Skin In The Game

*This article is meant as a precursor to the next three, where I will discuss the difference between investing, trading and owning.

Never count out those who have the most to lose.  In the investment work, we have what often feels like countless options and opportunities to direct our hard-earned capital.  Bonds, futures, options, equities, currencies, commodities, real estate, the list goes on.  Each of these categories have hundreds, thousands, perhaps tens of thousands of individual directions within them.  You can take any one of those pieces and then place your bets in either direction, up or down.  In some instances you can even gamble on the spread between the cost of buying or selling any one of them.  In true form, wherever opportunity awaits, countless brokers and dealers await, pimping their wares, and offering financial glory, or ruin.  The investment world is daunting, to say the least.

So how does one begin to wade these churning waters?  Some dive in and succeed, or don’t.  Others stick their toe in, but never take enough risk to equate any reward worth the time.  Most freeze, incapacitated and incapable of knowing where to start.  You only live once and money is better spent anyway, right?

I make the bold assumption that if you are reading this, or other financial blogs, that you are not in the third category.  Regardless of what brings you into the markets, there is a responsibility on your part to educate yourself, and work with professionals that value education more than instruction.  If you are blessed with funds beyond your needs, regardless of how many zero’s may be involved, then you are equally cursed with the responsibility of managing it prudently, and towards reward.

The first lesson everyone should learn about markets is best summed up by Rob Booker of The Traders Podcast; “The market doesn’t give an F about you.”  In many cases, financial markets can be labeled “manipulated” by the biggest players or governments involved, and can sometimes appear to respond in unnatural and unrestrained ways.  In reality, however these interventions are often only short-lived.  Markets change price for one reason only, either there is too much supply and not enough demand, so they go down, or the opposite.  That’s it.  There is nothing more.  Actually, there is a fair bit more, but it is all derived from this simple idea.  Even the supposed “manipulation” in the markets is a derivative of, and therefore subject to the basic laws of supply and demand.

A deep understanding of how supply and demand works is a huge step in the right direction.  I will discuss this further in future posts.  Putting this into action, you then learn through experience or education, how to determine the price at which supply will outweigh demand, or vice versa.  You place your trade at those levels, set your stop losses in case you are wrong, and then refine those entries and exits as you gain more experience.

So if it’s really that simple, then why do so many people lose money?  People who consistently lose money investing do it because they do not understand who the best player in the game is, and then try to play against them.  As they say in poker, if you sit down at a table and after a few hands you don’t know who the fish is, you’re the fish.

A quick side note, it is important to first mention that when I talk about investing, I’m not talking about blanket investing through a brokerage fIrm where you pay them a fee to put you into mutual funds.  I don’t generally consider that investing, it’s just assuming.  While I consider paying someone else to broker your account for you technically unnecessary, the reality is many people do not have the time to do it themselves, so picking the right firm who avoids the “assumptive portfolio” I mentioned above is paramount.  An assumptive portfolio simply hopes the market as a whole will go up, and the thousands of winners you own will outperform the thousands of losers.  Instead, I define investing, whether you do it yourself, or pay someone else to do it for you, as choosing specific asset classes, and assets within, where only you are able to pat yourself on the back, or slap yourself in the face.

The natural question follows, “Who has skin in each game?”  There is a reason farmers trade commodity options, bankers trade currencies and brokerage firms trade equities and bonds.  These are their markets.  Emphasis on the phrase, “their markets.”  When I quoted Rob Booker above, I think it better to replace the word “market” with the phrase “biggest player.”  The biggest player in the game doesn’t give an F about you.  Better yet, “The biggest player in the game cares greatly for you, as it is your mistakes that earns them their profits.”

How the Big Guy Responds, an example

I will use an example regarding a market I am fairly familiar with.  I am often asked regarding the commodities market, specifically the gold market, “Where is the bottom?”  Gold has been in a consolidation for roughly two years now, from it’s highs of over $1,900 an ounce to lows under $1,200.  The first thing I want to determine is who has the most skin in the game.  The people who dig it out of the ground, manufacture it into usable forms, and ship it out to mints and companies that use the refined product.

One way to monitor the manufacturer’s involvement in their specific markets it to look at the CFTC weekly reporting.  They make their data accessible via spreadsheets, and can be easily charted.  What I have found at any price under roughly $1,200 per ounce, is that the mining and manufacturers get extremely active in the futures and options markets, pushing prices up.  Any price under the worldwide average cost of production of $1,200 an ounce means there is no profit, so no need to dig it up.  Supply and Demand, plain and simple.  The manufacturers do not want to lay off labor, or close mines, and therefore are willing to take cash reserves to buy long futures/options contracts to make the future price appear more desirable.

Generally, manufacturers hold more short positions than long.  Reason being, they are not the only player in the game, just the one with the most to lose.  They understand that the market price for what they produce goes up and down and they generally cannot control those moves on a daily basis, there’s really no reason to try.  Unlike the traders and bankers, the manufacturers also carry inventory.  They have stuff, in this case gold, sitting warehouses.  They have land, mines, equipment and labor to pay for.  They are managing far more than just the current and future market price, but the inventory and efforts to acquire that inventory as well.  They do this by covering a percentage of their inventory in short positions.  Manufacturers “always” hold more short positions than long, the inventory they hold is an asset and can be considered a long position in itself.

In an effort to avoid major potential losses to capital when gold slipped under the $1,200 cost of productions, the manufacturers did something (at least to my knowledge) unprecedented.  They reversed their short positions into long, and held almost 20% more long contracts than short.  In my career, I have never seen the manufacturers hold more than about half as many long contracts as shorts.  The only explanation is that they took substantial reserve capital to hold the price above their cost of production.  They are the biggest player in the precious metals game, with the most to lose, and they were willing to shove everything they had into the table to keep their employees paid, mines open and business operating.  And it worked.

We are now nearing that level again.  So, will they do it again?  We can’t know.  What we can know is supply and demand.  If they allow the price to slip below their cost of production, they only survive for a limited amount of time before they have to start limiting supply.  This will cause supply and demand to find equilibrium, and inevitably profit seekers will see the bottom and start pouring in.

The problem with being a manufacturer, like most of American investors, is that you can generally only earn profits when something goes up in value; buy low and sell high, that old elementary understanding of investing.  The investment firms that are willing to take the counter-risk are perfectly comfortable making money regardless of which way price goes.  They can sell high first, and then buy low later.  You can too, but most people don’t.  And that is an important lesson to learn, it is irrelevant whether price goes up or down to a bank or investment institution, as long as they are on the right side of the movement.  If the biggest player in the game is willing to shove their chips into the middle of the table and push the price back up, the banks are perfectly happy reversing their short positions into long, and as we will discuss in the next post, you make your money investing WITH the big guys, not against them.

Advertisements

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s