Friday, July 31, 2009

Belveal, Charting Commodity Market Price Behavior

I will never understand why some perfectly dreadful trading books are touted as classics while books that could actually help the trader add to her bottom line remain in the shadows. L. Dee Belveal’s Charting Commodity Market Price Behavior (Traders Press, 2000) belongs to the second category. A commodity speculator for more than twenty years, Belveal is a sophisticated strategist. For the most part he traces the ebb and flow of buying and selling pressures using only price, volume, and open interest (with additional input from the Commitments of Traders reports that identify the strong and weak hands). His charts are not as clean as price action purists would desire but are, he contends, as clean as is necessary for him, at least, to make money.

Belveal contends that “the successful technician isn’t so much analyzing and forecasting the course of prices as he or she is analyzing and forecasting the behavior of an assortment of people whose amalgam of actions will determine the course of prices. The astute technician looks behind every event that’s traced out in his charts, relating it to the market participants whose interests were hurt or helped by it.” (p. 15) This point, I believe, is critical. Where would the strong and weak hands most likely have placed their stops? Would the event empower the bulls or the bears? Or is it only a head fake?

Belveal offers some rules incorporating price, trade volume, and open interest as his guideposts. These rules indicate, for instance, whether new buying or selling is present, whether the situation is technically strong or weak, or whether the situation should be viewed with suspicion. All the rules, as well as the conceptual principles underlying the rules, are illustrated with large easy-to-read charts.

This is not a book that can be absorbed in a single reading, which I consider a plus. The principles aren’t complicated, but it takes practice to apply them as a savvy trader would. Fortunately Belveal walks the reader through many trading scenarios, thereby accelerating the learning process.

Thursday, July 30, 2009

El-Erian, When Markets Collide

Mohamed El-Erian’s When Markets Collide: Investment Strategies for the Age of Global Economic Change (McGraw-Hill, 2008) achieved best seller status and won prestigious awards despite mixed reader reaction. I’m not going to weigh in on the merits of the book because, if I did, it would be “on the one hand, on the other hand, on the third hand” dithering best reserved for economists. Rather, I’m going to take a different tack, focusing on one point that caught my attention when I first read the book. El-Erian’s prose may be turgid, but I think he highlights a potentially fertile area for increased investment returns.

Rather than diversifying simply by using asset classes—a method that has seen some deterioration in results of late, he suggests starting with “the risk factors that give rise to investment returns over time.” He continues: “The ideal situation is to come up with a small set (three to five) of distinct (and ideally orthogonal) risk factors that command a risk premium. The next step is to assess the stability of the factors and how they can be best captured through the use of tradable instruments.” (p. 233)

I’m certainly no match for the experts at Harvard Management Company or PIMCO, and even they have found it hard to execute this game plan. But they set a high bar for themselves because they want their solutions to be quantifiable and optimizable (and we all know that they demand much more mathematical and statistical rigor than standard backtesting programs provide). I assume they want to build on the work of such academics as Fama and French—for instance, their 1992 paper “Common Risk Factors in the Returns on Stocks and Bonds,” which is not exactly bedtime reading.

So let’s try to dumb down the idea a bit. Where can the independent trader or investor earn risk premia? Some argue that using two systems, one trend following and the other mean reverting, is an answer, but I’m not convinced that this is the brightest idea. The trader earns risk premia on the one hand and loses it on the other. Think back to Einhorn’s argument against pairs trading; though not exactly analogous, the general point carries over. So let’s move on. One fairly sophisticated possibility is to look at the signal-to-noise ratio of an instrument. (Refer back to my review of Drobny’s Inside the House of Money for a little more insight into this trading hypothesis.) Another possibility is to exploit volatility risk; there are many strategies appropriate here, for the most part involving the use of options. Overnight risk is another area worthy of exploration, possibly as part of a multi-timeframe trading program. The list is bounded only by one’s imagination.

Whatever the hypothesis, the trader or investor must backtest it to determine whether, if we believe that history repeats itself or at least rhymes, it has any merit and, if so, on what markets it’s most successful. A strategy that works on currencies, for example, may provide no edge when applied to stock indices. And, of course, it always bears repeating that it is nothing short of suicidal to take on risk that’s too large for the size of the portfolio.

Ideally, the trader or investor will end up with three to five distinct, uncorrelated strategies that, when combined, will outperform any single strategy as well as any appropriate benchmarks. Some money managers claim to do this, but I’m certainly not touting their wares. I’m a Connecticut Yankee, a do-it-yourselfer by inclination. What I’m suggesting is that experienced traders or investors seek to develop a few trading strategies that fall well within their psychological comfort zone and their risk profile and that, when pursued simultaneously, have the potential to outperform the standard benchmarks and the more finely tuned benchmarks. A little outperformance here, a little outperformance there, it all adds up.

Bright Ideas

I'm starting a new thread today that shares ideas I consider bright. Some will come from books, some from newspapers and other blogs, and some from my own reflections. I'll label them with the green-friendly light bulb.

Wednesday, July 29, 2009

Fraser, Wall Street

Steve Fraser’s Wall Street: America’s Dream Palace (Yale University Press, 2008) is not so much a history of Wall Street as it is a history of our conflicting visions of the titans of finance. Is Wall Street a parasite that sucks the life blood out of hard-working Americans? Is it an essential part of a vibrant economy and a place where the ordinary American is well served? And who are the denizens of Wall Street? Who are these men who can “make or break”?

Fraser offers up four iconic Wall Street personality types that have vied for dominance in the imagination of the American public over the course of more than two hundred years: the aristocrat, the confidence man, the hero, and the immoralist. These personality types come to life in portraits of such men as William Duer, J. P. Morgan, Jim Fisk, and Jay Gould; they are further fleshed out in fictional characters created by novelists both familiar (Charles Dickens, Theodore Dreiser, Herman Melville) and blissfully forgotten.

Although this book was written for a broad audience (preferably those who took their “word wealth” lessons seriously) and was selected for Bill Moyers’s “Be a More Engaged Citizen” book list, traders and active investors should definitely set aside a couple of hours to read Fraser’s history. For instance, Fraser recounts the many times in American history that the speculator “who lived off the honest earnings of others” was seen as “offensive in the eyes of God.” (p. 144) He introduces us to a moralist who contended that “‘speculating in margins’ was ‘immeasurably worse’ than ordinary gambling because it was more dishonest.” (p. 163) He also exposes the seamy side of Jesse Livermore, the idol of most modern-day traders despite his sad end. “Supremely vulgar—he called Wall Street a ‘giant whorehouse’ and brokers ‘pimps’—he was also cagey, superstitious, and a show-off, flaunting his yellow Rolls Royce, steel yacht, and huge sapphire pinky ring.” (p. 80)

This book is particularly timely in light of the financial crisis and the Madoff scandal. Whether Americans will once again embrace Wall Street as a place where dreams can be fulfilled or whether they will view it with disgust as the burial ground of dashed hopes remains to be seen. But there’s no doubt that the aristocrat, the confidence man, the hero, and the immoralist will soldier on.

Tuesday, July 28, 2009

Steenbarger, The Daily Trading Coach

Many books can be read quickly because their authors take a couple of ideas worthy of perhaps twenty printed pages and then pad them to produce a 300-page book. Brett N. Steenbarger’s The Daily Trading Coach: 101 Lessons for Becoming Your Own Trading Psychologist (Wiley, 2009) is definitely not one of these books. It is jam packed with information and is thus best read one lesson at a time, as the author suggests. (I had to cheat for this review and try to swallow it whole, but now I plan to go back and do it the right way.)

Those who follow Dr. Brett’s blogs Trader Feed and Become Your Own Trading Coach have already been introduced, usually in an abbreviated form, to some of the material set forth here. But reading the blogs is no substitute for reading the book. They are complementary, and both are invaluable.

Contrary to most self-help books that promise quick and easy fixes (“five minutes a day to a waspish waist”) Dr. Brett outlines a pretty grueling regimen that includes research, self-therapy, psychological monitoring, recordkeeping, and—oh yes—trading. Even with all this effort success is not assured. Some people are simply not cut out to be traders. Without this effort, however, traders will never reach great heights. For instance, he writes, “Many traders sit down at their stations a little before markets open, trade through the day, and then go home, repeating the process day after day. . . . That is what you do if you’re the employee of [a] business, not the owner.” (p. 236)

About two-thirds of the lessons deal with ways to improve performance through psychological self-coaching. The final three chapters look at trading as a business, offer insights from trading professionals, and share some tips on using Excel to find historical patterns in markets.

Although there is no shortcut to trading success, The Daily Trading Coach empowers traders to create their own road maps, to set forth on the journey, and to keep checking the oil and logging their progress. And when the engine sputters, as it inevitably will, the wise trader will re-read the relevant lessons, fix the problems, and set out again. For now this book stays on my desk, not on the shelf.

Monday, July 27, 2009

Collins, When Supertraders Meet Kryptonite

Now and then we all succumb to Schadenfreude, pleasure derived from the misfortune of others. At first blush Art Collins’ When Supertraders Meet Kryptonite (Traders Press, 2002) might seem the perfect venue to indulge this perhaps warped hedonism. Watch big guys blow out their accounts, congratulate yourself because you haven’t done it. But a collection of trader obituaries isn’t an idea that any sane publisher would rush to embrace, so figure that you wouldn’t read this book to pat yourself on the back. A more accurate title for this book would have been “When Supertraders Met Kryptonite.” We’re introduced to thirty-five successful traders, many familiar to the online trading community, who at one point or another in their career were severely tested. For some it seemed like Armageddon, for others not quite at the brink of destruction it was still significantly worse than “a bad day at the office.”

This is an engrossing book. Although in an epilogue Art Collins offers some generalized takeaways, the fact is that each trader faced his or her own demons and somehow managed to overcome them. Some traders retooled their methods or modified their position sizes, others expanded their revenue streams. Whatever the solution, they were survivors—and survivors on a grander scale than most.

Each reader will identify with some traders more than others. To give a flavor of the tales told, here’s a sampling of chapter titles: “And then I’d have the ‘walk-on-water’ complex,” “I prayed for one thing—that when I liquidated everything, I wouldn’t owe the firm any money,” “It was like I was tied to a post, and they were shooting at me with shotguns,” and “The market doesn’t stop just because you’re stuck.”

The value of this book is probably best expressed in another chapter title: “I’ve learned more from the mistakes of the big traders than I did from how good they were.” Not all the crises recounted in this book resulted from genuine mistakes; sometimes Lady Luck just dealt the trader a losing hand. Whatever the cause, there were a lot of wrenching consequences. Art Collins’ book testifies to the resilience of these traders and offers the trader who is not yet “super” invaluable insights.

Sunday, July 26, 2009

Einhorn, Fooling Some of the People All of the Time

David Einhorn is perhaps best known to the investing community for challenging the transparency of Lehman Brothers’ balance sheet in May 2008. In Fooling Some of the People All of the Time: A Long Short Story (Wiley, 2008) he recounts his losing battle to unmask Allied Capital, a company he accused of fraud. The book is a scathing indictment of the regulatory system in this country. In the wake of the Madoff scandal and Harry Markopolos’ testimony that the SEC turned a deaf ear to his evidence Einhorn’s book speaks even more loudly.

But for today’s abbreviated--and admittedly intellectually lazy--post I want to highlight the way Einhorn’s hedge fund, Greenlight Capital, structures its portfolio because it offers an interesting twist on some accepted norms. Greenlight is a long short fund, but it does not practice pairs trading. The problem with pair trades, Einhorn argues, is that often “the second half of the pair trade is not a worthwhile investment other than as an industry and/or market hedge.” (p. 16) Greenlight looks for worthwhile longs and worthwhile shorts. In this way the fund achieves “a partial market hedge without having to spend capital on negative-expected-return propositions” (p. 16) such as an index hedge. “Selling short individual names offers two ways to win—either the market declines or the company-specific analysis proves correct. In practice, we have more long exposure than short exposure because our shorts tend to have greater market sensitivity and volatility than our longs. Also, the market tends to rise over time and we wish to participate.” (p. 17)

Greenlight Capital is a concentrated portfolio. Einhorn cites Joel Greenblatt’s observation that “holding eight stocks eliminates 81 percent of the risk in owning just one stock, and holding thirty-two stocks eliminates 96 percent of the risk.” (p. 18) Once an investor has a diversified portfolio of eight stocks or so, the law of diminishing returns starts to kick in when he adds additional stocks in an effort to decrease risk.

Just some food for thought.

Saturday, July 25, 2009

Lefèvre, Wall Street Stories

Edwin Lefèvre, author of the 1923 classic Reminiscences of a Stock Operator, a fictionalized biography of Jesse Livermore, launched his writing career twenty-two years earlier with Wall Street Stories. This collection of eight short stories, reissued by McGraw-Hill in 2008, is the perfect read for a rainy afternoon or a dull market. You’ll laugh, you’ll be forewarned (or admonished), you’ll even be educated.

The first and last story (“The Woman and Her Bonds” and “A Theological Tipster”) are very funny. The stories in between relate the shenanigans of syndicates, the inevitable fall of star-struck market amateurs, and the ruthlessness of most of the survivors.

Characters in these stories may listen to the “ticky-ticky-ticky-tick” of the ticker but they are not dispassionate tape readers. Quite often their trading is personal, sometimes the result of a vendetta. For instance, two “skillful stock operators, very rich and utterly without financial fear,” loathe another member of the NYSE and set out to “bust” him.

The educational value of this book, to my mind, lies in a theme common to many of the short stories—the process of accumulation and distribution. Markets may have grown exponentially, regulations may have been put in place to prevent many of the practices common in 1901, but the rhythm of accumulation and distribution hasn’t changed in any fundamental way. The problem today for someone trying to understand this rhythm is that accumulation and distribution have become abstract concepts. In Wall Street Stories they are personalized (and occur in warp speed). We watch, for instance, as one of the titans of Wall Street launches a campaign to gain a controlling interest in Iowa Midland. He looks for the support level (“Bagley has orders to buy 300 shares every quarter of a point down until 37 is reached, and then to take 5,000 shares at that figure.”) and sets off the herding instinct (“Mr. Brown had been seen whispering to Harry Wilson . . .”).

Set a couple of hours aside and thoroughly enjoy yourself. It’s like a trip to the spa.

Friday, July 24, 2009

Dobson and Reimer, Understanding Spreads

Understanding Spreads by Edward Dobson and Roger Reimer (Traders Press, 2007) is really a pamphlet rather than a book. But it’s packed with information for anyone contemplating spread trading.

A spread is normally a hedged position where the trader is long a futures position and simultaneously short a position in a related futures contract—for instance, long corn and short soybeans or long October ’09 sugar and short July ’10 sugar. Like the pairs trade commonly used by hedge funds, the idea is to make money on the difference between the two legs of the position.

Spreading has less upside profit potential than trading from only one side of the market, but it usually has less downside risk. It’s considered a conservative trading strategy. It’s not, however, for the uninitiated. I can laugh now over the fact that the first time I heard someone talk about trading beans I thought they were referring to green beans. But the depth of my agricultural ignorance (despite gardening for many years and actually growing soybeans for the first time this year) is such that I would be loath to venture into an area where I should be familiar with crop year cycles and planting acreage expectations. I may be basically a technical trader, but that’s no excuse for total ignorance of the fundamentals. Fortunately there are inter-market spreads virtually everywhere—for instance, bonds, currencies, and the energy complex.

Dobson and Reimer point out one reason to trade spreads that I was unaware of. “Spreads generally trend more often than outright futures and will occasionally trend strongly when outright futures are flat.” (p. 12) That’s definitely an area for further exploration.

Spread trading usually relies at least in part on seasonal analysis. Understanding Spreads offers a solid introduction to seasonals as they affect various commodities and suggests that a seasonal approach might be profitable even outside the world of commodities. Seasonal traders have not been particularly successful of late, but then virtually every trading strategy has been challenged by recent market dislocations. As markets start to right themselves and leverage is capped at more modest levels, the time might be ripe to start learning about spread trading.

High-frequency Trading

For those readers interested in high-frequency trading there's an article in today's New York Times entitled "Stock Traders Find Speed Pays, in Milliseconds."

Thursday, July 23, 2009

Elvin, Financial Risk Taking

Financial Risk Taking: An Introduction to the Psychology of Trading and Behavioural Finance by Mike Elvin (Wiley, 2004) is a derivative book. Elvin summarizes Mark Douglas’ The Disciplined Trader, Alexander Elder’s Trading for a Living and Come into My Trading Room, and Lewis Borsellino’s The Day Trader from the Pit to the PC. He reviews psychological literature as it relates to trading, and he looks for insights from the martial arts and Budo Zen. The problem is that the book reads like a shoebox full of note cards.

I did laugh, however, at one image that Elvin invokes twice: “Monitoring is a form of risk management and doing it well should allow your winners to run and assist you to cut your losers short. . . There is a downside to monitoring and I like the metaphor of the gardener who pulls out his plant to see how the roots are growing.” (p. 55) Again, “Worry has a significant and direct effect upon investment performance. The trader who continually worries about the outcome of his positions is not likely to do well. He is likely to be like the gardener . . . who digs up his plant to see how the roots are growing.” (p. 98)

For the novice unfamiliar with the literature on the psychology of trading and behavioral finance Elvin’s book may serve as an annotated bibliography. But there are definitely better books available; soon enough I’ll review one of the best.

Wednesday, July 22, 2009

Whiddon, The Investing Revolutionaries

James N. Whiddon is a free market populist who wants to empower individual investors to resist the wiles of Wall Street. In The Investing Revolutionaries: How the World’s Greatest Investors Take on Wall Street and Win in Any Market (McGraw-Hill, 2009) this Dallas financial planner and radio talk show host offers a straightforward approach to investing—build a diversified portfolio of passively managed asset-class mutual funds. Although this advice does not break new ground, many investors may be reading it for the first time. And The Investing Revolutionaries is a very good read indeed, even for someone who does not share all of the author’s opinions.

Whiddon draws from interviews he conducted on his syndicated radio show “The Investing Revolution.” His guests were a veritable who’s who in the financial world, so it’s not surprising that this book is engaging. Jeremy Siegel explains once again why gold is such a poor long-term investment (a dollar invested in gold in 1802 would be worth, after inflation, $2.55 today whereas a dollar invested in the stock market with dividends reinvested all along the way would have grown to three-quarters of a million dollars today, again after inflation). Arthur C. Brooks expands on his thesis that we could increase the GDP if people gave more to charity. Richard Thaler compares how contestants behave on the TV show Deal or No Deal to how investors make decisions about their portfolios.

In addition to Thaler’s study, Whiddon shares the insights of Barry Schwartz, Jason Zweig, Peter DeMarzo, Peter Bernstein, Ori Brafman, Gary Becker, and Tim Harford on investor behavior. In The Paradox of Choice, for instance, Schwarz looks at how consumers respond when confronted with a dizzying array of choices (for instance, too many 401(k) investing options). Schwartz, referencing the distinction from Herbert Simon’s 1957 book Models of Man: Social and Rational, says that people fall into two personality types—the maximizer, who wants the best, and the satisficer, who is looking for something that’s “good enough.” The maximizer has to examine all the choices to determine which is best; the satisficer can stop looking once he finds something that meets his standards. Maximizers are tormented souls, especially if the results of their decisions are not as good as they expected. Whiddon applies this distinction to investing. “A maximizer is going to play Wall Street’s games—picking stocks, timing the market, and chasing returns—all in the interest of beating the market. A satisficer, however, knows that there’s really only one decision to be made: owning the market. Once that decision is made and the satisficer investor holds a superdiversified portfolio, the work is largely done.” (p. 178)

In the light of market turmoil over the past decade many people have pronounced buy and hold dead. And as previously diversified asset classes started to move in lockstep in the most recent market meltdown, the diversification mantra was also called into question. Whiddon, however, believes that the financial crisis was just “a blip on the radar.” “[T]he reality is that the stock market simply does not have a tendency to go down and stay down for extended periods of time. Whether you are considering decades, years, or even monthly time frames, micro- and macroeconomic cycles ultimately bring favorable results to faithful free market disciples.” (pp. 108-109)

Tuesday, July 21, 2009

Davis, The Triumph of Contrarian Investing

Ned Davis Research (NDR) is a well respected advisory firm, known for its careful and at the same time imaginative data analysis. In The Triumph of Contrarian Investing (McGraw-Hill, 2004) Ned Davis argues that if market action is largely a result of mass psychology, as he believes, it makes sense to incorporate quantitative indicators of crowd psychology in market timing models.

For the trader who wants to catch major market turning points “wait for majority opinion to reach an extreme and then assume the opposite position. At turning points, contrary sentiment indicators are nearly always right.” (p. 9) The reason is simple; everyone who wants to buy a rising market, for instance, has already done so, there are no buyers left to drive prices higher.

And, as a corollary, with all the talk recently about crowded trades as a precipitating cause of market perturbations, Davis’s comparison of the market to a theater (with an obvious nod to Oliver Wendell Holmes) is particularly apt. “If someone yelled ‘fire’ in a theater full to the rafters with people, panic would break out and people would get crushed. But if someone yelled ‘fire’ in a theater with very few people, the people would get up and walk out in an orderly manner. In looking at any market, it is important to determine the degree to which the market is a crowded theater or an empty one.” (p. 10)

NDR uses a wide variety of sentiment indicators. For instance, stock mutual funds cash/assets ratio, Gallup poll presidential approval rating, press headlines and magazine cover stories, presidential sentiment (how the president describes the state of the Union and the economy), AAII responses, newsletter writer sentiment, short-term bond prices, Rydex fund flows, speculator COT index, and market strategist sentiment. NDR also uses valuation measures such as the PE ratio of the S&P 500 and the ratio of the yield on the 10-year Treasury note to the earnings yield of the S&P 500 as longer-term gauges of investor expectations. Extremes in the percentage of household financial assets held in stocks can also signal longer-term reversals in the stock market as can extremes in the number of active investment clubs.

Although it is possible to chart sentiment and assign ranges to extreme optimism and extreme pessimism (for instance, above 61.5 and 50 and below in the case of NDR’s proprietary crowd sentiment poll), turning points in sentiment can only be known after the fact—the standard problem with any zigzag indicator. For instance, NDR requires sentiment to be in an extreme range and then to reverse by 10% to qualify as “an extreme.” (p. 54) As such, there’s no way to identify “an extreme” in real time. But once there is sufficient data (NDR’s chart starts in 1996) the analyst can use the average reading at optimistic and pessimistic extremes “as a frame of reference for assessing sentiment going forward.” (p. 54) Davis dramatizes what would have happened if the Monday morning quarterback had bought at sentiment highs and sold at sentiment lows between 1996 and 2002, a sample size of about 45 (I didn’t double check my counting). In every single case he would have been wrong, losing a whopping total of 5,059 S&P points! But again, it’s the siren call of the zigzag.

How does Ned Davis himself invest? He writes, “When I came into the investment business, the conventional wisdom of nearly everyone was as follows: ‘I’ve never met a rich technician.’ ‘You can’t make money short-term trading.’ ‘Eighty-five percent of people who trade options and futures lose money.’ ‘Worrying all the time about risks will paralyze you from capturing the rewards from stocks.’ . . . While my techniques are not for everyone, they were right for my psyche. I mostly use technical analysis (with heavy doses of contrary opinion); I am a very short-term trader; I make big use of options and futures; and I constantly worry about risks. And taking the road less traveled has worked for me. Since I started Ned David Research in 1980, I’ve never had a losing year on my investments.” (pp. 13-14) It may also help that he’s smart and that he clearly works hard.

Monday, July 20, 2009

Stevenson, Precision Trading

Trade management is critical to a trader’s success, yet in the literature it often takes second place to entry strategies. J. R. Stevenson’s Precision Trading with Stevenson Price and Time Targets (Traders Press, 2004) combines the insights of Gann (measured move) and Hurst (cycles) to describe a way to manage trades, to understand where the market may go in relation to where it has been and when it might get there. It is not, he stresses, a trading method; it is an aid in trading and analyzing markets. The price and time targets “are guide posts or signs to help guide you on your journey.”

Software packages such as Ensign and Ninja Trader offer drawing tools that make it mindlessly easy to plot Stevenson’s price and time targets. The emphasis in the last sentence should be on the word “mindlessly.” Without a guide that explains the rationale for these targets and how to interpret target “misses” (overshooting or undershooting on price or on time) the trader is not using the charting tool to its full advantage.

Stevenson wrote this manual when he was 80 years old; he had plenty of time to test out his ideas. And fortunately he did not use valuable chunks of his remaining time to pad the book with information and advice readily available elsewhere. He describes his ideas, illustrates them with easily readable charts, and asks questions now and again of the reader to test comprehension of the material. That’s it.

By the way, for the reader in search of entry strategies Stevenson provides one suggestion that by itself is probably worth the price of the book (directly from Traders Press, not from the Amazon price-gouger). Like everything in Precision Trading, it is simple yet theoretically elegant.

Sunday, July 19, 2009

Faith, Inside the Mind of the Turtles

Curtis M. Faith’s Inside the Mind of the Turtles: How the World’s Best Traders Master Risk (McGraw-Hill, 2009) is the perfect beach book for traders. It’s a fast read, it doesn’t strain the brain, yet it addresses questions that haunt all traders and investors—how to proceed in the face of uncertainty and how to deal with risk.

This book is only tangentially about the famous Turtles; the reader looking for more information about Richard Dennis’s experiment will be disappointed (although Faith does pepper his book with autobiographical snippets). Moreover, Faith ventures beyond the world of trading to look at risk management in business and medicine. In brief, the title of the book is misleading. More appropriate would have been the title of the first part of the book, “The Seven Rules for Managing Risk,” though it wouldn’t have marketed nearly as well.

The seven rules, stated in their simplest form, are: overcome fear, remain flexible, take reasoned risks, prepare to be wrong, actively seek reality, respond quickly to change, and focus on decisions not outcomes. Faith devotes a chapter to each of these rules. In the second part of the book he applies these rules to societal issues such as education and transportation.

There are many takeaways for traders from Faith’s book, but here I’ll highlight only one—outcome bias—because it is so seductive. If a trade turns out well, the decision to make that trade must have been good; if it turns out poorly, the decision was bad. Sounds reasonable, doesn’t it? The problem is that it doesn’t account for, among other things, randomness and just dumb luck. This, by the way, reminds me of a quotation from a piece written in 2000 about the hugely successful James Simons of Renaissance Technologies. “‘Luck,’ he told a gathering of potential investors . . . , ‘is largely responsible for my reputation for genius. I don’t walk into the office in the morning and say, ‘Am I smart today?’ I walk in and wonder, ‘Am I lucky today?’” Simons, himself a brilliant mathematician, and his staff of mostly scientists and mathematicians mine the markets for best trading ideas, but like all the rest of us they have no control over the outcome of their decisions.

Faith contends that although it is important to learn from the past, if you focus on outcomes rather than decisions “you may end up learning the wrong things as you make mistakes.” (p. 157) Furthermore, you may start making really bad decisions. After a series of losing trades, for instance, a person may begin to tinker with a vibrant strategy or abandon it altogether. Plagued by recency bias and a belief in the law of small numbers, the trader becomes crippled with self-doubt. Risk becomes an enemy. The trader, on the other hand, who embraces reasoned risk and makes peace with uncertainty may, with a little luck, become a new “turtle.”

Saturday, July 18, 2009

Shipman, Big Money Little Effort

I’m not a fan of get rich quick schemes or of books that tout them. At first blush Mark Shipman’s Big Money Little Effort: A Winning Strategy for Profitable Long-term Investment (Kogan Page, 2008) would seem to be just such a book, especially if you ignore the subtitle. But in fact, it offers a simple get rich slow technical system predicated on the hypothesis that the stock market will rise over time.

Shipman, previously a hedge fund manager in London, advocates market timing in the form of systematic trend following. “Participating in . . . major price movements should be the goal of every long-term investor because it’s the only way for a conservative individual to attain serious profits without taking excessive risk.” (p. 46) He argues that a buy and hold strategy is extremely dangerous and offers an analogy. “Imagine you had to fly in a make of aircraft that had a reputation for having the odd crash, maybe only once in every 10 years or so, but still the history for this make of plane wasn’t flawless. Now if you were offered a parachute, would you accept or decline the offer? Of course, you’d be mad not to take the parachute and have some form of escape if things went wrong.” (p. 48)

Shipman spends some time walking the reader through the pitfalls of investing in long-only mutual funds and explaining why most investors get things wrong. There is much sound advice here and I’m doing the book a disservice by ignoring these pages. But I’m going to cut to the chase and outline the get rich slow system, one that in its general form is familiar to anyone with even a rudimentary knowledge of technical analysis so I don’t think I’m revealing any “secret sauce.” The rules of Shipman’s system are painfully simple. Choose an ETF that tracks a stock market index (for instance, SPY). Buy when the 30-week moving average (SMA) is greater than the 50-week moving average. Sell when the 50-week moving average is greater than the 30-week moving average. This is a binary, long-only system in which the investor is either “all in” or, when the system signals a sell, goes to cash, “deposited in the highest interest-bearing instant access savings account available at the time.” (p. 95)

Over the last 56 years this system applied to the S&P 500 has triggered only 21 buy signals. There were 15 profitable positions, with an average profit of 34.76% and a maximum profit of 178.78% (1995 to 2001). Of the losing trades the largest loss was 9.95% (1957) and the average loss was 5.48%. The ratio of average profit to average loss was 6.3/1. The last date in the system test was June 6, 2007.

Shipman didn’t compare buy and hold profits to the profits of his system, but according to my calculations the market timing system would have earned around 1600 S&P points plus the interest accrued when the system was in a “sell” mode. A buy and hold strategy would have earned around 1495 S&P points, with no interest. By the way, Shipman’s system issued a sell signal in early 2008 when the S&P was trading in the 1400 area; there has been no subsequent buy signal. Friday’s close was 940.

This weekly moving average crossover system is just one among many systems that the author trades personally. For those investors interested in developing their own systems, Shipman suggests that this system might be useful as a filter.

Friday, July 17, 2009

McDowell, A Trader's Money Management System

Bennett McDowell’s A Trader’s Money Management System: How to Ensure Profit and Avoid the Risk of Ruin (Wiley, 2008) is an elementary text. But there are a couple of points that even more seasoned traders should be reminded of, both covered in his chapter on stop-loss exit rules.

McDowell claims that the value of having an initial stop in place is that the trader can then unemotionally determine the best exit possible for the six main types of risk. I don’t agree with his justification for initial stops. For instance, if a trader is in a long position and the market drops like a rock, he can only pray that his stop doesn’t get hit miles away from where he placed it. He can’t unemotionally determine the best exit possible. But, that criticism aside, let’s turn to the various kinds of risk a trader may face.

1. Trade risk, determined by position sizing. McDowell repeats the mantra of never risking more than two percent of one’s capital on any given trade.
2. Market risk, over which the trader has no control. Since market risk can far exceed trade risk, McDowell suggests that a person never trade with more than ten percent of his or her net worth.
3. Margin risk, where a trader can end up in hawk to the brokerage firm.
4. Liquidity risk. Here McDowell recalls the plight of Enron shareholders in 2001.
5. Overnight risk. The dreaded gap open for traders who sleep.
6. Volatility risk. This is a risk factor that traders sometimes ignore; as a result they get stopped out over and over again.

Once a trade is on and the initial stop is in place, what kind of trailing stop should a trader use? (I know that many traders don’t believe in using trailing stops, but I’m not addressing that issue here.) McDowell offers a few possibilities.

1. Resistance stop. The name is a little odd, but the concept is well known, however difficult to implement in real time. That is, in a trend place stops just above or below countertrend swing highs or lows.
2. Three-bar trailing stop, which McDowell recommends for a market that seems to be losing momentum and where a reversal may be imminent.
3. One-bar trailing stop, to be used under two circumstances. First, once price reaches the trader’s profit target. And second, in the case of a break-away market where three to five bars have moved strongly in the trader’s favor and he wants to lock in profits.
4. Trend line stop, where the trade is exited once prices close on the opposite side of the trend line.
5. Regression channel stop. Similar to the trend line stop, the trade is exited when prices close outside the channel.

Money management and stop placement are critical to a trader’s success, and I expect to return to these themes many times in this blog. So stay tuned.

Thursday, July 16, 2009

Drobny, Inside the House of Money

Inside the House of Money by Steven Drobny (Wiley, 2006) is a collection of thirteen interviews with key players in global macro hedge funds. They focus on fundamentals (often very loosely defined) and are primarily discretionary traders. In addition, they are “scary smart.” To my mind Drobny’s book is one of those rare gems that merits frequent re-reading, quite independently of what or how one trades. Here I’ll mention only a couple of takeaways.

First, two insights from Jim Leitner of Falcon Management who trades options wherever possible in his fund (mostly his own money) because “it’s like paying for someone else to be your risk manager.” He contrasts how real money accounts such as the Yale Endowment Fund and hedge funds view risk management. The smart real money accounts use diversification and rebalancing as their primary risk management tools. That is, they determine their initial allocation mix and as markets rise and fall they rebalance. In so doing, they actually increase risk; they sell a portion of their winning instruments and buy more of the losing instruments. Hedge funds, by contrast, simply cut risk at some point.

Leitner tries to earn risk premia and considers currencies an obvious place to look. After outlining three possible strategies, he turns to the fact that in foreign exchange “daily volatilities are much higher than the information received.” He uses the euro as an example: in July 2001 it bottomed out at 0.83 to the dollar and by January 2004 was trading at 1.28. Dividing the 45 “big figure” by 900 days gives an average daily move of 5 pips. Now if the one-month volatility averaged around 10% during that time, the daily expected range would be 75 pips—a signal-to-noise ratio of 1 to 15. “Noise is just noise, and it’s clearly mean reverting. Knowing that, we should be trading mean reverting strategies.”

Peter Thiel, former CEO of PayPal, runs Clarium Capital Management. Arguing that markets have become highly correlated and that broad diversification is neither practicable nor desirable, he turns to the question of risk management. His hedge fund assumes that all their positions correlate perfectly and that the maximum loss they are willing to take in a disaster scenario is 15 to 20 percent. They size their portfolio accordingly and place stop losses (not trailing stops) on each trade. They also look to non-price (e.g., volatility and sentiment) indicators to assess the strength of their trades as they progress. “When price is used as the only indicator, things devolve into an ineffective charting exercise.”

Drobny’s book is replete with challenges to the way most retail investors and traders look at markets. As such, it’s a real keeper.

Wednesday, July 15, 2009

Hamilton, The Stock Market Barometer

Here’s a change of pace, compliments of Google Books: The Stock Market Barometer: A Study of Its Forecast Value Based on Charles H. Dow’s Theory of the Price Movement. With an Analysis of the Market and Its History Since 1897 by William Peter Hamilton, editor of The Wall Street Journal (Harper, 1923). Now that’s a mouthful.

Hamilton was the popularizer of Dow theory in the 1920s. Dow theory merits a blog post of its own; I’d rather wait to analyze the words of Dow himself. Moreover, the general thesis of the book is by now old hat—that the stock market is the barometer of the country’s, even the world’s business and that Dow theory shows us how to read the barometer. There’s no need to rehash the familiar. But the book is eerily timely, and since it is in the public domain I can quote from it extensively. I’ve chosen some passages that I think may resonate with today’s investors and traders; most of the excerpts contain quotable one-liners.

Hamilton starts by acknowledging the cycle of panic and prosperity. His description of this cycle rings true today, even if not in every detail. “Prosperity will drive men to excess, and repentance for the consequences of those excesses will produce a corresponding depression. Following the dark hour of absolute panic, labor will be thankful for what it can get and will save slowly out of smaller wages, while capital will be content with small profits and quick returns. There will be a period of readjustment like that which saw the reorganization of most of the American railroads after the panic of 1893. Presently we wake up to find that our income is in excess of our expenditure, that money is cheap, that the spirit of adventure is in the air. We proceed from dull or quiet business times to real activity. This gradually develops into extended speculation, with high money rates, inflated wages and other familiar symptoms. After a period of years of good times the strain of the chain is on its weakest link. There is a collapse like that of 1907, a depression foreshadowed in the stock market and in the price of commodities, followed by extensive unemployment, often an actual increase in savings-bank deposits, but a complete absence of money available for adventure.” (p. 3)

Given that there are business cycles, can one use cycle theory to time the market or the economy? Hamilton answers unequivocally in the negative. For instance, the twenty-year cyclists prophesied a minor crisis around 1903 and a major panic in 1913, but nothing happened in either of those two years. “Indeed, the volume of the world’s speculative business was not large enough to make a crisis in those years. It is reasonably certain that a smash cannot be brought about unless an edifice of speculation has been constructed sufficiently high to make a noise when it topples over.” (p. 119) Cycle theorists have to keep “humoring” their forecasts. Hamilton concludes: “. . . this whole method of playing the cycles looks to be absurdly like cheating yourself at solitaire. I can understand stringent rules, arbitrary rules, unreasonable rules, in any game. But my mind fails to grasp a game where you change the rules as you go along.” (p. 119) There is admittedly a rough periodicity to market swings, “but if we begin to twist them into some mathematically calculable, regularly recurring ‘cycle,’ the next main movement, up or down, will leave us all adrift, with nothing to hold on to but an empty theory and an empty purse.” (p. 124)

Hamilton also offers a word of caution for our times: “At the turn of a bear market there is a chaos of knowledge of all kinds, and an almost inextricable confusion of opinion, which is gradually resolving itself into order. It follows that speculators and investors tend to anticipate the market movement and often look too far ahead. It would be possible to offer endless instances of people who lost money in Wall Street because they were right too soon.” (pp. 130-31)

And on the amateur vs. the professional: “[I]n the long run, in nearly all games, the professional will win oftener than the amateur. He will win more when there is anything considerable at stake and he will lose less when losses are inevitable.” (p. 169) By ‘professional’ Hamilton does not mean only a person who works on Wall Street. “Of the many successful speculators who fight for their own hand, like Hal o’ the Wynd, those who, not being members of the Stock Exchange or partners in any brokerage house, are therefore obliged to concede the broker’s commission and the market turn, all sooner or later become, in any intent, professionals. They devote to the business of speculation exactly the jealously exclusive attention which a successful man gives to any kind of business. The outsider who takes only ‘an occasional flutter’ in the stock market, however shrewd and well informed he may be, will lose money in the secondary swings, where he is pitted against the professional. He cannot recognize the change in movement quickly enough to adapt his attitude; he is usually constitutionally averse to taking a loss where he has previously been right. The professional acts upon the shortest notice, and reactions or rallies give little notice.” (p. 146)

Finally, a word on speculation. “. . . I hope the day will never come when the speculative instinct is not at least latent in an American’s mind. If ever that day does come, if ever prohibition extends to the taking of a chance involving the risk of whole or partial loss, the result may be ‘good’ Americans, but of a merely negative type of goodness. If as you enter Wall Street you will pause a moment in Broadway, to look through the railings of Trinity churchyard, you will see a place full of good Americans. When speculation is dead this country will be dead also.” (p. 253)

Tuesday, July 14, 2009

Kiev, Hedge Fund Masters

Ari Kiev is a prolific writer on the psychology of trading. Today I will focus on his 2005 book (Wiley) Hedge Fund Masters: How Top Hedge Fund Traders Set Goals, Overcome Barriers, and Achieve Peak Performance.

The main theme of the book is that a trader must formulate a vision (a combination of his or her approach to the market and a profit target) and then commit to it, do everything possible to make it happen. Vision, he argues, “gives [a trader] conviction in the face of an unpredictable universe.” (p. 35) It also provides a benchmark against which to measure performance and serves as an antidote to mediocrity.

Although Kiev is no stylist, he works hard to give a sense of what it means to live in the gap—the gap between where a trader is and where he wants to be. Admittedly, the images are something of a jumble, but taken individually they have a certain power. My favorite, about bridging the gap, is that of the Road Runner “running full tilt beyond the lip of a cliff; the bird gets to the opposite cliff only if he does not stop to look down at the abyss beneath him.” (p. 49) The moral of the story, according to Kiev, is that the trader has to overcome the instinct for self-preservation because it inhibits action. (Presumably living in the gap doesn’t mean failing to get to the opposite cliff, miraculously surviving the fall only to die a slow and painful death in the abyss, although this macabre image may resonate with more than one trader.)

Another image makes me beg to be a Wal-Mart greeter rather than a trader. Here the trader is skydiving. The situation in which he finds himself is the context that defines the quality of his experience. He must manage his fall. “For the trader the context is the market.”

As a consultant to hedge funds, Kiev’s job is to boost traders’ returns. I assume that someone in the firm is always managing risk and that its traders are not duds since either they would not have been hired in the first place or they would already have been shown the door. So for the independent trader, especially one early on in his career, it can sometimes be dangerous to extrapolate from the advice that Kiev gives to hedge fund traders. For instance, take his claim that “the object of the game is not so much winning as it is playing all-out.” (p. 232) He offers a binary choice—playing to avoid losing or playing at 100%. I understand that he is not recommending trading with reckless abandon or ramping up size when there’s no compelling reason to do so. And I also understand that fear-based trading rarely produces anything but more fear. And that half-hearted efforts result at best in mediocre results. Unfortunately, I have a recurring image of the independent trader playing all-out without a clear edge. That’s a sure path to the abyss.

There’s no question that Kiev’s basic message—aim high and work relentlessly to achieve that goal—is part and parcel of the American dream, which has now been globalized. And waking up every morning revitalized to get to the opposite cliff is a worthy challenge. Just remember, there’s no safety net for the Road Runner.

Monday, July 13, 2009

Mauboussin, More Than You Know

Michael Mauboussin of Legg Mason is always worth reading. More Than You Know: Finding Financial Wisdom in Unconventional Places (Columbia University Press, 2006) is a collection of essays that flesh out his belief that people should approach problems from a multidisciplinary perspective. Here I’m going to summarize an essay entitled “Chasing Laplace’s Demon: The Role of Cause and Effect in Markets” because it addresses one of my pet peeves.

The stock market, Mauboussin argues, is a complex adaptive system. This means, among other things, that we can’t understand its global properties by analyzing its parts. It also means that “cause and effect defies any simple explanation.” But human beings are wired to find causes for events. When in doubt, we simply make up causes.

The stock market, to use the jargon of complex adaptive systems, is in a state of “self-organized criticality.” As such, “the magnitude of a perturbation within the system (cause) is not always proportionate to its effect. Small perturbations can lead to large outcomes, and vice versa.” (p. 188) To take an example that’s easier to understand than the stock market, a pile of sand, once it gets to a certain height and slope, enters into a self-organized, critical state. Sprinkling a few more grains on the pile may trigger a small or large avalanche. The size of the avalanche is not necessarily linked to the amount of sand added. Analogously, in the stock market a piece of information on one occasion may barely move the market and a very similar piece of information on another occasion may lead to a huge rally or selloff.

But the press is determined to find a cause, however silly, for every stock market move. And investors who buy into their explanations are at risk. First, they may mistake correlation for causality. “In one extreme example, Cal Tech’s David Leinweber found that the single best predictor of the S&P 500 Index’s performance was butter production in Bangladesh.” Although not even a half wit would trade the S&P 500 based on this information, there are more seductive correlations that pose as causes and can entrap traders. Second, investors may succumb to the pitfalls of anchoring, where we accept something that may be irrelevant or arbitrary and use it as a key reference point in making future decisions. (For an interesting experiment on anchoring see Dan Ariely, Predictably Irrational.)

So we’d all do well to tune out the gurus who confidently explain the cause of every flutter in the stock market.

Sunday, July 12, 2009

Chan, Quantitative Trading

Ernest Chan’s Quantitative Trading—How to Build Your Own Algorithmic Trading Business (Wiley, 2009) was not written for me so I won’t do it the disservice of reviewing it. But I’ve been intrigued with high-frequency trading strategies ever since I first heard of the phenomenal returns of James Simons’ Renaissance Technologies. My decidedly “low-frequency” programming skills are just one reason I could never be a high-frequency trader. The list goes on and on. The fascination remains.

Chan devotes only a couple of pages to high-frequency trading, but I think they’re interesting enough to share. The main appeal of high-frequency trading strategies is that they can achieve very high Sharpe ratios. That is, they can produce outsized returns per unit of risk. It all goes back to the law of large numbers. The more trades, the smaller the deviation from the mean return. As long as the strategy is sound (the mean return is positive) high-frequency trading grinds out results day in and day out that deviate only modestly from the mean. With this level of predictability the trader can boost leverage and reach for the sky.

What are the problems with high-frequency trading? The first, and most obvious, is that the trading strategy has be to rock solid, normally exploiting tiny inefficiencies in the market or providing temporary liquidity for a fee. Moreover, for any Goldman or Renaissance wannabe, transaction costs would undoubtedly be a nonstarter. In brief, for the retail trader high-frequency trading, at least in its “on steroids” form, is out of reach.

By the way, the question with which I began the last paragraph is increasingly being raised in a different context. The Zero Hedge blog recently posted a mini white paper entitled “Why Institutional Investors Should Be Concerned about High Frequency Traders" (

Saturday, July 11, 2009

Jankovsky, The Art of the Trade

Jason Alan Jankovsky’s The Art of the Trade: What I Learned (and Lost) Trading the Chicago Futures Markets (Wiley, 2008) is a challenging book. First, because it’s the tale, undoubtedly apocryphal at times, of a trader whose swagger puts him in a league with Jim Cramer. So it’s hard, at least for this reader, to empathize with him at his lows or to toast his highs. Also, as he himself admits, the book may seem “overly simplistic, esoteric, or philosophical with no trading value.” But there are valuable nuggets in The Art of the Trade that justify its place on a trader’s bookshelf. Today I want to share one of them.

Jankovsky probes the mindset of the loser, assuming that if you know how a loser thinks you can reshape your own thinking to become a winner. He makes a distinction between a person’s belief structure and his expectation of results. That is, if I do such and such (the belief structure) I’ll get what I want (expectation of results). Now if a person gets what he wants, he concludes that it was due to his belief structure. If he doesn’t, he is willing to change his belief structure. For instance, “Since I’m constantly losing, I should do something to improve my approach. I don’t know enough about ______ (fill in the blank).” The loser is saying that he expects a change in his belief structure to make a critical difference. Perhaps if he changed indicators, perhaps if he concentrated more on fundamentals the market would reward him. But it’s just more of the same; he will continue to be a loser. Jankovsky argues that the loser’s expectations are incorrect because he has a faulty view of the market. It simply doesn’t work according to these belief structures. Both fundamental and technical analysis, though not useless, are highly overrated.

Jankovsky contends that the market is “a constant inequality that we, all of us, who participate, wish to see push in our favor.” He also claims, less insightfully in my opinion, that it’s a mirror, that “the entire market and all price action are a perfect reflection of [our] own thoughts.” How do these redefinitions of the market translate into profits? Here’s one of his explanations of price action: “Now watch this, that is the last bunch of losers getting out. There they are, that’s their stops liquidating with the loss. Right now they are all sitting in their offices saying ‘I knew I should have waited.’ They can’t stand that so they will try to get it back. That means the angry ones will do the same trade from the same side in about an hour or so, especially if prices move back to their original entry.” . . . “Okay, the winners are probably thinking I have to do something right here, they probably will move their stops up. The pit wants those stops. When they force the market into those stops, the losers will jump on those prices. Their thinking is probably, ‘I’m gonna miss this trade if I don’t,’ but the pit needs their blood to get out. Once that happens the market will come right back. This is free money, I’m getting in.” (p. 139)

This testosterone-laced account of the give and take of the markets, of the tug-of-war between the losers and the winners recasts a lifeless chart into a charged trading environment. It’s a shift in thinking that software programs such as Market Delta have tried to capture. But Jankovsky would, I suspect, stick with his conviction that trading is an art in which you want to find the losers in the market and take their money away from them.

Friday, July 10, 2009

The Launch

I have launched this blog for three reasons: first, to review new books on trading and investing (assuming publishers are generous with review copies); second, to share insights from earlier published material; and third, to offer some ideas of my own now and again. What credentials do I have to undertake these tasks? I’m a trader and investor with an academic and business background. As an academic, I taught philosophy at Yale; as a businesswoman I headed a book production company. Books have always been a focal point in my life.

Traders and investors should be readers. We may not invest like Warren Buffett, but it may pay to emulate him in one respect. He reads. As Charlie Munger advised, "If you want to succeed, if you really want to be the outlier in terms of achievement, just sit down . . . and read -- and do it all the time." Admittedly, traders can’t spend their days reading the way a long-term investor like Buffett does, but then they don’t have to slog through countless financial statements and annual reports. They do, however, want to have an equity chart that slopes convincingly upward from left to right, indicating that they have an edge and are executing well. And one way to achieve this is to read and then read some more. Or, with those rare gems, to read and re-read, over and over.

Beginning traders and investors are sometimes loath to read because reading opens up too many vistas. Just buy that super-duper trading system or take that expensive seminar and go to it! We know that’s a path to financial perdition. And traders and investors with more experience may be complacent, figuring they know enough and they’re doing okay. But is “okay” the best they can do? “Okay” is no performance outlier.

Reading will not in and of itself guarantee improved returns, but it should be an integral part of any trader’s and investor’s program of continuing education and performance evaluation. And who knows? Perhaps Emerson was right: “Many times the reading of a book has made the fortune of the man. . . .”