How to Lose $1000?

There is a plethora of answers to this question, however I will explain my specific circumstance of losing such a sum. The severity of a nominal term such as $1,000 must first be put into perspective. Did I lose $1,000 on $1,000,000 or on $10,000. Percentages indicates that to lose $1,000 on $1,000,000 (1%) is a lot less severe than to lose $1,000 on $10,000 (10%). My specfic case is the latter rather than the former. I can blame it upon the failure of the efficient markets hypothesis. Efficient market hypothesis is based upon the fact that security prices adjust according to all available information at any particular time. There are 3 categories which efficient markets can divide into. First, there is the strong market. This market works exactly as the hypothesis says it should. All information, either private or public is priced into the security and is the most efficient form. The second form, is the semi-strong market. In this case, the prices adjust according to just public information. Therefore, if you have private information, you can in fact gain advantage of the system. The last form, is the weak market. This is the least efficient, and prices vary without basis of information. People trading in these markets are referred to as speculaters, gamblers, or adventurers. The U.S, financial index is in this weakest form of market efficiency.

This inefficiency is most prevalent in the money center banks. There is not a single person in the world who can quantify, with all information available, what Citigroup, Bank of America, or Wells Fargo is worth. The basis upon which banks are valued, in accounting terms, is based upon the Mark-to-Market value of assets. This is an efficient form of valuation, as we should expect that all information, from aggregate sources would find the true value of the assets, because if any one individual knew that it the current value deviated from the true value, they would either be willing to short or buy the security until it reached the true value. By this assumption, we should be able to accurately value the financial sector and there shouldn’t be any problems. Right?

Wrong. In the past year and a half, the markets for level 3 assets (assets which are independently valued), has dried up. This means that there are no comparable securities to benchmark against. An example of a level 3 asset would be a bundle of home loans. The value of each bundle is unique with an acceptable level of diversification, which reduces unique risk, but not systemic risk, which is exactly what we have today. Since there is no currently accepted way to measure these assets, because to do this would require every person with a mortgage to be measured continuously in their unique probability of repaying, no one is willing to buy these assets except at firesale levels, of which anyone ending up paying what they owe would make them profitable.

So what does this have to do with me? The current uncertainty, and inefficiency opens up an opportunity to make exceptional returns in short time increments based upon the volatility. Two of the best trading vehicles today are Direxion 3x Financial Bull ETF (FAS) and Direxion 3x Financial Bear ETF (FAZ). These 2 securities are inverses of one another, and are both pegged to the performance of Russell 1000 Financial Index (^RIFIN) * 300%. This means if RIFIN goes up 1%, FAS should go up 3%, while FAZ will go down 3%. These reset everyday, meaning over the long term, they will both trend to 0 as to a result of percentage friction from resetting daily. Because of this, it is unthinkable to hold as a long term play or even overnight. Therefore, my goal is to get in and out quickly, always less than a day, and hopefully less than 1 hour. This would concievably limit my gains, but also my losses. So I thought.

You can analyze the daily trends, the hourly trends and even the quarter hour trends and can still be wrong. At 2:40 p.m. I got into 180 shares of FAZ at $56 expecting to scalp a few percent, as the past hour trend was trading in a 5% range. Unfortunately, at 2:41 P.M., the White House came out and announced they would be buying common stock of major banks, Citigroup, Bank of America at a 10% discount to the February 9th price. The reasoning behind it, is that prices are so overtly oversold, that any recovery and the taxpayers would regain a higher return than if they just bought convertible bonds to preferred stock (which has no voting rights). Immediately when I saw this, I felt like crap.

The trend had just changed, as we were in an inefficient market where news moves securities more than actual data. In the next 10 minutes, I was down over $500 (5%). I had decided a few weeks ago, my loss tolerance was at $1,000. Therefore I watched to see if any profit taking would be taken off the sudden jump, which there was and I was down about $300. However, I maintained my $1,000 loss tolerance and waited to see what happened. At 3:30, my $1,000 loss triggered the sale of my shares at $51 (8.9%). Unfortunately, it bottomed out at $50, before mounting a strong retracement back to $56 at the close. This morning however, it opened at $51, and is currently at $47.50 as of this writing.

Did I do the right thing? This question I keep asking myself. Economically speaking I think I did. Behaving rationally, I understood that there would be pullbacks and rallys and therefore my position would need to have room to move in. However, once the $1,000 loss level was reached, it changed from tolerated range, to a sunk cost. I had to look at the possibility of losing more, or preserving my capital base. I chose to accept the loss and preserve my capital to fight another day. It’s unfortunate that the price retraced back to my purchase price, however I did not have that information at the time and it’s Monday quarterbacking. I knew I was not going to hold it overnight, as that breaks another trading rule, so I had about 50 minutes to decide what to do. It could have continued to go down, or go up as it did. It’s how the chips fly.

I chalk this up as an experience of the power of inefficient markets and 3x leveraged ETFs. As I saw a 3% rally turn into a 9% loss, the inverse (FAS) turned in a 9% increase within 30 minutes. This should beg to question why I didn’t hedge. There’s a number of reasons for it. First, Regulation T. SEC Regulation T prohibits pattern day trading to people with less than $25,000. This means, if you have less than $25,000 you cannot make more than 5 round trip trades within 5 business days, or you are suspended from trading for 90 days. The second reason, is that brokerage firms try to protect retail traders such as myself from the market. They believe if you don’t have the capital, you shouldn’t be trading. Ameritrade for example, claims although I have over the minimum for margin trading by 10 times in cash, I do not have the income sufficient for margin trading ($40,000). This affects me immensely. It takes 3 days to settle a trade.

Another SEC regulation requires cash only accounts to wait all 3 days for it to settle, while a margined account is allowed to use money used for buying, and gained from selling a security, but not yet settled, to trade more. If I had this ability. I could have sold immediately for the loss (albeit a smaller loss) while entering FAS to ride the rally up. The government tries to protect you from yourself by making you wear a strait jacket. Regulation here decreases liquidity in the market by limiting the amount of trades a retailer can make while increasing the power of established financial firms who are allowed to leverage their balance sheets 30-1, Lehman Brothers, or Bear Stearns 35-1. I’m trading 3-1 leveraged ETFs, I can only imagine how I could lose my ass if it was 35-1.

Ok, so that was a rant