Tuesday, June 9, 2009

strong hand, weak hand

Tonight want to talk about the concept of strong and weak hands. I’m going to start off with an analogy.

Let’s say you just bought a business, a small restaurant. You open for business on Monday and after a week you’ve grossed $6000. You’re feeling pretty good about yourself. Then all of a sudden Saturday comes around and you get a bill for your first food order, payroll, rent and CAM’s. Maybe you also have the misfortune to get hit with the gas and electric bills on top of that. By the time you finish writing checks your +$6000 has turned into -$1000. Now let me ask you this, would you immediately throw up your hands, lock the doors, and walk away?

I dare say most of you would stick it out a little longer than that. I would hope that most of us have enough common sense to realize that sometimes we have to persevere to get to the reward .

However most stock market investors do exactly that, they walk away from their “business” after the first minor set back even if they logically understand that there is no fundamental reason to lock the doors.

Now in my opinion the difference between a strong investor, one who is not easily knocked out of their position, and a weak one, has nothing to do with how deep ones pockets are. It has nothing to do with how much experience one has. And it certainly doesn’t matter what one uses to give them an edge, whether it be technicals, fundamentals, patterns or chicken gizzards.

I can tell you this: everyone when they enter a position starts out as a weak hand. No matter how deep their pockets. An investor has to graduate to strong hand status. That, my friends, can only be earned with patience. Let me show you what I mean.

Let’s say you bought mining stocks back in November. Now it’s June and your position is up almost 100%. You are now far enough into the green that a normal correction is not going to be able to knock you out of your position. You’ve become a strong hand.

However when you entered that position you would have immediately suffered a drawdown and unless you had the conviction to hold on to your trade, you would have gotten knocked out right away. Look what you would have missed.

It’s very rare that an investor will graduate to strong hand status quickly. The market rarely moves that fast. 90% of the time the only way you are going to move into the strong hand category is with patience. You are just going to have to let your position work long enough to put a lot of green between you and your entry. Eventually though, you will reach a point where you can weather almost any correction unaffected.

Now here’s the problem with trading. You almost never make it into the strong hand category.
An investor who tries to get “cute” with his investments has the same problem. As soon as you sell you immediately become a weak hand again. “Old Turkey” knew what he what he was talking about.

Let me describe what happens to most traders, novice and professional alike. Let’s say you take a position and you time it pretty well so that the trade goes your way immediately. You’re making money and now you’re feeling pretty good about yourself. The problem comes if you don’t have a clear cut exit. If you hold too long the market will almost always pull back enough to take your trade back into the red at some point. When that happens most traders freak out and sell for a loss.

Or how about this one? You enter a trade but you don’t time it well. You enter at a short term top. The market goes against you immediately and you freak out and sell for a loss. Of course if you would only hold tight, the reason you took the trade in the first place will usually turn the trade back in your favor eventually. Of course by that time you will be no where to be seen. The market already took your money. “Thanks, come back soon”

In the last scenario you will probably have two periods where the market takes you into the red. How many of you can hold through that kind of torture?

I have a friend who trades several accounts. In early March he correctly identified the bottom. In one account he took positions in several badly beaten up stocks (which was a stroke of genius BTW, I’m pissed I didn’t think of it) and then proceeded to … ignore it.

Meanwhile in his trading account he tried to time the ups and downs of this bear market rally.

So here’s the outcome. In his smaller account it wasn’t long before he graduated to strong hand status. His positions were so far in the green that he just didn’t have any need to watch them. Any corrections were pretty much meaningless to him. That account is now up huge.

However in his larger trading account he never held anything long enough to move to strong hand status. Every time he sold he immediately started over in the weakest position. The outcome was a whole lot of trading for not much profit. If he could have taken the same approach with his trading account and let his positions work long enough to reach strong hand status he would literally be rolling in cash.

Now I’m not suggesting we should all take positions in Crox and GM. Realistically it would not have been prudent to fill ones main account with companies that could have been on the verge of bankruptcy. I’m just making the point as to the trading strategy for each account and the outcome of those two very different strategies.

Short sellers are in the same position. Short selling just by its very nature is going to be pretty tough to achieve strong hand status. Let’s face it there is no way to get 200-300% in the green like you can on the long side. Plus bear market rallies are violent affairs that can evaporate a nice short sell in a matter of days if not minutes.

I suspect most of you right now are still weak hands when it comes to your mining positions. When gold moves down into the next daily cycle low I expect most of you are going to experience that first test as your initial profits turn red. This is the stage of the game where you have to decide whether you want to hang on long enough to move into the strong hand category or whether you are going to remain cannon fodder for the pros.