The Big Short is one of the most popular books and movies about our industry in recent times but did you learn the right lessons from it?

The story that most people understand is that a few smart traders, correctly identified weaknesses in a complex financial product and made fortunes by shorting these and related products. Of all the traders featured, Michael Burry has perhaps become the most well known yet I would suggest that many investors have overlooked one crucial aspect of his story.

When reading or watching Burry’s story we must consider that his investors nearly pulled their funds from him because the ‘Big Short’ took so much time to eventuate. The trade racked up losses for months. Another few weeks and we might never have heard about him.

The book and movie focus on a few winners from the ‘Big Short’ but how many other traders or funds were forced out of the trade due to ongoing losses? Survivorship bias means we don’t see them.

Why Am I writing this now?


Because I chat to and read about many traders/investors who currently believe we are in a ‘Big Short’ environment. They have been running short trades (for example in the NASDAQ or related stocks) for several months believing we are in a bubble.

I recently spoke to a trader who has been short the NASDAQ for over a year. His losses are piling up and it remains doubtful whether he will last until a correction comes. Even if one occurs, he now needs a huge correction to make a profit; a 25% correction would not even wipe out his losses.

I’m not going to offer my thoughts here on whether we are in a bubble or not. But as someone who has traded through a few, I will offer my suggestions on how to trade such a view.

Can you stay in the trade?


Rule Number One is Keynes famous quote “The market can remain irrational longer than you can stay solvent”. Being ‘right’ too early is a recipe for losses that are likely to force you out before the correction.

So the most important factor to consider when designing a trade in these markets is can I stay in the trade if conditions remain ‘exuberant’?

George Soros states, the way to trade a period of exuberance is not to short it but rather to jump on board the long side until the market starts to turn. The difference between skeptics and believers is that the former will start to short once the market turns while the latter keeping buying on the way down.

Soros’ idea sits well with another famous Keynes’ quote that investing in the markets is like trying to predict who will win a beauty contest. It doesn’t matter who you think is the prettiest, you need to work out who others will vote for. It is undeniable that we must include this type of thinking in our analysis.

Personally, I developed strategies specifically for this type of environment. They are trades that can be bearish on a big move lower but bullish on a rally. It’s all part of ensuring I have the right trade for the current conditions and that I am trading the market not just my view of the market.

Summary

It is fascinating to witness how so many people learned the wrong lessons from The Big Short. Indeed, one of the takeaways is that we can see that investors don’t always learn the right lessons from the past.

Perhaps the real story we should learn from the Big Short is that even being ‘right’ is not easy. Timing is difficult and when making these big calls, many won’t last long enough to profit.

The investment world is littered with the losses of traders who were ‘right’ too early.

Keep Grinding,

Gary