Happy New Year

A happy, healthy, prosperous 2013 to one and all.

Vanderkam, What the Most Successful People Do on the Weekend

Time management expert Laura Vanderkam has written such books as 168 Hours: You Have More Time Than You Think and What the Most Successful People Do Before Breakfast. Her latest offering is What the Most Successful People Do on the Weekend: A Short Guide to Making the Most of Your Days Off (Penguin, 2012). It’s a very quick read that might be helpful to some people who want to have a more fulfilling 2013.

The basic message is that at least part of every weekend should be planned. Otherwise what should be a leisurely weekend will most likely become either a slothful one or a marathon of exhausting chores. Moreover, the non-planner will miss the joy of anticipation. “When you plan enjoyable things ahead of time, you magnify the pleasure.”

Admittedly, Vanderkam’s examples of “awesome” weekends sound like excursions into hell to me. Take weekend #1, with events alternating between evening and day: friends over for game night, family beach trip, family dinner at a restaurant near the beach that you’ve been meaning to try, church, leisurely walk around the neighborhood. Weekend #2 starts with karaoke at a bar with friends, not much of an improvement as far as I’m concerned.

But even if I would be a miserable participant in Vanderkam’s “awesome” weekends (if you’ve read Susan Cain’s Quiet, you’d understand why), the basic idea of planning a few events makes sense. Moreover, after you’ve had your great Sunday evening event, “you still have one more thing to do to secure your weekend’s awesome status: carve out at least a few minutes to plan the week ahead. Schedule not just what you have to do, but what you want to do.”

Somehow I doubt that I’ve read what the most successful people do on the weekend. Can you imagine Jamie Dimon at a karaoke bar? But weekends are important and many of us let them dribble away. Personally, I devote much of my weekend time to reading and writing. If I had all those “awesome” (I hope you are beginning to understand how much I hate the hijacking of this adjective) weekends, you’d not have the pleasure of reading this blog.

Perry, The Art of Procrastination

Soon enough it will be time to make those yearly resolutions we never keep. I somehow doubt that this odd-sounding resolution will top most lists: “Become a structured procrastinator.” But John Perry, professor emeritus of philosophy at Stanford, explains in The Art of Procrastination (Workman, 2012) that structured procrastination will convert ordinary procrastinators into “effective human beings, respected and admired for all that they accomplish and the good use they make of time.” (p. 2) Still flawed, but productive.

Don’t think that Perry has strayed into snake-oil, self-help land, that he has written the kind of pretentious text that would make him a sought-after speaker at corporate retreats. No, this little book is an utterly delightful extended essay (the text is a mere 92 pages).

What is the secret to moving from being an ordinary procrastinator to being a productive procrastinator? Think of our priority lists, with tasks that seem the most urgent and important on top. The procrastinator will put these tasks off until some indefinite time in the future. “But there are also worthwhile tasks to perform lower down on the list. Doing these tasks becomes a way of not doing the things higher up on the list.” And by doing the less urgent, less important tasks, “the procrastinator becomes a useful citizen” who “can even acquire … a reputation for getting a lot done.” (p. 3)

Why do we procrastinate? One culprit is perfectionism. To do something “perfectly” takes a lot of time (presumably an infinite amount of time). When “the fantasies of perfection are replaced by the fantasies of utter failure,” it’s a lot easier just to “sit down and do an imperfect, but adequate, job.” (p. 18)

Perry not only endorses the common wisdom of breaking tasks down into small increments (the Kaizen way) but recommends practicing “defensive to-do list making.” That is, think about “how your day could get derailed in the early stages and put in safeguards to circumvent that.” Perry gives an example, and let me quote it at length because it’s not only humorous, it’s so me.

“Last night I saw When Harry Met Sally on TV. I knew there would be a good chance I’d want to start off this morning by googling ‘Meg Ryan,’ to see if there are some other movies of hers that I’d forgotten about and would like to see. Once I start googling, I seldom stop simply because I find what I was originally looking for: I see Meg was married to Dennis Quaid. Now which Quaid brother is that? I’ll check ‘Dennis Quaid’ on Wikipedia. Ah, the handsome one. I should have guessed. Look at that, his father was a cousin of Gene Autry! Haven’t thought about Gene Autry in a long time. Remember ‘Tumbling Tumbleweeds’? Great song. I wonder if I can get it on iTunes … And on and on. It’s best to short-circuit this whole waste of time by putting ‘Don’t google Meg Ryan’ on the to-do-list, along with other reminders not to be derailed.” (pp. 27-28)

The Art of Procrastination is a book that I laughed aloud over, admittedly often self-defensively. I am, at least in some ways, a structured procrastinator, though perhaps not the most productive one. I’m not sure I measure up to Perry’s standards (with a reference to Hayek, cum appropriate caveats): “You may often be wrong about what the best way to spend your time is. Wasting your time daydreaming about an impractical radio show may in the end prove more valuable than finishing whatever articles, reviews, and memoranda—all doomed to be largely unread—you could have been working on. The structured procrastinator may not be the world’s most effective human being, but by letting her ideas and energies wander spontaneously, she may accomplish all sorts of things that she would have missed out on by adhering to a more structured regimen.” (p. 83)

Now isn’t that uplifting! Yes, I think I will resolve to be a structured procrastinator in 2013. But, don’t fret, I’ll still write reviews in a timely fashion. There are always other less pleasant things ahead of reading and writing on my to-do lists.

Happy holidays

This is a photo of a window display in the Moravian Book Store, Bethlehem, PA. Let's hope the books don't topple if we go over the fiscal cliff.

Bulkowski, Trading Basics

Thomas N. Bulkowski is an inveterate tester. So even though this book is entitled Trading Basics, it is by no means a run-of-the-mill introduction. It analyzes money management, investigates whether stops really work, looks at support and resistance, and shares 45 tips every trader should know. It is the first of a three-book series, Evolution of a Trader, to be published by Wiley. The second volume will be Fundamental Analysis and Position Trading; the third, Swing and Day Trading.

Although I’m sure readers will dispute some of Bulkowski’s findings as well as some of the studies he cites, the fact is that he has actually crunched the numbers. He does not rely on anecdotal evidence. For example, he used a battery of tests to show that scaling out of positions bought at the start of the month and held until either the end of the month or when sold by scaling out or being stopped out (scaling out at two times a 21-day average of the high-low price change and moving the stop to breakeven after scaling out, with the stop trailed upward 10% below the highest high) reduces profits. I’ve conflated a series of Bulkowski tests here and in consequence made them only marginally intelligible, but the results stand. Although scaling out handily beats buy and hold by a margin of 10 to 1, it leaves money on the table if price is rising and incurs larger losses if price is dropping.

What about stops? Do they work? Bulkowski devotes a twenty-page chapter to this question and considers an assortment of stops. The answer, he concludes, is complicated. Traders “have to be selective in how they use stops” because “being stopped out means profits get whacked in half and yet the risk of loss does not diminish much.” (p. 61) That seemingly counterintuitive conclusion should inspire traders to study Bulkowski’s tests in order to figure out a way to improve their reward/risk ratio by using the right kinds of stops (and sometimes no hard stops at all) intelligently.

Although mantras are challenged throughout, Trading Basics is not a downbeat “what doesn’t work” book. On the contrary, Bulkowski offers a plethora of ideas for successful trading such as the inverted dead-cat bounce. As one might expect given the author’s previous works (one reviewed only last week), most of the ideas are pattern-based. If you’re a pattern trader, you’ll be in your element. But even if you’re not, this book has a host of challenging theses that just might lead you to rethink how to make money trading and perhaps even to devise a few tests of your own.

Murphy, Trading with Intermarket Analysis

Way back when, John J. Murphy was the voice of technical analysis. With his pioneering 1991 book, Intermarket Technical Analysis, he added a new dimension to his earlier work. Fast forward. We have new trading products available (ETFs, not merely futures), a new economic environment, and relatively inexpensive color printing. Hence Trading with Intermarket Analysis: A Visual Approach to Beating the Financial Markets Using Exchange-Traded Funds (Wiley, 2013).

The book is awash with color: color charts, of course; color heads for “John’s Tips”; color definitions; color “Did You Know?” tidbits. The text’s typeface is elegant but designed for those with perfect vision; it’s about a point size too small for easy reading. Admittedly, with so many charts it would have been tough to keep text and charts in sync if the type size were larger.

Taking a quasi-historical approach to the subject, Murphy divides the book into four parts: the old normal, the 2000 and 2007 tops, the business cycle and ETFs, and the new normal. At every turn he illustrates intermarket relationships with comparative StockCharts, many with their correlation coefficient indicator added.

The basic relationships are: (1) the dollar and commodities trend in opposite directions, (2) bond prices and commodities trend in opposite directions, (3) since 1998 bond and stock prices have trended inversely, and (4) since 2008 stocks and commodities have been more closely correlated. How do they interact? “Bonds usually change direction before stocks. Stocks usually change direction before commodities. Bond yields peak first, stocks second, and commodities last. Those rotations are more reliable at tops than at bottoms.” Globally, stocks are closely correlated and “emerging markets are closely tied to commodity trends.” (p. 216)

Naturally, as Murphy points out, the markets are not static; relationships ebb and flow. For instance, even though stocks usually change direction before commodities, in 2011 commodities led stocks lower. (p. 153) Or consider the performance of gold bullion versus the gold miners stocks. “During the 10 years starting in 2002, gold and gold miners gained 484 percent and 429 percent, respectively, versus a 12 percent gain for the S&P 500 during the same decade. As is usually the case, gold miners did better than bullion in the first few years of that decade. … The relationship changed, however, in a big way during 2008. A plunge in the miners/bullion ratio occurred during that year, when mining stocks fell nearly 30 percent while bullion held relatively flat. The ratio shows that miners have generally matched the performance of bullion since then. They did a little better than the commodity during 2009, but underperformed during 2011.” (pp. 156-57) Murphy offers some possible explanations for the 2008 move and draws some lessons from the miners/bullion ratio over this period, among them: “An uptrend in gold is stronger if gold miners are moving in the same direction.” (p. 158)

Trying to use intermarket relationships to drive profitable trading is a very tricky undertaking, but Murphy’s book is an excellent place to start.

Bulkowski, Visual Guide to Chart Patterns

In general, the Bloomberg visual guides are a conceptual stretch, but Thomas N. Bulkowski’s Visual Guide to Chart Patterns (Wiley/Bloomberg, 2013) is an obvious exception. Charts are by definition visual.

Bulkowski’s books on chart patterns and their statistical characteristics are classics. So why yet another book? First, the Bloomberg visual guides are in color. Second, Bulkowski has updated his statistics through 2011, so we can see how trading off of chart patterns might have performed over a more extended period of time.

Bulkowski deals with the standard fare of charting: minor highs and lows, trendlines, support and resistance, gaps, throwbacks and pullbacks, pattern identification, rectangles, ascending triangles, descending triangles, symmetrical triangles, flags and pennants, double bottoms, triple bottoms, double tops, triple tops, head-and-shoulders bottoms, head-and-shoulders tops, basic buy setups, failures, the throwback buy setup, measuring flags and pennants, busted pattern buy setups, trading setups and tips, chart pattern sell signals, busted pattern sell signals, triangle apex sell signal, trendline sell signals, swing rule, and—finally—a tale of two trades.

But Bulkowski writes in a light-hearted, often humorous way that should prevent even the least engaged reader’s eyes from glazing over. The book also includes exercises and tests to keep the reader on track.

If you’re an accomplished chartist, you don’t need this book (unless a little levity would cheer you up). But if you’re new or relatively new to the game, it’s a perfect introduction.

Chan, The Prop Trader’s Chronicles

Francis James Chan’s The Prop Trader’s Chronicles: Short-Term Proprietary Trading Strategies for Both Bull and Bear Markets (Wiley, 2013) is a strange little book. It is in part a memoir that, quite frankly, isn’t very interesting and that often is not even tangential to trading. Do we really care about the dinner table fights of his ex-fiancée’s family?

Fortunately, in larger part it is an account of Chan’s experiences as a novice day trader with what was then a Toronto-based prop firm, Swift Trade Securities. There he learned to throw away charts and abandon technical analysis. Swift taught and practiced the art of reading the tape and depth of market. The firm also stressed how to route trades to capture the most advantageous fee structure. Since Swift’s forte was high-volume scalping of NYSE stocks for pennies, risk management was critical. Trainees were expected to limit their losses to around two cents a share—at least on a stock like GE (then about $40), which Chan was trading.

Although Chan describes some of the basics of Swift’s program and tries to illustrate the trading process, I suspect that it is the rare reader who would come away with a viable way to emulate a non-automated, high-frequency, high-volume stock scalping game plan. Especially if the reader is a lone wolf, not part of a prop firm.

There are, however, two more general points that Chan makes that I think are worth repeating. The first is the distinction between hard and soft edges. A hard edge “is typically transient but allows traders who are equipped to exploit it to do so with minimal skill, discipline, or experience.” With soft edges “skill, discipline, and experience is a much more significant deciding factor in one’s net profitability.” (p. 75) A generation of traders at Swift exploited a weakness in dark pool algorithms. “The strategy could be summed up with its main premise: to seek out large orders resting in the dark pool systems and to play the market against the large institutions that entered those orders.” (p. 73) These traders had a hard edge. Hard edges “would actually not be illegal but are often on the very edge of the cliff of compliance. In other words, they might be outlawed or circumvented within a few years.” (p. 80)

The core strategies of most traders rely on soft edges. “Since the real mathematical advantage behind such an edge is rarely more than 1 to 5 percent above a raw 50-50 bet, a very large dose of discipline, consistency, and skill should be developed to properly exploit these soft edges.” (p. 80)

Chan believes in exploiting transient soft edges. These edges may not be statistically robust over years of data, but “money is money.” “As long as such a strategy is not overemphasized in your mind to the point where you consider it your staple trading strategy, there’s really nothing wrong with collecting short term paychecks for something that may not last much longer than a few months.” (p. 81)

Chan offers a few building blocks of trading strategies, among them layered position sizing. He writes: “Depending on the nature of your strategy, the idea of a single entry and a single exit can either be slightly inefficient or outright idiotic.” For scalpers, “splitting up your entries and exits into smaller orders makes a lot of sense simply because it’s unlikely that the stock will stand in place for long and there’s a lot more room to take extra profits by scaling in and out rather than making a flat single-entry single-exit bet.” (pp. 135-36)

For those who are thinking about hooking up with a prop shop or who are interested in tape reading, The Prop Trader’s Chronicles should probably be a core library holding. For other traders it’s a peripheral book but nonetheless worthy of a couple of hours of reading time.

Black et al., Advanced Core Topics in Alternative Investments, 2d ed.

The Chartered Alternative Investment Analyst (CAIA) Association offers a two-tiered exam process (Levels I and II) through which a candidate can earn the CAIA Charter. The Charter is designed for individuals specializing in institutional quality alternative investments. Earlier I reviewed the Level I text. It’s now time to look at CAIA Level II: Advanced Core Topics in Alternative Investments, 2d ed., edited by Keith H. Black, Donald R. Chambers, and Hossein Kazemi (Wiley, 2012).

This book is yet another educational triumph and a worthwhile read not only for those in search of certification but for every investor who wants to expand his horizons and be intellectually challenged in the process. It’s divided into five parts: asset allocation and portfolio management, private equity, real assets, commodities, and hedge funds and managed futures.

I spent some time deciding what to choose to write about in this post. It was a tough decision. After all, the book is some 700 pages long and covers a host of important topics. I debated whether to focus on farmland and timber investments—or perhaps investing in intellectual property. Then I thought I’d write about convertible arbitrage, a strategy that represents less than 3% of the assets managed by hedge funds and that is not available to the retail investor but nonetheless remains a strategy that options traders should understand. That choice, however, was fatally flawed because there was no way I could condense the chapter into a reasonable blog length.

Then there were the geekier topics, such as unsmoothing appraisal-based real estate returns, which I’d be hard pressed to write about with any degree of confidence. I hope you’re beginning to see the richness of this book, and my dilemma.

So here are just a couple of snippets, chosen almost at random. First, art as an investment asset. Odds are that this is out of your league (at least really high-end art), but don’t feel depressed. You’re not missing out on high returns, and you may be avoiding high volatility. In the U.S. the return for high-quality art between 1980 and 2007 was 4.85%, the volatility 20.95%; for medium-quality art 3.78% and 14.49%; and for low-quality art 3.25% and 11.13%. So unless you’re trying to impress your friends, you’re a true aesthete, or you’re a Russian oligarch trying to stash some of your wealth abroad, there’s no compelling reason to invest in art.

Second, an example of how securities can become drastically mispriced—and here I’m dipping my toe into the chapter on convertibles. In 2008 the Dow Jones Credit Suisse Core Convertible Arbitrage Fund fell by over 30%. “Convertible arbitrage hedge funds were required to liquidate assets both to meet redemptions and to reduce leverage as the price of convertible bonds declined. The liquidation included the sale of convertible bonds, the sale of put option hedges, and the covering of equity short sales. This massive selling pressure … drove bond prices even lower, which necessitated further selling, as the asset value was declining as the prime brokerage loan balances remained stable, which was increasing the leverage multiple. Finally, prime brokers reduced the amount of leverage available. If a prime broker reduced the maximum leverage from 10 times to 5 times assets, a fund manager would be required to sell half of the fund’s positions in a matter of hours or days. … The mispricing of convertible bonds became so extreme that the convertible bonds of some firms were priced at below the option-free debt of the same firm, essentially offering the valuable stock option for a negative price.” (p. 518)

CAIA Level II is an excellent text and reference work for anyone interested in alternative investments either in and of themselves or as part of a diversified portfolio. And, of course, it’s essential for those aspiring for certification.

Nations, Options Math for Traders

Scott Nations, probably best known as a contributor to CNBC, is a trader and a financial engineer. Both of these skills are evident in Options Math for Traders: How to Pick the Best Option Strategies for Your Market Outlook (Wiley, 2012). I should say up front, however, that this book is not for the reader in search of lots of formulas. Even the appendix has formulas for only such basic concepts as standard deviation, realized volatility, linear interpolation, and annualizing yield. The text itself has but a single formula—the Black-Scholes pricing model. In brief, it is a book for “the rest of us.”

The primary themes of the book are volatility, skew, time decay, and the bid/ask spread. The strategies analyzed are covered calls and their synthetic equivalent selling puts, calendar spreads, risk reversal, and vertical spreads.

In this post I’m going to focus on a single chapter—vertical spreads—to illustrate how Nations brings the threads of his book together. I’m offering mere snippets out of context. If the excerpts I quote are not intelligible, it’s not the author’s fault (Nations is a clear writer) but the result of my overly aggressive scissors.

Nations uses vertical spreads to get bearish exposure to the underlying. Why bearish? Because skew works against bullish vertical spreads. As examples, he takes a 180/200 put debit spread and a 210/230 call credit spread. “In both the put spread bought and the call spread sold, skew generated a net benefit. There would certainly be other phenomena that would be helping or hurting these trades. The volatility risk premium would be helping the call spread since our trader would likely be selling the 210 strike call for more than it was worth, and that benefit would probably overwhelm the damage that the volatility risk premium would do to the profitability of the 230 strike call option bought. Time decay would also likely help the profitability of the call spread, since the daily erosion received from the call our trader is short (the 210 strike call) is going to be greater than the daily erosion paid on the option our trader is long (the 230 strike call).” (p. 219) By contrast, the profitability of the put spread will likely be hurt by the volatility risk premium and time decay.

How does one determine whether a vertical spread is expensive or cheap? A reasonable way to go about this is to compare the cost of the spread to the width of the spread, taking into consideration how close it is to being at-the-money. If, for instance, a put spread costs $3.30 and the spread is $20 wide, the spread would cost 16.5% of the width of the spread. This ratio is “pretty inexpensive given that one strike is so close to at-the-money.” (p. 226)

And how good a hedge is one leg of the spread for the other? “As vertical spreads get wider each option is a less effective hedge for the other option…. As a vertical spread gets wider, the option that is closer to at-the-money starts to act more like an outright option rather than as part of a spread.” (p. 229)

A last take-away: “Skew tends to generate a much smaller benefit for short call spreads than for long put spreads; the difference in implied volatility is lower for call spreads. … The result of selling the strike price that is in the ‘trough’ of the skew curve is that every possible call spread using that strike as the short strike is worse off because of skew.” (p. 232)

If these excerpts whet your appetite, I can heartily recommend Options Math for Traders. No, it doesn’t cover straddles and strangles and wing spreads. But once you understand calls and puts and vertical spreads, you’re a long way toward grasping these other strategies. Moreover, Nations does a very good job with calendars, which I personally consider one of the toughest option spreads to trade well. It’s an “in the trenches” book and as such could be of great help to the intermediate options trader.