In the mid-80s Money Morning contributing editor Shah Gilani ran a hedge fund from the floor of the Chicago Board of Options Exchange Inc. As an independent market maker, he could trade in any pit on the floor. The most important lesson he learned there was how to play the crowd. It’s one of the four basic rules of contrarian investing.

More from Shah:

My approach was to walk into the pit and chat up the crowd. My intention was to gauge whether the other market makers and locals were net long (bullish) or net short (bearish). Most of the locals are independents and not extremely well capitalized. But I was.

If I gauged the locals to be bullish, meaning they had positioned themselves in anticipation of the underlying stock rising in price, by either being long “calls,” short “puts,” or engaged in bullish “spread” trades, I would start by buying some calls.

I would use coded signals to my clerks to start buying the underlying stock.

The locals would see stock “prints” go up on the New York Stock Exchange (now the NYSE EuroNext (NYX)) at higher prices. I was moving the stock higher. Usually, the locals would start adding to their bullish positions.

At the same time, I would have my clerks send in orders to the post where I was trading to buy puts – a lot of puts. Usually, it was the bullish locals selling the puts to my broker.

When I had the bearish position I wanted, I would offer to sell my calls to the crowd.

Shortly after that, I would signal my clerks to start selling my long stock positions on the Big Board.

I wasn’t trying to get the best price. I was “hitting bids” on the NYSE. After I had sold my long stock position, I started to short the stock. In the meantime, I was doing nothing visible in the pit.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves.

As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am not a bad guy. I am a trader. That’s my job. I trade to make money. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• • Know the instruments you are trading.
  • Know your capital and leverage limitations.
  • Gauge the psychology of the market.
  • And have a plan.

PS: This is the eighth installment of an ongoing series in which Shah Gilani breaks down the credit crisis for readers.

Source: How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis