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Gaining A Trading Edge By Thinking A Few Steps Ahead

In late 2011, once the market bounced off its early October lows, there was increasing chatter over how it was probably too early for a real full-blown European debt crisis at that point and how the "powers that be" would likely run the market higher into the new year.

But, the real "tell" would be how the markets behaved, come the New Year, and that's when all hell would likely break loose all over again. At that time, I, too, began to think that, while the rest of 2011 may lead to a good bounce in the markets, early 2012 could bring back some real turmoil.

Then a thought struck me. With all the blog posts, newspaper articles and commentary by television pundits calling for a "let's see how January goes" moment -- hey, even I myself began thinking the same thing…"What if, with all of us worrying over the same possibility, January turned out just fine -- a perfect 'non-event'?"

And, heck, even Ben Bernanke was probably worried about the New Year, and we all know what that leads to: More cheap money and credit would likely be dumped right back into the markets at the first hint of trouble.

So, as 2011 came to a close, although I did sell a few positions just in case, I decided to leave most of my longer-term positions as is. And, while hindsight is always 20/20, that did turn out to be a great decision. Of course, we never know for sure, and that's why traders and investors must consistently practice sound risk management.

One must always protect against the times one misses. This approach not only serves to protect and preserve your bankroll but also helps provide the clarity and peace of mind necessary -- an edge in itself -- to properly consider and evaluate the information available to you. Worrying if your over-leveraged position might blow up in your face is not going to help you make a smart decision.

Traders and investors alike must always be open to taking every piece of relevant information into consideration, including our own preconceived notions and biases. As Ray Dalio of Bridgewater Associates once said, "I constantly want to know what I don't know. I want to know when I am wrong. And it helps when someone points it out."

While it certainly helps when someone else points out when we're wrong, we can also objectively look at our own thought process and emotions and consider how they too may be wrong or dangerously biased. This in itself becomes part of a valid trading edge.

Everything counts, and we are often our own worst enemy in most endeavors we pursue. In chess or poker, those players who patiently take a step back to "see the bigger picture" and contemplate the best moves will, in the long run, always triumph over those less savvy players just itching to make a move.

We should always ask ourselves, "What do other traders think they know?" "What are they worried about or afraid of and to what extent?" "Am I starting to feel worried or nervous myself, and are these thoughts rational and based on sound reasoning?"

There was a great line in the movie Margin Call when CEO Tuld (played by Jeremy Irons) says, "It's not panicking if you're the first one out the door." Granted, no one (and no firm) should ever be leveraged to that extent in the first place, but from the "clear" perspective of the character in that movie, the mortgage game was up. And, you certainly don't want to be the one panicking out at the bottom of a move, with or without margin calls over your head.

Am I afraid that, if I don't buy some stock tanking like a "falling knife" right now, I'll miss the huge bounce coming right around the corner? Is it possible that many other traders are thinking the same way? The reality is that it's rarely "too late" to get a better price when buying into a crashing stock. When the price action settles down, stabilizes and starts to rebound, the stock will probably still be priced below your initial entry.

Sometimes, our own feelings can give us strong clues as to what the "crowd" is thinking as well. There was no need to predict ahead of time that October 4, 2011 would be the low of the last crisis and panic. However, through awareness of our own feelings, astute observation of the collective thoughts of others and by watching the price action in relation to the current headlines, we are continually provided with clues as to what is most likely to happen next.

For example, each time new headlines appeared about Greece and its debt problems, the chatter they generated seemed to lead to increasingly complacent market action and behavior. There would be short-lived dips that would quickly recover -- as if no one really cared anymore.

And then, earlier this year, how did the market react as we were hitting new multi-year highs? Here's some irony for you: The VIX (fear) index (and even more so, the publicly traded VXX index based on the VIX futures) was acting more fearful of a potential coming crash the higher the market traded.

Markets don't generally crash right after making new highs -- unless they've just gone through a high-volume blow-off top.

I recently read a study analyzing future market behavior when there are strong upward moves in both the VIX/VXX and the overall market in the same day. The study showed that it has led to even stronger upward price action in the near future. And, so far in 2012, that's exactly how things played out in the market.

But, human behavior is not rational, and memory of the recent volatile past is still imprinted in traders' minds. So, with each new high in the market, traders would buy the VIX products expecting a crash that never materialized, and were then hit over the head with some of the highest levels of contango (the huge cost of rolling over current futures and options contracts to the next month) the VIX market had ever experienced.

And, of course, traders were then also greeted with another leg up in the market as well. Never has it been easier for me to explain or visualize the term "climbing a wall of worry".

In reality, it is the unexpected shocks that lead to the most "real" fear. Especially where credit and leverage is concerned, it is these quick shocks that are most likely to catch firms (such as MF Global) unprepared. But, the more time that goes by with an event in the forefront, the longer the world has to deal with it, adjust by preparing for the worst and "get used to" the new norm.

Just remember back to the Japanese nuclear crisis, the BP oil spill, or even more recently, the fears over a massively understated Greek CDS credit event once the ISDA declared the Greek bond "re-pricing" a credit event.

As of earlier this year, banks, governments and central banks had upwards of eight months to deal with the possibility of messy CDS defaults. While there were some pundits calling for the possibility of three trillion dollars worth of losses versus the three or so billion claimed, it was likely that "the powers that be" had all the time they needed to deal with these issues.

And, believe it or not, the ISDA CDS auction also came to pass without incident. That's not to say there aren't plenty more roaches crawling around everywhere (as we've once again seen in Europe, with PFG, and the like). But, just as Countrywide Financial and Morgan Stanley were rolled into Bank of America to, perhaps, conceal a much worse situation in the sub-prime mortgage market, the "powers that be" likely had enough time to take similar measures to deal with any more potential blow-ups in the Greek bond market and others (well, at least for a short time being).

It's always best to consider all the information available to you, be aware of what you don't know and consider where you might be flat-out wrong. Seek to develop the focus and patience to position yourself in the best possible way, as opposed to merely trying to capture the next small wiggle.

Instead of missing out or being incorrectly positioned, you may provide yourself with a much better chance to capture a nice chunk of the real move about to appear just around the bend.