Monday, March 11, 2013

Trade Like a Pawn Star

Why do I think this tv show is helpful to traders? In many ways traders must manage risk and approach the market much the same way as those who run a successful and profitable pawn shop. Here are 15 trading lessons you could learn from watching a successful pawn store’s operations:
  1. Kiss A Lot Of Frogs:  A deal between the pawn shop and a seller is made less than 20% of the time. That means the pawn shop owner has to spend a lot of time and energy sifting through lots of deals, most of which are a complete waste of time. Trading Lesson: For every hundred trades you review, there will be one or two deserving of your attention and capital. BUT you still have to invest a huge amount of time and effort to find the few that do. Remember, every day you are going to kiss a lot of frogs in your quest to find the princess. There are no short cuts.
  2. Focus On Profit Margins:  In every transaction, you have your transaction cost plus time and labor of getting it sold. Pawn shop operators focus on profit margins more than anything else, taking into consideration opportunity costs, labor costs, taxes, etc. Trading Lesson: Traders need to keep a close eye on their profit margins and underlying costs the very same way. After all, when it comes to taxes, commissions, and various expenses, you need to know the bottom line and watch it closely. Traders who do not know the bottom line are set up to fail.
  3. Find And Exploit All Desparation:  The only reason a person brings in something to sell to a pawn shop even more so than to pawn it is that they need money and they need it now! This gives the pawn shop owner the advantage due to the underlying motivation and need to sell. Otherwise, why not sell it on eBay or Craigslist at the best price you can get? Trading Lesson: The same is true in the market – there are times you’ll see situations where sellers are desperate to get out at any price. Likewise, you’ll see situations where buyers want in at any price, offering the potential for a good short sell. Highly-skilled traders become acutely aware of emotionally-fueled imbalances in the market and focus their time and capital on these situations to benefit from the desperate decision-making of others. Remember, the more extreme the situation and the more pain and desire, the better the potential trade. If you research some of the best trades over the past few years you’ll often find an extreme emotional imbalance present before their big moves.
  4. Develop Your Team Of Trusted Experts:  When an unusual item comes through the pawn shop’s doors, the employees do not waste any time calling in an expert to examine the item and assess its value. Trading Lesson: Don’t think for one second that as an independent trader that you can do this all on your own – because no matter how good you are, there is always someone who knows more. In the 20 years I’ve been trading, I have developed close friendships with other traders who posses different skills and knowledge than I do. There are things for example, in which I am weak (such as quantitative formula creation and back testing) and I do not hesitate to ask them for their opinion about something if I think it can be useful. It takes years of time and energy to develop your team of trusted experts (most out there don’t have a clue what they are doing), but once you have them, they can be real assets. Part of this, of course, is that you also must posses something of value for them as well. So, know and understand your limitations and find ways to help you overcome them. Guessing is for gamblers and losers.
  5. Unprofitable Transactions Are Simply A Cost Of Doing Business:  Although it doesn’t happen frequently, Rick and the guys at their pawn shop get taken and lose money as a result. Here’s a quick video where they talk about some of their worst transactions. Trading Lesson: No matter how much you know and what research you put into something, there will still be losing trades. The trader who never has a bad trade is either a liar or a charlatan. In an average year, there are always a handful of trades that cost me big time, but that’s trading. Accept this as a cost of doing business (we traders often call it tuition). This is also why you never trade what you can’t afford to lose.
  6. Recognize Your Personal Bias:  If you watch Pawn Stars, after a while you get to know that each of the pawn store employees has things that they are personally interested in. For example, Richard “Old Man” Harrison likes anything vintage; Rick Harrison loves unique historical-based items that draw lots of tourists to the shop; Corey “Big Hoss” likes motorcycles, and Austin “Chumlee” Russell likes video games and comic books. You also learn by watching them that when they haggle over price in these specific items they are much easier to deal with and will reach a deal that is more favorable to the seller. Trading Lesson: What we know and like the most will cause us to be biased in the trade. We all have specific companies, sectors, etc. that we like and admire and, in most cases, we must recognize our personal bias and disadvantage from the onset to realize we cannot trade it effectively. In fact, most traders would be better served by focusing on trades away from their personal interests and likes for this very same reason. Many of the best technical traders I know make a habit NOT to learn a lot about the companies behind the stocks they trade because they don’t want to develop any bias beyond their technical analysis. If you “fall in love” with stocks and ETFs you trade, consider that “knowing less” can be helpful. Knowing more can be an obstacle. In addition, the more time and effort you spend researching something, it is only natural that you’ll be become more emotionally attached to the trade.
  7. No Dead Money Transactions:  Pawn shop owners don’t like buying things that are not selling well. They know and study pricing trends not only in their own stores but within the overall retail market. Trading Lesson: Traders must look at their portfolio much the same way. Traders must always have positions in play that are doing well and growing in value. Traders must avoid dead money trades and setups that require a lot of time to work out and which are trending lower. An investment should never be a trade that went awry. If the trade doesn’t have a catalyst (news event, technical pattern, etc.) ahead with the potential to significantly increase its value, don’t make the trade until the moment it does. Remember, there is no profit without a catalyst.
  8. Learn To Walk Away:  Even when pawn shop owners see something they really like they walk away when the price isn’t right. Trading Lesson: By focusing on price and risk management versus desire and need, your trading will improve. Know the entry price that offers you the best risk versus reward ratio and stick to it. Sometimes I will stalk stocks for years before making a first trade for this very reason. For every situation, traders must get their timing right. Only really long-term focused and very patient investors have the luxury of buying whenever they feel like it because time is on their side and they posses the consistent emotional wherewithal to accept pain for relatively long periods of time.
  9. Know The Worst Case Scenario:  When pawn shop owners consider buying something, the first thing they figure out is how much it is going to cost them. In essence – their worst case scenario if they can’t sell the item later on. Trading Lesson: This is a much different mentality than most traders have. Successful traders identify, understand and accept the worst case scenario for every trade at the very beginning – this is their very first step. This is always their focus – not how much money they can make from it, but rather what is the most they can lose and whether the risk is worth the potential reward. If you don’t know your downside risk in any trade, don’t make it. This one simple lesson would have prevented every single big financial disaster and crisis we’ve seen over the past few decades. If you can’t figure out what that worst case scenario is, you have no business making the trade.
  10. Look For The Easy Money:  Pawn shop owners look for the easy money – i.e. buying items that are easy to sell, that sell relatively quickly, offer large profit margins and the least amount of labor. Trading Lesson: Traders often make the mistake of taking trades that are too complex. They employ strategies that are time-consuming and difficult to consistently maintain. Indeed, we are often our own worst enemies. Instead of focusing on the easy trades that go with the trend, many traders spend time trying to play the hero by getting ahead of major reversals which require excellent timing and precise execution. This causes very inconsistent results because every trade is difficult, complex, and requires a lot of things to change and go right for it to be profitable. Traders must learn to avoid these transactions like the plague and train their eyes and strategies to seek lower-hanging fruit. The more complex the trade or strategy, the more likely it will fail and ultimately be unprofitable.
  11. Keep A Diversified Inventory:  Pawn shop owners don’t buy more of same stuff they already have in the shop if it is not selling. No, they don’t need another Samurai sword if the two they already own are just sitting there and collecting dust. Trading Lesson: Too much of anything is not a good thing. Spread your trades out to different sectors and markets. This will give you the best odds and help smooth out your returns. For example, you shouldn’t have five tech stocks in your portfolio at any time, just like the pawn store owner should not have five similar swords to sell. Spread your bets out. If you want tech exposure, for example, use an ETF proxy to gain exposure without the the same news/event/rumor risk present in every stock.
  12. Most Profits Will Come From Boring Transactions:   The bulk of the money that a pawn shop owner makes is from small bread-and-butter transactions – not the occasionally home run. Trading Lesson: Many new traders focus on making home runs in every trade they make instead of realizing that the 5-10% winning trades, over time, will provide a very good income. The greedy and impatient trader who only focuses on making the big score is usually the same one who will be out of the game before too long because they lacked a strategy that offered a decent, steady income over time.
  13. Nothing Beats Experience:  Experience is the best teacher for the pawn shop owner. Through time and many transactions, proper record-keeping and routine evaluations, a pawn store owner knows what sells best, where the profits are, and what to avoid. Trading Lesson: Nothing beats experience. The more experience you get as a trader, the better you will be able to evaluate each future trade. This is where the occasionally, very part-time trader is at a significant disadvantage. These folks only make a few dozen trades a year, so they never really develop a lot of experience or skill level when compared with those traders who evaluate dozens of potential trades every single day. In addition, proper record-keeping is important to know where your profits and losses are coming from so you can learn how to improve. Most individual traders are too lazy to do this, and that’s also why they fail as they don’t even have the information they need to properly evaluate what they are currently doing.
  14. Be Honest At All Times:  There have been many times when a specific item has come into the shop that the owner knows is worth much more than what is being asked for it. Whether this is just for TV cameras or not, the pawn shop employee will explain its value. Trading Lesson: Trading is difficult enough without lying to others (like family members whom you are financially responsible or to yourself) about your bottom line performance. The only way to improve and achieve great things in this game is to be honest and hold yourself completely accountable for every trade you make. This is not easy because you will make some really stupid trades. You will be so very embarrassed at the mistakes you make that you wouldn’t want anyone in the world to know about them and it is too painful to even think about them. Because trading can often be so emotionally painful and frustrating, it is simple human nature to lie to ourselves and at the same time blame others for our mistakes. However, the path to greater success in the markets absolutely requires you to be honest at all times and to hold yourself accountable for every trade you make. Only then will you be on the path to greater success in the markets.
  15. Value Always Equals What Another Person Is Willing To Pay Right Now:   Most of the time people who bring things into the pawn shop have an unrealistic assessment of real world value because of their emotional attachment to it or lack of understanding of the marketplace. Trading Lesson: No matter how much you think something is worth, in reality it is only worth what you can sell it for today. It doesn’t matter how much the same item sold for last week, last month, last year, etc. – it only matters what someone will pay you for it today. Traders and, many investors for that matter, often lie to themselves to justify a bad trade/investment arguing that the market is wrong and they are right. This is never the case. Just because you think it is cheap, doesn’t mean it is. Remember, the market is never wrong. Do not hold any losing trade only because you think it is cheap and undervalued. While you may get your money back (if held long enough) this is no way to make big money in the markets. Over time poor discipline will result in the loss of significant time and capital – it is the grim reaper for all traders.

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