Here’s the thing: It doesn’t really matter what I think. It matters what they think.

As we’ve pointed out before, good trading is built more on sober technique than hot stock tips. Investors must be confident enough to take a position, yet humble enough to abandon it just the same. After all, the market is constantly changing, and no matter how good our analysis might be, we can always be wrong. Whether you’re Abby Joseph Cohen or Ms. Cleo, the future is always unknowable and largely out of our control.

But while we can’t change the market, we can alter our position within it. And I can’t stress enough that the most important aspect of any trading decision is never the condition of the market, but rather that of your own position. For active managers not content to buy and hope, the trick is to be constantly moving toward a position of strength, both within an individual trade and within the marketplace at large. Just like basketball, chess or any other activity that requires focus, you know you’re in the “zone” of trading when you start playing for position, not for points.

As tough as it may be, tear open your account statements and evaluate your exposure. Take a good look at each position and how it relates to your current market outlook. If there’s deadwood, cut it away. If there are promising buds on appropriately sized branches, let them be.

Of course, your biggest strength should be psychological. You must analyze your overall financial position, which has undoubtedly changed over the last couple of years, and ask yourself some tough questions. What are your assets and liabilities? What are your obligations and responsibilities? In short, just how much risk can you really afford to take? As I wrote last week, the best “big picture” position to be in is that of having ample savings and no debt. You should trade because you want to, not because you have to.

Within your portfolio, one way to ensure a position of strength at all times is to have ample cash on hand to pursue new opportunities as they arise. From a trader’s perspective, sometimes the best move is no move at all. As I wrote a few months back, it takes only one or two good ideas a year to make money. Despite the intense psychological need to be fully invested, you shouldn’t be afraid to sit and wait for the specific risks you truly want to assume. After all, you can’t harvest a garden if you’ve already squandered all your seeds.

Another way of moving toward a position of strength is to stop sitting on huge losing positions, waiting week after week for them to “come back.” As we started writing more than a year ago, when it comes to trading, the mathematics of the underdog simply don’t work out. You must prune your portfolio and evaluate your current top picks, not those you liked back when Bill Clinton was president. Losses are a fact of life for every trader, but sitting on them for months on end isn’t just a financial loss, but an opportunity cost as well.

A final technique for moving your portfolio toward a position of strength is to look at your liquidity. Although I’m in favor of finding risk in less liquid names, when it comes to strengthening your portfolio’s internals, a good general step is to sell your least liquid holdings first.

As anyone who has ever traded small-cap stocks or listed options knows, liquidity can be your greatest friend or your worst nightmare. When an illiquid stock or security moves, it really moves. If you’re on the wrong side of the trade, getting out can be annoying, expensive or just plain impossible. So when it’s time to head for the hills, don’t hide in short options or penny stocks. Seek deep cover.

It’s the real trading lesson of Long-Term Capital Management, beautifully documented in Nicholas Dunbar’s excellent book, “Inventing Money.” As Nobel Laureate and LTCM principal Myron Scholes observed, “There’s always a tendency to reduce or sell your more liquid securities first. [But] if things go against you, then you’re left with the more illiquid securities that’s a very bad strategy indeed.”

Trading is very much a game of financial Darwinism, in which only the strong survive. Even if you don’t change your portfolio daily, you should constantly be steering it toward a position of strength.

– Originally on Oct 14, 2002 by Jonathan Hoenig

What moves stocks, bonds or anything else is the relationship between demand and supply. By definition, traders and speculators profit by adding liquidity to illiquid markets. Doesn’t matter if it’s Cisco Systems (CSCO) or soybeans, traders narrow the spreads between the price at which someone’s willing to sell and the price at which someone else is willing to buy, bringing down the cost of execution. Trading isn’t about predicting the future, but about gaming the liquidity demands for a particular security. Generally speaking, I want to be long illiquid markets and short liquid markets.

First, a little background. You can’t imagine how drastically the liquidity picture has changed in just a few short years. Back in the early 1990s, when most market pros still referred to the Nasdaq as the “over-the-counter” market, stocks traded in eighths. That meant there were only eight “price points” within a particular dollar increment in which you could own Nasdaq stocks. And while 12.5 cents — one-eighth of a dollar — was the minimum spread between every price fluctuation, many stocks traded with half-point spreads or more. With mutual funds exploding in popularity and a huge influx of Internet-driven retail trade, this made making markets a very profitable business. In a sense, you had a big “edge” on every trade.

Now the moment someone else makes speculative capital available to make markets, he’s slicing off a piece of the liquidity pie. As competition to make markets grows, spreads become more narrow and there’s less opportunity to make money by making markets. As the spread between the bid and offer gets smaller, so does the profit margin that comes from trading in that particular security.

You don’t need a Harvard MBA to know that highly liquid industries are competitive, and competition is what brings down the cost of goods to consumers. It’s what makes other mature industries like retail or restaurants so difficult. In an effort to gain market share, companies cut prices. Their sales expand, but their margins shrink. The only reason McDonald’s (MCD) can make any money selling burgers for 49 cents is because they sell hundreds of millions a year. What they lose in margin they make up for in volume. Cutthroat competition is terrific for the consumer, since it brings prices down. That’s great when you’re buying hamburgers — but nightmarish when you’re buying stocks for “the long haul.”

This same maturation toward efficiency, competition and liquidity has occurred in the stock market over the past 10 years. As money has flowed into stocks, the Nasdaq hasn’t just become more liquid…but sopping, dripping wet — even after its 60%-plus decline.

How liquid has the Nasdaq become? According to the statistics complied by the National Association of Securities Dealers, spreads on Nasdaq stocks have fallen by over 75% in the past nine years. In 1992, the average relative spread was slightly above 1.70%. By September 2000, it had fallen to only 0.22%. Today, most Nasdaq stocks trade in 1/16th increments, with the typical spread being about 14 cents. Large-cap names routinely trade in increments of 1/256th, on average OTC volume of well over 1.5 billion shares. Decimalization will bring down spreads even further.

As markets become more liquid, traders must make up for small margins (small bid/ask spreads), by trading huge volume, and while I run a hedge fund, like most investors, I’m a small fry compared to the big boys. Think of it this way: When spreads were an eighth, if you snapped up a stock at 10 1/4, the least it could rise to was 10 3/8. So you didn’t have to be particularly right, or trading in particularly high volume, to make some money. But there’s less incentive to provide liquidity to markets that don’t need it, like large caps on the Nasdaq today. If I bid for 10,000 shares of WXYZ at 15, someone else is simply going to bid .004 of a cent (1/256) higher. It’s just not enough gravy in my book. I’ve either got to be right (that is, the stock has to go up) a lot more, or I have to trade in much higher volume to make any money.

The history of Internet stocks provides an object lesson in liquidity. What drove these stocks higher in the early years was that there were very few ways to get Internet exposure in 1995. While analysts suggested that “first-mover advantage” was huge, the real reason Internet stocks performed so well wasn’t because of their business prospects, but because of the supply/demand picture for the stocks themselves. Lest we forget, among Yahoo! (YHOO), Amazon.com (AMZN), (then independent) Netscape and America Online (now AOL Time Warner (AOL) but then trading on the OTC under ticker “AMER”) there were only a few Internet stocks — but tons of investor interest. If you wanted to own the future, you had only a couple choices. Remember when K-TEL (KTEL) or Zapata were seen as legitimate “Internet plays” that would own their respective markets? What happened, of course, is that the supply began to outstrip demand. As more issues came to market and companies learned how to embrace new technology, the demand for so-called pure-play Internet stocks evaporated. Somewhere down the line we realized that every company is an Internet stock.

As more companies went public, there were more choices of where to invest your Internet or technology dollars — more companies and instruments siphoning off and using liquidity. How many exchange-traded funds, or ETFs, that track large-cap tech do we really need? Generally speaking, when everybody else is getting into a business, that’s when you should think about getting out. It goes for tech stocks as well as television-series formats.

And as the large-cap tech stocks that populate the Nasdaq continue to mark new 52-week lows, you might consider investigating some less liquid but technically strong markets that could use some speculative investment dollars. As I wrote a few weeks back, there is life beyond Cisco.

While I don’t make investment recommendations, there are three areas worth checking out. One of them is the bond market, which has soundly outperformed stocks, and from my perspective looks exceptionally bullish. Fundamentalists suggest inflation could tank Treasurys, but I watch the charts. These securities look strong, and while there are 30 different ETFs that track tech stocks, there still are none that directly mirror bonds. Smells like an opportunity to provide liquidity.

On the equities side, now might be a time to consider a position in real estate investment trusts, which have also soundly outpaced stocks. While the Nasdaq is making two-year lows, the Morgan Stanley REIT Index, or RMS, is near two-year highs. The two biggest REITS, Equity Office Property Trust (EOP) and Equity Residential Properties Trust (EQR) trade around one million shares a day, compared with Cisco, which trades over 100 million. Where is my speculative dollar going to get the most bang for its buck? Underowned, outperforming and not yet too terribly liquid, REITs might be an asset class deserving a position in your portfolio.

Finally, as new markets continue to need liquidity, you might consider diversifying your portfolio away from solely stocks. Rare books and fine collectables don’t pay dividends, but are uncorrelated to equities and most certainly will benefit from new auction-driven liquidity. Our fund maintains a small position in first-edition copies of Ayn Rand’s “Atlas Shrugged.” Only about 100,000 were printed so the float isn’t huge, and over the past few years prices have more than kept pace with inflation. It’s one claim the highly liquid and much heralded Nasdaq can’t make.

– Originally on Mar 29, 2001 by Jonathan Hoenig