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.

I recall a discussion I had around 5 years ago with a semi-sucker.

This particular semi-sucker had misunderstood a trading book. He believed it should be possible using money management techniques to beat the casino at roulette. Provided he could cut his losses (by leaving the casino when he was losing) and let his profits run (by continuing to play when he was winning) he was “bound to make money”.

Now, I know this gambling strategy sounds superficially similar to Livermore’s strategy of quickly closing losing trades and allowing winning trades to run: but there’s one crucial difference. Livermore’s strategy – through his tape reading and trend following – had positive mathematical expectation. ^*

The suckers who play roulette in casinos do so under the handicap of negative expectation. It’s the casino owners who enjoy positive expectation – why else would they be in the business? The direction of money flow is from a casino’s customers to its owners.

Money management can’t turn a game with negative expectation into one you can win – it can only keep you playing longer. All that our semi-sucker friend could hope to achieve was more nights at the casino. Eventually, the casino would take all of his money.

The same outcome awaits the sucker who begins trading when his mathematical expectation is negative. Unless he is lucky, money will flow from him to people who have better trading strategies than he does. If he wins through good luck, the more often he plays, the likelier it is that his luck will run out.

The good news is that some markets are more forgiving than others. Given the long-term uptrend of the major stock indices, it’s often possible to turn a profit on long stock trades, even if you have poorer than average trading skills. Your profit will, of course, be lower than if you had simply put your money into an index-fund. And, with below average skills/knowledge/strategy, you’re more likely to end up with a big loss than a small profit – especially if you trade frequently.

^* Mathematical Expectation: Your chances are 50/50 when you bet on the toss of a fair coin. If the coin is loaded, however, and it landed heads more often than tails, then betting on heads has positive expectation and betting on tails has negative expectation.

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?