Fat fingering, flash crash and all the fun stuff called investing

I am not a stock trader, but I occasionally burn my fingers attempting to do just that. This post is a look into the rearview of my experience with trading in the stock market. It has been a while since I bought or sold into the market. I incurred severe losses in my attempts to make money in the stock markets during the years 2008 and 2009. I was long in 2008 and short in 2009. Yes, stupid right. Needless to say, I had better success at trading in a flea market. I wouldn't be writing this post if I made money in those years.

Date: May 6th, 2010.
Subject: Fat fingering could save a trade.
By Noon that day, the markets have lost about 5%. I had entered a trade the previous night to execute at $22/share. I don't remember the security nor do I remember the number of shares. So anyway, when I was taking a coffee at around 2:30 PM, a colleague mentioned that the market was tanking pretty bad. I also recieved a phone call from my friend to deliver the good news. I was worried that the trade I had entered was executed and deeply in red from the broad market tanking. One of the reasons for the markets to crash, I heard during that day, was that an unidentified futures trader had fat fingered a sell order for $5 Billion worth of securities while he meant only to palce $5 million worth of them. An extra zero never meant so much to so many people around the world like it did on that day.  I went home and eagerly logged into my trading account to find how much loss I had incurred on my trade. Surprisingly, I did not see the security in my account. I checked the order status and it showed that the order was cancelled. I checked the trading range for the security to see if for some reason the secruity did not hit my buy price. The security did go to as low as 13 bucks. I reviewed my cancelled order to find that I had set my buy limit order at $12.00 and not $22.00 as I had intended. This casual mistake of mine kind of saved my day. However I did feel a tinge of disappointment because, had the security gone down to $12 and my order been executed, I would have made 33% on that day for my fat fingering error. How is that possible? When right after what is now called flash crash the market rebounded, recovering most of the losses between 2:30 PM to 3:00 PM. The security I was interested in buying rebounded to $16.00. While I was happy, I did not suffer a loss of about 30%, I was also unhappy that my mistake did not make me rich by 33%. Well the way my trades were going, the only way I was going to make money was by mistakes. Alas it was not meant to be.

Note: It was later revealed that the cause of the crash was not fat finger, but a sell algorithm that executed the sell order of S&P 500 futures. The report by SEC was be viewed here -http://www.sec.gov/news/studies/2010/marketevents-report.pdf.

So with that preview in mind, I have to go a bit earlier into my life of trading. Why did I get into this mess to begin with? It was that one odd year when for the first time in my life I discovered I may have to payback Uncle Sam on my tax returns. It turns out that I was being withdrawn less taxes in my paycheck and hence would have to pay back those taxes. One of the ways to avoid that was to open a traditional IRA account. So I did just that. This was 2008 and the market was tanking. Now opening an IRA account opened a whole new oppurtunity to prove to myself that I could make more money outside my profession.

I began reading books, a lots of them, by Benjamin Graham, John Bogle, Warren Buffett, even Suzy Orman. Since I began with books by value investors, I took a long only approach and stocks for life approach. Besides the word value in value investing kind of appealed to the way I approach life. So I did some screens for low P/E ratios, high dividends etc and put money in those. It was a time when commodities were bullish. I did not buy any when the market was going up as I felt they were expensive(read - I tricked myself into thinking like a value investor). So when the market began to crash, I began to buy them assuming there was capitulation and that I need to go in when the market was falling. I also did cost averaging as the securities were losing more and more. In 2008, the pit was bottomless. All the theories I had read were becoming useless and fear took over. I realized that times have changed and every recession is different. I also recognized that the market way ripe for shorting.

However I could not short since the account I was trading was an IRA account. I could not buy put options(which was the one way to short a market in an IRA) as my account was not setup for options trading. I could buy inverse etfs(that shorted the market), but since most inverse etfs are shorted on a daily basis, the gains from shorting the market were lost by the inherent defects of the etf. I had applied to change my account to allow option trading and opened a regular trading account with another broker. (Yes, more money and less restriction would fix everything and now I could go on to be a millionnaire shorting the market. The irony is that easy access to more money, hence leverage, and lax regulation were the causes of the current recession.)

I realized the lossess in my IRA account about the end of 2009 and began shorting the market with option puts. I also bought leveraged inverse etfs. With these moves and the economy still tanking, things turned around a bit in my account for some time though the losses were not completely recovered. From losses in thousands to have recovered within hundreds was a major achievement. I was euphoric and once on a phone call to a friend of mine said this "value investing has no place now. In this age investors have to be nimble". Clearly I was overconfident and not following my own statements.

The market turned around and I did not realize the gains in time. I failed to stagger my profits. Instead I was still stuck in the bear mode. I said to myself that the market was irrational, the fundamentals have not changed and hence it was only a matter of time before the market begins to tank again. It wasn't meant to be.

Weeks become months and market takes an ascent I havent seem before. I begin looking into technical analysis as everyone on the web was talking about it. It was also widely said that Hedge funds with their HFTs use largely technical analysis to make their trades. The S&P500 index hung around the 200MA for a few days and it gave me hope that my thesis could be right and the bear market was set to begin. Well, ever a contrarion indicator, the market broke through the 200 moving average and began it ascent with greater vigor. That was it for me; I took my losses, which were now more than when I began to short the market.

I stayed away from trading the market for about 6 months. Infact, I did not get back into it until 2010. Well the rally was slow in 2010 compared to 2009 and 2011 was deja vu all over again. Only the player now is Europe and not US and I am long the market only this time in my 401K accounts. I cant do much there which probably is a good thing.

In all this, I tried almost everyt trick. Well! not everything; I havent developed an algorithm for automatic trading with back testing. Other than that I have done everything and for every recommendation I have proof that they wont work. I attended webinars, earnings reports(live as well as transcripts), did screeners for etfs and mutual funds. Bought etfs, straight and leveraged, long and short. I did market orders, limit orders, stop loss orders, trailing limit orders. I did options both calls and puts. I did not go into covered calls, spreads and other exotic option trading. Nor did I deal with forex trading and futures trading, well not directly(but did so through etfs that use forex and futures trading). In all this the only thing that I learned was that, there is no formula for successful trading. A recommendation by a successful trader/investor is no guarantee for success. Infact it can be guarantee for failure as was in my case.

With so much rumination on things that have failed, I feel obligated to disclose what worked for me.
1. Buy No Load, No Transaction Fee Mutual Funds only. Avoid transaction fees in anyway you can.
2. Avoid futures derived commodity etfs, leveraged etfs, short etfs, options unless you know clearly how these are valued and how they work.
3. Buy Big Cap dividend players.
4. Buy index funds or index based etfs.
5. If you can pick a bottom or if you are sure the bottom has passed, buy securities that are oversold due to certain events. For Eg., BP was a good pick a few months after the oil spill. In these cases, the markets sells more not knowing what the impact would be of the event.
6. Realize your gains when they are. There is merit to the statement 'ride your winners', but it is only a matter of time before your winners become losers. So try layering your sell orders when you have profits.
7. Cut your losses at the earliest. Have some percentage and time based rules for getting out. Follow them strictly.

Of the above, the last rule is most difficult to implement. I have most trouble implementing this rule. I still have a few securities that violate this rule and are sitting blood red in my account as of now. The problem for me is that, the securities that I have sold have done a volte face as soon as I have sold. Also losses are difficult to realize. You hold on to the losers in a hope that things may change as soon as you sell them. Sometimes you are waiting for the market to turn around to minimize the losses. You say to yourself, this security is oversold. Let it turn around a bit and I will sell. When they do, you dont know when to sell. Your mind plays tricks. Do you let your mind rule your trades or do you let the rules mind your trades. Experienced traders say it should be your rules.