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Traders As Modern Day Hunter-Gatherers
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Traders As Modern Day Hunter-Gatherers

Entering the market is like entering an entirely different world. This world functions nothing like modern society.

Modern society has laws and social norms in place to protect you. If you screw up, you have a safety net. People will generally reach out and help.

Modern society is cushy. Even people who are disabled, suffering mental illness, or are unable to care for themselves in other ways still get by. (Maybe not as well as we’d always like, but far better than at any other time in the past.)

Markets aren’t like modern society.

They’re much closer to being like the world in its most natural state.

The strong prey on the weak.

You live or die based on your own ability.

While the system can sustain a vast array of life and species for large spans of time, each player constantly faces the risk of death. Markets are unforgiving and brutal, yet incredibly abundant places to thrive — just like natural ecosystems.

In this world… traders are the modern day hunter-gatherers.

Hunter-gatherers sustain themselves by staying in sync with the large, complex ecosystem they’re apart of. This ecosystem is full of both opportunities and threats. The hunter-gatherers don’t control anything, but instead seek to achieve harmony with the changes around them.

A key component of long-term survival in the wild is adapting and evolving. Failure to adapt to the changing landscape means you won’t be fed.

The same goes in markets. Markets trade a lot differently now than they did in 1980. If you don’t adapt your strategy along the way you’ll become irrelevant. You’ll starve.

Hunter-gatherers don’t try to extract every last bit of value from a situation. They wouldn’t kill all the deer in a herd even if they could. What would they do with all that meat? There’s no fear of “leaving money on the table” as long as they get what they need to thrive.

Instead of maximizing return, hunter-gatherers seek to achieve satisfactory returns while minimizing risk. They focus on risk-adjusted return. Risk is easily forgotten in a civilized society where nearly everything is already idiot-proofed. But risk has to be at the front of a hunter-gatherer’s mind.

Hunter-gatherers don’t have to win all the time. They just need to win often enough to stay fed. In the markets, you can make billions by calling it right just 55% of the time.

Since the world is abundant, hunter-gathers’ timeframes are shortened. Unlike farmers or industrialists, hunter-gatherers focus on the next season (or maybe next few if they build up stores to ride out the lean times). But beyond that, why worry? The world will provide endless opportunities for someone who can live off the land. There’s never a “fear of missing out”.

As a trader, embracing this hunter-gatherer mindset will align you with the reality of markets. Doing so will help you take your returns to the next level.

The above passage is straight from Operator Biren, a member of the Macro Ops Hub. To learn more about the Hub and how you can join our Operator team, click here.

 

Markets as a Range of Reasonable Opinions
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Markets as a Range of Reasonable Opinions

The following is from The Philosopher in Drobny’s classic The Invisible Hands (emphasis mine):

Some people can trade markets using only numbers, prices on a screen but this approach does not work for me. The numbers have to mean something — I have to understand the fundamental drivers behind the numbers. And while fundamentals are important, they are only one of many important inputs to the process. Just as a Value-at-Risk (VaR) model alone cannot tell you what your overall risk is, economic analysis alone cannot tell you where the bond market should be.

Let us use an interest rate trade around central bank policy as a straightforward example to illustrate my process. Economic drivers will create the framework: What is the outlook for growth, inflation, employment, and other key variables? What will the reaction of the central bank be? We then build a model of the potential outcomes of these economic drivers, weighting them according to probabilistic assumptions about our expectations. We look at what the central bank could do in each scenario, comparing this with market prices to see if there are any interesting differences. When differences exist, we then think about what can drive those differences to widen or converge.

It is important to note that a key element to this exercise is the fact that what other people believe will happen is just as important as the eventual outcome. A market is not a truth mechanism, but rather an interaction of human beings whereby their expectations, beliefs, hopes, and fears shape overall market prices.

A good example of this psychological element can be seen in inflation. At the end of 2008, U.S. government fixed income was pricing in deflation forever. At that point, the only thing of interest to me was the question of whether people might think that there could be inflation at some point in the future. Quantitative easing made it easy to answer this question affirmatively, because there are many monetarists in the world who believe that the quantity of money is the driver of inflation. Whether they are right or not is a problem for the future — what is important to me is that such people exist today. Their existence makes the market pricing for U.S. long bonds completely lopsided. Such pricing only makes sense if you are a died-in-the-wool output gapper who believes that when unemployment goes up, inflation goes down, end of story. Market prices reflect the probability of potential future outcomes at that moment, not the outcomes themselves. Some people do not believe in the output gap theory of inflation, and these people believe that pricing for U.S. bonds should be somewhere else. Because these two divergent schools of thought exist, it is possible that market sentiment can shift from deflation to inflation and that pricing will follow.

One way to think about my process is to view markets in terms of the range of reasonable opinions. The opinion that we are going to have declining and low inflation for the next decade is entirely reasonable. The opinion that we are going to have inflation because central banks have printed trillions of dollars is also reasonable. While most pundits and many market participants try to decide which potential outcome will be the right one, I am much more interested in finding out where the market is mispricing that inflation will go to the moon, then I will start talking about unemployment rates, wages going down, and how we are going to have disinflation. If you tell me the markets are pricing deflation forever, I will start talking about the quantity theory of money, explaining how this skews outcomes the other way. Most market participants I know do not think in these terms. The market is extremely poor at pricing macroeconomics. People always talk about being forward looking, but few actually are. People tell stories to rationalize historical price action more frequently than they use potential future hypotheses to work out where prices could be.

Beauty contestsPlaying the player… Second level thinking… Viewing markets as a range of reasonable outcomes… These are points we write about over and over. And that’s because the overarching concept is so important and yet so misunderstood.

Let me give you an example.

Your average retail trader (and even most “professionals”) read in the paper, magazines, blogs, etc. that Europe is on the brink of collapse. Deutsche bank is teetering on insolvency… populism is rising… the UK is leaving… it’s all going to hell in a handbasket.

They think to themselves, “Man, Europe is in trouble. I need to short some European banks and sell the euro.”

But those playing the game at the second level and above read the same articles and come away with a completely different train of thought:

Bearish sentiment on Europe is really reaching a zenith… Every market pundit and blogger is railing about how bad Europe is… Bearish positioning is extremely one-sided as there’s definite market consensus… Which means this narrative is likely baked into the price as everybody who’s going to sell has already sold… And if the public narrative is this bearish then the central bankers will be too… So they’ll err on the dovish side for the foreseeable future… Which means that the entire market is standing on the wrong side of the boat… I need to buy Deutsche call options and go long the euro.

The first level thinkers are part of the herd and the second level thinkers are the wranglers anticipating where the dumb herd will swing to next.

First level traders believe trading is about correctly predicting the future. They are wrong.

Successful trading is about understanding prevailing market expectations.

Understand the narrative and you can understand the key drivers. Understand the key drivers and you can identify the fulcrum point of the narrative (the data point that if changed, will force a new narrative to be adopted).

Then you take this understanding and closely watch how reality unfolds in comparison to expectations, all while keeping an eye on divergences (mispricings) that create asymmetric trade opportunities.  

Here’s the Palindrome (George Soros) on the topic (emphasis mine).

There is always a divergence between prevailing expectations and the actual course of events. Financial success depends on the ability to anticipate prevailing expectations and not real-world developments. But, as we have seen, my approach rarely produces firm predictions even about the future course of financial markets; it is only a framework for understanding the course of events as they unfold. If it has any validity it is because the theoretical framework corresponds to the way that financial markets operate. That means that the markets themselves can be viewed as formulating hypotheses about the future and then submitting them to the test of the actual course of events. The hypotheses that survive the test are reinforced; those that fail are discarded. The main difference between me and the markets is that the markets seem to engage in a process of trial and error without the participants fully understanding what is going on, while I do it consciously. Presumably that is why I can do better than the market.

Understand that the things you read in the paper, see on Twitter, or hear on TV, are all popular knowledge — in game theory this is knowns as common or mutual knowledge. The more widely known the information, the more likely it’s already been discounted by the market.

Markets lead the news… not the other way around.

Truly understanding this and applying it is how you become an effective contrarian. And operating as an effective contrarian is the only way you can win in the game of speculation.

If you want to learn how to become an effective contrarian, then check out our Trading Instructional Guide here.

 

 

Bill Ackman Finally Pukes Beware Of False Narratives
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Bill Ackman Finally Pukes: Beware Of False Narratives

A year ago we wrote about why Bill Ackman should learn a bit of technical analysis. We weren’t suggesting he become an Elliott Wave nut or anything, but that he should adopt the risk management philosophy of a technician. TA clearly defines when to exit a trade. And with this clarity comes superb risk control — our number one job as traders.

But of course our advice fell on deaf ears. Ackman continued to ignore all the technical sell signals in his very public Valeant position. From that time, the stock has dropped another 65%…  

Fundamental investing relies on narratives. This is both a feature and a bug. Without a compelling narrative, other investors won’t flock to your stock and bid up prices.

But narratives aren’t cut and dry like an MA crossover or trend line. This reality makes it’s hard for a portfolio manager to cut risk at the right time. Before he realizes the narrative has departed from reality, the stock could’ve already made a nasty drawdown.

The key is to use narratives to initiate trades. But after the trade is on the book, let technical analysis take over and manage the risk. That’s why we’re proponents of combining different styles of investment analysis. Fundies and techs can add value.

In Valeant’s case, the dominant narrative during its rise was how its CEO Michael Pearson created a new, highly profitable way to run a drug company. Instead of using gobs of money to research new drugs, just acquire old drugs and jack up their prices. This practice slashed costs, boosted revenues, and made Wall Street happy. Ackman and many other hedge funds bought into this narrative and created one of the largest hedge fund hotels of all time.

But eventually the narrative started to turn bearish. Skeptics argued that Valeant’s “growth” was achieved through price gouging. Then more news came out that a speciality pharmacy was in cahoots with Valeant — changing codes on doctors’ prescriptions to Valeant’s brand even when much cheaper generics were available. Valeant was basically ripping off insurance companies to juice their own sales numbers.

By the Fall of 2015 the stock had already fallen 70% from its highs. Here’s where technical analysis could’ve come in handy for Ackman. Technicals clearly signaled that the narrative had changed. It would’ve been easy to observe a trend break on the chart and exit.

But Ackman didn’t have this risk control method in his toolbox. He was instead forced to reassess the narrative and evaluate whether or not his original thesis was still intact. This is an impossible task that requires advanced mental gymnastics. It’s too easy to get emotionally attached to a narrative and succumb to things like confirmation bias and the sunk cost fallacy. Ackman did just that as he continued to buy more Valeant.

That’s why investment narratives should be used to initiate trades, not manage them.

Compelling narratives create large trends which are what you need for huge gains. But technical analysis is what you need to manage your trades. It lets you objectively define your exit. If you’re relying on your interpretation of a complex narrative as an exit strategy, you’re exposing your portfolio to huge drawdowns.

The reality of the market is that no matter how rich or how smart you are, you’ll eventually be wrong. The best in the business call it right a little over 50% of the time. It’s crucial to have a reliable and objective risk management process for when things go south. Without it, you’re setting yourself up to follow in Ackman’s shameful footsteps.

If you want to learn how our team at Macro Ops successfully manages risk, then check out our Trading Instructional Guide here.

 

 

Flying Too Close To The Ground
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Flying Too Close To The Ground

It’s not how close you get to the ground, but how precise you can fly the airplane. If you feel so careless with your life that you want to be the world’s lowest flying aviator, then you might do it for a while — but then a great many former friends of mine are no longer with us, simply because they cut their margins too close. ~ Bob Hoover

Bob Hoover was known as the “pilot’s pilot” — one of the greatest to have ever flown. He learned his skills as a fighter and test pilot for the Air Force and is best known for revolutionizing modern aerobatics.

As a crack flyboy, Hoover understood risk better than most. And it was this firm grasp of calculated risk-taking that allowed him to become one of the best aerobatic pilots in the skies and still live to the ripe old age of 94.

There’s an old trading adage that goes “There are old traders, and bold traders, but no bold old traders.” Like the pilots that “cut their margins too close”, markets are constantly claiming the accounts of those who recklessly risk their capital in search of easy profits.

Here’s a rule of thumb to live by: Your margin of risk is dependent on your experience. But no matter how deep your experience, never cut your margins too thin that you risk hitting the ground.

First and foremost, trading is about survival. And to survive, you need to protect your capital.

Many traders, especially inexperienced ones, fly way too close to the ground. This makes their blow up an eventuality.

Bruce Kovner said, “My experience with novice traders is that they trade three to five times too big. They are taking 5 to 10 percent risks on a trade when they should be taking 1 to 2 percent risks.”

Newer traders don’t respect risk because they haven’t gotten burned badly enough… yet. On average our team at Macro Ops risks a fraction of 1% per trade.

A good trader is a good risk manager above all else. Everybody should follow Buffett’s two rules of investing, “Rule number 1, don’t lose money. Rule number 2, don’t forget rule number 1.”

This will not only protect you from fighting the powerful headwinds of negative compounding, but it’ll keep you alive and in the game. Stay alive and you can continue to grow. Continue to grow and maybe someday you’ll acquire the skills to become an ace.

I got my tail clipped roughly ten years ago. Getting your tail clipped is when they cut off the tail of your shirt after your first solo flight (the photo is of me after my successful landing).

First Solo Flight

My first solo was supposed to take place a week earlier than it did. But it was cancelled. As I was going through my pre-flight checklist that morning, there was a horrible crash on the runway.

Another student working towards his pilot’s license botched his landing. Unlike other students flying slow and easy Cessnas, he insisted on learning to fly in a P-52 Mustang. The difference is like learning to drive a Toyota Camry versus a drag racer.

He was learning on a powerful machine… like a trader learning to trade while using too much leverage.

When coming in to land, he knew he wasn’t going to stick it, so he tried to do a pass through. A pass through is when you push the throttle and climb back into the air to circle around and try again. He put his throttle all the way in — on a Cessna this is fine — but on a P-52 Mustang the engine is so powerful that the torque flipped the plane over. The pilot stuck the landing on his head. The crash was fatal.

As traders we’re not dealing with anything as serious as our lives — it’s just money. But to make it in this game, you need to take the preservation of your capital just as seriously.

Paul Tudor Jones said, “… at the end of the day, the most important thing is how good are you at risk control. Ninety-percent of any great trader is going to be the risk control.”

Keep your margins wide. Stay well above the ground and carefully calculate risk. Only press the leverage as you gain the experience.

If you want to learn how our team at Macro Ops manages risk, then check out our Trading Instructional Guide here.

 

 

George Soros
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Lies, Untruths, and False-Trends: George Soros on what really moves markets

George Soros was quoted in a speech he gave to the Committee for Monetary Research and Education back in the early 90’s as follows:

Economic history is a never-ending series of episodes based on falsehoods and lies, not truths. It represents the path to big money. The object is to recognize the trend whose premise is false, ride that trend, and step off before it is discredited.

“Falsehoods and lies…,” these are some striking words from one of the greatest traders of all time. It’s also profound insight into how markets really work.

What the Palindrome (his name is spelled the same forward and backwards) is really talking about here is his theory on false trends.

The idea of false trends in markets is predicated on the belief that contrary to common Western thinking, reality cannot be neatly packaged into true and false; black and white.

Rather, Soros believes that reality (and markets) should be classified into three categories:

● Things that are true
● Things that are untrue
● Things that are reflexive

He noted the importance of differentiating between these when he said:

The truth value of reflexive statements is indeterminate. It is possible to find other statements with an indeterminate truth value, but we can live without them. We cannot live without reflexive statements. I hardly need to emphasize the profound significance of this proposition. Nothing is more fundamental to our thinking than our concept of truth.

For those of you not familiar with the concept of reflexivity, go and read our explanation here, it’ll be worth your time.

The benefit of judging truth and untruth on a sliding scale versus fixed one has also been discussed by Nassim Taleb:

Since Plato, Western thought and the theory of knowledge have focused on the notions of True-False; as commendable as it was, it is high time to shift the concern to Robust- Fragile, and social epistemology to the more serious problem of Sucker-Nonsucker.

False trends arise when a dominant belief (what we refer to as a narrative) is founded on untrue assumptions, but the narrative is so strong it moves price action anyway. The false narrative’s effect on the market actually acts to reinforce the strength of the belief that its initial assumptions are correct; thus driving price action further away from reality (what is true) in a reflexive loop. This is how bubbles are created.

Soros discussed the large impact false trends can have on markets in his 2010 “Act II of the Drama” speech. Below is an excerpt and the full text can be found here:

Let me briefly recapitulate my theory for those who are not familiar with it. It can be summed up in two propositions. First, financial markets, far from accurately reflecting all the available knowledge, always provide a distorted view of reality. This is the principle of fallibility. The degree of distortion may vary from time to time. Sometimes it’s quite insignificant, at other times it is quite pronounced. When there is a significant divergence between market prices and the underlying reality I speak of far from equilibrium conditions. That is where we are now.

Second, financial markets do not play a purely passive role; they can also affect the so-called fundamentals they are supposed to reflect. These two functions that financial markets perform work in opposite directions. In the passive or cognitive function, the fundamentals are supposed to determine market prices. In the active or manipulative function market, prices find ways of influencing the fundamentals. When both functions operate at the same time, they interfere with each other. The supposedly independent variable of one function is the dependent variable of the other, so that neither function has a truly independent variable. As a result, neither market prices nor the underlying reality is fully determined. Both suffer from an element of uncertainty that cannot be quantified. I call the interaction between the two functions reflexivity. Frank Knight recognized and explicated this element of unquantifiable uncertainty in a book published in 1921, but the Efficient Market Hypothesis and Rational Expectation Theory have deliberately ignored it. That is what made them so misleading.

Reflexivity sets up a feedback loop between market valuations and the so-called fundamentals which are being valued. The feedback can be either positive or negative. Negative feedback brings market prices and the underlying reality closer together. In other words, negative feedback is self-correcting. It can go on forever, and if the underlying reality remains unchanged, it may eventually lead to an equilibrium in which market prices accurately reflect the fundamentals. By contrast, a positive feedback is self-reinforcing. It cannot go on forever because eventually, market prices would become so far removed from reality that market participants would have to recognize them as unrealistic. When that tipping point is reached, the process becomes self-reinforcing in the opposite direction. That is how financial markets produce boom-bust phenomena or bubbles. Bubbles are not the only manifestations of reflexivity, but they are the most spectacular.

In my interpretation equilibrium, which is the central case in economic theory, turns out to be a limiting case where negative feedback is carried to its ultimate limit. Positive feedback has been largely assumed away by the prevailing dogma, and it deserves a lot more attention.

I have developed a rudimentary theory of bubbles along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. When a positive feedback develops between the trend and the misconception, a boom-bust process is set in motion. The process is liable to be tested by negative feedback along the way, and if it is strong enough to survive these tests, both the trend and the misconception will be reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow and more and more people lose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup, said, “As long as the music is playing, you’ve got to get up and dance. We are still dancing.” Eventually a tipping point is reached when the trend is reversed; it then becomes self-reinforcing in the opposite direction.

Typically bubbles have an asymmetric shape. The boom is long and slow to start. It accelerates gradually until it flattens out again during the twilight period. The bust is short and steep because it involves the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

The simplest case of a purely financial bubble can be found in real estate. The trend that precipitates it is the availability of credit; the misconception that continues to recur in various forms is that the value of the collateral is independent of the availability of credit. As a matter of fact, the relationship is reflexive. When credit becomes cheaper, activity picks up and real estate values rise. There are fewer defaults, credit performance improves, and lending standards are relaxed. So at the height of the boom, the amount of credit outstanding is at its peak, and a reversal precipitates false liquidation, depressing real estate values.

The bubble that led to the current financial crisis is much more complicated. The collapse of the subprime bubble in 2007 set off a chain reaction, much as an ordinary bomb sets off a nuclear explosion. I call it a superbubble. It has developed over a longer period of time, and it is composed of a number of simpler bubbles. What makes the superbubble so interesting is the role that the smaller bubbles have played in its development.

The prevailing trend in the superbubble was the ever-increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self-correcting and should be left to their own devices. President Reagan called it the “magic of the marketplace,” and I call it market fundamentalism. It became the dominant creed in the 1980s. Since market fundamentalism was based on false premises, its adoption led to a series of financial crises. Each time, the authorities intervened, merged away, or otherwise took care of the failing financial institutions, and applied monetary and fiscal stimuli to protect the economy. These measures reinforced the prevailing trend of ever-increasing credit and leverage, and as long as they worked, they also reinforced the prevailing misconception that markets can be safely left to their own devices. The intervention of the authorities is generally recognized as creating amoral hazard; more accurately it served as a successful test of a false belief, thereby inflating the superbubble even further.

If nothing else, these words from Soros should impart a deep respect for the complexity of the trading game we play. It should also explain why, like the Palindrome, our approach to markets should start with the full acceptance of our own fallibility, first and foremost.

The occurrence of false trends will only rise as global information and interpretation flow increases and narratives become more uniformed and accordant. Taleb put it well, when he said:

The mind can be a wonderful tool for self-delusion – it was not designed to deal with complexity and nonlinear uncertainties. Counter to the common discourse, more information means more delusions: our detection of false patterns is growing faster and faster as a side effect of modernity and the information age: there is this mismatch between the messy randomness of the information-rich current world with complex interactions and our intuitions of events, derived in a simpler ancestral habitat – our mental architecture is at an increased mismatch with the world in which we live.

Look around you… do you see any false trends in the markets at the moment?

 

 

The Philosopher On Playing The Player
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The Philosopher on Playing the Player

Market sentiment is a fuzzy concept.

In its most basic sense, it’s the aggregate beliefs and moods of actors that comprise the total market.

It’s tough to measure, gauge and test. And so, it’s often discarded completely or superfluously used to confirm one’s own biases. Read more

Bewar The Top Performers.
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Beware The Top Performers

“And, at any point in time, the richest traders are often the worst traders. This, I will call the cross-sectional problem: At a given time in the market, the most successful traders are likely to be those that are best fit to the last cycle. This does not happen too often with dentists or pianists—because these professions are more immune to randomness.” Read more

Reflexivity and Soros
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Understanding George Soros’ Theory of Reflexivity in Markets

My conceptual framework enabled me both to anticipate the crisis and to deal with it when it finally struck. It has also enabled me to explain and predict events better than most others. This has changed my own evaluation and that of many others. My philosophy is no longer a personal matter; it deserves to be taken seriously as a possible contribution to our understanding of reality. ~ George Soros (via FT) Read more

Seneca's Investments
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Seneca On Sticking To Your Trading Strategy

“…nothing hinders a cure so much as frequent changes of treatment; a wound will not heal over if it is being made the subject of experiments with different ointments; a plant which is frequently moved never grows strong. Nothing is so useful that it can be of any service in the mere passing.”

“To be everywhere is to be nowhere.”

– Seneca; Letter II Read more

Liquidity Freeze
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Liquidity and Frozen Ice Theory

Howard Marks on liquidity:

It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell.

In other words, the liquidity of an asset often depends on which way you want to go . . . and which way everyone else wants to go. If you want to sell when everyone else wants to buy, you’re likely to find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case – and I’m sure it is – then the asset can’t be described as being either liquid or illiquid. It’s entirely situational.

Traders and investors often discount liquidity’s importance as an input in their decision making process. This is mostly because, as Mark’s notes, “liquidity is ephemeral.” It has a tendency to be abundant, most of the time… except for those times when you may need it most.

The inability to get out of a losing position due to illiquidity is a soul-crushing experience. Liquidity is risk, and should be looked at as such in your analysis process.

Here’s the currency specialist’s take on liquidity and risk, from Drobny’s book; Inside the House of Money:

I have this theory on liquidity, relative value, and markets that I call my “frozen ice theory.” It also highlights the dangers of negative gamma — again! The frozen ice theory goes like this: When a lake freezes, it’s thicker at the sides than at the middle right?

Go back to 1995 when the Japanese yen was trading at an all-time low of 80 to the dollar. Everyone was blaming everything that was wrong in the world on the yen’s strength. The economy in Japan was sliding, they had repatriated all their money, politicians were protesting the level — bloody, bloody blah. It was clear to everyone that the dollar/yen exchange rate was the wrong price at 80.

Eventually, traders started buying dollar/yen in anticipation of yen weakness. Smart trade, right trade. In the frozen ice theory, this occurs at the sides of the lake where the ice is thickest. The trade is solid and the theory behind it is sound.

Dollar/yen started to go up as expected and the people involved cashed in their profits, but they took their profits too early. As dollar/yen continued to rally, they were left watching their macro call run away from them without position. By now dollar/yen has gone from 80 to 100 and it looks to be on its way to 120, but everyone took profit when it was in the 90s.

Traders have a very hard time buying something at a greater value than what they just took profit on, so they look for a proxy, or relative value. They buy dollar/Thai and go through the same process. Then it’s dollar/Malay, dollar/Korea, dollar/Phillippine peso, and so on.

Next thing you know, everyone and their grandmother is long dollar/Taiwan, dollar/rupee, and dollar/rubbish, yet they don’t remember why they have dollar/Asia on in the first place. Nobody is long dollar/yen anymore and it’s at 135.

Everyone has rotated out toward the middle of the lake where the ice is thinnest. In essence, they’ve all moved out the spectrum of, guess what, our old friends: liquidity and credit. Suddenly, dollar/yen (the liquid stuff) starts to reverse. Game over. Everyone stops, looks around, and finally notices everyone is surrounded by people with the same illiquid stuff on the thin ice. People start trying to get out and asking for prices in size. Yeah, right. How about down here, buddy? No, off that, actually how about down here? And so on and so on.

The weaker credits always have the least liquidity and the so-called highest returns. All the crap rallies at the end of a bull market, which is how you know it’s near the end. When triple rubbish like wingandaprayer.com is suddenly worth more than the great, long-standing companies, you have to stop and question things.

It happens time and time again in the markets. Everybody’s standing there in the middle of the thin ice with pretty much the same position, having forgotten why they put the trade on in the first place. The reason they’ve forgotten is because they don’t have the original trade on anymore because they got out too early. They’re in, they’re out. They missed the main move so they buy something else, and then something else and something else. We’ve all done it. Everybody does it. Everybody runs a vicarious relative value book in how they trade. The yen in the second half of the 1990s was a classic case.

It’s always important to look back at why you did something. If you don’t, you start doing what economists do, which is raise a price target after it gets hit.

This thin ice argument works when you look at funds of hedge funds as well. Institutional hedge fund investors often allocate to a hedge fund only after it has had a solid run, when performance is peaking. Investors who got in at the beginning can weather a drawdown because they’ve made some money, but institutional investors usually aren’t there at the beginning. They get exposure late in the game and wind up getting hurt.

Know why you’re in a position.

Understand why others are in it.

Keep an eye on the exit.

And don’t ever skate on thin ice.