The Stock Market Game

"Infinite games have infinite time horizons. And because there is no finish line, no practical end to the game, there is no such thing as "winning" an infinite game. In an infinite game, the objective is to keep playing, to perpetuate the game."

– Simon Sinek

The financial services industry is facing a severe existential crisis. The only things melting faster than the polar ice caps are assets under active management. Evolution does not take prisoners. If active managers do not want to go join the bluefin tuna on the list of endangered species, then maybe learning to sell short would be an invaluable skill to add to their arsenal. As the global financial crisis of 2007-2008 showed us, it's crucial for market participants to be capable of generating profits not only in bull but also in bear markets. To that end, this book will cover the ins and outs of short selling, and develop algorithmic strategies...

Is the stock market art or science?

"When bankers get together for dinner, they discuss art. When artists get together for dinner, they discuss money."

– Oscar Wilde

Once upon a time, Lorenzo de Medici praised Michelangelo for the quality of his craftsmanship. Il Divino replied to il Magnifico, "it appears as art only to those who have not worked hard enough to see the craft."

Every market participant has wondered whether the stock market was more of an art than science. The assumption behind art is the notion of innate talent. Some naturals are born gifted. Some aren't, and I am one of those. If talent is innate, then we mere mortals have to resign ourselves that we simply do not have it. However, talent is often an excuse for laziness. Michael Jordan was not a natural. He was thrown out of his basketball team, so he trained and would not go home until he landed 100 free throws. Landed 98? Oops. Do it again. This way, skills...

How do you win this complex, infinite, random game?

"There are known knowns, things we know that we know; and there are known unknowns, things that we know we don't know. But there are also unknown unknowns, things we do not know we don't know."

– Donald Rumsfeld

Share prices may reflect fundamentals over time, but the journey is likely to be a random walk. The random walk theory was popularized by Burton Malkiel in A Random Walk Down Wall Street. It essentially postulates that every financial asset has an intrinsic value, yet market prices are hard to accurately predict. Randomness routinely throws market participants off. When even the best of the best in the business succeed roughly 50% of the time, the only conclusion is that randomness cannot be eradicated.

There are two types of games: finite and infinite. A finite game has a clear set of rules, participants, a beginning, a middle, and an end. An infinite game has no set...

Playing the short selling game

"Follow me if you want to live."

– Arnold Schwarzenegger, Terminator

The mechanics of short selling are deceptively simple. For example, you sell a stock at 100, buy it back at 90, and pocket the 10. It works in absolute or relative to a benchmark. There is only one additional step that needs to take place before the short sale. Short sellers deliver shares they do not own. So, they borrow those shares from a stock lending desk with their brokerage house first. Once they buy the shares back and close the trade, they return those shares.

Do not let that simplicity fool you. Due to the infinite, complex, random nature of the game that we have considered in this chapter, 90% of market participants fail. Of the remaining 10%, fewer than half will ever engage in short selling. That is the unapologetic reality of the markets.

Our objective is to navigate these challenges and succeed on both sides of the portfolio...

Summary

In this chapter, we set the context for the rest of the book. The stock market is neither an art form nor a science. Market wizards are not born, nor do they need to be supremely intelligent. They are forged in the crucible of adversity. The stock market is an infinite, complex, random game. The only way to win this game is to stay in it, by adapting your strategy to the market's infinite, complex, random nature, and to pick stocks and cut losses accordingly. In the coming chapters, we will consider how to incorporate short selling into your trading strategy, and implement techniques to improve your success rate and gain expectancy.

Market participants are generally less comfortable selling short than buying long. This is down to a number of technical factors, but also because of a general fear of the practice, propagated by the number of myths related to short selling. We will discuss and disprove these in the next chapter.