Anatomy Of A Trade: Knowing When You Are Wrong

In the market analysis and financial punditry field where I live and work, admitting that you got something wrong or that a move took you completely by surprise is frowned upon. We are all supposed to believe, or at least make others believe, that we are infallible, that we only make good calls, and that we see everything coming. That may be a good attitude from a self-promotion and marketing perspective, but it is not very helpful to the reader. The fact is that in trading and investing, we all make mistakes. Whether or not you can recognize them before too much damage is done and how you react to them will ultimately decide your success and failure.

I thought about this last week when an adjusted stop forced me to see the folly of a trade that, on the surface, made sense, but that just refused to work out.

The stock concerned was Alliance Resource Partners L.P. (ARLP). They are a limited partnership focused on coal and, when they released earnings that beat expectations on the first of this month, the stock soared. That wasn't a fluke as they had been making good money consistently since mid-2020, but I convinced myself it was something that just couldn't last. After all, ARLP is a coal stock and coal, as we all know has at best a limited future.

At that time, Joe Biden, after trailing in the polls for a long time was making a bit of a comeback and seemed determined to shore up his base by moving to the left on most things. The weirdly named Inflation Reduction Act, a climate change bill, was making its way through Congress and looked like passing, and the subsidies in it for green energy would leave coal at even more of a disadvantage than it had previously been. Add in the fact that ARLP had gained around 200% in a year at that time and a collapse seemed inevitable. So, I shorted it.

Here's what happened…

As ARLP bounced on those earnings, I sold short at 22.50. At first that looked good, as the stock turned the next day, and dropped over the next week. I, though, had visions of a complete collapse, so declined to take a profit when it reached my initial target of 21.50 and simply tightened my stop to 23.70 at that time. A week later, that stop was hit, and I took another spontaneous decision. Clearly, this was a stock that was ignoring the kind of big picture logic that I was using, and something was propelling it ever higher. I decided to reassess my thinking and find out what that was. If it was a good enough reason to expect further gains, I would not just cut, but reverse and convert to a long position.

When I looked again, it seemed that the stock was being driven higher by something that always constitutes a good reason to buy a stock…good old-fashioned value. ARLP, at that time, had a trailing P/E of around 12.5 and a forward multiple under 5. Of course, I was aware of that when I sold the stock short but, convinced of the validity of my bear case, I thought it was fully justified. If I had been able to take a truly impartial view back then, though, I would have realized that whatever the long-term outlook for coal it was still a commodity which was in a bit of a supply squeeze and that, as China bounced back from its zero-Covid restrictions, it would climb in price terms.

Once I did consider that, I decided not just to cut my losses, but also to actually reverse to a long position, one that I still have. This morning, with ARLP having a good start to the day, I adjusted my stop on that position to $24.90, meaning that my worst possible outcome of the trade is flat, with still some upside. The point here is not to say that I am a genius (although obviously I am!) but just to point out the value of knowing that you will get some things wrong. In my experience, good traders have enough arrogance to follow their convictions, but also enough humility to know when they are wrong. As you can see from the above trade, if you can get that balance right, even losers can sometimes become winners.