George Taylor emailed me asking why I don’t share the complete details of my personal trading methods. While I’m more than happy to talk about the general principles of how to trade and how Jesse Livermore’s view of trading can still be used as the basis of a trading system today, I won’t share specific details of my own techniques. Here’s why:

If you have a trading system that gives you an edge, you don’t go sharing it - not if you want to keep using it profitably. Think of it this way:

Imagine you discovered that at 4 a.m. each morning 100 gold coins would magically appear, scattered over a local beach. Getting up in the middle of the night is a pain but for 100 gold coins – well it’s good money. After a few days, in a generous mood, you share your secret with your best friend. Next morning at 4 a.m., you’ve got company on the beach. Your friend is there too – following an identical strategy to yours, gathering up the coins. From now on, you’re averaging only 50 coins a night.

Things go from bad to worse. Your friend tells his brother and his brother tells his uncle about the coins. Now you’re averaging 25 coins a night. Before too long, over 100 people know about the beach and then thousands have learned the secret. People are now making more money from selling books about gold coins on the beach than they are from actually going to the beach.

Arriving on the beach at 4 a.m. is no longer a useful strategy. It costs you more getting to the beach than you’ll be able to take in profit.

I hope that helps.

As its price rises to fresh heights I’m going to return to the topic of oil.

At the beginning of July 2007 I wrote about how I had profited from my long-term view of oil prices and I mentioned three stocks I got into several years ago. As of July 2007, the Canadian Oil Sands Trust (COS-UN.TO) had quadrupled in price in five years, Suncor (SU) had quintupled and UTS Energy (UTS.TO) had sextupled.

So, since then, what has happened to the prices of these stocks?

COS-UN.TO from 32.94 to 48.18 …………..up 46.3%

UTS.TO from 6.06 to 5.45 …………..down 10.0%

SU from 89.92 to 120.44 …………..up 33.9%

In ten months the average rise has been 23.4% (equal weighting) giving an annualized return of 27.5% - which is pretty good.

It would have been a lot better if I’d ditched UTS.TO last year, when it looked like the long-term uptrend was over. I was very patient with UTS.TO though because of my bullish view of oil in general, but it’s time to call it a day. I have now culled UTS.TO because its chart has been moribund for a couple of years. I’ll keep my eye on the other two stocks because the long-term slope of the uptrend has reduced in the last couple of years and it may be time to reassess how I should try to profit from oil in the long term.

I say this especially because I got into these stocks because I thought their price would rise faster than the price of oil. In the past year, however, the price of oil has doubled and the stocks haven’t kept pace.

Today’s Oil News

Goldman Sachs has predicted that oil could rise to $150 to $200 within two years as a result of demand rising faster than supply. (Others disagree.)

Why I Agree with Goldman Sachs and why Hillary Clinton won’t increase anyone’s Oil Production

I tend to avoid politics but I noted Hillary Clinton saying yesterday that she was going to use anti-trust legislation to force the OPEC cartel to pump more oil and bring the price down. Okay, yes, it’s a “political promise” - most of which are worthless - but I’ll use it to make my own point.

My question for Hillary Clinton is: why not use anti-trust legislation to force Texas to quadruple its oil output? Surely that would be easier to enact? The trouble is, of course, that Texas is running out of oil and governments can’t legislate for the magical creation of new oil. (Although the Fed seems to be doing it all the time with money!)

Just as Texas produces less oil than it used to, so does Saudi Arabia, the world’s biggest producer. Saudi Arabian oil production has almost certainly passed its peak. Hillary, you can’t force a country to pump oil it doesn’t have using anti-trust legislation.

Once we are aware of the initial velocity of an object we can accurately predict its entire journey. We use these principles to send spaceships to other planets. Similarly with oil, once we have the first few years’ of production data from a single oil field, or from a country’s oil fields or indeed a planet’s oil fields we can predict the entire trajectory of oil production. This is the basis of the famous Hubbert Curve and Peak. (Google it if you’re one of the few not yet familiar with it.)

This is the heart of the problem. The world’s population continues to rise. Industrialisation of the huge population centers of China and India continues apace. And – just like Texas produces less oil than it used to - so will planet Earth. It may be we’ve reached the peak. It may be the peak is still a year or two away.

Where will the price of oil go? In the short term, I don’t know. As traders we know that when a price trends upward, more people buy for technical reasons – trend followers, momentum traders, chartists - technical analysts of all persuasions. It’s difficult to say how much of today’s price is driven by speculation.

I’m happy to trade on the long-term trend without worrying massively about the fundamentals.

When I consider the fundamentals, the only thing I see that can bring the long-term price of oil down is reduced demand relative to supply; but I don’t see many signs of this happening.

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.

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.

I’ve heard experienced traders talk about trading on “gut feel”. Inexperienced traders need to be cautious about this sort of trading - if they don’t want to see their trading accounts clobbered.

What exactly is gut feel? I see it as the way our previous experiences have stacked up to guide our decision taking.

You’ll need to forgive me for bringing science in here, but scientists and traders have quite a few things in common - one of which is that we’re constantly trying to analyze data to construct the most accurate or financially beneficial models of our worlds. The astronomer James Christy’s discovery of Charon - Pluto’s moon - is a great example of using previous experiences to see the true picture.

After Christy discovered Charon he looked back at other people’s work and he realized that Charon had already appeared on many other images of Pluto - but people hadn’t seen it.

So why hadn’t the people who had analyzed the images before - and we’re talking about professional astronomers here - realized Pluto had a moon? It turns out that Pluto and Charon were closer together than anyone had ever expected a planet and its moon to be. The astronomers who had seen images of Pluto and its moon together had discarded them, believing the images were distorted because Pluto appeared to be “elongated”. The “elongation” was, of course, Charon.

The astronomers’ minds had been conditioned to interpret the images incorrectly. Here’s what Christy said about the discovery (from Planets Beyond by Mark Littman):

“When I first saw these exposures on June 22, 1978, I was looking with the mind and eyes of an astronomer who had examined roughly 50,000 images in recent years. Many of these images had been of double stars exposed in the course of the U.S. Naval Observatory’s extensive double-star program. I had seen dual images blended together in all possible circumstances by all combinations of image distortions. My mind was now attuned to two celestial bodies disguised as one. Now I could think: Pluto has a moon.”

Christy’s mind had been conditioned by years of experience to see the possibility that the elongation in images of Pluto was actually its moon.

In our day-to-day lives, our minds are conditioned and tuned - just as Christy’s was - on the basis of our previous experiences. When we use these accumulated experiences sub-consciously we call it gut feel.

The better the mind has been conditioned, the better the prospects of gut feel actions having a successful outcome.

When we’re trading, if our minds have been conditioned by years of observations and experiences during different phases of market behavior they can reach better conclusions than if they’re less experienced. The sort of gut feel that can sweep across stocks, commodity and FX markets and pick up more than its fair share of good trades doesn’t come quick and it doesn’t come cheap. It takes years of experience with plenty of costly mistakes along the way.