Last night, I watched the first season of the Showtime series “Billions” for the first time in years.
For those who don’t recall, the show — co-produced by CNBC journalist Andrew Ross Sorkin — pits a wealthy hedge fund manager and his web of unethical trading strategies against an ambitious federal prosecutor in Manhattan.
It’s loosely based on former U.S. Attorney for the Southern District of New York Preet Bharara’s pursuit of former hedge fund manager Steven A. Cohen, who now owns the New York Mets and a family office called Point72 Asset Management (converted from S.A.C. Capital Advisors).
The show will kick off its fifth season next month. Though it’s a tad over the top at times, it’s an intriguing drama about a fund manager’s desire to cut corners to make incredible wealth, and the determination of prosecutors to stop insider trading.
There’s also an occasional great lesson about trading itself.
I wanted to share this lesson with you today and why it matters.
This market has been sideways for several months. And this one rule will help you better manage your money.
Ride the Lightning
In the first season, fictional hedge fund manager Bobby Axelrod takes three of his friends on a private jet to Quebec to see the band Metallica.
While they are departing, one of his friends overhears that Axelrod is shorting a transportation company (betting that the stock will go down), and decides to call his broker and short the stock himself.
The decision doesn’t end well for the friend.
As part of the heightened drama of the episode, a rival of the hedge fund manager discovers that Axelrod is shorting.
This rival manipulates the market, creates a false narrative about a potential buyout of the transportation company, and initiates a short squeeze on the stock. When a short squeeze occurs, it can typically force the people shorting a stock to repurchase it at a higher price to cover their positions.
Here’s how that works. Let’s say you want to short a stock that is trading at $50 per share. In this situation, you would borrow the stock from a brokerage or dealer and pay a commission for the right to borrow the stock. At that point, you would sell the borrowed shares on the market. Then, if the stock falls to $40, you could repurchase the stock and give the shares back to the dealer.
In this situation, you borrowed the stock and sold it for $50 on the open market.
Then, you repurchased it for $40 to close the trade.
You have made $10 for every share that you shorted.
But let’s say that you borrowed the stock for $50 and sold it. Then, the stock rallies to $100 because of an unpredictable short squeeze. While everyone else is repurchasing the stock, you might need to do the same. You will lose $50 for every share if you are covering the position.
If you lack the margin in your account to pay that $50, your broker may call margin on you and force you to liquidate other positions or put cash into the account to ensure you can cover the loss.
In the case of Axelrod’s friend, he ended up underwater on this short trade by $210,000. And his broker was calling margin on him.
Now, Axelrod — spoiler alert — acts as a good friend and helps cover the margin (and makes a significant gain in the process).
But right after he helps his friend, he offers a lesson. He explains that he doesn’t hold a position that can cause him to lose more than he can afford.
“I don’t lie to myself, and I don’t hold on to a loser,” Axelrod says. “The moment it doesn’t feel right, I let it go, get away from it.”
This sentiment is brutal to learn when you’re a new investor. But, unfortunately, you might make a very simple mistake that can hurt you in two different ways.
Just Walk Away
I’ve warned before about falling in love with a company and how that can cost you money.
If you buy into a stock and it falls 30%, one of the most common mistakes is believing that it will come back. Playing the waiting game is the failure to recognize a loss.
The failure to sell a big loser is an error — mainly if you’re talking about stocks that have hit their trailing stops, have moved into negative momentum, and can continue to plunge. You might find yourself in such a position, as I noted with the ETFMG Alternative Harvest ETF.
The ETF hit $34.58 in February and stopped out on TradeSmith Finance in March. However, if you were invested in this ETF and stuck in the belief that it would bounce back, you wouldn’t be making the best use of your money. You’ve seen this fund fall by more than 50%. With little institutional buying and continued selling, it’s unclear when and if this will bottom out.
This brings me to the second error: Waiting and waiting and waiting for a bounce back creates an opportunity cost. How long are you willing to wait for a stock or asset to get back to even? For example, if you bought gold at the 2011 highs, you would have waited nearly a decade for the asset to bounce back above that $1,900 level.
Imagine tying up your money hoping for that bounce back while we experienced a decade-long bull market up to 2020.
Learning when to cut your losers is a difficult lesson. That’s why we always encourage our readers to use behavioral tools like trailing stops to help them manage their positions. Remember, every stock has a different historical level of volatility, which means that every stock has a unique trailing stop. I’ll talk more about the TradeSmith VQ Score later next week and how to use it the right way.