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Sunday, January 17, 2016

Infidelity and stock market crashes

Original source: unknown

Once upon a time there was a village in which there lived many married couples. There were certain qualities about this village, though, that made this village unique.

Whenever a man had an affair with another man’s wife, every woman in the village got to know about the affair, except his own wife. This happened because the woman who he had slept with talked about their affair with all the other women in the village, except his wife. Moreover, no one ever told his wife about the affair. 

The strict laws of the village required that if a woman could prove that her own husband had been unfaithful towards her, then she must kill him that very day before midnight. Also, every woman was law-abiding, intelligent, and aware of the intelligence of other women living in that village.

You and I know that exactly twenty of the men had been unfaithful to their wives. However, as no woman could prove the guilt of her husband, the village life proceeded smoothly.

Then, one morning, a wise old man with a long, white beard came to the village. His magical powers, and honesty was acknowledged by all and his word was taken as the gospel truth.

The wise old man asked all villagers to gather together in the village compound and then announced:

“At least one of the men in this village has been unfaithful to his wife.”


1. What happened next?
2. And what this got to do with stock market crashes?

Answer 1:

After the wise old man has spoken, there shall be 19 peaceful days followed by a massive slaughter before the midnight of the 20th day when twenty women will kill their husbands.


We will use backward thinking for the proof. Indeed, the very purpose of this post is to demonstrate the utility of the backward thinking style.

Let’s start by assuming that there is only one unfaithful man in the village - Mr. A. Later, we shall drop this assumption.

Every woman in the village except Mrs. A knows that he is unfaithful. However, since no one has told her anything, and she remains blissfully ignorant. But only until the old man speaks the words, “At least one of the men in this village has been unfaithful to his wife.”

The old man’s words are news only for Mrs. A, and mean nothing to the other women. And because she is intelligent, she correctly reasons that if any man other than her own husband was unfaithful, she would have known about it. And since she has no such knowledge in her possession, it must mean that it’s her own husband who is unfaithful. And so, before the midnight of the day the old man spoke, she must execute her husband.

Now, let’s assume that there were exactly two unfaithful men in the village - Mr. A and Mr. B.

The moment the old man speaks the words, “At least one of the men in this village has been unfaithful to his wife,” the village’s women population gets divided as follows:
- Every woman other than Mrs. A and Mrs. B knows the whole truth;
- Mrs. A knows about philanderer Mr. B, but, as of now, knows nothing about her own husband’s unfaithfulness, so she assumes that there is only one unfaithful man - Mr. B - who will be executed by Mrs. B that night; and Mrs. B knows about philanderer Mr. A, but, as of now, knows nothing about her own husband’s unfaithfulness, so she assumes that there is only one unfaithful man - Mr. A - who will be executed by Mrs. A that night.

As the midnight of day one approaches, Mrs. A is expecting Mrs. B to execute her husband, and vice versa. But, and this is key, none of them do what the other one is expecting them to do!

The clock is ticking away and passes midnight and day 2 starts. What happens now is sudden realization on the part of both Mrs. A and Mrs. B, that there must be more than one man who is unfaithful. And, since none of them had prior knowledge about this other unfaithful man, then it must be their own respective husbands who were unfaithful!

In other words, the inaction of one represents new information for the other.

Therefore, using the principles of inductive logic requiring backward thinking, both Mrs. A and Mrs. B will execute their respective husbands before the midnight of day 2.

Now, let’s assume that there are exactly three unfaithful men in the village- Mr. A, Mr. B., and Mr. C. The same procedure can be used to show that in such a scenario, the wives of these three philandering men will kill them before the midnight of day 3.

Using the same process, it can be shown that if exactly twenty husbands are unfaithful, their wives would finally be able to prove it on the 20th day, which will also be the day of the bloodbath.

Answer 2: Connection with Stock Market Crashes

If you replace the announcement of the old man with that provided, by say, SEBI, the nervousness of the wives with the nervousness of the investors, the wives’ contentment as long as their own husbands weren’t cheating on them with the investors’ contentment so long as their own companies were not indulging in fraud, the execution of twenty husbands with massive dumping of stocks, and the time lag between the old man’s announcement and the killings with the time lag between the old man’s announcement and the market crash, the connection between the story and market crashes becomes obvious.


One of the most interesting aspects about the story is the role of information asymmetry.

You and I knew that there were exactly twenty unfaithful men in the village. We had complete information about the number of unfaithful men in that village but not their identity.

On the other hand, every woman in the village knew the identity of at least nineteen unfaithful men. For example, if you were Mrs. A, you would have known about nineteen unfaithful men, but not about your own husband’s unfaithfulness. And, if you were one of the women whose husband was faithful, then you’d know the identity of twenty unfaithful men.

But the old man did not say that there were twenty unfaithful men in the village. All he said was that there was at least one unfaithful man in the village. So, his statement, did not add anything to the knowledge of any individual woman because each of them knew of at least nineteen unfaithful men!

And yet, his statement caused the bloodbath after twenty days!

The lesson is simple: It’s not necessary for any new information to cause havoc in the stock market. Sudden realizations about the stupidity of gross overvaluations and dubious accounting practices followed by some companies in bubble markets can and do occur simultaneously in the minds of the crowd. And that sudden realization can cause markets to crash!

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Cycle of market emotions

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How to identify stocks making new high/ low intraday

A stock making a new high or low intraday can offer an excellent trading opportunity. You can do some additional filtering by looking at EOD chart to confirm a breakout and then start trading.

I am describing a method where you can identify this high/ low breakout by using your broker provided trading software. This is working with RKSV terminal as well as NSE NOW terminal. I am sure other terminals will also offer some sort of a similar feature.

You do NOT need any 3rd party charting software or datafeed.

Here is how to go about it.

In RKSV, I have made a market watch of 35-40 stocks... these are the most liquid ones. Let's assume that from now on, this will be the stock universe for daytrading.

Next step .. right click anywhere on the market watch and click on customize option. Alternatively, in the menu bar, click on Preferences - User Settings - Market Watch.

You will see the following box:

Select the colors (BackGround) for the Market Events as shown and then click Apply - then OK.

Now whenever a stock makes a new intraday high or low, the stock row will flash with the indicated color. At this point, you should then inspect the intraday ( and EOD) chart and then decide whether to initiate a trade or not.

And this is a real example... SSLT made a new intraday low.

And this is a real example of 2 stocks making new intraday highs.

- The stock row will also flash with a different color if the stock makes a lifetime high or low.
- You should consider these signals after 30 min of market open so that some trading range has developed.
- For increased reliability, ensure the stock has already moved by 1%
Hope this helps.

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Support and resistance explained

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You should quit trading IF

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Big loss in stock markets?

If you have incurred a big loss in the stock markets, then spend some time understanding what exactly went wrong.

For eg., some common reasons could be: long instead of trading short
2.taking a position in derivatives instead of cash
3.taking a position far bigger than mandated by risk management
4.lack of any system in trading
5... any other reason you can think of.

The first situation is common and happens when you take a short trade fully knowing the trend is up simply because you feel the stock has run up a lot and it should start correcting. In my view, this is a stupid way to trade because you are trading your emotions and not the chart so if you have lost money, you rightly deserve to lose. The other situation is you trade a breakout (long) and smart money shorts the stock. Here you followed your system, traded in the right direction but  what you got was a breakout failure. Don't worry this can happen half the time but will not cause losses.

In both cases, the outcome is not in your hand. But what you can control and this should be a part of your plan before you trade is what will you do if your trade goes wrong? If you have a plan (exit strategy) then you will automatically be out of a trade but if you have no exit plan in place, then you will be just left hoping and praying for a situation to get out with some dignity.

Point 2 and 3 are essentially the same. Trading beyond your means or taking a leveraged position is essentially the same thing. The keyword here is taking a position more than mandated by "risk management".

Risk management is the most most important part of any trade and you will realise this as you move along from a novice or amateur trader to a professional trader. Once you learn to manage the risk, everything will fall in place. First, your losses will start becoming smaller and as this happens, your profits will automatically coming in.

Risk management at the most basic level is simple. First define your stop loss (this should not be some random figure but a sensible one which takes into account the average trading range of a stock). Second, define what percentage of your capital you are willing to lose on a wrong trade. Ideally this should be less than 1%. The beauty of risk management is once you quantify this before taking a trade, the loss does not hit you or affect you emotionally whenever a trade goes wrong.

The last point is lack of  a system. Whatever you do, you should always have clearly defined entry and exit rules. A very simple and extremely powerful rule could be consider a long position only if a stock makes  a 52 week high. Or buying  a stock closing above last 2-3 months highs. Now having a system is one thing but not being able to follow it is another (bigger) problem. So you design a system you are comfortable with and what happens in real life is your first 4-5 trades whipsaw with the result you start having second thoughts about your system or fall prey to redesigning or attempting to improve a perfectly fine system.

Other factors

Timeframe: For the same system, a smaller timeframe is likely to produce more trades and whipsaws than a higher timeframe. The emotional roller coaster one goes thru day trading whipsaws is far worse than someone who takes  a position for few weeks or months. So a system like 3 bar swing will give fantastic results on monthly charts and average results on daily charts and worse results on hourly or 15 min charts.

Put conversely, it is the same as saying that for same system, higher timeframe investors have a higher chance of earning money as compared to lower timeframe traders (day traders?). This is also borne by real life experiences - the richest people are all investors holding for months or years. You will never hear day traders being amongst the richest folks.

Discipline: No trading can be complete without this very important factor. I have not mentioned this before but whenever you talk of any rule based trading or inability to manage losses, the culprit is always discipline. It is no use having a fancy system or risk management rules when you have no intentions or are simply unable to follow these.

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Trading lessons learned by FACTOR LLC (Peter Brandt)

Trading Lessons Learned by Factor During the Years

  • Except for a few tremendously gifted traders (not including me), day trading is generally a loser’s game
  • Trades decided upon at a moment in time during active market hours have contributed negatively to my net bottom line
  • Managing my emotions (fear, greed, false hope) is my primary challenge in trading
  • It is better to miss a trade all together than to be obsessed about being in a certain market
  • I do not need to recover losses from the same market. A given market owes me nothing.
  • No tolerance should be given to breakouts that are not decisive or to trades in the red; Agonizing patience should be given to trades that remain in the black – providing these trades plenty of leeway to reach their targets.
  • My focus needs to remain the search for the 20 or so of the best examples of classical charting principles each year, with the goal of successfully trading the majority of these market situations.
  • The trading plan will be profitable in about 35% of trading events over an extended period of time. However, over shorter periods of time the plan may be profitable in as few as 15% of trading events.
  • Expect the bottom line over an extended time frame to be represented by only 10% of all trades. The other 90% of trades will be washes.
  • There will be losing trades, losing weeks, losing months, and very unfortunately, even losing years.
  • Every year will experience a drawdown of 10% of assets. Many years will encounter a drawdown of 15% of assets.
  • Most chart patterns, especially those of shorter duration (less than 8 to 10 weeks), completely fail or morph into larger chart construction.
  • Being profitable over an extended period of time is far more important than being right on the next trade or series of trading events – consistently following a sound trading plan is not measured by the results of any given trade or series of trades.
  • An emphasis on sound (in fact, ruthless) risk management protocols with the faith that preserving trading assets is a prerequisite to be positioned for long-term profitability. A trader’s pile of chips needs to be protected as a first priority.
  • Severe drawdowns are very difficult to overcome. A trader should never be more than one to three fully leveraged good trades away from new capital highs.
  • I need to retain an intentional alertness for a few trading events per year (two or three) that are characterized by multiple technical confirmations and a low risk entry point where extraordinary leverage can be employed with only marginally greater risk
  • A difficult but necessary component for success is an extreme amount of patience, waiting and waiting for a pattern to become fully mature – and then the discipline to pull the trigger with an appropriate amount of leverage.
  • A sum of profits or certain rate-of-return is not a legitimate goal in trading. Rather, the goal must be to properly execute clearly understood strategic and tactic maneuvers. Control the controllable, let go of the uncontrollable!
  • Failure to achieve the above will happen. A trader needs to have the ability for immediate self-forgiveness when getting off the script, realizing that a focus on past/recent mistakes can lead to a vicious cycle.

*Factor LLC is the organizational entity through which Peter L. Brandt trades his own proprietary  accounts and provides personal opinions about futures, forex and equity markets via social media  channels, including email. As such, reference to Factor LLC is to be considered as synonymous with  Mr. Brandt’s market analysis as it exclusively pertains to his personal opinions and proprietary trading.
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The 80 - 20 rule of stock markets

The Pareto principle states that, for many events, 80% of the effects come from 20% of the causes.

This rule applies to a lot of things in life. For eg., 80% of the wealth is owned by 20% people, 80% of your business comes from 20% of your clients or is generated by 20% of your employees and so on.

You can extrapolate this to stock markets and generally assume that 80% of your profits will come from 20% of your trades (metaphorically speaking).

For successful trading, you require 3 factors - a trading system, risk management and discipline (not necessarily in same order).

Risk management takes care of losses, discipline ensures you stick to your rules (choose some other occupation if you cannot do this) and trading system helps with appropriate entries and exits.

So when you take a trade, there are 4 possible outcomes each of which has a 25% probability of happening:
- small losses
- small profits
- big losses
- big profits

The first 2 cancel each other so what you are left with is big losses and big profits. Obviously, the only way you can make is by focusing on loss minimization. You need NOT worry about profit maximization because profits is whatever the markets give and you have no way of knowing how much profits a trade can generate. 

Cut losses fast and hold to winning positions as long as possible.

Do this on a regular basis and you will see how 80% of your profits will come from 20% of your trades.

If you cannot do this, you will be better off doing something else.

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