Saturday, October 30, 2010

Amazon links

A special thanks to those readers who have used my links to purchase items from Amazon. In case you don’t know, I get a small referral fee for anything you buy during your shopping session after you’ve clicked on one of my links—it could be a book, clothing, electronics, you name it. And since Halloween is upon us, that means that the Christmas shopping season is nigh. I mention this only because I’m striving to improve on the sub-fifty-cents-an-hour wages I get for writing this blog. I know, I know, it should be a labor of love but sometimes even love needs stoking.

Friday, October 29, 2010

Haslett, Risk Management

Risk Management: Foundations for a Changing Financial World, edited by Walter V. “Bud” Haslett Jr. (Wiley, 2010), is part of the CFA Institute Investment Perspective Series, “a thematically organized compilation of high-quality content developed to address the needs of serious investment professionals.” This is the third volume in the series. It is a collection of fifty-three reprints from such sources as the AIMR Conference Proceedings and the Financial Analysts Journal. Most of the contributions predate the financial meltdown. But if not all the contributions are timely (although I suppose that in some sense classic papers are always timely), many of their authors are or were industry heavyweights. Just to mention a few: Fischer Black, Robert Merton, William Sharpe, John Bogle, Burton Malkiel, Emanuel Derman, Clifford Asness, Richard Bookstaber, Aswath Damodaran, and Andrew Lo.

This 797-page book is wide-ranging. The reader is introduced to such topics as value and risk, volatility and diversification, the uncorrelated return myth, risk management for hedge funds, managing geopolitical risks, behavioral risk, and regulating financial markets. It may not qualify as an “everything you ever wanted to know about risk management” book since it doesn’t delve very deeply into quantitative issues and since risk management is ever evolving, but it provides a solid foundation for professionals and students alike.

There is no way I can do justice to this book in a single post, so I’ve decided to select two articles I think might be of particular interest to readers of this blog, both with a somewhat philosophical bent, and summarize them in separate posts over the course of the next week.

Thursday, October 28, 2010

Hirsch and Person, Commodity Trader’s Almanac 2011

The fifth edition of the Commodity Trader’s Almanac (Wiley, 2011), edited by Jeffrey A. Hirsch and John L. Person, has just been released. It follows the standard format of the Hirsch Organization almanacs; it is spiral-bound and contains two sections, the almanac proper and a databank section. The databank includes near-term contract monthly closing prices and percent changes as well as the annual highs, lows, and closes for the entire history of each product. It also provides specifications for commodities’ contracts as well as for related securities. For instance, under “cocoa” we find Hershey; the individual grains reference not only CRBA and MOO but such stocks as Archer Daniels Midland, Bunge, Conagra, John Deere, Monsanto, Mosaic, and Potash.

Commodities are the most seasonal of all traded instruments, so they lend themselves perfectly to seasonal studies, many of which this almanac describes. The almanac also suggests ways to improve entries, exits, and stops with pattern recognition as taught by John Person.

Each month in this almanac has an overview page, and each week features a seasonal study and chart. On the weekly calendar pages the editors have added first notice, last trade, and standard option expiration days for all nineteen markets included in the book. I suppose I should mention that, as was the case last year, in addition to the thirteen top commodities the almanac also includes data on how the U.S. dollar fares against four currencies (the euro, Swiss franc, Japanese yen, and British pound) as well as the S&P 500 index futures and the 30-year Treasury bonds.

The almanac offers apposite daily quotations, many of them familiar but nonetheless welcome. For instance, from Peter Lynch: “Whatever method you use to pick stocks . . . , your ultimate success or failure will depend on your ability to ignore the worries of the world long enough to allow your investments to succeed. It isn’t the head but the stomach that determines the fate of the stockpicker.” Or, T. S. Eliot: “Only those who will risk going too far can possibly find out how far one can go.”

As always, this almanac is beautifully produced and would adorn any desk that doesn’t already have far too many books cluttering it.

Wednesday, October 27, 2010

Jankovsky, Time Compression Trading

This is Jason Alan Jankovsky’s third book. Last year I wrote about Trading Rules That Work and The Art of the Trade. In Time Compression Trading: Exploiting Multiple Time Frames in Zero-Sum Markets (Wiley, 2010) Jankovsky expands on his overarching premise that the winning trader sits on a trade as long as there is a secure uptrend or downtrend and then exploits changes in order flow.

Zero-sum markets such as futures, options, and FOREX are a tug-of-war between buyers and sellers (as opposed to equities which are more like a game of musical chairs). Individuals win or lose depending on the actions of other traders.

The structure of these markets can be dissected into four components which are, in order of importance, time, volume, open interest, and price. Price is the least important; much more important is how the market got to that price. As Jankovsky writes, “If you knew the order flow was about to change, and it was about to go heavy on the buy side, and that would likely be in the next 10 minutes, would you buy the current price no matter what it was? Absolutely you would. It doesn’t matter what the price is when the order flow changes; it only matters that you are on the right side and slightly ahead of that change.” (p. 28)

Time is the most important element of market structure, and this includes both holding time and time compression. As to holding time, Jankovsky recalls that as a young trader he thought it was wise to be flat at the end of the day. He came to realize that all he was really doing was “providing liquidity to the larger professionals on the other side” and that his liquidation orders and the liquidation orders of all those other traders who wanted to reduce risk by being flat every day “were a large reason why the market continued to advance in trend for the professionals day after day.” (p. 31)

Time compression “is what happens when everyone wants to do the same thing at about the same time for roughly the same reasons.” (p. 51) Understanding time compression in the markets enables the trader to see when an order-flow imbalance is likely to occur. Changes in volume and open interest are tipoffs, and using multiple time frames (and not those lower time frames that losing traders tend to focus on) to discern market structure is critical.

Jankovsky analyzes in some detail five basic market structures—topping and bottoming markets and secure uptrends, downtrends, and ranges—and the time/price relationships that obtain in each of them.

Although time compression is the main thread of this book, Jankovsky is not a single-strand thinker. He writes about the illusion of technical analysis (though it can be useful in identifying the losers in the market and, when used with market structure and time compression, can help confirm the presence of an opportunity). He has a chapter on the psychology of initiating and liquidating a position—a conflict/resolution cycle that “happens only in the mind of traders and nowhere else.” (p. 44) He writes about how traders lose perspective and how “losing traders are attempting to predict where the market will go whereas winning traders are attempting to participate with what is happening.” (p. 85) He looks at the problem of leverage and suggests trading smaller while running a wider stop. And he exhorts the trader to think about who’s on the other side of his trade—is it someone trading size or a little fish he can swallow up?

Time Compression Trading offers a refreshing perspective on the markets. It’s an easy, if sometimes repetitive, read. And although there is no magic formula for transforming a losing trader into a winner, it challenges some patterns of thinking and acting that can put a trader squarely in the losers’ camp.

Tuesday, October 26, 2010

Kaminsky, Smarter Than the Street

Gary Kaminsky’s Smarter Than the Street: Invest and Make Money in Any Market (McGraw-Hill, 2011) proceeds on the assumption that the market will trade in a range for the next decade, essentially doing nothing. One model that supports this thesis is Thomas H. Kee’s
“Investment Rate,” which is grounded in demographics. The idea is that “people put much more money into the markets after they have put their children through college, or at about age 48.” Kee suggests that we are swimming against the demographic tide and hence “are entering a very tough period” in which investment dollars will be shrinking and that it will be “very difficult to achieve any new highs in the market until 2023.” (pp. 34-35)

How can the retail investor shine in a stagnant market? Kaminsky outlines a contrarian strategy of buying or shorting against the crowd, taking advantage of a market dislocation, as long as there is a sound fundamental reason to do so. The person who proceeds in this way will be investing in a two-decision stock; that is, he must know both when to buy (or short) and when to sell (or cover).

In selecting stocks that will outperform, the investor should employ a series of litmus tests to analyze potential candidates: changes in the company itself, how the company uses its cash, and company fundamentals (sustainable competitive advantage, strong financial metrics, long-term free cash flow generation, shareholder focus, and insider ownership). In addition, he should monitor the macro environment in which the company operates.

Kaminsky rounds out his book by revealing Wall Street’s greatest myths, suggesting how many stocks an investor should own, and giving pointers on how to manage the downside of a portfolio.

Smarter Than the Street is a quick read. It is an easy introduction for the investor who uses fundamentals to make decisions and who believes with Kaminsky that buy and hold is a strategy for mighty few stocks. The average investor who follows advice of this book should be able to improve his returns, though whether he can truly outperform is another question.

Monday, October 25, 2010

Augen, Trading Realities

In Trading Realities: The Truth, the Lies, and the Hype In-Between (FT Press, 2011) Jeff Augen ventures beyond his safe haven of option trading to take on a world filled with bogeymen. There is Ben Bernanke whose appointment “hammered the final nail in the dollar’s coffin.” There are the government number crunchers who offer data that “have been adjusted to mislead the market,” that are “fake.” And there is the “mystery buyer” who “seems to step in at key times to stop potential meltdowns.” These bogeymen, to Augen’s mind, are only too real.

As if these alleged government manipulations were not enough, the retail investor is faced with some stark realities in the markets themselves. Long-term investing is a relic, and with the advent of high-frequency trading the markets are increasingly efficient. Technical analysis as a standalone approach is no longer viable for the retail investor. The gap between the power of the large institutional investors and all other market participants is widening. The tools that individual investors use “operate in time frames that are thousands of times too slow to compete with the large systems that drive the market. More important, private investors looking at patterns on stock charts are competing with the very systems that create and exploit those patterns.” (p. 156)

All is not lost. Augen claims that “smart private investors who do their homework and follow the financial markets can run with the best institutional investors over long periods of time. The simplest and best approach combines two important sources of information that everyone has access to—the daily stock chart and readily available financial news. Separately, they’re not all that useful, but the combination is much more valuable than the sum of the individual parts.” (pp. 70-71) Augen illustrates his claim with a marked-up eight-month chart of U.S. Steel. It includes analyst upgrades and downgrades, earnings reports, and macro news. Armed with this kind of information, the investor will be able to make profitable decisions, especially with regard to trend failures.

In addition to his chart/news combination, Augen offers another indicator for predicting market corrections, the ratio of the VIX to true volatility.

As might be expected, Augen considers stocks to be a dangerous way to invest and diversification an “overly simplistic and ineffective way to hedge. Most effective solutions,” he argues, “involve structured positions that use both options and stock, or just options alone.” (p. 191) He provides an overview of some basic option strategies.

I fear that in this sweep through his book I have made Augen’s arguments appear a bit simple-minded. They are not. As he fleshes them out, they become more intriguing and more compelling. (I’m excluding the anti-Washington vent, since I find little that happens in Washington, for good or ill, either intriguing or compelling.) Most reflective readers will disagree with some of what Augen has written. That is only natural. But this brief book will most likely force them to hone their arguments—and that’s a tribute to Augen’s insights.

Trading Realities provides a foundation, and rationale, for anyone who aspires to become a macro informed, volatility driven options (or hybrid) trader. And it stands as a challenge to those who don’t.

Sunday, October 24, 2010

Bill Gross

For those who relish stories about trading titans, here's a piece in The Globe and Mail.

This link comes via eWallstreeter, a site I found as a result of reading Gary Kaminsky's Smarter Than the Street (review to come this week).

Friday, October 22, 2010

Coming attractions

I’ve got a stack of books here to review, among them:

Jeff Augen. Trading Realities
Quint Tatro. Trade the Trader
Gary Kaminsky. Smarter Than the Street
John Nyaradi. Super Sectors
Jason Jankovsky. Time Compression Trading
Ross Beck. The Gartley Trading Method
Kent Baker & John Nofsinger, eds. Behavioral Finance (757 pp.)
“Bud” Haslett. Risk Management (797 pp.)

I’ve done a quick flip-through, and some of them look promising. Stay tuned.

Thursday, October 21, 2010

Aldridge & Krawciw, The Quant Investor’s Almanac 2011

First came the Stock Trader’s Almanac, then the Commodity Trader’s Almanac. The latest arrival is the Quant Investor’s Almanac 2011: A Road Map to Investing by Irene Aldridge and Steven Krawciw (Wiley, 2010). It is not, let me be quick to point out, a product of the Hirsch Organization nor does it rise to the standard of the other two almanacs.

The driving idea behind this almanac was to make “cutting-edge quantitative investment strategies accessible to all investors.” I suspect that few of the top-performing quants would line up to take credit for these strategies. The book focuses on economic data releases and the response of individual stocks or the market as a whole to positive and negative reports. The authors also share findings from academic papers appearing in such publications as the Journal of Finance and the Journal of International Economics.

Some of the correlations to economic news should be obvious—for instance, that Home Depot stock rises in response to increases in new home sales and falls when new home sales drop. Allstate’s similar relationship to increasing and decreasing construction spending may be slightly less intuitive. Then there are the non-intuitive choices for study. To take a single example: IBM’s response to retail sales news. Why analyze IBM, which derives most of its revenue from business and technology services and middleware software? Perhaps this is why the impact of retail sales data on IBM’s stock tends to be short-lived. (I wonder how the short-term performance of IBM’s stock compares to that of Best Buy or Wal-Mart or Nike.) Those not steeped in the currency markets will also learn that positive changes in the Johnson Redbook Report lead to a drop in the Euro relative to the U.S. dollar.

The authors assiduously avoid math, even tables. They do, however, provide line graphs that plot the average percentage return relative to price at announcement time on the y-axis and time to announcement (both negative and positive) on the x-axis. Each graph has three lines—all changes, positive changes, and negative changes. The graphs might be more helpful if we knew what time periods they covered.

This book is laid out in the standard almanac style, with an events calendar on the right-hand pages and text and graphs on the left-hand pages. It also has a useful glossary. Unlike its spiral-bound counterparts, however, this almanac is paperbound, which limits its effectiveness as a desk calendar.

In my opinion, if this almanac is to have a future it needs a major overhaul. First and foremost, it should be true to its title and provide quant studies, basic math included. It’s not enough to say that a stock goes up or down. The reader should be told how far it moves and how long the effect lasts. Moreover, the authors should move beyond economic reports even if this entails forcing an almanac style on non-calendar related data. After all, the cartoons in The New Yorker's highly successful desk diary are not time dependent.

Wednesday, October 20, 2010

Gonzales, Deep Survival: closed attitudes, normalizing risk

One of my aunts, more comfortable with results than principles, used to bring her granddaughter to the family Easter egg hunts. Over and over, as she would spot eggs that her granddaughter hadn’t seen, she would intone, “Karen Lee, open up your big brown eyes!” She thought, as most people do, that you can see what’s there simply by opening up your eyes and looking.

Magicians consistently disprove this notion. Harvard psychologists quantified it. In a well-known study, they showed subjects a video of basketball players passing the ball and asking them to count the number of passes made by either the white-uniformed or the black-uniformed team. In the middle of the video one of two strange things happened, lasting for about five seconds—either a woman with an umbrella or a person in a gorilla costume walked through the center of the action. Thirty-five percent of the subjects failed to notice the woman, 56% missed the gorilla, though both the woman and the gorilla were obvious to anyone not engaged in the counting task.

Those who had been given no instructions but merely watched the video came to their task with “an attitude open to an unfamiliar world, accepting of whatever was there. There was no model and there were no expectations. The order ‘Tell me what you see’ produces curiosity. The order ‘Count the passes’ produces a closed system, a narrowing of attention directed at a particular task, which fills up working memory. The implicit assumption is that you know what you’re doing and know what sort of perceptual input you want. … Such a closed attitude can prevent new perceptions from being incorporated into the model. Such a closed attitude can kill you.” (p. 77) The positive version: “Some people update their models better than others. They’re called survivors.” (p. 79)

Count the bars, recognize the pattern, and—oops—miss that gorilla in the room. Or broaden your focus so that you at least see the gorilla, and then decide whether or not it’s relevant.

The final takeaway for this two-part post on Deep Survival comes from the theory of risk homeostatis, which says that people accept a given level of risk. “While it’s different for each person, you tend to keep the risk you’re willing to take at about the same level. If you perceive conditions as less risky, you’ll take more risk. If conditions seem more risky, you’ll take less risk.” (p. 112) For instance, when antilock brakes were introduced, the expectation was that the accident rate would be go down. In fact, it went up because people figured that driving was safer with the new brakes so they drove more aggressively.

People tend to normalize risk which means, in part, that “if you’ve tallied a lot of experience in dangerous, iffy environments without significant calamity, the mental path of least resistance is to assume it was your skill and savvy that told the tale.” Ah, but every new experience is different. “… even if you are intimately familiar with [the mountain’s or a trading instrument’s] subtleties of character, it can make a mockery of the most thoughtful plans. Experience is nothing more than the engine that drives adaptation, so it’s always important to ask: Adaptation to what? You need to know if your particular experience has produced the sort of adaptation that will contribute to survival in the particular environment you choose. And when the environment changes, you have to be aware that your own experience might be inappropriate.” (p. 113)

Tuesday, October 19, 2010

Rachev et al. Probability and Statistics for Finance

I make it a policy never to review a book until I have finished it. In the case of Probability and Statistics for Finance by Svetlozar T. Rachev, Markus Höchstötter, Frank J. Fabozzi, and Sergio M. Focardi (Wiley, 2010) I feel compelled to make an exception. The fault lies not in the book but in the reader. Although I am progressing at a reasonable clip given some of the gaps in my math background, I decided that it would be unfair to the authors to wait until I had read the last part of the book, multivariate linear regression analysis. So I’ll confine my brief remarks (brief, lest I demonstrate to the world that I really am a quant dolt) to the first three parts: descriptive statistics, basic probability theory, and inductive statistics. That’s 518 of the 632 pages of text and appendixes, so although it’s not a representative sample it’s a pretty good chunk.

I never studied probability and statistics formally but instead read assorted texts and watched educational videos. The result was an unstructured intellectual hodgepodge, little of it directly linked to financial issues. This book solves my scattershot problem, one that I suspect I am not alone in experiencing. First, it proceeds clearly and deliberately and does not skimp on equations. Second, it explains the strengths and weaknesses of particular concepts when applied to finance. And third, its examples, and there are many, are exclusively financial. For instance, we read about the application of the hypergeometric distribution in a Federal Reserve study to assess whether U.S. exchange-rate intervention resulted in a desired depreciation of the dollar. (p. 209) And we learn how to decompose the daily S&P 500 returns to determine whether there is any difference in price changes depending on the day of the week. (p. 157)

The authors balance mathematically appealing concepts with those that are “sometimes rather complicated, using parameters that are not necessarily intuitive.” (p. 277) As one might suspect, the latter are necessary to deal with extreme events. A chapter is devoted to such continuous probability distributions as the generalized extreme value distribution, the generalized Pareto distribution, the normal inverse Gaussian distribution, and the α-stable distribution. Yet even these alternative distribution models, the authors point out, tend to come up short in extreme circumstances. For instance, what was the likelihood that AIG could lose 60% of its value in a single day? According to a normal distribution model the probability was near zero. When the parameters for an α-stable distribution are selected to fit the AIG returns, the probability is still nearly negligible, only 0.003%. “That brings to light the immense risk inherent in the return distributions when they are truly α-stable.” (p. 292)

No book on statistics is complete without considering the formulation and testing of hypotheses. This section is surprisingly dense mathematically, which is where I got bogged down.

Probability and Statistics for Finance is not for the casual reader who comes from the “physics for poets” school of thought. It can be tough sledding. But for anyone who is serious about gaining a solid foundation in quantitative analysis this book is a very good place to start.

Monday, October 18, 2010

Gonzales, Deep Survival: making plans, savoring uncertainty

On the recommendation of one of the readers of this blog I borrowed Deep Survival: Who Lives, Who Dies, and Why by Laurence Gonzales (W. W. Norton, 2003) from the public library. It was not a book I thought I needed in my permanent collection because, as I readily admitted in my post "Trading and alpine climbing," I’m not the sort who spends her weekends climbing mountains, running rapids, or snowboarding. But even I, the non-adventurer, found the book intriguing. After all, one question all traders should ponder, and ideally have an answer to, is who survives, who fails, and why.

Although Gonzales devotes the lion’s share of the book to recounting tales of disaster and survival, he regularly steps back to dissect what gets people into trouble in the first place and what separates the survivor from the victim. Over the course of two posts I’m going to look at a couple of things we do to put ourselves in harm’s way and how we can survive our own bad instincts.

We are inveterate planners. Plans, as Gonzales sees them, are not simply some emotionless ideas we write down on a piece of paper; they are suffused with the emotional values of past realities—earlier climbs, former trades. These memories are “beacons of incentive.” We apply our memories of successes, good feelings, favorable conditions to the new and unfamiliar challenge.

Plans are stored in memory just as past events are. To the brain, the future is as real as the past.” “If this is indeed the case, the pitfalls of plans should be apparent. “The difficulty begins when reality doesn’t match the plan. … If things don’t go according to the plan, revising such a robust model may be difficult. In an environment that has high objective hazards, the longer it takes to dislodge the imagined world in favor of the real one, the greater the risk. In nature, adaptation is important; the plan is not. It’s a Zen thing. We must plan. But we must be able to let go of the plan, too.” (pp. 81-82)

We must abandon the plan even as we confront unexpected turns of events and additional stresses—and hence find it difficult to think clearly. Reason can easily be overwhelmed.

How do we revise the script and learn to adapt? Rigorous training is critical—“not only in the technical stuff … but in emotional control. All elite performers train hard, and when you follow in their path, you’d better train hard, too, or be exceptionally alert. That’s the main difficulty with neophytes who go into the wilderness: We face the same challenges the experts face. Nature doesn’t adjust to our level of skill.” (pp. 87-88) Nor, of course, do the markets.

Both nature and the markets are filled with uncertainties. Gonzales quotes advice from a wildland firefighter: “… you must not merely tolerate uncertainty, you must savor it. Or you won’t last long. The most efficient preparation is a general mental, physical, and professional readiness nurtured over years of training and experience. … Preparing is itself an activity, and action is preparation.” (p. 245)

A footnote: Gonzales more or less equates letting go of a plan with breaking rules when he looks at patients who have in effect been handed a death sentence by their doctor. (“The plan … can become the equivalent of doctor’s orders, the tyrannical rule you can either obey or rebel against.”) People who survive cancer are notoriously “bad patients.” They are “unruly, troublesome. They don’t follow directions. They question everything. They’re annoying. They’re survivors.” (p. 82) I’m not sure that the equivalence holds or that we want to adopt the cancer survivor model wholeheartedly when it comes to trading. Nonetheless, experienced traders know that money is often not found where the compass points.

Friday, October 15, 2010

Wright, The First Wall Street

Sometimes it’s refreshing to step back from all the current political folderol and read about a time when American economic and political systems were being developed. Let me recommend Robert E. Wright’s The First Wall Street: Chestnut Street, Philadelphia, and the Birth of American Finance (University of Chicago Press, 2005). It’s not a new book, but the recent financial turmoil makes it an even more worthwhile read today than when it was published. Readers of all political stripes can find some eerie parallels here and there. In contrast to most books on finance, it’s also very well written.

This post will share a series of (unfortunately disconnected) snippets from the book. They don’t do the book justice, but maybe they’ll inspire readers interested in financial history to turn to the original.

Philadelphia was the financial center of America until 1836. It had the advantage of being the nation’s political capital for the better part of 25 years and its commercial capital as well. Both early U.S. central banks had their headquarters in the Chestnut Street district. Equally important, “Philadelphia’s early financiers were the nation’s greatest innovators, responsible for America’s first forays into negotiable ground rents; marine, fire, and life insurance; commercial, savings, and investment banking; building and loan securities; and securities markets.” (p. 11)

A side note for those who are unfamiliar with ground rents: “Despite its name, a ground rent was really more of a perpetual mortgage than a lease. The buyer got full title to the land. So long as he paid the annual ‘rent,’ which was actually the interest on a perpetual loan, he could do with the land as he pleased. He could even sell it, subject to the ground rent. Best of all, the rent could never increase and the contract never expired. For just a few coins each year, he could secure his economic independence. Before ground rents were effectively outlawed late in the nineteenth century, hundreds of thousands if not millions of people took advantage of their unique attributes.” (p. 19)

Early commercial banks were very cautious lenders. Apparently the Bank of New York made “only ‘one bad Debt of about twenty pounds’ through the first seven years of its existence.” (p. 77) The Bank of North America, whose interest rate was capped by law at 6%, “carefully screened loan applicants, selecting only the best of the best.” Those who were rejected had to go to Chestnut Street’s back alleys and pay considerably more. (p. 38) Surprisingly, the best of the best was not an exclusively male club. “Elizabeth Helm, one of many examples, enjoyed extensive dealings with the Bank of North America as early as 1792, when over $18,000, a princely sum for the day, flowed through her account. She made large cash deposits every fortnight or so, continually drawing down her balance with checks made out to her suppliers. When her account fell a little short, a quick loan bridged the gap until her next deposit.” (p. 79)

Philadelphia’s Chestnut Street may have been the nation’s financial center, but Wall Street was hot on its heels. “Soon after a new institution appeared in Philadelphia, an eerily similar-looking one cropped up in Manhattan. The Bank of New York formed soon after the Bank of North America’s monopoly ended with the Revolutionary War. New York brokers signed the Buttonwood Agreement, which created a proto-New York Stock Exchange, shortly after Philadelphia brokers formed a proto-exchange. The Bank for Savings popped up shortly after the Philadelphia Savings Fund Society organized. Ditto with all three major types of insurance, building and loans, and other financial innovations. Save for ground rents, which New York never adopted, the general rule was: Where Chestnut Street led, Wall Street followed.” (p. 148)

How Wall Street eventually wrested power away from Chestnut Street is far too long a tale to tell here. Suffice it to say that government in the persons of Andrew Jackson and Martin Van Buren waged a fierce campaign against its own central bank--the “monopolistic” Second Bank, founded in 1816 and headquartered in Philadelphia. Nicholas Biddle, “the most storied banker in U.S. history to that time” and “firmly at the helm” of the bank, unwittingly helped them out. (p. 150) Eventually, the Second Bank failed. “Biddle was largely to blame; without board approval, he directed some $16 million into risky cotton speculations and the ill-fated run [on Wall Street banks] was his idea.” The failure of the Second Bank “further cemented Wall Street’s new position atop the nation’s financial system.” (p. 163)

Thursday, October 14, 2010

Hirsch, Stock Trader’s Almanac, 2011

As the leaves change color we not only savor the glorious sight but look forward to 2011. Once again, for the forty-fourth time, the Hirsch Organization offers us the Stock Trader’s Almanac (Wiley, 2011). Under the editorship of Jeffrey A. Hirsch, the almanac continues its familiar format. Spiral bound, printed on sturdy stock, and now 192 pages long, it includes a calendar section and an index data section. On the recto pages of the calendar section are entries for a week, including the market probability numbers each day for the Dow, S&P 500, and NASDAQ as well as historical performance highlights and quotations. On the verso are well-documented studies.

There is a plethora of data for anyone with the slightest interest in calendar effects on market prices. From the classic January barometer to the impact of the presidential cycle, the almanac lays out track record after track record. Investors should be comforted to know that “there hasn’t been a down year in the third year of a presidential term since war-torn 1939, Dow off 2.9%. The only severe loss in a pre-presidential election year going back 100 years occurred in 1931 during the Depression.” (p. 32)

The almanac’s prediction of Dow 38820 by 2025 may be a little over the top, though it certainly would be loverly. The case for this forecast presumes that we exit Iraq and Afghanistan in a timely fashion, that we begin to experience inflation, and that enabling technologies such as energy technology and/or biotechnology create “major cultural paradigm shifts and sustained prosperity.” (p. 36) Alas, don’t expect a straight line to this target; if the market follows the pattern of 1974 through the first half of 1982 we may be in for another seven relatively lean years before takeoff.

For those who have a shorter time frame and want to play both sides of the market the almanac provides data on seasonal corrections in the Dow and offers a sector index seasonality strategy calendar. Those in search of a very short-term trading strategy might explore Wall Street’s only “free lunch.” And those who simply love “best” and “worst” data can have a field day. My personal favorite: the trading day in 2011 with the highest chance of the Dow Jones Industrial Average rising, based on data from January 1953 to December 2009, is my birthday! (Perhaps my parents were market timers.)

Wednesday, October 13, 2010

Morales & Kacher, Trade Like an O’Neil Disciple

The CANSLIM enthusiasts, and they seem to be legion if the reviews on Amazon are any indication, have nothing but praise for Trade Like an O’Neil Disciple by Gil Morales and Chris Kacher (Wiley, 2010). I decided to be a little more focused and less ebullient in this post and write about a trade setup not found in the standard O’Neil repertoire. Consider this a follow-up to yesterday’s discussion about the eye of ambiguity.

The setup is alternatively described as a pocket pivot or buying in the pocket. It is “an early base breakout indicator, which is designed to find buyable pivot points within a stock’s base shortly before the stock actually breaks out of its chart base or consolidation and emerges into new high price ground.” (p. 128) The pocket pivot indicator provides direction in what might be seen as an ambiguous situation. It is, the authors claim, particularly valuable in sideways moving markets.

A major virtue of a pocket pivot buy point is that it is a low-risk entry point—relatively close to support and far enough from resistance to be profitable even if the stock can’t break through to higher highs. Or, as the more optimistic authors claim, “the pocket pivot buy point technique can get an investor into a stock at a lower-risk price point and thereby make it more possible for the investor to sit through a pullback if the all-too-obvious new-high breakout buy point fails initially and the stock retrenches, corrects, or sells off.” (p. 129)

What are the characteristics of a pocket pivot buy point? “[A] stock should be showing constructive price/volume action preceding the pocket pivot. … [T]ighter price formations, that is, less volatility should be evident in the stock’s price/volume action as viewed on its chart. The stock should have been ‘respecting’ or ‘obeying’ the 50-day moving average during the price run that occurred prior to the time the stock began building its current base. … Except in very rare cases, … pocket pivots should only be bought when they occur above the 50-day moving average. Ideally, the stock’s price/volume action should become ‘quiet’ over the previous several days, which contrasts with the much larger and stronger volume move that comes on the pocket pivot itself. On the pocket pivot you want to see up-volume equal to or greater than the largest down-volume day over the prior 10 days.” (pp. 132-33)

The authors offer a series of variations on this generic trade setup. For instance, there’s the continuation trade: buying on volume after a pullback to the 10-day moving average. Or the bottom-fishing trade where a stock, after carving out a bottom, pushes through its 50-day moving average. They urge caution if a pocket pivot is too extended from its 10- or 50-day moving average when it begins its move or if a stock has been “wedging” upward instead of drifting downward before a pocket pivot. As they write, “context is everything.” (p. 162)

This setup is certainly not a revolutionary breakthrough in the world of technical analysis. In fact, anyone familiar with the literature might recognize several patterns rolled into one here. In the context of yesterday’s post, it is a “fast-follower” strategy because it requires a volume spike, created by the “first movers.”

Tuesday, October 12, 2010

Buytendijk, Dealing with Dilemmas, part 2: the “eye of ambiguity”

When do we jump on the next trend? Buytendijk sets out the dilemma. “If you analyze too long, the window of opportunity closes; you have suffered from analysis paralysis. If you jump on a new opportunity immediately—“shoot first, ask questions later”—your fail rate is most likely to be higher than others as well.” (pp. 93-94)

Yes, I know this sounds terribly familiar, but Buytendijk puts a slightly different spin on it, so it’s worth reading further. He uses the S-curve to depict the rise and fall of trends.

“A trend starts hopefully; with a lot of passion, a small group of people pioneer a technology, test a new business model, or bring a new product to market. This is usually followed by a phase of disappointment. The new development turns out to be something less than a miracle. Reality kicks in. At some point, best practices emerge and a phase of evolution follows. Product functionality improves, market adoption grows, and the profitability increases. Then something else is introduced, usually by someone else. … This replacement then goes through the same steps.” (p. 95)

“The best place to jump to the next S-curve to secure sustained growth is obviously at the beginning of the ‘eye of ambiguity.’ While the current cash-cow business is still profitable and growing, the next wave can be adopted, preparing for future profitability. Both the now and the later are considered in an ambidextrous way. The cash-cow business can fund the new investment. The new trend has not broken through yet, so there is time to experiment in a safe way. Experimentation leads to additional insight on how to capitalize on this new trend, which decreases the risk of failure and moves you toward the optimal decision point.” (p. 95)

“Yet, paradoxically, the least likely point to jump to the next S-curve is at that exact same point. …the eye of ambiguity is a source of great confusion. Experts disagree on the impact of the new trend and the benefits are more of a promise than a proven reality. And in difficult times we tend to rely on what we know and what has proven to work best. As a result, most likely nothing will happen until the new trend has overtaken the old one, and it is too late.” (p. 96)

We don’t know, of course, in the eye of ambiguity whether the new trend is real or a mirage. There is an art to distinguishing between the two and to finding the optimal decision point. Sometimes, Buytendijk suggests, it makes sense to give up the first-mover advantage in favor of a fast-follower strategy. The latter “limits the risks while keeping chances of success relatively high.” (p. 98) Or you can dip a toe in the water as you continue to assess the ambiguity.

It would be unwise to extrapolate too literally from Buytendijk’s S-curve to market trends. But I think the imaginative reader might be able to devise some position management hypotheses worthy of testing based on the marvelously mixed metaphor of the cash cow and the eye of ambiguity.

Monday, October 11, 2010

Izraylevich and Tsudikman, Systematic Options Trading

Not surprisingly, quants tend to gravitate to options. For one thing, option pricing models can be mathematically challenging because, unlike stocks, options have a nonlinear payoff function. Sergey Izraylevich and Vadim Tsudikman, whom readers may have previously encountered through their contributions to
Futures Magazine, use quantitative methods to find profitable option trades. In Systematic Options Trading: Evaluating, Analyzing, and Profiting from Mispriced Option Opportunities (FT Press, 2010) they introduce the reader to techniques by which to calculate the difference between the market price of an option and its fair value. This difference represents a trading opportunity.

The authors explain the advantages of their approach over the traditional, admittedly tedious, route of using scanners, rankers, and payoff charts. The traditional method is a “differential approach. It is a forced measure resulting from the imperfection of analytical tools limited to simple scanning and visual analysis of payoff functions…. What [the authors] oppose to a differential approach is an integral systematic approach based on the strictly formalized assessment criteria, universal procedures of multicriteria analysis, and well-structured selection algorithms. The systematic approach enables simultaneous processing of a considerable number of option strategies and underlying assets. Without such an integral system, the investor has little or even no chance to make prompt selection decisions and to adapt successfully to changing market conditions.” (pp. xxiii-xxiv)

Izraylevich and Tsudikman develop a series of criteria to evaluate and compare individual options and their combinations; the higher the criterion value the better the profit potential. The primary criteria they use are: expected profit on the basis of lognormal distribution (EPLN), empirical distribution (EPEM), and symmetrized empirical distribution (EPES); profit probability on the basis of the same three distributions (PPLN, PPEM, and PPES); the ratio of expected profit to loss based on these distributions (RPLL, RPLE, and RPLS); the ratio of implied to historical volatility (IV/HV), and the break-even range (BEVR).

Not every criterion is equally effective for the four option strategies the authors consider here (long and short strangle/straddle, long and short calendar spread). They employ various indicators, such as the correlation between a criterion and profit indexes, the correlation between the Sharpe ratios of the criterion and profit, and the areas ratio, to measure their effectiveness. But, as the authors readily admit, these indicators just skim the surface: “Undoubtedly, a creative approach allows developing a lot of additional indicators based on various evaluation principles.” (p. 102)

Although most of the criteria, taken individually, “show statistically reliable predictive power, in most cases it is rather weak. Nevertheless, this small forecasting effect gives a considerable advantage to those who use it over those who ignore systematic criteria application. … Concurrent utilization of many criteria allows exploiting different individual advantages inherent to each of them. The cumulative synergetic effect of such a multifaceted approach is expected to be quite noticeable.” (p. 182) It is, of course, critical to measure the correlation between different criteria when pursuing a multicriteria strategy.

The reader who wants to replicate the authors’ work at home or expand on it will need, at the very least, an end-of-day database of option prices. A solid foundation in statistics and probability theory is also a prerequisite. And without some programming skills all those numbers (I just experimented with a sample download—a single day of strike prices for U.S. equities fills some 300,000 lines in an Excel spreadsheet, which is of course not where the data should be housed) will be unmanageable. The ill-equipped or lazy reader can go to the book's website for daily updates on trading opportunities using single criteria for straddles and strangles, calendar spreads, butterflies, and condors.

Sunday, October 10, 2010

Vix and More, the Engle lectures

Many thanks to Bill Luby of Vix and More for the kind words about this blog. He also found the video links to the Engle mini-lectures, so those who want more than my notes and graphics can now have the whole shebang.

Saturday, October 9, 2010

Econ graphs

For those whose life is not complete without reviewing economic graphs here are a couple you may not have seen: monetary policy decisions (Australia, Indonesia, Japan, Europe, UK, Philippines); U.S. non-manufacturing PMI, consumer credit, and nonfarm payrolls; and Australian employment. Compliments of Econ Grapher.

Friday, October 8, 2010

Buytendijk, Dealing with Dilemmas, part 1: big-picture issues

As readers of this blog know, I often look for insights in books that were not written with investors and traders in mind. Most of the time my search comes up empty. But now and again I hit pay dirt. Frank Buytendijk’s Dealing with Dilemmas: Where Business Analytics Fall Short (Wiley, 2010) is my latest discovery. I’ll devote two posts to his ideas.

Buytendijk, currently a vice president and fellow at Oracle responsible for “thought leadership,” sets out to counter the obsession with analysis. Why, he asks, are there so many analysts and no synthesists? Especially since synthesis is particularly useful in dealing with “something more fundamental than a straightforward problem—such as a dilemma.” (p. xv)

“A dilemma can be defined as a situation requiring a choice between equally undesirable or unfavorable alternatives. It is a state of things in which evils or obstacles present themselves on every side, and it is difficult to determine what course to pursue. … Whatever decision you take, there is an unacceptable downside.” At the same time, “a dilemma is an opportunity to fundamentally solve a problem, as understanding the dilemma lifts you to another dimension of insight” (p. 3)—an echo, duly noted, of the thesis-antithesis-synthesis process of Hegelian dialectic.

Buytendijk focuses on strategy management (formulation, implementation, and performance measurement). A strategy, understood informally, is “an action plan to achieve the organization’s long-term goals.” (p. 14) Does this mean that strategy is about making big choices? The author suggests that a better way to think about strategy is to view it as “creating a portfolio of options,” somewhat akin to a portfolio of stock options. “Options, as opposed to choices, do not limit our flexibility in the future; they create strategic flexibility.” (p. 16)

Creating options, of course, does not preclude making choices. “You cannot have a contingency plan for every possible future; not making any choices at all, while trying to go along with everything that passes by, leaves you unfocused and most probably unsuccessful. The trick is to make the strategic choices that create the right options.” (pp. 32-33)

Buytendijk describes six quintessential strategy dilemmas that businesses face: value/profit, inside-out/outside-in, top-down/bottom-up, listen/lead, optimize/innovate, and long-term/short-term. He then introduces the image of a strategy elastic to visualize how businesses are dealing with these dilemmas. “Creating strategic stretch is very much like working with an elastic band. If you pull it from only one side, the other side will move along in the same direction. You can stretch it only if you pull it from both sides. And the harder you pull in multiple directions at the same time, the more space you create, which is the objective of strategic management. The metaphor of an elastic band is particularly appropriate because it implies you cannot stop pulling; otherwise, the elastic band goes back to its neutral position” which translates into average results for the organization. (p. 69)

These are some big-picture issues that managers in every kind of business face, whether it be manufacturing or financial, large or small. If you haven’t given them any thought, perhaps it’s time to reevaluate how you’re managing your business.

Thursday, October 7, 2010

Robert Engle’s FT lectures on volatility, part 5: global financial volatility

This is the final installment of my notes on Robert Engle's FT lectures. As I wrote earlier, the transcripts of these mini-lectures are available on the FT website.

Global volatility over time is very similar to S&P volatility. Some more detailed findings from Engle’s study:

The larger the stock market (i.e. the more companies listed) the lower the volatility.

The faster the GDP is growing, the lower the volatility. When GNP is declining, the volatility will rise.

When you have high inflation rates you tend to have high volatility. When there’s a lot of fluctuation in short-term interest rates or short-term real output this macro economic volatility contributes to financial market volatility.

Wednesday, October 6, 2010

Peterson and Murtha, MarketPsych

Traders, especially discretionary traders, have long recognized the importance of psychology to their endeavor—trying to fathom not only what’s in their own heads but what’s in the heads of those on the other side of their trades. As a result, there is a fairly extensive bibliography of books and articles on trader psychology. Not so with investor psychology, at least not outside the world of academe. Richard L. Peterson and Frank F. Murtha, co-authors of MarketPsych: How to Manage Fear and Build Your Investor Identity (Wiley, 2010), seek to help fill that void.

The authors, by training a psychiatrist and a psychologist, are also the co-founders of MarketPsych LLC, a company that “trains financial advisors, portfolio managers, traders, and executives in emotion management and intuitive decision skills.” Its website offers free personality tests for investors and traders.

Throughout the book the authors draw on the findings of research in behavioral finance. For instance, in one chapter the authors identify ten investor blind spots (or mental traps), some of which should be familiar to those who have read (or read summaries of) the work of Kahneman, Tversky, Thaler, and their colleagues and followers. The traps are: win/lose mentality, down with the ship syndrome, anchoring, mean reversion bias, endowment effect, media hype effect, short-termism, overconfidence, herding, and hindsight bias. The authors profile hypothetical investors, each of whom falls into between two and five of these traps. We meet the Wicked Gardener, Corporal Clinger, Mr. Magoo, the Roulette Player, and Maxwell Smart. Let your imaginations run wild trying to match them up!

Topics covered in the book run the gamut from the genetics of risk taking to the pitfalls of self-affirmation. (“…some studies show that people who think they need affirmations—the insecure and the doubtful—typically have a negative response to affirmations. The people who benefit from daily affirmations are positive, confident, optimistic people—exactly those whom you wouldn’t expect to need them.”) (p. 182)

The authors also dig into investor values. I particularly enjoyed the set of questions a top financial advisor asks his clients. They include: What about money is exciting (stressful) for you? What are three things you lie to yourself (to others) about when it comes to your money? (p. 112)

MarketPsych offers case studies, exercises, planning templates, and down-to-earth advice. All are designed to take the investor from being an underperformer to being an achiever. And for those who think that being average is good enough, here is a stunning statistic. $100,000 invested in the S&P 500 index on January 1, 1989, would have grown to $292,329 by 2009, after accounting for inflation. The average equities investor, by contrast, would have ended up with $82,288 over the same 20-year period!

I personally didn’t learn a great deal from this book, but then I’ve read thousands of pages on behavioral finance and trading psychology. For those who need help managing their investing selves but have no intention of ensconcing themselves in the library or laying out countless dollars, MarketPsych is a quick yet wide-ranging 240-page read.

Tuesday, October 5, 2010

Phillipson, Adam Smith

Back when I received the galleys of this book I wrote a post entitled “Who Was Adam Smith?” Now that Nicholas Phillipson’s Adam Smith: An Enlightened Life (Yale University Press, 2010) is being officially released today it’s time to revisit the book.

First, for those who care about such things, it’s a handsomely produced book—from the coated dust jacket to the color plates to the sewn binding. Second, and of course much more important, the work is skillfully crafted. Phillipson not only explores the interconnectedness of Smith’s moral, political, and economic ideas; he also demonstrates that the Scottish Enlightenment was far more than a backdrop for Smith’s work.

Adam Smith is a compelling, albeit difficult, subject for an intellectual biography. He viewed himself as a philosopher. He had wide-ranging interests: ethics, aesthetics, rhetoric, jurisprudence, history, politics, and economics. And yet, as one reviewer noted, we tend to disregard his “far greater and nobler … intellectual goals” and reduce him to “the hard-nosed high priest of self-interested capitalism.”

Admittedly, Adam Smith defended the Humean principle that “Till there be property there can be no government, the very end of which is to secure wealth, and to defend the rich from the poor.” (p. 174) But this principle is not as crass as it appears. Just as virtue is the goal of morality so opulence is the goal of political economy. In both cases Smith invoked the idea of improvement “which lay at the heart of the culture of enlightened Scotland….” He showed that “commerce and improvement were natural to human beings, a function of their natural indigence, their need for society and their love of the satisfactions improvement brings.” (p. 179)

Smith bemoaned the slow progress of opulence in Europe. “For Smith the root cause of the slow progress … was the feudal system. As he had shown in his lectures on jurisprudence, the feudal system had encouraged landowners to extend rather than improve their estates, reducing their tenantry to a state of dependency and even slavery—always in Smith’s reckoning the least productive form of labour. What is more, it was a system that had been artificially preserved by means of primogeniture and a system of tenures and entails which were as offensive to a people’s sense of natural justice as to the cause of economic efficiency.” (p. 223)

Colonial America, with its rapid progress, stood in stark contrast to Europe. In The Wealth of Nations he explained that “the root cause of the American colonies’ progress was simple enough: ‘plenty of good land, and liberty to manage their own affairs their own way.’ American land was cheap, and inheritance—in some colonies at least—was unencumbered by primogeniture, entails and high taxes. The colonists themselves appeared educated, frugal, tractable and hardworking. They were natural Smithian improvers who invested their stock in agriculture and simple manufactures and, because labour was relatively scarce, paid their labourers high wages, which encouraged them to set up on their own. Above all, they possessed a spirit of equality that encouraged a ‘republican’ attitude to government.” (p. 228)

I have teased but a single thread from Phillipson’s sympathetic yet balanced portrait of Adam Smith the man and the thinker. It’s an opulent biography.

Monday, October 4, 2010

Fullman, Increasing Alpha with Options

Scott H. Fullman’s Increasing Alpha with Options: Trading Strategies Using Technical Analysis and Market Indicators (Bloomberg Press, 2010) is not a book for option traders. Its intended audience is money managers who want to improve their equity returns and smooth out their P/L curve by adding options to their portfolios. The strategies are sufficiently elementary that I see no reason the individual investor couldn’t learn from Fullman’s book as well. That said, the investor or money manager who wants to implement any of the author’s strategies should have a solid understanding of option fundamentals, which this book was not designed to provide. A foundation in technical analysis would also be a plus.

Fullman concentrates on directional option strategies--calls and puts (and he’s not squeamish about being naked) and vertical spreads. He outlines a series of scenarios in which it could be advantageous to buy or sell options rather than stock, to replace stock with options, or to hedge a stock position or a portfolio with options.

Here are a couple of examples that use simple option strategies in not so simple ways. The first is a pairs trade that keys off of the relative strength of stocks within an ETF. Assume that you own XLB, the materials ETF, and that it is outperforming the S&P 500. Of the ETF’s 29 component stocks IFF, a former leader, is experiencing weakening relative performance and its momentum is turning lower. Consider the following two possible trades, both seven weeks to expiration. First, with IFF at $30.48 buy the 30/25 bear put spread on IFF. Second, write 30 strike IFF calls. A variation on this theme occurs when a sector “appreciates past the point at which its initial leaders begin to lose upward power, pushed by lagging stocks that often appreciate for longer than the leaders—though not necessarily for an extended time period.” (p. 97) In this case a fund manager could sell the XLB stock and buy a call on a laggard in the ETF.

One of Fullman’s favorite strategies is the covered combination in which “managers use a margin account to purchase between one-quarter and one-half of the manager’s normal position in the underlying shares, then write an equivalent number of out-of-the-money calls and out-of-the-money puts.” (p. 81) This strategy makes money if the stock goes up or remains unchanged. If the stock drops below the strike price of the put and the contract is assigned, “the manager buys the remaining one-half or one-quarter of the position, depending on the number of contracts sold, yielding a lower average purchase price than that offered by the stock’s original value.” (p. 82) Of course, some people would consider this an example of the often dangerous practice of doubling down.

Readers of books on investing and trading often complain that they are long on theory and short on practice. Fullman’s book offers specifics. It’s up to the manager to decide what kinds of strategies fit the risk profile of his fund and what he personally is comfortable with.

Friday, October 1, 2010

Robert Engle’s FT lectures on volatility, part 4: long run risk

When we are measuring volatility using the GARCH model we’re using high frequency data. This measures only short-term volatility—over the next few days, for instance. The options market, using implied volatility, estimates volatility over various time horizons.

The two-year volatility measured in red versus the one-month volatility measured in blue oscillate—sometimes short-term volatility is predicted to be higher than long-term volatility, sometimes lower.

The above graph shows the period between 2004 and 2005. Here the long-horizon volatility in red is much higher than short-horizon volatility. This disparity is even more pronounced if you look at longer-term options which are traded only OTC.

What is the implication of having long-run volatility so much higher than short-run volatility? For one thing, the sophisticated investor is not going to put money into the market under these conditions because the odds of losing money in a higher volatility environment are greater.