Wednesday, October 31, 2012

Passarelli, Trading Option Greeks, 2d ed.

If you want to trade options, you have to know the greeks. You may not use them as primary inputs in your everyday trading, but if you don’t have a handle on them there will come a time that you’ll suffer mightily. In this second edition of Trading Option Greeks: How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg/Wiley, 2012) Dan Passarelli offers what one might describe, co-opting (and abusing) option language, as a preemptive strike.

He first explains the basics of the greeks and how they interact, then moves on to spreads (vertical, wing, and calendar and diagonal), volatility (especially in the context of delta-neutral trading), and advanced option trading (straddles and strangles, ratio spreads and complex spreads).

For retail traders, at least for those without large portfolios, the first two parts of the book (the basics and spreads) will probably be the most valuable, although the third and fourth parts are must reads for everyone.

Passarelli does an excellent job of explaining the greeks, complete with tables and graphs. Take gamma, for instance. What does a 7-day call gamma graph look like as opposed to a 92-day call gamma? “As expiration draws nearer, the gamma decreases for ITMs and OTMs and increases for the ATM strikes.” And what happens if we raise the volatility assumption? It “flattens the curve, causing ITM and OTM to have higher gamma while lowering the gamma for ATMs.” In brief, “Short-term ATM options with low volatility have the highest gamma. Lower gamma is found in ATMs when volatility is higher and it is lower for ITMs and OTMs and in longer-dated options.” (p. 37)

Or how do the greeks come into play with the single-legged trades—buying or selling calls or puts? Here Passarelli illustrates the impact of the greeks with multiple trade examples. Some of his fictional traders are faced with specific problems such as how far the stock price can advance before the calls are at 1.10. Or what is the likelihood of an option’s gaining value from delta against the risk of theta erosion if one holds the trade for 35 days?

After two chapters on put-call parity and synthetics and dividends and option pricing, Passarelli turns to spreads. He describes credit and debit spread similarities, explains why strike selection is essential for a successful condor, and maintains that calendar-family spreads, which are “veritable volatility spreads, … allow traders to take their trading to a higher level of sophistication.” (p. 233)

The rank novice will probably find this book overwhelming. But anyone with even a couple of months of exposure to options will find it enlightening. Every option trader who doesn’t have the greeks down cold would do themselves a favor by reading Passarelli’s book.

Monday, October 29, 2012

Commodity Trader’s Almanac 2013

Commodities are clearly seasonal. Almost like clockwork there are corn harvests, winter heating demands, and holiday gold buying. Not every year is the same, of course. A drought can ravage the corn crop as it did this year, winters can be unseasonably warm or cold, and the general state of the economy can affect how much gold jewelry ends up under the Christmas tree.

Now in its seventh edition, the Commodity Trader’s Almanac (Wiley, 2012), compiled by Jeffrey A. Hirsch and John L. Person, is designed “for active traders of futures, forex, stocks, options, and ETFs.” It follows the general format of its older sister, the Stock Trader’s Almanac, with the first section devoted to the almanac proper and the second to trade strategies and detailed data on the twenty markets covered. These markets are the S&P 500, 30-year Treasury bonds, crude oil, natural gas, heating oil (a newcomer this year), copper, gold, silver, corn, soybeans, CBOT wheat, cocoa, coffee, sugar, live cattle, lean hogs, British pound, euro, Swiss franc, and Japanese yen.

On a two-page table the authors describe the seasonal trades that are the backbone of the almanac. They are the top percentage plays over the life of the traded commodity. For instance, short heating oil on the second trading day of January and hold for 30 trading days. This trade has a success rate of 69.7%, with 23 gains and 10 losses, and a total gain of $34,184, with a best gain of $17,686 and a worst loss of $11,155.

For traders who don’t have the stomach (or the wallet) for trading commodity futures, either individually or as spreads, the almanac introduces them to weekly and binary options. Another, more familiar alternative is to trade ETFs or ETNs, or even related stocks. The trader who couldn’t absorb a loss of over $11,000 on a heating oil futures contract could opt for RJN, the ELEMENTS Rogers International Commodity Energy ETN. “Despite the fact that RJN is composed of a basket of six different energy futures (47.7% crude oil, 31.8% Brent crude oil, 6.8% natural gas, 6.8% RBOB gasoline, 4.1% heating oil, and 2.7% gas oil), it is extremely closely correlated to the price trend of heating oil.” (p. 92)

If you’re looking for a desk calendar with a lot more meat to it than, say, The New Yorker’s cartoon-laden desk diary, the Commodity Trader’s Almanac would be an ideal choice. It is chock full of data and might even make you some money.

Friday, October 26, 2012

Rowland and Lawson, The Permanent Portfolio

Talk about simple. Investing doesn’t get much simpler than The Permanent Portfolio: Harry Browne’s Long-Term Investment Strategy (Wiley, 2012). Craig Rowland and J. M. Lawson explain how to implement the 25%-25%-25%-25% (stocks, bonds, cash, gold) asset allocation strategy that Harry Browne recommended in his 1987 book Why the Best Laid Investment Plans Usually Go Wrong.

Browne assumed that financial markets are uncertain, which to him meant that no can predict what the market is going to do next and, as a corollary, that no one can time the market. He also admonished investors not to depend on any one investment, institution, or person for their financial safety. He even urged investors to keep some of their assets outside the country in which they live as protection against natural or manmade disasters and “against a government that may try to solve its financial problems by confiscating citizens’ private property.” (p. 11)

The Permanent Portfolio is a steady Eddie performer. Starting in 1972 after the gold standard ended and then looking at annualized real returns by decade (ending in 2009), the Permanent Portfolio returned +5.7%, +4.7%, +4.3%, and +4.2% with less volatility than competing portfolios. A 75/25 portfolio returned -2.3%, +10.5%, +12.4%, and -1.2%; a 50/50 portfolio -2.1%, +9.1%, +9.8%, and +0.6%; and a 25/75 portfolio -2.0%, +7.6%, +7.2%, and +2.2%.

Although there is a Permanent Portfolio mutual fund (with a different allocation: 20% gold, 5% silver, 10% short-term Swiss government debt, 15% real estate and natural resource stocks, 15% aggressive growth stocks, and 35% U.S. Treasury bills and bonds) and a new Permanent ETF, the authors suggest that investors, unless they want convenience, can get better diversification geographically and institutionally on their own.

It is somewhat amazing that the authors can fill over 300 pages writing about Browne’s 25-25-25-25 asset allocation strategy, but they manage—and in a way that investors searching for a way to grow their wealth can learn from. For instance, Rowland and Lawson explain rebalancing bands, tax considerations, and buying and storing gold (yes, they suggest holding at least some physical gold and storing part of it locally for emergencies and the rest abroad if you are able).

Browne’s strategy won’t appeal to those who are convinced they can outsmart the markets. It may not even be the best passive asset allocation plan. But it’s certainly better than investing on a wing and a prayer.

Wednesday, October 24, 2012

Little, Trend Trading Set-Ups

If you’ve read L. A. Little’s previous book, Trend Qualification and Trading, which I reviewed last year, you can skim through the first part of Trend Trading Set-Ups: Entering and Exiting Trends for Maximum Profit (Wiley, 2012). Essentially, Little introduces what he calls neoclassical technical analysis based solely on price, volume, and time. No squiggly lines, no patterns. Neoclassical technical analysis relies on the distinction between qualified and suspect trends for trade direction, anchor bars and zones for timing, and a trading cube that “offers a visual of the qualified trends across the differing time frames for a stock, its sector, and the general market it is part of as well as the inherent relationships between these three related components.” (p. 56)

In the second part of the book Little moves on to the task of formulating a trading plan and finding the highest probability trade set-ups.

Part and parcel of any trading plan is determining position size. But since in trading nothing is black and white, when trying to figure out trade size it can be misleading (and dangerous to the bottom line) to plug some numbers into a ready-made model and then confidently go full steam ahead. “Knowing when the probabilities for success are significantly greater than failure affords the market participant the luxury of making comparatively outsized trades in such situations. Money is made in the markets in bundles most of the time. It does not just arrive day in and day out. In fact, it usually leaks out rather than leaks in. Being able to make a larger bet when the probability for success is greater while at the same time the reward-to-risk of the trade is quite favorable is the Holy Grail of trading.” (p. 100)

So how does a trader identify high probability set-ups? First of all, there are only two basic trade types—breakouts and retraces. But there are seven possible and related scenarios for these set-ups, which I can’t possibly describe in a brief review. These scenarios are “tightly coupled” around the concept of retest and regenerate. “The term retest and regenerate was first coined to describe the common and repetitive situation where a swing point is broken and a suspect trend created (volume does not expand on the break). In the ebb and flow that accompanies most markets and stocks, it is overwhelmingly probable that when a stock breaks out under such conditions it will, after some period of time, retrace back to the area where it broke out to retest.” (p. 115) It is turns out that this is true not only of suspect trends but of confirmed trends as well.

The author has done extensive work to assign probabilities of failure to each of these scenarios. For example, the probability that a confirmed bullish trend will fail when a retest and regenerate sequence occurs within six bars of the breakout is 19.86%. For a suspect bullish trend, the probability is 11.35%.

Little provides trade entry decision ledgers for a range of scenarios. They are essentially checklists where, if a certain number of items is true, it is then appropriate to check the potential reward versus risk to make a final trading decision.

Trend Trading Set-Ups is a clear testament to the principle that trading is simple (although not too simple) but not easy. I don’t know what a good trader’s track record would be following Little’s method. I can say, however, that it’s a thoughtful, plausible approach to trading. And I don’t say that too often.

Monday, October 22, 2012

Stock Trader’s Almanac 2013

The election season is nearing its end and the candidates are making their last ditch efforts to sway voters. Which means, among other things, that it’s time for another look at how the presidential cycle influences stock prices. The Stock Trader’s Almanac (Wiley, 2013), edited by Jeffrey A. Hirsch and Yale Hirsch and now in its 46th annual edition, is the premiere source of this information.

A spiral-bound hardcover, the almanac includes a calendar section, a directory of trading patterns and databank, and a strategy planning and record section. The calendar section has on facing pages historical data on market performance (verso) and a week’s worth of calendar entries (recto). January’s verso pages, for example, give the month’s vital statistics, January’s first five days as an early warning system, the January barometer (which has had only seven significant errors in 62 years), and the January barometer in graphic form. Each trading day’s entry on the recto pages includes the probability, based on a 21-year lookback period, that the Dow, S&P, and Nasdaq will rise. Particularly favorable days (based on the performance of the S&P) are flagged with a bull icon; particularly unfavorable trading days get a bear icon. A witch icon appears on options expiration days. At the bottom of each entry is an apt quotation. There’s about a five-square-inch space in which to write.

So what, based on history, do we have to look forward to post-election? For starters, the post-election year is the worst performing year of the four-year presidential cycle. The average annual gain in the DJIA for the four-year cycle beginning in 1833 was: post-election year 2.0%, mid-term year 4.2%, pre-election year 10.4%, and election year 5.8%. The total percentage gains were 86.1%, 187.0%, 469.5%, and 254.5%. Of the 21 post-presidential election years since 1929, the Dow closed up 11 times: 1933, 1945, 1949, 1961, 1965, 1985, 1989, 1993, 1997, 2005, and 2009. Jeffrey Hirsch doubts that 2013 will be number 12. “After the yearend rally and positive 2012, we are concerned that the next major bear market will occur in the 2013-2014 period.”

So far this year Hirsch’s favorite defensive play has been HDGE (AdvisorShares Active Bear ETF), managed by John Del Vecchio and Brad Lamensdorf. Del Vecchio is also the co-author of the almanac’s choice for best investment book of the year: What’s Behind the Numbers? (With any luck I should be getting my review copy of this book soon.)

Traders and active investors who thrive on historical data will once again have a heyday with this almanac. Take, for instance, the notion of the super-8 days. “The market currently exhibits greater bullish bias from the last three trading days of the previous month through the first two days of the current month, and now shows significant bullishness during the middle three trading days, 9 to 11, due to 401(k) cash inflows.” (p. 88) In 2011 the super-8 day returns totaled 13.93%, the rest of the month (13 days) saw a total loss of 5.68%.

The promotional blurb describes the Stock Trader’s Almanac as “the ultimate desktop market data bank.” I never consider anything ultimate, but this almanac comes pretty darned close. And that’s praise from someone who tends not to pay very much attention to seasonals.

Saturday, October 20, 2012

Addicted to reading?

For those who follow this blog because they like to read, here's an enjoyable piece from the WSJ: My 6,128 Favorite Books by Joe Queenan.

Friday, October 19, 2012

Travers, Hedge Fund Analysis

Investors who are thinking about handing over a portion of their assets to a hedge fund manager are often at a loss about where to turn. Some of the legendary funds have either closed or are not accepting new outside money. A lot of funds are underperforming duds. A few are frauds. New funds that often outperform are unknown quantities. What is an individual investor (admittedly, one with a fair amount of time on his hands) or a professional responsible for allocating institutional money to do? For starters, he can read Frank J. Travers’s Hedge Fund Analysis: An In-Depth Guide to Evaluating Return Potential and Assessing Risks (Wiley, 2012) and learn how to become his own due diligence analyst.

The first step is to troll through hedge fund databases, some available at no cost, screening for potential candidates. Let’s say you want an equity long/short fund in the U.S. with a minimum three-year track record, annualized return in the top quartile of its peers, minimum assets under management of $250 million, and reasonable liquidity terms. You can narrow the field substantially with just these parameters. Making some qualitative judgments here and there, let’s assume that you manage to whittle the funds down to just five for further review. Your real work is about to begin as you evaluate which fund is the best fit with your total portfolio of investments.

Travers chooses one of these funds, which he dubs Fictional Capital Management, as his case study. He analyzes it from start to finish, including mock interviews with key investment personnel and an operational review. The analysis is exhaustive.

In fact, the book is so detailed that I’m sure even the least astute analyst could successfully use it as a complete cheat sheet (or, the less tainted word, template) in performing his own due diligence. Travers has performed a real service for anyone who is trying to find the right hedge fund to add to his portfolio.

Wednesday, October 17, 2012

Nahin, The Logician and the Engineer

Back when I took high school physics, a course taught by a thoroughly uninspired and uninspiring man whose name I have mercifully forgotten, a group of guys (who I suspect went on to become TV repairmen) and I had a pact. I would do their math homework and they would do my “hands-on” projects, especially those involving electrical circuitry. Left to my own devices I would undoubtedly have sent sparks flying in all directions.

Fast forward. Here I am with Paul J. Nahin’s book The Logician and the Engineer: How George Boole and Claude Shannon Created the Information Age (Princeton University Press, 2012). The author promises that no knowledge of electronics is required, just an understanding of polarity, Ohm’s law for resistors, and the circuit laws of Kirchhoff. “No more than a technically minded college-prep high school junior or senior would have.” Well, that stirred up a lot of bad memories.

So, rather than pretend that I relish looking at wiring diagrams I decided on a different tack. Motivated by a book I recently finished but cannot review for a while (Mastery), I thought it might be worthwhile to look at how Boole and Shannon, men from different centuries and very different backgrounds, came to be such remarkable thinkers.

In today’s post I’m not drawing any conclusions, just presenting short biographies.

George Boole was born in Lincoln, England, in 1815. His father was a cobbler who “seems to have been able to do anything well except his own business of managing the shop.” His real interests lay in mathematics and the construction of optical instruments, interests that he shared with George.

Boole’s formal education was scanty—after primary school a brief stint at a commercial school. He taught himself languages in preparation for becoming a clergyman. But fortunately for the world he soon enough found his true calling. At the age of sixteen he became an assistant teacher of Latin and mathematics at a small boarding school, a job he lost after two years. Among his many sins, he did math problems in chapel. In the evenings, “after a day of being a bad teacher to dull boys,” he plowed through a book on differential calculus which prepared him to read the classics of Lagrange, Laplace, Newton, and Poisson. “As Boole later explained to a friend, he managed it all by sheer force of will, just reading and re-reading, over and over, until he understood.” (p. 20)

Boole continued to teach at various day and boarding schools, all the while writing math papers, inspired perhaps by the establishment of a new math journal, the Cambridge Mathematical Journal. The editor of the journal, Duncan F. Gregory, gave Boole “almost incredibly generous aid,” without which “it is not unreasonable to imagine that Boole’s spirit would have been crushed right at the start.” Gregory published Boole’s early papers and then, when one was too elaborate for the Journal, recommended that Boole submit it to the Transactions of the Royal Society of London. This paper earned Boole a Royal Medal as the best mathematics paper published in the Transactions in the previous three years.

At the age of 34, with no university degree, Boole was appointed professor of mathematics at Queen’s College (today’s University College), Cork, Ireland, where he spent the rest of his short life. He continued to publish and moved “from one honor and achievement to the next.” (p. 27) He died, presumably from pneumonia, shy of his fiftieth birthday.

Claude Shannon was born in Michigan in 1916. His father was a business man and probate judge; his mother, a language teacher and high school principal. Early on Shannon displayed an interest in how things work; when he was in high school he earned pocket money by fixing radios at a local department store. He graduated from the University of Michigan with degrees in mathematics and electrical engineering and then, as a graduate student, got a job as a research assistant in MIT’s Department of Electrical Engineering to work part-time on Vannevar Bush’s differential analyzer, the world’s most advanced analog computer.

In Bush Shannon found “an early mentor” (and champion) “every bit as important to him as Gregory had been to Boole.” (p. 29) Shannon’s job involved understanding and maintaining the analyzer’s controller, a complex circuit of over 100 relays. It wasn’t long before Shannon had his epiphany of marrying Boolean algebra with electrical switching circuits. He described his work in his MIT master’s thesis, labeled by many “the most important master’s thesis ever written.”

After a foray into genetics (and eugenics) for his Ph.D., Shannon eventually ended up at Bell Labs for “an astonishingly creative fifteen years,” doing some work early on in cryptography, and in 1948 publishing “the Magna Carta of the information age,” his “Mathematical Theory of Communication.”

Shannon was strange man. Not only did he ride a unicycle through the corridors of Bell Labs while juggling balls, but he created all manner of toylike gadgetry. Some of the gadgets were scientifically intriguing, others pointless. Perhaps the weirdest was Shannon’s “Ultimate Machine.” Arthur C. Clarke described it thus: “It sits on Claude Shannon’s desk driving people mad. Nothing could look simpler. It is merely a small wooden casket the size and shape of a cigar box, with a single switch on one face. When you throw the switch, there is an angry, purposeful buzzing. The lid slowly rises, and from beneath it emerges a hand. The hand reaches down, turns the switch off, and retreats into the box. With the finality of a closing coffin, the lid snaps shut, the buzzing ceases, and peace reigns once more. The psychological effect, if you do not know what to expect, is devastating. There is something unspeakably sinister about a machine that does nothing—absolutely nothing—except switch itself off.” (pp. 35-36)

In 1958 Shannon left Bell Labs to go back to MIT. There he became interested in portfolio theory and, as William Poundstone described in Fortune’s Formula, became wealthy by applying his ideas to his personal finances.

Unfortunately Shannon was eventually afflicted with Alzheimer’s disease and spent the last seven years of his life in a nursing home.

Monday, October 15, 2012

Wachtel, The Sensible Guide to Forex

HSBC recently released a report announcing a new era for FX where, as a result of central bank intervention and low interest rates, currency trading has become much more volatile and harder for investors to interpret. “The demise of carry has brought ‘onion skin’ layers of uncertainty into the FX market, tears and all.”

Enter Cliff Wachtel’s The Sensible Guide to Forex: Safer, Smarter Ways to Survive and Prosper from the Start (Wiley, 2012). It is a beginner’s book, written for those who never participated in the glory days of carry when “the FX market had the luxury of a clear framework for understanding and trading currencies, “ a time when, if you got your interest rate calls right, you were basically home free.

Wachtel offers a different kind of framework, one centered on trader psychology and what the author calls RAMM (risk and money management). He complements these key elements with technical analysis and a smattering of fundamental analysis. Although this framework is certainly not unique to forex, Wachtel explains at length how it can help an investor identify, execute, and manage simple, low-risk, high-yield, longer-term FX trades.

The first half of the book deals with the basics; the second half with trade examples, momentum and timing indicators, intermarket analysis, and “newer, smarter” methods. If you’re one of those impatient souls who peeks at the last pages of a mystery before you’re even familiar with the characters, I’m sure you’ll want to know up front what the newer, smarter methods are. I’ll accommodate, but only with a single sentence. “For those seeking simpler ways to tap the potentially faster profits from short- to medium-term (ranging from minutes to weeks) trading of forex, with more controlled risk, we introduce two new and very useful instruments: forex social trading [and] forex binary options.” (p. 295)

Wachtel breaks little new ground in this book, but he offers a solid, far-reaching course in trading. Beginners will learn a great deal (even though, if they have little experience in the markets, they will have to stretch to grasp everything). For those who have yet to trade profitably the book may serve as a useful refresher course. Even investors who think that “trading” is a four-letter word will discover how to use currencies to diversify their portfolios and to ride long-term forex trends for lower risk, higher income.

Saturday, October 13, 2012

Let’s expand our horizons

A host of publishers have banded together to lend digital galleys of forthcoming books to qualified reviewers. I have already taken advantage of this service to bring you reviews of the following titles: Who Stole the American Dream?, The Power of Habit, Makers, and Practice Perfect. Among the coming attractions are The Logician and the Engineer (How George Boole and Claude Shannon Created the Information Age), Mastery, and The Secret Financial Life of Food. I don’t review a book before its official publication date, so not all of the coming attractions are imminent.

This venture is a win-win for both publishers and readers. Since publishers don’t have to ship hard copies, they are more generous with their new releases. It gives them greater exposure for presumably much less money. And it means I can review books I think would (or should) be interesting to traders and investors even though few have financial keywords in their titles.

Naturally, it’s more work for me since I will also keep up my reviews of financial titles, but I like expanding my horizons and I trust you do as well. I promise no Harlequin romances.

Friday, October 12, 2012

Singer, Trade the Congressional Effect

Congress, Eric T. Singer argues, is bad for your portfolio’s health. And he’s not referring to just the current dysfunctional Congress. “[C]ongressional dysfunction is the norm and … is likely to be permanent.” (p. 58)

In an article he wrote for Barron’s in 1992 Singer introduced the notion of the Congressional effect—that equities earn less when Congress is in session than when it is not. Trade the Congressional Effect: How to Profit from Congress’s Impact on the Stock Market (Wiley, 2012) updates and elaborates on this notion. For starters, and most compellingly, “from 1965 through 2011, measuring each of the 11,832 trading days during that period, the price of the Standard & Poor’s (S&P) 500 Index rose at an annualized rate of less than 1 percent on days Congress was in session, but over 16 percent on days they were out of session.” (p. 13) Moreover, “the Congressional Effect is growing as government grows and investors become more wary about its impact on the market.” (p. 39)

Singer, who is on the right on the political spectrum, subscribes to Thomas Paine’s advice that “that government is best that governs least.” As a result, he sometimes ascribes to Congress more damaging power than it probably has. For instance, he argues that “the proximate cause of the Crash of 1987 was the inexplicably casual trial balloon of eliminating interest deductions for junk bonds if they were used for acquisitions.” (p. 38) Well, perhaps, and I certainly can’t take the other side of the argument, but on the surface the claim seems a bit exaggerated.

Congressmen are, in the words of one of their own, “issues entrepreneurs.” They look for issues they can use as leverage to gain campaign dollars and voter support. And at least until the passage of the Stop Trading on Congressional Knowledge Act (the STOCK Act) this past March, they were also remarkably good investors, consistently beating the market in a way that only people trading on inside information can. Moreover, “public servants enter Congress from all walks of life, but they almost all emerge rich, and the implication is that they all used their influence to feather their nests." (p. 55)

Congressmen become rich even as their constituents’ equity portfolios languish. So how can you dodge Congress’s bullets? One obvious way is to hold some S&P 500 analog on the days when Congress is out of session and be in cash otherwise. Singer manages the Congressional Effect Fund, which has slightly underperformed the S&P 500 since its inception in 2008 but with much less volatility.

Otherwise, investors can look to value funds, international markets, and gold to help preserve their wealth. Active investors can track proposed regulatory legislation since it “usually has unintended consequences that adversely affect that industry and the sectors of the economy that industry serves.” (p. 110)

Among the highlights of this book are data on the election cycle and lame duck sessions as well as an analysis of Congress’s approach to behavioral finance.

Trading the Congressional Effect is a timely, provocative book. It also illustrates how difficult it is to capitalize on a clearly defined trading edge.

Thursday, October 11, 2012

Lemov, Practice Perfect

Although the authors of Practice Perfect: 42 Rules for Getting Better at Getting Better (Jossey-Bass/Wiley, 2012)-- Doug Lemov, Erica Woolway, and Katie Yezzi—are teachers and focus on how to coach teachers to do a better job, the book has lessons for everyone who wants to coach himself to improve his game.

By now I assume nearly everybody has heard about the 10,000 hour rule, detailed among other places in Malcolm Gladwell’s Outliers. That is, it takes 10,000 hours of practice to become an expert. But what kind of practice? To borrow (and recast) a 2008 Republican campaign slogan, “Drill, baby, drill!” Practice should focus on drills rather than on scrimmages. “A drill deliberately distorts the setting in which participants will ultimately perform in order to focus on a specific skill under maximum concentration and to refine that skill intentionally. Drills … increase density, the number of productive iterations of a skill per minute of practice. … A scrimmage, by contrast, is designed not to distort the game but to replicate its complexity and uncertainty.” (pp. 49-50) Scrimmages should be used to evaluate one’s readiness for performance: “success in scrimmage is the best indicator of true mastery—participants can perform a skill when the time and place of its application is unpredictable.” (p. 51)

Okay, we should drill. The trader could, for instance, practice the physical act of trade entry (and drill in a variety of conditions—entering via a limit order or a buy stop, reacting to a partial fill, canceling a trade) until he can do it quickly and virtually automatically, preferably without a fat finger. It makes no sense to spend an inordinate amount of time figuring out entry rules only to stumble when actually placing the trade. Even algo traders need to know how to override their systems manually.

It is important to practice getting simple things right before adding complexity; that is, we want to encode success. As the authors write, “failure builds character better than it builds skills.” (p. 251) And we should spend most of our time on the skills that matter most—the old 80-20 rule (spend 80% of your time practicing the 20% of skills that are most important).

The best performers continue to drill even after they have attained mastery: “the value of practice begins at mastery!” (p. 32) “Keep going so that what you develop is automaticity, fluidity, and even … creativity.” (p. 30)

Through practice people develop “’economical rote algorithms’ so that ‘in the heat of battle the right maneuvers will come automatically.’ Consider hitting a baseball. It takes about 0.4 seconds for a serious fastball to reach the plate. ‘Conscious awareness takes longer than that: about half a second,’ … so most batters are not consciously aware of the ball’s flight. … Success is based on habits the batter has built but cannot consciously manage in the moment when they are most needed.” (p. 34) Sounds a lot like Curtis Faith’s Trading from Your Gut, which I reviewed almost three years ago.

Since it is geared to teachers, Practice Perfect is not essential reading for traders, but it contains some key lessons—among them, stop scrimmaging so much and start drilling.

Wednesday, October 10, 2012

Book sale

Once again, I’m offering readers of this blog an opportunity to get books that I’ve reviewed at cut-rate prices.

Here’s the deal. I will sell the books on the first list for half the current official Amazon U.S. price plus the cost of domestic media mail—figure between $3 and $3.50 for a single title, less per book for multiple titles. (I’m willing to ship outside the U.S., but shipping charges can be prohibitive.) Books on the second list I’ll part with for a third of the Amazon price. If outside sellers on Amazon are offering new copies for less than that price, I’ll match them. Orders that total over $100, excluding shipping, will be eligible for an additional 10% discount.

As I’ve written many times before, the books are officially used because, yes, I read them. But I have one of the tiniest “book footprints” on the planet; my used books look better than most new books at the local bookstore. No dog ears, no coffee—or, in my case, tea—stains, no visible fingerprints.

In deference to the publishers who so kindly supply me with review copies, I am not offering anything I have reviewed in the last three months.

If you would like to buy any of these books, please email me at My preferred method of payment is PayPal. I’ll fill “orders” on a first come, first served basis and I’ll update the list as I receive payment.

So, here goes with


Anson et al., The Handbook of Traditional and Alternative Investment  Vehicles
Bernstein, The Power of Gold (paper)
Byers, Blind Spot (stamped “review copy not for resale” on bottom    edge)
Caliskan, Market Threads (stamped “review copy not for resale” on  bottom edge)
Doty, Bloomberg Visual Guide to Municipal Bonds
Esperti et al., Protect and Enhance Your Estate, 3rd ed. (paper)
Fogarty & Lamb, Investing in the Renewable Power Market
Frush, The Strategic ETF Investor
Klein, Dalko, and Wang, Regulating Competition in Stock Markets
Kolb, Financial Contagion
Malz, Financial Risk Management
Phillipson, Adam Smith
Rahemtulla, Where in the World Should I Invest?
Schneeweis et al., The New Science of Asset Allocation
Sklarew, Techniques of a Professional Commodity Chart Analyst
Standard and Poor’s 500 Guide, 2012 ed. (paper)
Stoken, Survival of the Fittest for Investors
Toma, The Risk of Trading
Wagner, Trading ETFs, 2d ed.
Weiss, The Big Win


Au, A Modern Approach to Graham & Dodd Investing
Ayache, The Blank Swan
Bhuyan, Reverse Mortgages and Linked Securities
Biggs, A Hedge Fund Tale of Reach and Grasp
Diacu, Mega Disasters (stamped “review copy not for resale” on top  edge)
Dobson & Reimer, Understanding Spreads (paper)
Fraser, Wall Street: America’s Dream Palace (paper)
Harstad, Live It Up! But Don’t Outlive Your Income (paper)
Isbitts, The Flexible Investing Playbook
Levinson & Horowitz, Guerrilla Marketing Goes Green (paper)
Sorkin, Too Big to Fail
Standard & Poor’s 500 Guide, 2011 ed. (paper)
Triana, The Number That Killed Us
Wasendorf, The Secret Keys to Smart Investing (paper)

Tuesday, October 9, 2012

Upcoming half-price book sale

Time once again for fall housecleaning so my bookshelves don’t collapse. Tomorrow I’m going to offer some of the books I’ve reviewed in the past three years for half the listed Amazon price and others at an even deeper discount. The post will go up at 9 a.m. EDT. First come, first served. And once you’ve taken what you want, why don’t you share the url with some of your trader/investor friends?

Monday, October 8, 2012

Anderson, Makers

Chris Anderson, editor-in-chief of Wired magazine, best-selling author of The Long Tail, and founder of 3D Robotics, is back with another book, Makers: The New Industrial Revolution (Crown Business, 2012). The basic premise of this book is that micro-manufacturing, where tinkerers use computer resources to make physical things once again, will be the next big movement driving Western economies.

Over the past two decades the Web lowered the barriers to entry for would-be entrepreneurs in the digital space; they are now “ankle-high.” But although the Web’s model of democratized innovation spurred entrepreneurship and economic growth and bits forever changed the world, we live “mostly in the world of atoms, also known as the Real World of Places and Stuff. … [T]he world of atoms is at least five times larger than the world of bits.” (pp. 8-9) Today, thanks to a new class of “rapid prototyping” technologies, from 3-D printers to laser cutters, we’re starting to see a democratization of innovation in atoms. Welcome to the Maker Movement.

The Maker Movement shares three transformative characteristics: “1. People using digital desktop tools to create designs for new products and prototype them (‘digital DIY’). 2. A cultural norm to share those designs and collaborate with others in online communities. 3. The use of common design file standards that allow anyone, if they desire, to send their designs to commercial manufacturing services to be produced in any number, just as easily as they can fabricate them on their desktop.” (p. 21)

Once the Maker Movement is firmly entrenched it’s but a short hop to the Third Industrial Revolution. “[T]he Third Industrial Revolution is best seen as the combination of digital manufacturing and personal manufacturing: the industrialization of the Maker Movement.” (p. 41)

Entrepreneurs will produce bespoke products that serve individual needs. These products will increasingly be produced “using digital manufacturing where there is no cost to complexity and no penalty for short production runs.” (p. 68) The Third Industrial Revolution will ratchet up Adam Smith’s notion of specialization as the key to an efficient market.

Anderson describes some of the technology currently available to budding entrepreneurs, fabrication shops, sources of funding, and marketplaces for selling products. He tries to inspire the reader: “what starts as a hobby can become a mini-empire.” For those who do in fact become inspired, he has an appendix listing some main tools in the 21st-century workshop. For the DIYer it’s all really cool stuff. Alas, I know my limitations. I’ll let someone else buy the Picoscope USB oscilloscope and the Saleae USB logic analyzer.

Wednesday, October 3, 2012

Kelly, The New Tycoons

With Mitt Romney’s presidential bid private equity has been drawn into the limelight. Even so, the public gets only glimpses, often skewed, of this behemoth industry and remains largely ignorant of what it is that private equity really does, whether it is as nefarious as it has often been portrayed, and whether it is a job creator or a job destroyer. Jason Kelly’s The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything (Bloomberg/Wiley, 2012) is a refreshingly balanced account.

Kelly interviewed scores of people for this book, including some of the biggest names in private equity. Granting Kelly access, of course, gave these titans the opportunity to shape the story. Naturally, they have—but in the process they have given private equity a human face, undoubtedly touched up a bit here and there with a few virtual botox injections.

Kelly explores the history and strategies of the best-known funds. In the process he tackles some of the issues that have hounded the industry such as excessive leverage, the tax deductibility of debt, financial engineering vs. operational expertise, the calculation of returns (where 66% of funds can justifiably claim to be in the top quartile on some basis or other), dividend recapitalization, and the lavish lifestyles of the super-rich fund managers. (By the way, although Stephen Schwarzman’s sixtieth birthday party was the most notorious example of “post-industrial late capitalism’s gaudy depravity,” as Schwarzman himself was described in Salon, it was “far from the only party of its type in the annals of private equity. TPG’s Bonderman had thrown himself a sixtieth birthday blowout five years earlier, in Las Vegas, with the Rolling Stones as the entertainment. In 2011, Apollo’s Leon Black threw a lavish sixtieth in the Hamptons featuring Elton John.” [p. 173])

Data on private equity firms can be difficult to come by, sometimes justifiably so. Take the question of job creation, for instance. Oliver Gottschalg, a professor at HEC in Paris, criticizes private equity for not providing enough data. This lack of data “points largely to the immaturity, and potentially the arrogance, of the industry and the individual firms. For years they took incoming fire around their activities without responding and developed a reputation as ‘strip and flip’ artists. Yet they never produced any evidence to the contrary, which looked to those on the outside like at best, pleading the Fifth Amendment.” Kelly continues, “The reality in several cases seemed to be that the data didn’t exist, at least in an easily accessible way. There also were questions around what constituted creating a job. Private-equity firms wrestled with whether they could or should count jobs where they were a minority investor, and whether jobs created after they sold their stake in the company should count. Echoing the political calculation used by the Obama administration, they also wondered aloud whether they should get credit for ‘saving’ jobs, that is, employment in cases where they bought a company that was likely to go out of business without their investment.” (p. 130) In recent years some private equity firms have been trying to gather employment information, but without a generally agreed upon benchmark their statistics will likely be viewed as so much fluff.

The New Tycoons is a gentle read even though it is packed with information. I’d wager to say that even private equity insiders will discover things here they didn’t know. For the rest of us with an interest in private equity but without the requisite keys to the kingdom, the book provides a carefully drawn portrait of an important part of our economy.

Monday, October 1, 2012

Silver, The Signal and the Noise

Nate Silver, the author of the popular political forecasting blog FiveThirtyEight, now part of The New York Times stable, is out with his first book, The Signal and the Noise: Why So Many Predictions Fail—but Some Don’t (Penguin Press, 2012). Although Silver covers a broad spectrum of topics, from weather forecasting to sports, with a terrific chapter on poker from the vantage point of a Bayesian, I am going to focus on a couple of general ideas that are relevant for investors and traders and then turn to his discussion of the financial markets.

We live in an age of information glut. A few years back retail investors opened up their daily newspapers to see how their investments were doing; now they can follow their holdings in real time, tick by tick. In the past they got stock recommendations from their broker, read (or didn’t read) annual reports, and perhaps watched Wall $treet Week with Louis Rukeyser. Now they are deluged with the constant chatter of pundits, twitter feeds, webinars—you name it. But are investors better off with all this information? Silver doesn’t think so: “We face danger whenever information growth outpaces our understanding of how to process it.” (p. 7)

The challenge is to separate the signal from the noise, to construct a predictive model that rises above the fanciful level of a child finding animal patterns in clouds. “Finding patterns is easy in any kind of data-rich environment…. The key is in determining whether the patterns represent noise or signal.” (p. 240) If the NYSE has closed higher on Mondays 59% of the time over the past year (a figure I invented) but over the last five months has been up only twice and down a whopping 17 (information I gleaned a while back from Bespoke: it is not current), does this information offer a tradeable signal? Or is it just noise? Even if it has statistical significance, does it have practical significance? That is, could an investor profit from this pattern? Silver offers his own example to suggest a negative outcome: the “Manic Momentum” strategy, that over a ten-year period outperformed the market handily without transaction costs but lost almost 99% of the trader’s original capital with a 0.25% per trade transaction cost.

Technical traders have another problem: in trying to find signals amid the noise they are prone to overfitting. They devise a complex function that “chases down every outlying data point, weaving up and down implausibly as it tries to connect the dots. This moves us further away from the true relationship,” if there is in fact any true relationship in price action, “and will lead to worse predictions.” (p. 166)

Simply trying to parse data in search of a predictive signal is a fool’s errand, Silver believes. He illustrates this point when he takes ECRI to task for its September 2011 prediction of the near certainty of a double dip recession. In explaining its reasoning ECRI invoked “dozens of specialized leading indexes.” “Theirs,” Silver writes, “was a story about data—as though data itself caused recessions—and not a story about the economy. ECRI actually seems quite proud of this approach. ‘Just as you do not need to know exactly how a car engine works in order to drive safely,’ it advised its clients in a 2004 book, ‘You do not need to understand all the intricacies of the economy to accurately read those gauges.’ This kind of statement is becoming more common in the age of Big Data. Who needs theory when you have so much information? But this is categorically the wrong attitude to take toward forecasting, especially in a field like economics where the data is so noisy. Statistical inferences are much stronger when backed up by theory or at least some deeper thinking about their root causes.” (p. 197)

We make predictions every day, most of them quite mindless. But when predictions are important, mindlessness has no place. Not only should we theorize about causes and relationships, we should also couch our conclusions probabilistically. And yet “most of us—including most of us who invest for a living—are [very poor] at estimating probabilities.” The exceptions are the skilled options traders “who make bets on probabilistic assessments of how much a share price might move.” (Silver is quick to point out, lest the reader miss the qualifier ‘skilled’, that “You should not rush out and become an options trader. … [M]ost options traders receive a poor return.”) (p. 364)

The Signal and the Noise is a very rich book, one that I highly recommend. It takes a technical topic and makes it not only accessible to the statistically unwashed but engrossing. And does so with vividly portrayed illustrations. Let me close with one of my favorites: the two-track market.

“There is the signal track, the stock market of the 1950s that we read about in textbooks. This is the market that prevails in the long run, with investors making relatively few trades, and prices well tied down to fundamentals. … Then there is the fast track, the noise track, which is full of momentum trading, positive feedbacks, skewed incentives and herding behavior. Usually it is just a rock-paper-scissors game that does no real good to the broader economy—but also perhaps no real harm. It’s just a bunch of sweaty traders passing money around. However, these tracks happen to run along the same road, as though some city decided to hold a Formula 1 race but by some bureaucratic oversight forgot to close one lane to commuter traffic. Sometimes, like during the financial crisis, there is a big accident, and regular investors get run over.” (p. 368)