Baldwin, Heroes & Villains of Finance

A recent study by Microsoft has found that our attention span is now a mere eight seconds, less than that of a goldfish (on average nine seconds). Not exactly conducive to reading War and Peace. On the other hand, this truncated attention span is perfectly matched to A. Baldwin’s Heroes & Villains of Finance: The 50 Most Colourful Characters in the History of Finance (Wiley, 2015).

Baldwin devotes four pages to each of his colorful characters. The first page has only the person’s name and dates. The second, and sometimes part of the third, is given over to a biographical sketch. The rest of the space displays, in large type and all caps, noteworthy quotations attributed to the person. These quotation pages are designed to be eye-catching and attention-getting. Occasionally there is white text on a black background, sometimes the type is blue, here and there the quotation is slanted.

Baldwin starts with Thales, who offers the earliest example of options trading, and ends with Dick Fuld. In between we have an assortment of economists, politicians, and financial titans and scoundrels. I would list the cast of characters, but I might be accused of copyright infringement. If I included their dates, I would have reproduced a quarter of the book.

This book is superficial, yes, but it seems to reflect a distracted “text and read” culture. Perhaps one day publishers and lovers of good books will start their own knock-off ad campaign: “Don’t text while reading.”

Griffin, Charlie Munger

Fans of Warren Buffett’s sidekick will welcome the publication of Charlie Munger: The Complete Investor by Tren Griffin (forthcoming, Columbia Business School Publishing). Unfortunately, they most likely won’t learn much that they didn’t already know. The author relies exclusively on published material—speeches, records of annual meetings, interviews, and writings.

For those who aren’t familiar with Munger’s ideas, however, this brief book offers a solid introduction. It sets out quotations from Munger “in a logical order, typically followed by an explanation” by the author. It also places his thought within the context of the value investing principles of Benjamin Graham.

A voracious reader whose knowledge spans a wide range of academic disciplines (as Griffin describes him, “He knows a lot about a lot, and he knows a little about nearly everything”), Munger is probably best known for his notion of a latticework of mental models. As he said, “You have to realize the truth of biologist Julian Huxley’s idea that ‘Life is just one damn relatedness after another.’ So you must have the models, and you must see the relatedness and the effects from the relatedness.” (p. 46)

For Munger, the wise investor should read extensively, analyze like a fox (as opposed to a hedgehog), and act decisively and in scale when the right opportunity presents itself.

A corollary of his multidisciplinary approach to investing is that one shouldn’t rely solely on quantitative analysis. Although Munger was a math major as an undergraduate, he recognizes the limitations of measuring. “You’ve got a complex system and it spews out a lot of wonderful numbers that enable you to measure some factors. But there are other factors that are terribly important, [yet] there’s no precise numbering you can put to these factors. … Well, practically (1) everybody overweighs the stuff that can be numbered, because it yields to the statistical techniques they’re taught in academia, and (2) doesn’t mix in the hard-to-measure stuff that may be more important. That is a mistake I’ve tried all my life to avoid….” (p. 45) And again, “People calculate too much and think too little.” (p. 46)

As for acting decisively, Munger said during the 1996 Wesco annual meeting: “Experience tends to confirm a long-held notion that being prepared, on a few occasions in a lifetime, to act promptly in scale, in doing some simple and logical thing, will often dramatically improve the financial results of that lifetime. A few major opportunities, clearly recognizable as such, will usually come to one who continuously searches and waits, with a curious mind that loves diagnosis involving multiple variables. And then all that is required is a willingness to bet heavily when the odds are extremely favorable, using resources available as a result of prudence and patience in the past.” (p. 65)

Charlie Munger is a wise (as well as an exceedingly smart—and rich) man. It’s worth an investor’s while to know what makes him tick.

Lacalle and Parrilla, The Energy World Is Flat

With a nod to Thomas Friedman’s 2005 book, The World Is Flat, Daniel Lacalle and Diego Parrilla envisage a time when The Energy World Is Flat and explore, in the words of the book’s subtitle, Opportunities from the End of Peak Oil (Wiley, 2015).

Ten forces are flattening the energy world, helping to make energy more of an enabler and less of a constraint: geopolitics; the energy reserves and resources glut; horizontal drilling and fracking; the energy broadband; overcapacity; globalization, industrialization, and urbanization; demand destruction; demand displacement; regulation and government intervention; and fiscal, monetary and macroeconomic flatteners.

This is, as the ten forces should make evident, a “big picture” book. It looks at how high oil prices have to be for Venezuela and Iran to balance their budgets (over $100/bbl) and at world demographic trends (population growth is slowing, on average the global population is getting older). It uses estimates from the UN for population growth, from the IMF for economic growth, and from the IEA for demand growth to conclude that “a global population growth of 0.7% pa may be able to generate economic growth in real GDP terms of 3.6% pa, while increasing energy consumption by 1.5% pa. These trends are consistent with the work from Laherrere, who claims that world oil consumption and production per capita peaked in 1979.” (p. 128)

How can the investor profit from the current energy revolution? The answers are complicated. For instance, the lead author believes that natural gas will emerge a winner, but, for two reasons, does not recommend buying the natural gas ETF: (1) natural gas will be a winner in volume but not necessarily in price and (2) the U.S. natural gas ETF has historically been a “financial weapon of wealth destruction.” (p. 247) The reason for the latter is that “the roll yield in natural gas has been so extreme, that over the long run the shape of the forward curve has been a more important factor in determining the value of the ETF than the actual price of natural gas.” At the time the author was writing this section, “the price of US natural gas was down 40% since launch, but the ETF was down 95%.” (p. 268)

The key to successful energy investing is to follow capital expenditure. “The winners will be those that ignore fashionable trends and favour good old return on capital as their key guideline—without ignoring [government] policy.” (p. 277)

“In the end,” the book concludes, “energy will continue to be about displacement of the least competitive. And the last barrel of oil will not be worth millions. It will be worth zero.” (p. 278)

Kase on Technical Analysis

Cynthia Kase is a veteran market technician who is an educator, author (multiple papers and a 1996 book, Trading with the Odds), former energy trader, and trading indicator developer. Her Kase StatWare package can be purchased for use on multiple trading platforms.

Kase on Technical Analysis (Wiley, 2015) is a multimedia package: a 13-part video series (online or in DVD format) with a complementary paperback, Kase on Technical Analysis Workbook. The videos run roughly 6.5 hours; the workbook is just shy of 200 pages, although nearly half the book is white space.

As one might expect, the videos highlight Kase’s proprietary studies as an improvement over classic indicators, but they are more than a lengthy infomercial. Moreover, as Kase suggests, she has tried “to describe enough about [her] indicators, including the basic math, so that those who understand the concepts explained, and who have the programming capability, could, if they wanted, duplicate or at least come close to duplicating [her] work, for their personal use.” For instance, unlike traditional momentum indicators, which “generally evaluate current closes relative to past closes or high-low ranges,” hers “are based on statistical measures of serial dependency, normalized for logarithmic volatility, and optimized for cycle length.” (p. 173) Reverse engineering these indicators sounds like a daunting task; approximating them is probably achievable; understanding their rationale should be within the reach of every trader.

Despite the mathematical complexity of the Kase studies, the videos are most appropriate for relative beginners. They explain how to forecast and estimate risk and how to enter and exit trades using chart patterns and traditional indicators such as moving averages, DMI, ADX, RSI, and MACD, as well as Kase StatWare.

Rouah, The Heston Model

In 2013 Fabrice Douglas Rouah published The Heston Model and Its Extensions in Matlab and C#. Now, for those who feel more at home with Excel spreadsheets, comes The Heston Model and Its Extensions in VBA (Wiley, 2015). It is a condensed and readapted version of the original book, although both books follow the same chapter outline. In the author’s words, “it serves as a ‘VBA cookbook’ for the models covered in the original book, rather than a reference guide for the theoretical aspects of the models.” (p. xvii) VBA code snippets, those that are vital to the calculations, are illustrated in the text and are available for download to those who purchase the book.

The Heston stochastic volatility model for pricing options was introduced in 1993, six years after the stock market crash of October 1987. The crash, with its subsequent “exacerbation of smiles and skews in the implied volatility surface,” called into question the restrictive assumptions of the Black-Scholes model. “The most tenuous of these assumptions is that of continuously compounded stock returns being normally distributed with constant volatility.” Returns are not normally distributed but exhibit skewness and kurtosis, and volatility is not constant in time but tends to be inversely related to price.

Readers of Rouah’s book should be well schooled in advanced calculus. This is a book for quants, not the casual options trader. As far as I know, no retail options trading platform offers the alternative of using the Heston pricing model even though the deficiencies of Black-Scholes are well documented. In fact, one rationale for sticking with Black-Scholes is precisely that its deficiencies are so well known. The Heston model remains a work in progress.

Morales & Kacher, Short-Selling with the O’Neil Disciples

Gil Morales and Chris Kacher, the self-styled O’Neil disciples, have established something of a franchise. This is their third book. First came Trade Like an O’Neil Disciple (2010), then In The Trading Cockpit with the O’Neil Disciples (2012), and now Short-Selling with the O’Neil Disciples: Turn to the Dark Side of Trading (Wiley, 2015).

The authors remain true to their basic philosophy and method, which they dubbed OWL for O’Neil-Wyckoff-Livermore. Here they apply it to short selling.

They sketch out six rules, which deal with cycle timing, stock selection (in terms of price action and volume), trade timing, and setting stops and profit targets. They display chart patterns that serve as short-selling set-ups. They explain the mechanics of short selling. They analyze five case studies that occurred between 2011 and 2014—AAPL, NFLX, GMCR, DDD, and MCP.

And, in what they consider the “real meat of the book,” they offer 91 “templates of doom,” or “what one might consider models of the greatest short-selling plays in recent history.” Studying these templates—marked-up daily and weekly charts—“can give one an edge in recognizing when a major short-selling opportunity is at hand.” (pp. 175-76)

In a cautionary note, the authors readily admit that “there is nothing mechanistic or deterministic about short-selling. Sometimes these set-ups work beautifully, sometimes they don’t, and the probabilities of success rely heavily on contextual factors. These contextual factors include the current action of the major market averages, the phase of the market, the overall national and global economic backdrop, industry developments, earnings news, and the occasional, random, and sudden positive news or rumors that trigger a bounce in an otherwise weak, down-trending stock. Relative to the long side of the market, my experience is that the short side tends to be far more volatile and fraught with uncertainty.” (p. 176)

However potentially treacherous the short side, there are times that short positions are the only money makers. And yet many investors and traders remain squeamish about shorting stocks, not so much because they fear “the dark side” but because it’s uncharted territory. Morales and Kacher have literally charted the way for them.

Mental toughness and mountain climbing

I recall reading that Julian Robertson took his young Tiger hires mountain climbing as a test of their risk-taking skills and their mental toughness. Well, I thought at the time, given my acute acrophobia, I would have been summarily bounced to the secretarial pool.

There are obvious parallels between mountain climbing and trading. In a paper in the edited volume Mental Toughness in Sport (Daniel F. Gucciardi and Sandy Gordon, eds, Routledge Research in Sport and Exercise Science, 2011) Tom Fawcett takes as his first case study Alex, a high-level mountaineer with over 30 years’ climbing experience.

Alex said that mental toughness means different things at different times of an expedition. In advance of a trip, he identified “preparation, attention to detail, accurate risk assessment, the need to be realistic, seeing the bigger picture and having a sense of perspective and being adaptable” as important factors.

During the climb mental toughness is about having a “correct response [psychological and physical] in the moment it [whatever ‘it’ may be] happens.” It involves risk assessment (yet again) and managing anxiety. Importantly, it means having the ability and courage to accept failure at the expense of personal achievement or ego satisfaction. “People get carried away with their own egos, and the need to summit takes control over more logical judgments. People ‘lose it’ and many people have unfortunately lost their lives because of their obsession to get to the top. … They gamble and forfeit their lives in the quest for absolute success and the need to avoid failure.”

Being successful, he suggested, is an indication that one has not been truly tested to the ultimate limit. Failing, on the other hand, is both extremely difficult and, perhaps paradoxically, emotionally satisfying. As Alex said, “Failures are inner rewarding and not external like reaching a summit. I climb to live, not to die. The summit is optional, but returning is mandatory.”

You can draw the obvious parallels.

Sherbin, How to Price and Trade Options

Retail options traders may remember Al Sherbin from his days as the director of research for Tastytrade. He can now add to his list of credits an excellent book: How to Price and Trade Options: Identify, Analyze, and Execute the Best Trade Probabilities (Bloomberg / Wiley, 2015).

This book is most useful for those who are familiar with the basics of options and who, following probabilities, prefer short premium trades. If your idea of option trading is buying lottery-ticket out-of-the-money calls or puts, you will either be thoroughly annoyed with this book or experience a revelation.

Unlike most options books, Sherbin’s is practical. It doesn’t replace the classic texts but complements them. As he says, his entire book is about pricing risk transference and subsequently managing that risk. He explains, among other things, how to choose a strategy, how to match it to the number of days to expiration, and how to trade earnings announcements.

What I found most valuable was his chapter on exiting trades. He uses a stripped-down version of the often maligned Kelly Criterion to design a positive expectancy strategy. Setting the Kelly percent to zero, he can “back off” one of the three variables—percentage of winners (or, if forecasting, probability of profit), average gain of winning trades, and average loss of losing trades—to create a winning formula. You can calculate, for instance, where you would have to take losses to break even if you sell strangles at a 90% probability of profit and take profits at 25% of maximum profit. For those who don’t want to risk messing up the math, Sherbin provides—on a linked website—a Kelly Criterion worksheet.

As for logging trades, he is a firm believer in keeping records. A log serves many purposes, but its main rationale is “to be able to compare expected probabilities to actual probabilities over an extended period of time.” (p. 197) From the website the reader can download a useful trading log template.

Continuing with the nuts and bolts of trading, Sherbin discusses order execution, an area where traders often stumble. He then moves on to portfolio management, which is “perhaps the most difficult area of trading.” (p. 215) He delves into a range of topics here--correlation (with yet another downloadable spreadsheet), systemic risk, trade sizing (and no, he doesn’t use the Kelly Criterion to size his positions), and early exercise.

Those who are comfortable with the idea of mechanical, probability-driven options trading or who want to learn more about how to be profitable following this approach will find Sherbin’s book a most welcome addition to the literature. It’s both smart and practical.