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The Speculator
How to ride a bucking market
Before you strap yourself onto an ill-tempered 10,000-point monster with a bloody past, advice from a rodeo cowboy makes perfect sense. Also, 5 stocks to test our Endgame theory.
By Victor Niederhoffer and Laurel Kenner

Bow to all the pretty girls as you exit the arena, and take your check to the bank.
-- Smokey, rodeo rider

In science, one time-honored way of developing principles is to synthesize knowledge from different fields. We therefore were delighted to hear from a reader in a field that in the wildest stretches of our imagination we never thought to examine.

His letter provides a unique perspective from an endeavor where the cost of improperly assessing risk is immediate and potentially lethal. We therefore hasten to share his insights with our readers and believe they provide a nice follow-up to our columns on music, tennis, squash, chess, checkers, fishing, ecology, dodge ball, martial arts, elephant rampages, poker, electricity, biology and horse racing.

The cowboy named Smokey writes:

"The market's constant ability to amaze even the experts reminds me of rodeo events throughout my life. I grew up on the back of a horse, worked with cows for a living until I was about 25, and participated in local related competitions and events: fairs, horse shows and rodeos. I know something of cows and horses. I have often heard spectators comment on the possible dangers related to rodeo. Hogwash!

"Rule No. 1: If you play long enough, you are going to get hurt. (The only consideration is how badly and how often.)

"The market has always appeared similar to me: If you play the game long enough, you are going to suffer loss. Be it uncontrollable disaster, acts of war, unfavorable market conditions or acting on ill advice, something will go wrong. The geometrical proportion of the loss depends upon all the prevailing elements involved, and a given individual's response, presumably based on one's preparation, training, experience...and luck.

"Bull riding is measured in seconds. In the market, while it is true that split-second decisions and lightning-fast reactions to change determine yield, they must be more instinctual than reactive.

"Rule No. 2: Practice before you play.
Good decisions are not made under pressure. They are made before the event begins. They are made when one visualizes all the possible scenarios that might prevail and the appropriate responses to them: buy, hold or sell.
         Buy: The bull swings smooth and wide; rake him for maximum points.
         Hold: The bull goes rouge and you are sucked down into the well. That extra wrap grips your hand like death himself. Hold on tight and pray for a good bullfighter whilst you thrill and amaze the crowd.
         Sell: You lose your position when you are raked at the gate. A meeting of the minds is at hand: bail and run like hell. 'Tis better to fight and run away...'

"Obviously, no one can think of all these things in eight seconds. Dedicated practice. Perfect practice. This lends itself to good decisions when everyone else is standing in the bleachers screaming.

"While at college, I watched a young superstar with special interest. He studied each bull he might draw and detailed his ride for that animal's idiosyncrasies. Once a bull was selected, he secluded himself to mentally finalize his impending contest. A few years later, this same young man came into his own as America's No. 1 cowboy for a time.

"Rule No. 3: Establish a good, valid game plan. Stick to it.
The superstars of the sport are those who continue, especially in the face of adversity. I have witnessed friends and neighbors continue their quest while suffering bruises, sprains, twist, lacerations, even broken bones.

"Rule No. 4: Understand the consequences and true cost.
Regardless of all of the apparent 'best' efforts to prevent it, the market will cycle. Realize the market will respond to its environment, whether the experts understand it or not. Today, once-great companies lie crippled before us. So, never play with monies you cannot afford to lose. ‘Nuff said."

How to ride a bucking market
We'll say straight out, before our readers can point it out, that we have never competed in or judged a rodeo (just as we've never been invited to speak at the Society of Technical Analysts.) But clearly, Smokey's assessment of the inevitability of punishment in trading and rodeo riding has the ring of truth. Clearly, he is a man who has seen the elephant, heard the owl and flown the screaming eagle.

After reading Smokey's letter, we can appreciate why old rodeo riders always seem to limp. We understand that many of them find canes helpful, and we'll be sending one to Smokey. We don't ride bulls, but we do use canes now and then as recommended in one of our oft-quoted books, "Twenty-Eight Years in Wall Street" by Henry Clews (1887): "In times of panic, these old veterans of the Street will be seen hobbling down on their canes to their brokers' offices, to buy good stocks to the extent of their bank balances."

The question is, When do you take out the canes, and when do you deposit the profits?

For an answer, we turned to Smokey's rules. The rewards from staying on a bucking market would seem to be at least as alluring as those from staying on the bull.

We therefore looked at the first three moves that the market comes out of the chute with each week. We looked at all eight combinations of rises and falls in S&P 500 futures that can occur on Monday, Tuesday and Wednesday that occurred since June 1994. Next, we looked at what happens five days later.

The results show that after a very bad start on Monday and Tuesday, with some improvement on Wednesday, the ride will tend to be smooth over the ensuing five trading days – with a 1 in 20 shot of that occurring by chance. Conversely, after a very good start on Monday and Tuesday with bad vibes on Wednesday, the ride tends to be unpleasant.


 

But Smokey's inspiring rules also deserve application to individual stocks. Inspired by the future rodeo star who carefully studied each bull's idiosyncrasies, we tested some individual stocks for the down-Monday, down-Tuesday, up-Wednesday pattern and can report that most were highly bullish over the next five days.

We report below a typical run for IBM over the last five years. IBM showed the pattern on 23 occasions. The average move over the next five days was two full points, with 95% confidence that the move will be between 0 and 4. Only seven of the 23 changes were down, and the average percentage for all the moves, taking account of profits and losses, was 0.7%.

Last week, we introduced the Endgame Trade, a one-day strategy to use at the end of a week after a down Friday. We suggested finding the four Dow stocks that fell the most on the down Friday, buying them at the close next Thursday and selling them at the next day's close.

We pointed out that each of the last 10 trades for those stocks over the past five months was profitable, and that the average percentage change from applying it was about 1%. We enumerated the second- through fifth-worst-performing stock in each of those weeks, and reported the results. It turns out that buying the five worst stocks shows the same average 1% profit, and thus we feel more comfortable going with the five worst rather than the four corresponding to checker rows.

Last Friday was a good time to short the market, as it fell some 2% after a previous up Friday. However, we did not recommend shorting individual stocks, as that's not our métier. But this Friday, after a nice down Friday last week, we plan to test the water and propose a little buying. The five biggest Dow losers last Friday were Intel (INTC, news, msgs), -6.9%, General Motors (GM, news, msgs), -5.0%, Microsoft (MSFT, news, msgs), -4.2%, Walt Disney (DIS, news, msgs), -3.0% and Citigroup (C, news, msgs), -2.7%.

Kids, don't try this at home
Apparently our article last Thursday touched a sensitive nerve, as we received well over 400 requests for the Tom Wiswell checkers proverbs that inspired the Endgame Trade. We speculate that the reason for this interest is that investors are tired of holding and being subjected to losses as Nasdaq stocks in particular succumb to one big decline after another. However, we must point out that our strategy is a very specialized one. It is based on a limited sample. It didn't work in the beginning weeks of the year. And it is subject to weakening, based on the principle of ever-changing cycles, as well as Smokey's Rule No. 1, that if you play long enough you are bound to get hurt.

Even if this were not true, the strategy is viable only for those who are set up to trade short-term with great efficiency and at very low commissions. In practice, this means less than a few cents a share, and the ability to trade at the close or near it without giving up too great a portion of the bid-asked spread.

Remember also if you do get involved that you should only use a very small part of your funds for this trade or any other, and that you should leave enough in the pocket so that you can make a series of at least 10 such trades so that the averages, if they stay intact, have a reasonable chance of working in your favor.

Our own strategy will be to ease into these stocks during appropriate weakness on Thursday and to hold for a reasonable profit on the trade on Friday or some strong days after. We also intend to buy some futures on Thursday with a view to holding until Friday's close. But we'll be doing this with less than 0.5% of the liquid money that we can afford to lose. Beware not to get in over your head, as Tom Wiswell and Smokey would say.

We will report the results of our trade and give it one of our patented self-evaluations in our next column.

End note
IBM has shown the down Monday, down Tuesday, up Wednesday pattern this week -- something that happens just four or times a year on average. The closes on Friday, Monday, Tuesday and Wednesday, respectively, were 104.59, 104.10, 101.89, 103.96.

More Tom Wiswell checkers proverbs
We will e-mail or fax a selection of Tom Wiswell's proverbs on checkers openings to any reader requesting it. E-mail us at dciocca@bloomberg.net.

At the time of publication, Victor Niederhoffer owned or controlled shares in the following equities mentioned in this column: IBM. Laurel Kenner owned no equities mentioned in this column.