1. Market commentators say money’s going to be made by anyone who goes long volatility. You decide it’s time to:

2. Tomorrow is your birthday and you’re feeling good. To celebrate your birthday, you’re going to:

3. It’s vacation time. You’re on a tropical island and a street vendor offers you a bag of peanuts for 50c. You:

4. Selling short is inherently riskier than going long because:

5. The 3-6-3 rule is:

Check out what sort of trader you are on Spot the Sucker.

In his 1987 letter to shareholders, the masterfully quotable Warren Buffett said, “If you’ve been in the [poker] game 30 minutes and you don’t know who the patsy is, you’re the patsy.”

In the same letter, he said, “If you aren’t certain that you understand and can value your business far better than Mr. Market, you don’t belong in the game.”

Four Grades of Sucker

The equally masterful quote-smith, Jesse Livermore, categorized four grades of sucker:

The Beginning Sucker: has read little and knows little.

The Semi-Sucker: has read books about trading – usually written by higher-grade suckers. He can recite wise stock market sayings. He does not realize that reading books is not the same as trading experience. He loses money more slowly than the beginning sucker because he has learned some basic trading rules.

The Wall Street Fool: knows enough to make a profit if he sticks faithfully to his trading rules. The excitement of the market overpowers the fool; he trades more often than he should and loses his advantage over the market.

The Higher Grade Sucker: makes his money from selling trading books because he can’t make money in the markets.

Although Buffett and Livermore are at opposite ends of the financial spectrum in terms of buy and sell criteria, they wholeheartedly agree that if you don’t have some advantage over average market participants, you’ll lose money.

There are a lot of intelligent players in the markets and plenty of fools too. Unfortunately, too many stock market books try to persuade their readers that fools predominate, lulling the semi-sucker into a false sense of security. If only you will do what it says in the book (often with too little detail to put together a truly effective trading strategy) you’ll be successful.

Before you trade, you should have some idea of where your advantage is coming from. You should paper trade to verify your advantage.

Then you need to trade for real – this is hardest of all because once you have your own money in the markets, your emotional involvement increases. The emotions – greed and fear start kicking in – cause difficulties for many traders. Some find the advantage they thought they had evaporates.

So, do you call yourself a beginning sucker, a semi-sucker, a Wall Street fool, a higher-grade sucker or a successful trader? The best test is the direction of your trading account balance over several years. As an alternative, though, you could try passing the Stock Market Sucker Test.

After an exciting week on the markets, one I’m sure Jesse Livermore at the peak of his powers would have relished, here are a few jokes – probably as old as Jesse – to ease us into the weekend:

“I’m giving you three weeks’ vacation,” said the boss at the investment bank.

“Wow, thank you very much sir.”

“And make sure you enjoy yourself. When you come back I shall have something very serious to say to you.”

***

The assistant at the meat counter had been fired and had sworn vengeance on the store.

He returned on Saturday, when the store was swarming with customers, and very publicly placed a dead cat on the counter, calling out cheerily,

“Hey guys, that’s the last of this week’s dozen.”

***
At the investment bank:

“Sir, there’s a debt collector in your office.”

“Tell him he can have the pile in my in-tray.”

I’ll begin with an apology to economists. If an untrained economist were to write an article about physics or chemistry, it’s likely he or she would be given short shrift. So don’t take what I’ve got to say seriously. My opinions don’t matter – all that matters is my ability to take a steady flow of income from the markets.

And now for a little history…

On March 10 1988, an opposition MP goaded British Prime Minister Margaret Thatcher at “Question Time” about the way her Treasury (run by Nigel Lawson) was using interest rate policy and intervention in the foreign exchange markets to keep sterling trading in a tight band with the deutschemark. Mrs. Thatcher actually deeply disapproved of Lawson’s exchange rate policy and she replied – famously:

“Adjustments are needed, as we learnt when we had a Bretton Woods system, as those in the EMS have learnt that they must have revaluation and devaluation from time to time. There is no way in which one can buck the market.”

Unfortunately for United Kingdom taxpayers, Mrs. Thatcher’s successor, John Major, did not subscribe to her views. Under his government the UK joined the European Exchange Rate Mechanism at an unrealistic level. George Soros and others pounced on sterling, shorting it at considerable cost to taxpayers – whose money was recklessly wasted as the government sought to prop up sterling on FX markets.

Soros told the Times: “Our total position by Black Wednesday had to be worth almost $10 billion. We planned to sell more than that. In fact, when Norman Lamont [Treasury Chief] said just before the devaluation that he would borrow nearly $15 billion to defend sterling, we were amused because that was about how much we wanted to sell.”

Moving on a few years came the Greenspan Put. Following the collapse of Long-Term Capital Management, Federal Reserve Chairman Alan Greenspan – who had previously offered an opinion that stocks were overvalued – cut interest rates. Traders called Greenspan’s position “The Greenspan Put” because a put option gives investors the right to sell their stocks at a set price. Greenspan’s actions were seen as a guarantee to the market that he would keep cutting interest rates to prop up the stock market.

We can see the damage low interest rates and reckless loans have done to the economy. US consumers are expected to be the engine of world economic growth – even if they have to get into serious debt to do so. Every time consumers stop to get their breath back, they’re told to wake up and get out spending their money again (or more likely someone else’s money).

Today Ben Bernanke has talked about stimulating the economy again – through cutting interest rates and cutting taxes. This despite the fact that both inflation and government debt are already higher than anyone thinks is prudent.

It now seems all the more credible that the Fed. Chairman is trying to write the Bernanke Put. With the steep falls in stock prices today it seems the markets are telling him that – even with all the intervention in the world – they’ve realized that American consumers and taxpayers cannot go on borrowing forever to fund the expansion of their own and overseas economies.

Perhaps Ben Bernanke should pay heed to those famous words I’ve quoted from Margaret Thatcher?

Today, here’s another fine example – from Germany – of a company and analysts telling investors that everything was fine when its chart told an entirely different story.

Hypo Real Estate Holding AG had been insisting that it wasn’t exposed to the subprime crisis.

Analysts, as of 12.11.2007 were still recommending “BUY”.

Just last week ratings agencies S&P and Moody’s had the outlook for Hypo marked “STABLE”.

Meanwhile the chart was saying “SELL” and had been doing so for some time.

Finally, today, Hypo admitted a writedown of $580m (390 million euros) on debt it had bought. Given that Hypo’s total profit last year was 429 million euros, there’ll be little if any profit this year. In today’s trading, Hypo’s shares promptly lost one third of their value.

Somewhat incredibly, Hypo’s CEO, Georg Funke commented that Hypo’s management had “not made any mistakes”. In fact he said they had done a “fantastic job”.

Sounds like another good year for bonuses then.

Here’s Hypo’s 12 months “SELL” chart with today’s 30%+ fall at the end. Below the chart are recent analyst recommendations from Hypo’s website.

Chart Recommends “SELL”

12.11.2007 Analysts Recommend “BUY”

In case the image on the left makes you think I’m quietly going insane, I am not going to talk about using sunspots as trading signals.

(Although, now that I think about it, sunspot activity does influence climate and climate does influence the economy and the economy does influence the stock market – hey maybe I should be using sunspot activity!)

Let’s get back to the point – and the point is how to avoid unreliable trading methods.

The Spots are Wrong
I remember reading about a researcher a long time ago who took a huge amount – many, many years’ worth – of sunspot data. He used the data to build a new model of sunspot activity. The model seemed to perform brilliantly. When asked to predict sunspot activity at any time in the past, it did so perfectly. But its predictions of future activity were woeful.

The Fools are fools
In similar vein, the Motley Fool’s much hyped Foolish Four technique attempted to beat the stock market. Apparently, by spending just 15 minutes a year, you could crush other investing strategies. The method had worked for 25 years, beating the Dow by 10 percent per annum.

The 15 minutes work consisted of:

1. Find the five stocks out of the 30 stocks in the Dow Jones that have the lowest price and highest dividend yield. (Divide the yield by the square root of stock price.)
2. From the five selected stocks, buy equal dollar amounts of the stocks ranking the second, third, fourth and fifth highest. Discard the highest-ranked stock.
3. Repeat annually until rich beyond the dreams of avarice.

Methods Need to Work in “The Now”
Naturally enough, as soon as this nonsensical method was faced with “the now” instead of “the past” it failed – totally.

All that the sunspot researcher and the Fools showed, in my opinion, was that they didn’t understand numbers.

If you take a large amount of data – as the Fools did – it will contain number patterns. Often these patterns have occurred through mere chance. Sometimes they have a real cause. The Foolish Four latched onto a chance pattern and confused it with reality. Here’s what they said:

“With a Spartan commitment of just minutes a year for research (entailing not much more than clicking into our Today’s Stock List page once a year, figuring out the amount you need to put in each stock, and placing your trades), you can use a strategy that has thrashed the Wall Street professionals for decades. How very Foolish!”

Well, at least they got one thing right.

Here are some nice numbers:

1. A Python can survive quite happily on 1 good victim per year. (Finally proving there’s a difference between snakes and stockbrokers.)
2. According to an old Chinese proverb, there are only 2 types of good people: the dead and the unborn. (So that’s more bad news for stockbrokers then!)
3. During the 1890s, Emperor Menelek II of Ethiopia was told about electric chairs, and he promptly ordered 3 as a neat way of disposing of undesirables. Unfortunately, he didn’t realize that before you could kill people with them, you needed an electricity supply – which Ethiopia hadn’t quite got round to. The ever-resourceful Menelek put one of the chairs to use as his new imperial throne.
4. 4 record companies turned down the Beatles before they were signed to Parlaphone. (Most businesses stay in business by minimizing risks – take heed beginning traders. Too much risk-minimization can lead to under-performance – take heed experienced traders.)
5. Jesse Livermore says it took him 5 years to learn to enough about stock market speculation to make big money when he was right.
6. In 1932 the Soviet Union ruled that there should be only 6 days per week.
7. A mediaeval superstition from Central Europe says a woman can regain her virginity by bearing 7 bastard children. (I heard an analyst say something similar about one of his stocks last week.)
8. In pre-Christian times, there were 8 days in the Graeco-Roman week.
9. An old Turkish proverb seems to have been designed to offend everybody: “Among any 10 men, 9 are women.”
10. The British press tycoon Lord Northcliffe put notices up in his office, saying: “They are only 10.” It helped remind him of the mental age of his newspapers’ readers.

I love numbers. Nine of the number facts above are from A Book of Numbers by John Grant. One is from Reminiscences of a Stock Operator.

In How to Trade in Stocks, Jesse Livermore discussed “the folly of trying to find out a good reason why you should buy or sell a given stock.”

He wrote in the context of the behavior of U.S. stocks, whose four major sectors – including steel makers – had risen after World War 2 began. While other sectors continued to advance, U.S. steel stocks stopped rising.

Livermore wrote that there must have been a good reason why the steel stocks had stopped rising but he didn’t know what it was.

It was not until four months later that the public was given the facts and the action of the steel stocks – which had by now fallen 26 to 29 points – was finally explained. The British and Canadian governments had been selling large volumes of shares in U.S. steel makers. (Presumably to fund their war efforts.)

“If you wait until you have the reason given, you will have missed the opportunity of acting at the proper time!

“The only reason an investor or speculator should ever want to have pointed out to him is the action of the market itself.

“Whenever the market does not act right or in the way it should – that is reason enough for you to change your opinion and change it immediately.

“Remember: there is always a reason for a stock acting the way it does.

“But also remember: the chances are that you will not become acquainted with that reason until some time in the future, when it is too late to act on it profitably.”