized the gravity of the situation even before he sent for you. I not only will not sell any more stocks to-day, but I am going in and buy as much as I can carry.” And I kept my word. I bought one hundred thousand shares that day, for the long account. I did not sell another stock short for nine months.

That is why I said to friends that my dream had come true and that I had been king for a moment. The stock market at one time that day certainly was at the mercy of anybody who wanted to hammer it. I do not surfer from delusions of grandeur; in fact you know how I feel about being accused of raiding the market and about the way my operations are exaggerated by the gossip of the Street. I came out of it in fine shape. The newspapers said that Larry Livingston, the Boy Plunger, had made several millions. Well, I was worth over one million after the close of business that day. But my biggest winnings were not in dollars but in the intangibles: I had been right, I had looked ahead and followed a clear-cut plan. I had learned what a man must do in order to make big money; I was permanently out of the gambler class; I had at last learned to trade intelligently in a big way. It was a day of days for me.

Jesse Livermore learned about the best stock tips the hard way.

Having learned his lesson, he enjoyed discussing how their willingness to take stock tips had hit other traders in their pockets.

In this excerpt from Reminiscences of a Stock Operator, ‘Larry Livingston’ (aka Jesse Livermore) tells the tale of Walker, Hood and the Atlantic & Southern tips:

But the prize tip story of my collection concerns one of the most popular members of the New York Stock Exchange, J. T. Hood. One day another floor trader, Bert Walker, told him that he had done a good turn to a prominent director of the Atlantic & Southern. In return the grateful insider told him to buy all the A. & S. he could carry.

The directors were going to do something that would put the stock up at least twenty-five points. All the directors were not in the deal, but the majority would be sure to vote as wanted.

Bert Walker concluded that the dividend rate was going to be raised. He told his friend Hood and they each bought a couple of thousand shares of A. & S. The stock was very weak, before and after they bought, but Hood said that was obviously intended to facilitate accumulation by the inside clique, headed by Bert’s grateful friend.

On the following Thursday, after the market closed, the directors of the Atlantic & Southern met and passed the dividend. The stock broke six points in the first six minutes of trading Friday morning.

Bert Walker was sore as a pup. He called on the grateful director, who was broken-hearted about it and very penitent. He said that he had forgotten that he had told Walker to buy. That was the reason he had neglected to call him up to tell him of a change in the plans of the dominant faction in the board. The remorseful director was so anxious to make up that he gave Bert another tip. He kindly explained that a couple of his colleagues wanted to get cheap stock and against his judgment resorted to coarse work.

He had to yield to win their votes. But now that they all had accumulated their full lines there was nothing to stop the advance. It was a double, riveted, lead-pipe cinch to buy A. & S. now.

Bert not only forgave him but shook hands warmly with the high financier. Naturally he hastened to find his friend and fellow-victim, Hood, to impart the glad tidings to him.

They were going to make a killing. The stock had been tipped for a rise before and they bought. But now it was fifteen points lower. That made it a cinch. So they bought five thousand shares, joint account.

As if they had rung a bell to start it, the stock broke badly on what quite obviously was inside selling. Two specialists cheerfully confirmed the suspicion. Hood sold out their five thousand shares. When he got through Bert Walker said to him, “If that blankety blank blanker hadn’t gone to Florida day before yesterday I’d lick the stuffing out of him.

Yes, I would. But you come with me.”

“Where to?” asked Hood.

“To the telegraph office. I want to send that skunk a telegram that he’ll never forget. Come on.”

Hood went on. Bert led the way to the telegraph office. There, carried away by his feelings they had taken quite a loss on the five thousand shares he composed a masterpiece of vituperation. He read it to Hood and finished, “That will come pretty near to showing him what I think of him.”

He was about to slide it toward the waiting clerk when Hood said, “Hold on, Bert!”

“What’s the matter?”

“I wouldn’t send it,” advised Hood earnestly.

“Why not?” snapped Bert.

“It will make him sore as the dickens.”

“That’s what we want, isn’t it?” said Bert, looking at Hood in surprise. But Hood shook his head disapprovingly and said in all seriousness,

“We’ll never get another tip from him if you send that telegram!”

A professional trader actually said that. Now what’s the use of talking about sucker tip-takers?

John Wheeler is a theoretical physicist with a talent for memorable communication. In the nineteen-sixties he came up with the term “black hole” to describe the phenomenon we now know as…….. a black hole.

On scientific laws he offered: “There is no law except the law that there is no law.”

More generally, for anyone chasing knowledge, he said: “In any field, find the strangest thing and then explore it.”

So, in stock trading – or speculation - what is the strangest thing?

Surely it must be the large number of people willing to be losers so that others might gain.

Ours is a zero (or negative) sum game. On every stock index, one half of all shares traded must, on average, be traded for a loss, relative to the movement of the index itself. When trading fees and costs are taken into account, it’s plain to see that compared with buying the index there’s a net average loss associated with trading.

The winners must be a minority. So why on earth would anyone want to start trading?

Funnily enough, an answer comes from another theoretical physicist – the iconoclastic Richard Feynman.

In Surely You’re Joking Mr. Feynman, a collection of anecdotes about his life, he talks about his times in Las Vegas. Feynman, like Jesse Livermore, was a womanizer. He knew gambling was a sucker’s game but he liked visiting Vegas for the female company.

Here’s what he had to say about a visit to a casino:

….and she said “See that man over there, walking across the lawn? That’s Nick the Greek. He’s a professional gambler.”

Now I knew damn well what all the odds were in Las Vegas, so I said, “How can he be a professional gambler?”

“I’ll call him over.”

Nick came over and she introduced us. “Marilyn tells me that you’re a professional gambler.”

“That’s correct.”

“Well, I’d like to know how it’s possible to make your living gambling, because at the table, the odds are 0.493.”

“You’re right,” he said, “and I’ll explain it to you. I don’t bet on the table, or things like that. I only bet when the odds are in my favor.”

“Huh? When are the odds ever in your favor?” I asked incredulously.

“It’s really quite easy,” he said. “I’m standing around a table, when some guy says, ‘It’s comin’ out nine! It’s gotta be a nine!’

The guy’s excited; he thinks it’s going to be a nine, and he wants to bet. Now I know the odds for all the numbers inside out, so I say to him, ‘I’ll bet you four to three it’s not a nine,’ and I win in the long run. I don’t bet on the table; instead, I bet with people around the table who have prejudices - superstitious ideas about lucky numbers.”

Nick continued: “Now that I’ve got a reputation, it’s even easier, because people will bet with me even when they know the odds aren’t very good, just to have the chance of telling the story, if they win, of how they beat Nick the Greek. So I really do make a living gambling, and it’s wonderful!”

So Nick the Greek was really an educated character. He was a very nice and engaging man. I thanked him for the explanation; now I understood it. I have to understand the world, you see.

So, what’s the moral I take from this story?

Given the sheer number of suckers who make their way to Las Vegas hoping to win, but deep down knowing they’ll lose, and the numbers who lose money trading, it has to be that more people have an instinct for gambling than have an instinct for winning. They also like to experience the thrill of the game – whether it’s chasing the big win on the one armed bandits or on the trading screen. They like to talk about their experiences – “I beat Nick the Greek” or “I made 30% on the breakout”. Occasionally they’ll be lucky and have a big victory they can brag about. Losses are often kept quiet.

In addition to and tied in with the gambling behavior is the “I’m better than he is” attitude often seen in car drivers. Survey after survey shows the vast majority of drivers believe their driving is above average. Clearly it’s impossible for the majority to be above average at anything. People are systematically overestimating their own ability.

The trouble with trading is that a lot of books actually tell beginning suckers that, by following the advice of the book, they will become better than average traders. This reinforces their in-built car-driving/I’m better than he is attitude. Only bitter experiences and, sometimes, large losses change that.

For me, the willingness of traders to repeatedly lose money was the strangest thing in trading. What do you think?

A couple of my recent articles have been about ‘gut feel‘.

I’m writing about gut feel for the last time today - about how our gut feel for numbers - probability/chance in particular - is inaccurate. This is important because trading is a game of chance. We should trade when we have the highest expectation of success.

Most of this post is taken up with the Monty Hall game. If you’re not already familiar with it, Monty Hall can be a surprising introduction to how we misjudge our chances of winning. I’ll begin, though, with a quick look at birthdays.

Gut Feel Misjudges Birthday Probabilities

How many people do you think would need to occupy a room for a 50/50 chance that two of them share the same birthday? The answer is 23.

For a 99%+ chance that two people share a birthday, only 57 people are needed.

These results are counterintuitive. Our gut feel is that more people should be needed.

Gut Feel Misjudges Chances of Winning a Game

Another well-known example of how our gut feel gets confused about probability is the Monty Hall Game - named after the host of the 1960s television quiz show Let’s Make a Deal.

Each week, Monty Hall would offer the contestant three doors. Behind one door was a big prize and behind the other two doors was nothing. Obviously, the contestant had a 1 in 3 chance of choosing the winning door.

Let’s imagine that you are a contestant.

You pick a door - the blue one - hoping to win the prize.

Then Monty has a bit of fun with you. Monty knows which door the prize lies behind. After you tell Monty your choice, he opens one of the doors to show you that the prize isn’t there.

Monty then asks you if you want to change your mind.

So what do you do? Stick with your first choice or change?

I’ll give you a moment to make your choice - try to choose without reading ahead.

Made your mind up? Good.

The correct answer is that you should accept Monty’s offer and change your selection to the yellow door. Doing so increases your chances of winning the prize.

Now, I must admit when I first heard this puzzle, my initial instinct was to stick with my original choice - I didn’t think it would make any difference switching doors. Surely, after Monty had shown me one empty door, I would have a 50/50 chance of winning the prize whether or not I switched my choice of doors. But, no, that’s not the case. In fact, after Monty has shown you one empty door, there’s a two-thirds likelihood that the prize lies behind the door you did not originally pick. Let’s see why.

First, you are presented with a choice.

You have a one in three chance of choosing the right door.

Second, you choose a door.

There is a one in three chance the prize is behind this door. There is a two in three chance that it lies behind another door.

Now Monty opens a door.

In doing so, he changes your chances, if only you realized it. There must still be a two in three chance that the prize lies behind one of the doors you haven’t chosen. You have now been shown which of these doors doesn’t have the prize behind it. This means that choosing the final door - the yellow door on the right - has a two-thirds chance of winning the prize.

Summing Up

If we rely on gut feel in activities involving probabilities we are likely to make big mistakes.

There’s a stock market saying that bulls can make money, bears can make money but the pigs get slaughtered. Make sure you leave gut feel to the pigs and write your trading plans using predefined, objective criteria.

Last week, I wrote about one of Jesse Livermore’s triumphs. This week, however, it’s a tragedy I’m writing about.

Seventy-three years ago, on March 19 1934, Time Magazine reported Jesse Livermore’s final bankruptcy.

From the 1929 pinnacle of his career, when he shorted the market for a profit of $100 million, less than five years had passed.

A few months earlier, Jesse Livermore had gone missing and his wife had called in the police. A day after disappearing he had returned home, walking unsteadily. He had spent the night in a hotel and had awoken with a blank mind. Reading newspaper headlines about his disappearance brought him to his senses. His doctor’s verdict: “Amnesia nervous breakdown.”

It’s likely that during this period of his life, Livermore was suffering badly from the clinical depression he suffered from at various times.

He listed liabilities of $2,259,212.48, and assets of $184,900, mostly life insurance. (He also had large annuities bought to protect his family in the event of bankruptcy.)

Livermore’s financial plight also produced further evidence, adding to his reputation as a womanizer:

To Lucille Ballantine - a dancer - he had promised to pay $150 per month for five years for keeping him “cheered and amused” while he was getting his second divorce.

A former employee - Naida L. Krasnova - was suing him for breach of promise. (Claiming he had promised to marry her.)

Time commented: “Perhaps Jesse L. Livermore will come back as he has done three times before. That was what his lawyers had in mind last week when they declared: ‘Mr. Livermore has made three very large fortunes. … He has failed three times, on each occasion [he] has paid 100 cents on the dollar with interest, and hopes to do so again.’ ”

Sadly, on this occasion, the lawyers’ optimism was misplaced.

I want to talk a little more about how conditioned minds can prosper in trading. You’ll be relieved to know that I’m going to use a trader rather than a scientist as the example this time.

Jim Leitner runs Falcon Management in New Jersey. He has taken $2 billion profit out of the market in his career. Jim gave an interview to Steven Drobny for his book The House of Money. Jim’s mind has been conditioned by a huge amount of experience in trading, as follows:

• While studying international finance and Russian at graduate school, Jim worked half days as a “monkey” - a money broker trainee adding data from around the world to the big board for the brokers to see.
• While still working as a monkey, he started broking - calling small banks in the Midwest. He did this for two years.
• He then took a big salary cut to get more experience, working at J.P. Morgan, trading the Eurodollar market. Jim became an expert on euroswiss francs, eurodeutsche marks and europesetas.
• He then became an FX trainee with J.P. Morgan and then a currency forward trader.
• After a few years, Jim was hired by the Bank of America to run forwards, exotics and all currency trading outside the major currencies.
• He moved to Shearson Lehman as a proprietary trader.
• He moved to Banker’s Trust and spent five years trading currencies.

With all this experience behind him, Jim was asked whether he has an innate trading skill and can “just tell” when prices are out of line. He answered:

“I don’t have an innate skill. It comes from being extremely interested in markets and looking at everything all the time. After doing it for years I’ve developed a mental database of where things should be, such that when something makes an irregular move, it shows up on my radar screen. I used to have so much fun playing around in the market and knowing that I knew my markets better than other people.”

So here again, is an example of a conditioned mind prospering where others fail. Where others might claim an innate skill or a gut feel for trading, Jim Leitner attributes his success to conditioning of the mind - a mental database - built up from many years’ trading.

Jim Leitner’s hedge fund, Falcon Management, has a website. You can find out their address and their phone number but nothing else.

I’m off now to condition my own mind.