Trading and investing draw distinct comparisons to blackjack and poker, all three are situations of uncertainty in which your success depends upon you putting the odds in your favor. There are no sure things, outside of cheating (insider trading, collusion with the card dealer, etc), and losses cannot be avoided.
Players of markets, blackjack, and poker also realize that they as humans are fundamentally flawed at making optimal decisions on the fly, so they devise systems. If X happens, do Y. It can get as complex as OTC swaps market making algorithms, to as simple as following an expected value chart in poker to choose your starting hands.
The main similarity between these card games and financial markets is making decisions with incomplete information. In face of this, the only two choices one has to play out an edge is using discretionary knowledge built over years of experience, or devising a system that will have an edge over statistical randomness.
Mathematical Poker Player
The analogy between successful poker playing and trading financial markets is one often made, both by poker players and traders. The skillsets of making decisions based on incomplete information and money management is so similar that hedge funds often recruit professional poker players to teach them to trade at their firm.
A trader managing money has to make sure he doesn’t lose a significant amount of his capital on any given trade. Because all trades have a high degree of uncertainty, risking something like 50% of your capital on one trade because you have a high degree of conviction, can lead to ruin for a trader. The same stands true in poker. Trading in markets and playing poker both contain a great degree of variance, meaning even with optimal play/trading, sometimes you will go on a losing streak. It’s important to only risk a small portion of your trading account/bankroll because of this. Many poker players will only use something like 5% of their bankroll for one buy-in to a cash
I like to compare the selection of starting hands in poker to stock screening and stock selection for traders. Poker players know that at a full table of nine people, they will fold the majority of their starting hands, because of their expected value. Playing a hand like 7-2 offsuit (two different suits, like a 7 of clubs and 2 of diamonds) when four people are in the pot is a negative expected value play in the long run. Sometimes you will flop two pairs or three of a kind, but play that hand 1,000 times and you will lose money.
Similarly, a stock trader deploying a momentum strategy may get lucky once in a while when they buy a stock that is trading sideways and it shoots up, but do that 1,000 times instead of buying stocks according to your momentum criteria, and you will invariably lose money.
The situation poker players often find themselves in is when they know that their hand is probably beat, but the bet their opponent made gives them the proper odds to call the bet. For example, the pot has $1,000 in it, and you have the bottom pair on the board. Your opponent bets $100 on the river (the last round of betting). Due to your opponents behavior during the hand, you think his hand is probably better than yours, however, you have 9-to-1 odds to win the pot, so it’s worth your money to call the bet. Your opponent will be bluffing often enough for you to be profitable on that bet over time.
In markets, the same principle of pot odds apply for unlikely bets like out-of-the-money options. For example, one may think there’s a good chance of Tesla Motors going bankrupt, so you buy 24 month to expiration super out-of-the-money puts on the company for extremely cheap. While the market judges it as unlikely that Tesla will be bankrupt within two years, if the bets pays off, you will have earned many multiples on your money.
The Blackjack Card Counter
The blackjack card counter draws similarities to traders in a higher-level sense. I like to think of the regular game of blackjack without card counting as the market. In a casino game of blackjack, the house puts the odds in their favor, in markets, the “house,” or large institutions have an edge over the rest of the market participants. They underwrote many of the companies, have close contacts with the executives, have intimate knowledge of companies, and have enough capital to move markets and manipulate options markets. There have even been allegations of VIX options manipulation.
In order to combat “the house,” one has to deploy a systematic approach. Blackjack players count the cards and bet large when the remaining cards in the deck give them favorable odds, and bet small when the remaining cards do not bode well for them. Traders do much of the same. They develop a system to combat their emotions and market noise, something like a fundamental stock picking strategy like buying companies with cheap valuations, or a momentum strategy that buys high flying uptrending stocks, with little to no regard for the trader’s personal emotions.
As mentioned earlier, there’s a reason hedge funds prefer to develop professional card players to trade their capital, the players already have an intimate knowledge of applying statistics and keeping their emotions in check in the face of uncertainty. Traders looking to become more detached from their individual trades should try playing blackjack and applying something like Ed Thorp’s 10-count. Traders looking to optimize their decision making skills and game theory should look to poker games like Texas Hold’em.
Activist short sellers are heavily criticized by the media and the corporate world, often accused of market manipulation and anti-American sentiment. In some examples, this is quite true, however, there is an argument to made that short sellers are the watchdogs of financial markets. Activist short seller Jim Chanos often says that short sellers are “are the market’s real-time financial regulators” and that regulatory agencies are the “archaeologists” of the markets.
From his start at a shady cold-calling commodities brokerage in the 90s, to shorting boiler room and internet bulletin board darlings, clearly Andrew Left didn’t get his start in the market through traditional means.
He currently runs Citron Research, his website where he posts his short ideas. Rather than the traditional funky accounting-based shorts that most short sellers are known for, Left’s style is different to say the least.
He identifies companies that make bold claims about their products and technology. For example, one of his most recent and controversial shorts was on Shopify. His short thesis was based on Shopify’s supposedly over-ambitious marketing claims used by their affiliates. He went on to compare the company to multi-level marketing company Herbalife, titling his Shopify report “THE HOTTEST STOCK ON THE NYSE IS … A COMPLETELY ILLEGAL GET-RICH-QUICK SCHEME (WITH A GOOD SOFTWARE PLATFORM).” The reaction from Wall Street and the financial media was quite negative, and many attacked Left as a market manipulator, taking advantage of the affect his reports have on stocks. However, Left doesn’t always get it wrong. He is widely credited for exposing Valeant Pharmaceuticals, calling them the “next Enron.”
Perhaps the cornerstone of Left’s success is his use of copywriting. He uses inflammatory, fiery headlines that raises one’s eyebrows, and makes his reports simple enough for the layman to understand.
Jim Chanos is the head of short selling hedge fund Kynikos Associates. He is known for calling out multiple fraudulent companies, mostly based on their shoddy accounting practices. Most of time, these companies, like Enron, are darlings on Wall Street when Chanos gets short.
He is most well known for his short call on energy merchant bank Enron, which was eventually the subject of a book and documentary The Smartest Guys in the Room. The catalysts for his short call was a long string of acquisitions, which is always a sign for Chanos to take a closer look, but most of all, when the energy merchant banking industry successfully lobbied the SEC to apply mark-to-market accounting to their company reporting. After noticing this and other red flags like insider selling and mass executive departures, Chanos & Co. initiated their short position in November 2000. Just 13 months later, in December 2001, Enron filed for bankruptcy.
In the current day, Chanos is best known for his views on China and Tesla. He called Tesla a “walking insolvency” and thinks the company is heading towards bankruptcy. He cites, among other things, Tesla’s acquisition of SolarCity, their burn-rate, and their inability to keep up with auto autonomy technology.
Chanos’ view on China is based on their supposed real estate bubble, to simplify this he described a conversation he had with his real estate analyst that went like this:
Analyst: “Currently, China has, under development, 5.6 billion square meters of high rises. Roughly half residential, and half office in mixed use.
Chanos: “Alex, you’re getting your nomenclature wrong because we think in square feet, and they think in square feet. That’s 60 billion square feet, which would make a 5×5 cubical for every man, woman, and child in China.”
Analyst, with a look of horror: “I’ve tripled checked. It’s 5.6 billion square meters.
Chanos additionally made correct short calls on companies like Tyco International, Boston Chicken, Baldwin-United, and many others.
Perhaps Barry Ritholtz best described Chano’s abilities:
“Jim has the combination of an accountant’s ability to dive into the numbers and a detective’s ability to sniff out nonsense, and he has done it throughout his whole career”
Bill Ackman is the CEO of Pershing Square Capital Management, a hedge fund he started in 2004 shortly after his previous fund, Gotham Partners, was blown up by a failed investment into a golf course operator.
Bill Ackman’s day job is value investing, but when he comes across a short idea he likes, he goes “to the end of the earth,” as he said in regard to his Herbalife short. Ackman has made two big short plays in his career, one was massively successful, MBIA, the other, Herbalife, was a massive failure for him.
Looking at the two businesses, they were different types of shorts. MBIA, which he began shorting in 2002, was due to their risk as a bond insurer, in his report “Is MBIA Triple-A?,” he theorized that they didn’t have enough capital to insure the bonds they were insuring should a financial crisis occur.
Conversely, Ackman’s Herbalife short wasn’t based on the company’s financials, but their business model. Ackman went public with his Herbalife short, claiming the company is a pyramid scheme. It started in December 2012 with a 300 slide presentation called “Who Wants to Be a Millionaire,” and went on until late 2017, when Ackman finally exited his short position.
The Herbalife short was all about public relations, he had to convince the public that Herbalife was a scam, and put enough pressure on regulators to investigate the company. After lobbying Washington, spending $50 million on a public relations campaign, working with a filmmaker, and working with civil rights groups, the stock was still going up consistently. The FTC eventually had a ruling on Herbalife’s business model, in which they did not describe it as a pyramid scheme. After closing the position, Ackman’s firm lost an estimated $455 million dollars.
Ackman claims he will never handle a short position the way he handled Herbalife again, saying “In the future I am going to bet against the stock and then deliver my material to John Oliver,” referencing Oliver’s investigative report on multi-level marketing schemes which heavily featured Herbalife.
Short sellers, specifically short sellers who publicize their positions with reports, are some of the most disliked people on Wall Street. Often times, the line between a whistle blower and a market manipulator is blurred. Without a doubt, short seller’s reports are meant to move the market, however the same could be said about any bullish investor on CNBC, touting their favorite stocks. Both propositions have the potential to lose the investing public money.
After the bankruptcy of energy merchant bank Enron and subsequent criminal trials of the company’s executives, everyone on Wall Street knew Jim Chanos’ name, as he was short the stock before the Street began to suspect anything. Since then, he has continued to impress with bearish calls on Boston Chicken, Sunbeam, Tyco International, and countless others. He stills makes headlines frequently for his bearish bets against Tesla and the Chinese economy.
So, what does it take to be Jim Chanos? How did he manage to uncover all of these disastrous companies? Well, in this article, we’re going to look at key criteria Chanos looks for when researching a company.
One of the key indicators that Chanos and his team looks at are when executives begin to leave the company. To them, this tells the story best, if things were going good, they would at least want to stick around to get some credit for it.
This indicator was used in their short of Enron, Valeant, First Solar, Tesla, and others. In addition to regulatory filings, Kynikos uses LinkedIn employment statuses as a real-time indicator of executive turnover.
“One tip off in Valeant was exodus of senior executives. One of our historical sign posts is when numbers of senior people leave over a short period of time. Tesla fits that bill. We have a chart of senior executives leaving Tesla, it is a flood in the last few years. This is not just Model X, these people are going to be needed for the Model 3.”
Listen to Chanos talk about executive turnover in his own words on Wall Street Week:
Massive Insider Selling
This is another qualitative factor that any unsophisticated can look at with a simple web search. In addition to high executive turnover, Chanos likes to see those executives selling their shares. Analyzing insider selling can be dangerous, because as Peter Lynch says “insiders might sell their shares for any number of reasons, but they buy them for only one: they think the price will rise.” However, in large numbers, combined with high executive turnover, one cannot deny the fact that executives, those who know the company best, are bearish on the company.
Chanos successfully applied this tactic when shorting Enron, Valeant, Keurig Green Mountain, First Solar, and others.
Suspect Accounting Practices
Ultimately, Chanos and Kynikos are forensic accountants, although they use other qualitative indicators like executive turnover and insider selling, it’s safe to say it’s their bread and butter.
Chanos attributes the amount of suspicious and borderline fraudulent accounting to the rules-based, as opposed to standards-based system in corporate finance, as he told Value Investor Insight:
“We want every single possible transaction to have a rule. So you have armies of investment bankers and lawyers who do nothing but think about how to get around the rules. I can’t think of one major fraud where the auditors didn’t sign off on the statements. In a rules-based system it’s easier for unscrupulous people to fix the numbers and get people to sign off on them as proper”
One accounting insight that tipped off Chanos to short Enron was mark-to-model pricing. This is when a company measures the value of their assets using their own financial models, when there is no efficient market by which to price the assets. Even without fraud, mark-to-model pricing often makes faulty assumptions, like assuming liquidity and consistent market conditions. In the case of fraud, one can imagine how easy it would be to distort the price of an asset on a balance sheet using a computer model.
Another accounting aspect that Chanos stresses is the quality of cash flows. While the majority of investors pay close attention to earnings, Chanos believes they are too easily manipulated by accounting, while cash flow is more difficult to manipulate.
Other accounting metrics that Chanos pays close attention to are ratios like ROIC (return on invested capital), and ROE (return on equity).
Chanos doesn’t like when a company uses aggressive marketing language when describing itself to investors. When the annual report looks more like a stock promotion placed by a microcap on a newswire, Chanos gets excited. Further, when the company lambasts critics rather than responding to their claims, that is even more of a red flag.
Perhaps no company displays this quality better than Tesla and CEO Elon Musk, which is a main reason Chanos is short. Chanos told CNBC that Musk “has a broad interpretation of the truth.” In a Rolling Stone profile, Musk told his children that short sellers of Tesla’s stock are “jerks who wants us to die.”
A huge part of Chanos’ and Kynikos edge in finding short ideas is in their decades of accounting and equity research experience. They’ve read thousands of annual reports, and have a keen sense for something fishy in financial statements. However, for the the less astute investor, one can learn from Chanos and at the very least, use the advice to avoid stocks to buy.
What started as a friendly bet with a fellow trader changed the lives of many and started a whole school of thought in trading. Richard Dennis believed that anyone could become a trader if given a working system and mentoring, and William Eckhardt took him on that bet. After publishing an ad in the Wall Street Journal, he recruited 14 inexperienced traders to start his experiment. Those traders were the “turtles,” as Dennis called them, whom he taught his simple breakout trading system.
The Turtle trading system was quite simple and easy to follow. Nowadays, even a novice programmer can write an algorithm to automate the strategy.
Basics of the System
Dennis’ system was buying breakouts of 20 and 55-day highs, and selling breakdowns of 20 and 55-day lows. The system is clearly part of the trend following school of thought in trading, starkly contrasting to mean reversion, which they were firmly against. The original Wall Street Journal ad had a true/false statement to weed out traders with a mean reversion way of thinking, “The big money in trading is made when one can get long at lows after a big downtrend.”
The system exclusively traded futures contracts, all except grains and meats. They avoid meats because of rampant price manipulation of meats futures in the 1980s, which has presumably ended.
They managed risk by risking a fixed amount of capital per trade, and using average true range to quantify risk, and ensure they were placing stops correctly.
There were two time frames that the Turtles traded, one based on a 20-day lookback window, the other on a longer term 55-day lookback. The way they traded these time frames slightly diverge.
Buy when price trades one tick above the 20-day high.
Short when price trades one tick below the 20-day low.
Additional rule for shorts and longs: If the previous 20-day breakout trade was successful, do not take this trade.
Buy when price trades one tick above the 55-day high
Short when price trades one tick below the 55-day low.
No additional rules based on previous breakout success.
The Turtles used a quantified stop loss. To figure out what price their stops would be placed at, they used a volatility measure Dennis called N.
N is the 20-day exponential moving average of the average true range indicator. Looking at an ATR indicator, you can see it is quite choppy and overstates recent volatility, hence why Dennis smoothed it with a moving average.
For example, the S&P E-mini’s N level is at 44.43 points. Risking 44.43 points would represent 1% of account equity, and Turtles risked 2% of their account per trade, so they would have 2N stops.
The Turtles used quite advanced position sizing techniques for their day, and even today, compared to many traders.
Each position was limited to a maximum loss of 2% of account equity.
In order to quantify the amount of contracts they should trade, they came up with a formula called Dollar Volatility, which took N, their risk parameter, and multiplied it by the dollars per point of a contract. This number is Dollar Volatility.
After arriving at Dollar Volatility, the would divide 1% of their account by Dollar Volatility.
S&P futures move in 25 cent increments, called ticks. Each tick is $12.50 per contract. So, a $0.25 * 4 = $50. The S&P’s dollars per point is $50. Now we multiply that by it’s N, which is 44.43. We get 2,221.50, which is our dollar volatility for the S&P E-minis.
Let’s assume we have a $1,000,000 account value. 1% of the account is $10,000. Divide this by the dollar volatility of 2,221.50, and we get 4.5. The Turtles would round down their contract size, so in this case, you would trade 4 contracts.
In addition to their stop losses, the Turtles had other exit criteria to improve their trade expectancy. The exits differed slightly from the 20-day to 55-day system.
Exit at a 10-day low.
Exit at a 10-day high
Exit trade intraday, not at close.
Many of the markets the Turtles traded were closely correlated, because of this, trades would often occur together. So, if crude oil broke out, Natural Gas might follow shortly after. In order to ensure they weren’t too exposed to one sector of the market, they would set limits to how many units, or contracts they can be long/short.
Here is a table taken from Curtis Faith whitepaper on the Turtle strategy:
Closely Correlated Markets
Loosely Correlated Markets
Single Direction – Long/Short
Richard Dennis often said that you could publish trading rules in the newspaper and it wouldn’t matter because people couldn’t follow them. There are plenty of positive expectancy trading systems out there, but there are much fewer tradings successfully trading them. When large amounts of capital are on the line, the human reptile brain is engaged and their emotions force them to override their system, ruining their expectancy.
There were multiple failed traders who were fired from the program because they could not follow the simple rules. Even though an experienced trader worth over $100 million was mentoring them on following the trading rules, and acquainting them with the inconsistencies of each market, some still couldn’t bare to override the rules, thinking they know better. If the Turtles teach you anything, it’s to follow your system.
Andrew Left is a famed short seller, who publishes his short ideas through his website CitronResearch.com, formerly known as StockLemon.com. Citron’s main goal, according to their website, is “identifying fraud and terminal business models.”
Who is Andrew Left?
“Citron’s reports are a lot more fun to read than just about anything published by a mainstream Wall Street stock analyst”- Bloomberg News
Plastered on the top of Citron’s website, it’s clear that Left is proud of the reputation he garnered on Wall Street.
Left is an outcast on the Street by default, living in Beverly Hills. He got his start in finance through a cold-calling job at a shady commodities brokerage, for which he was sanctioned by the National Futures Association, and in their words he “made false and misleading statements to cheat, defraud or deceive a customer in violation of NFA compliance rules.” After this inside knowledge on how securities promotion works, he began shorting stocks pushed by “boiler rooms,” and later, internet bulletin boards.
This lead to the creation of StockLemon.com, where Left published reports on the company’s he was shorting. After a rough divorce with his ex-wife, he decided to start anew with Citron Research.
Left has garnered mainstream exposure due to his firebrand nature. He makes sweeping, confident assumptions about the companies he is shorting and is known for simplifying his findings. While the typical Wall Street research report is long, filled with jargon and metrics, Citron’s reports are short and use layman-language. This is by design.
Left’s success at promoting his positions makes sense when put into perspective by a Bloomberg tech. “You’re our best guest, our most controversial guest,” he told Left.
Left’s Big Short: Valeant
In 2015, Left announced he was short Valeant and accused them of channel stuffing, calling them the “Pharmaceutical Enron” in his report on the company. This lead to a saga of reporting on the inner workings of Enron by the wider mainstream media, one New York Times op-ed was called “Is Valeant the Next Enron?,” while a Business Insider article was called “Valeant is not Enron, It’s WorldCom.” The tide was shifting for Valeant.
Left struck at the perfect time, in the midst of the controversy surrounding Martin Shkreli’s price-hike of AIDS drug Daraprim. Left tactfully used Shkreli as an example, citing that while the media is distracted by the “Pharma Bro” hiking the price of one drug, Valeant had been doing it for dozens of drugs for years.
Valeant’s stock went from $240 to $75 in just two months, and then down to $27 in another four months. At the time of writing, in February 2018, Valeant is trading at $18
Most of the financial media credits Left for bringing Valeant down. Here are just a few articles:
- The Short Who Sank Valeant – WSJ
- The Short Seller Who Crushed Valeant Has Picked His Next Target – Bloomberg
- The Short-Seller Who Uncovered Valeant Has Found His Next Target – CNBC
This is just a sampling of the dozens of articles crediting him for Valeant’s burst.
Left’s Most Controversial Short: Shopify
Many would agree, Left’s Valeant short was pretty popular. The media immediately ran with the story, and although Valeant was a Wall Street darling before the report, their reaction to the controversy speaks volumes. Left doesn’t always hit it out of the park like he did with Valeant.
In October 2017, Left published on the Citron website that he was short Shopify, and the report made lofty accusations. The title of the report being “THE HOTTEST STOCK ON THE NYSE IS … A COMPLETELY ILLEGAL GET-RICH-QUICK SCHEME (WITH A GOOD SOFTWARE PLATFORM).”
The report compares Shopify to Herbalife, because the majority of Shopify’s clients do not make a profit, and because of Shopify’s affiliate program. It goes further to claim that Shopify has broken multiple FTC regulations with their marketing language and behavior.
The report displays YouTube videos of Shopify affiliates pushing the “become a millionaire” dream, like the image below.
After the initial report, Shopify’s shares dropped 12% in one day, however, the stock quickly bounced back. The best way to see how Wall Street viewed Citron’s report is how the stock reacted. Although it initially took a dive, investors happily bought the dip, crushing Left’s short position. Presumably, the report made trigger happy investors, as well as momentum short sellers, sell the stock, and made Wall Street take a closer look at the claims. Unlike the case of Valeant, where his report tipped Wall Street off to actual fraud within the company, the market voted in favor of Shopify on this one.
Additionally, there was a multitude of responses criticizing the Citron report like the ones below.
Baird Equity Research analyst Colin Sebastian responded saying:
“First, we view the comparison with Herbalife as clearly misleading, as Shopify is not a multi-level marketing company… Second, and more to the point, our survey of Shopify ads today indicate very few (1 out of 20) contain the word millionaire, whereas the vast majority of the marketing campaigns are focused on easy online store set-up, building a brand, selling on Facebook, or creating an online shop. In fact, in order to find references to “millionaire ads,” even the short report suggests needing to search Google very specifically with the keywords “Shopify Millionaire” to uncover such ads, since they are not very apparent otherwise… Third, the short call on valuation is based on the long-standing view among some investors that the non-subscription part of Shopify’s revenues (Merchant Solutions) deserves a lower multiple, since it is largely volume-based commissions for payments and other “back office” functionality rather than “core” e-commerce functionality. We agree that this part of Shopify could be valued differently, however, we would note that both segments of the business are somewhat interdependent, and represent a fixed and variable component to revenues for a more complete end-to-end platform offering that align Shopify’s interests and incentives with their customers.”
D.A. Davidson analyst Tom Forte had this response:
“The way that he is spinning it is unfair and incorrect, it’s laughable-all smoke and no fire.”
Activist short sellers are often accused of trying to manipulate the market, however, few get more flack than Left, who is routinely criticized and sued by the companies he shorts. Some make the case that he is a sort-of market vigilante, someone who identifies fraudulent companies and informs investors.
Whichever is the case, one thing that can be said is he is very successful at what he does. Short sellers, and short activists especially, should take notes on what he does. Rather than holding 3 hour presentations a la Bill Ackman, Left goes the route of the catchy headline, with the report being easy enough for the layman investor to understand. Ultimately an activist wants to make their thesis as widely available as possible, so it is difficult to argue with his methods, from a purely practical point of view.