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Bad Trading Discipline Pays Off (Sometimes)

In my previous post, Short Term Speculation on the Yen, I outlined the reasoning behind my short Yen, long Dollar trade. I described the reasoning from the dollar perspective, but I had not described the yen perspective, as I believe the story has been better describe by people like Kyle Bass much better than I can describe it. Here is his latest video on CNBC.

The Bank of Japan has moved as I had expected. They have released an unprecedented stimulus measure of essentially doubling the monetary base. Put another way, they will print out the same amount of currency that is already in circulation.

However, I was wrong in my reasoning from the dollar perspective. I did not realize that current fundamental relationship of the dollar to the stock market is a positive correlation – global players have shifted into the U.S. markets as China and Europe have performed poorly. If the U.S. stock market fails to perform at the same pace, these global players may move elsewhere.

Because the stock market performed poorly earlier in the week, the dollar moved lower versus the Yen. There was additional pressure from the other side, as people who had shorted the Yen previously were covering because they were unsure what the BOJ would announce. This resulted in the USDJPY exchange rate hitting my stop limit of 93.70, and plowing all the way down to a low of 92.33.

However, I committed the cardinal sin in trading. I moved my stop. I set my limit down to the 91 mark set in late February. (Moving the stop limit is dangerous, because it changes the risk/reward profile of the trade. By moving down the stop, I was risking more, to gain the same potential profit).

Why? I was convinced the BOJ had been backed into a corner. There is no way out of Japan’s mess but printing money, and even this measure is not sure to work. Therefore I justified the move to myself. While it paid out in this case, it may not in the future, and moving the stop is, in general, not a good practice to adopt.

Short Term Speculation on the Yen

I have established a small short term position long USD and short JPY (Japanese Yen). This is ahead of the Bank of Japan meeting April 3-4, on the expectation that they will announce a more ambitious plan to devalue the yen than the market expects.

I believe this will occur because, in the current risk-on environment, the US Dollar has been sinking. I do not believe this will last. Equities are continuing to make all time highs, however, if stocks continue much higher, they will be entering overvalued territory. I believe the markets are getting ahead of themselves.

However, the theory of reflexivity would predict that this strength in stock prices would subsequently strengthen the economic fundamentals. An advancing stock market draws foreign and domestic capital and allows companies to issue their own stock at advantageous prices to fund acquisitions and organic growth. In such an environment, the risk-on environment may continue.

The reason I am not paying attention to the reflexive implications of a rising stock market is that the positive bias that would normally accompany such a move is not there. More and more, so-called experts are questioning whether the current economic strength can continue in the absence of the Fed’s monetary stimulus, which will be coming to an end this year. If the conclusion of the Fed’s program pulled out the legs from the market, we might end up with a “sell-in-May-and-go-away” type scenario.

The government’s sequestration lends further support to the “sell-in-May” hypothesis. Economic think tanks are reducing their estimates of the impact of sequestration. I think these estimates are short-sighted. The full effects of sequestration will only be felt later in the year, and I believe they will take the market by surprise. As a consequence, I believe the stock market will suffer a pullback sometime in the coming months. I am watching the markets closely for signs of technical weakness, so that I can make an opportunistic short.

A decreasing market would lead to a “risk-off” environment, in which the US Dollar would go higher. This, coupled with the Bank of Japan’s plans to devalue the yen, should propel the USD-JPY exchange rate much higher. To help matters, there was a doji reversal in the one-day charts last week. I have set a stop limit at the bottom of this reversal, near the 93.70 mark.

Closing the 3D Systems Corporation (DDD) Short

I closed out my 3D Systems Corporation (DDD) short position early last week. The trend has become unreliable.

As I pointed out on March 5, the downward trend was imperiled by Stratasys’s (SSYS) strong earnings. Further, rumors of an acquisition have been floating around.

Owners of manufacturing companies and conventional printer companies would like to get in on this trend, and may consider $3 billion a small price to pay for DDD’s patent portfolio, plus its future earnings. And, with a larger company’s capital at its back, DDD would no longer need to resort to equity-financed acquisitions, which put it at the risk of such reflexive boom-busts as we have just seen.

My March 2012 puts were saved in the nick of time on March 15, closing in the money before expiration. In retrospect, these were the wrong tool to use; I must remember to use puts further out into the future to avoid such a high time-value depreciation.

My May 2012 puts fared much better, and made a many-fold profit. In addition, my short equity position generated a substantial profit.

The negative trend may continue a little longer, but we are currently in a test period. There have been numerous articles recently highlighting the DDD’s fall in stock price as a bargain. This kind of positive perception is not what I would expect in a typical reflexive bust. I would expect the perception to turn increasingly more negative as the stock falls, until a true capitulation point.

I cannot predict what will happen with DDD until I see the next earnings report. If that shows a disappointing low earnings growth figure, then we will have proof that the negative perceptions have affected the fundamentals via the stock price, and it may be safe to re-engage in a short until the stock capitulates.

Given that the next earnings is not due for another couple of months, I cannot justify taking any action on DDD. If the stock reaches levels of ~$20/share, I would consider purchasing it as a long position, but until then, I am simply watching.

For more updates on my portfolio, check my blog BetterStockIdeas.com