Aldridge & Krawciw, Real-Time Risk

Real-Time Risk: What Investors Should Know About FinTech, High-Frequency Trading, and Flash Crashes (Wiley, 2017) by Irene Aldridge and Steve Krawciw is in large measure an advertisement for AbleMarkets, of which the authors are, respectively, president and CEO. That said, and it is a major caveat, the book provides insight into the often overlooked, or inaccessible, world of market microstructure.

Let’s start with front-running’s cousin, pre-hedging. Front-running is illegal, but pre-hedging or anticipatory hedging, though forbidden on the CME, is allowed in the FX market, and equities regulators allow the use of derivatives to pre-hedge. Let’s say you, a sophisticated trader, place an order to sell shares in IBM. Your broker may buy “put options on IBM before executing your order, with the explicit purpose of protecting itself against your information asymmetry. ….The seemingly innocuous options purchase by the broker has wild ramifications in today’s interconnected markets. Aggressive high-frequency traders … continuously scan markets for arbitrage opportunities and will see the temporal discrepancy between the options activity and the still-lethargic IBM stock (your order still has not hit the markets). The HFTs will take off the price you saw when you placed the order just before your order had a chance to execute,” thereby widening the spread and increasing volatility through the larger bid-ask bounce.

The authors tackle the causes of flash crashes, both market-wide and in individual stocks. Market-wide, they pin the blame primarily on broad-based ETFs such as SPY. According to the law of one price, the basket of securities making up the S&P 500 should have the same price as SPY, and normally stat-arb traders quickly eliminate any disparity in price. But consider the following scenario. An S&P 500 stock falls sharply. Stat-arb traders bring SPY into line. But once SPY’s price falls, “a new force comes to influence the markets, potentially causing widespread contagion among other financial instruments in the markets. This new force is macro arbitrage. … Once the price of the ETF drops, most of the securities in the underlying basket are revalued by the macro traders and algorithms, dragging down the prices of most individual securities in the basket. The basket is now once again priced below the corresponding ETF! Next, the vicious cycle repeats itself.” And “once the flash crash begins in a particular market, it can rapidly spread to other instruments, affecting markets across all asset classes and continents. The recovery can be just as swift: All it takes is for one market participant or system to realize the artificial absurdity in the present crash and the low valuations of the securities to begin to repurchase the underpriced instruments.”

To be able to predict intraday risks one has to understand market microstructure. The authors claim that “in addition to the risks associated with HFT, understanding market microstructure can help predict flash crashes days ahead, minimize slippage when placing trades, and, of course, predict short-term price movements in the markets.” And so, they conclude, “incorporating the market microstructure analytics into financial decisions is no longer an option but a requirement for sound portfolio management.” AbleMarkets is, of course, a market microstructure analytics firm.

Schwager & Etzkorn, A Complete Guide to the Futures Market, 2d ed.

The first edition of Jack Schwager’s A Complete Guide to the Futures Market came out in 1984. No, that’s not a typo. It was 33 years ago. In revising and updating his classic work for publication this year, Schwager teamed up with Mark Etzkorn.

At nearly 700 pages, A Complete Guide to the Futures Market: Technical Analysis and Trading Systems, Fundamental Analysis, Options, Spreads, and Trading Principles covers all the bases, or at least all the bases traders knew about back in the day.

Today the book seems almost quaint. With the exception of six appendixes on statistics in general and regression in particular, there’s almost no math, certainly no machine learning. Quantitative traders would undoubtedly argue that no one can make money with the techniques described in this book. But we’ve heard similar arguments before—technical traders claiming that one couldn’t make money trading fundamentals, fundamental traders countering that they never knew a rich technical trader. The reality is that trading’s incredibly difficult, and the more ways you can think about it the better off you probably are. Unless, of course, you’re willing to accept a completely black-box strategy.

The authors devote about half the book to chart analysis, technical indicators, trading systems, and performance measurement. With the exception of the problem of how to link contract series (nearest futures versus continuous futures), most of the material in this part of the book is not specific to futures trading.

The fundamentals of the various futures markets are trickier. As the authors explain, “Because of the heterogeneous nature of commodity markets, there is no such thing as a standard fundamental model. Among the key substantive characteristics that differentiate markets are degree of storability, availability of substitutes, importance of imports and exports, types of government intervention, and sensitivity to general economic conditions. Consequently, in contrast to technical analysis, in which a specific system or methodology can often be applied to a broad spectrum of markets, the fundamental approach requires a separate analysis for each market.”

Many commodity traders use spreads, simultaneously buying one futures contract and selling another either in the same market or in a related market. As a general rule, spread traders who expect price appreciation in a commodity will initiate an intramarket time spread, long the near month and short the distant month. Gold and silver, however, move inversely to this rule. And the rule has no applicability to nonstorable commodities (cattle and live hogs).

Commodity traders can also use options to express their opinions. The authors devote a chapter to option trading strategies, complete with risk graphs and profit/loss calculation tables for a range of strategies.

The final part of the book is devoted to practical trading guidelines, including 75 trading rules and market observations and 50 market wizard lessons. There’s a lot of wisdom here.

A Complete Guide to the Futures Market lives up to its title and then some. Even those who have no intention of ever trading futures can profit from this book. Yes, it’s old school, but ‘old school’ in this case doesn’t mean ‘passé’.

Weiss, Key to IP

I know this book is off topic, but I thought it worth bringing to your attention anyway.

If you know as much about intellectual property as I did before I read Chris Weiss’s Key to IP: Identifying Your Patents, Trademarks, Copyrights, and Trade Secrets, you’ll come away enlightened.

Weiss is a patent attorney who, in about 70 pages, explains the basics in a non-lawyerly way. That is, his prose is clear, occasionally even amusing. And always informative. I now understand why so many products have “patent pending” printed on their labels. Spoiler: getting a patent can be a very long process.

Become a financial superforecaster

Superforecasting was one of my favorite books of 2015. Although Philip E. Tetlock and Dan Gardner pretty well steered clear of the financial markets in the book, recognizing that markets are, as I wrote in my review, “rife with aleatory uncertainty (the unknowable),” they nevertheless believed that, even in the financial markets, learning to become a superforecaster would pay off.

Now we all have a chance to become part of the Good Judgment community and try our hands at forecasting. Who knows, maybe we’ll discover that we have what it takes to become a superforecaster.

Here’s the press release announcing the challenge.

Good Judgment Inc (GJI) and the CFA Society Los Angeles are launching an exciting new partnership for the members of CFA Society Los Angeles, the wider global CFA community, and those interested in becoming better forecasters in the world of economics and finance.

CFA charterholders and other interested parties will have the opportunity to compete in the “CFA Society Los Angeles 2017 Finance & Economic Challenge” (www.gjopen.com/cfa) on a battery of forecastable questions debuting on February 16 on Good Judgment Open (GJI’s crowdsourced forecasting platform). Participants will be challenged to forecast pressing questions on a variety of topics, such as:

• Before 1 July 2017, will new federal funding be approved for the California High-Speed Rail Authority's "bullet train" project?
• What will be the end-of-day closing value for the euro against the U.S. dollar on 15 February 2018?
• Before 2018, will Tesla file for bankruptcy or begin restructuring their debt in a corporate workout?

The CFA Society Los Angeles Board of Governors agreed that posting a challenge focused on economics and finance on Good Judgment Open would provide its members a superb platform to interact on important questions of the day, while simultaneously improving their ability to make good judgments.

Why forecast with GJI and CFA Society Los Angeles?

1. Keeping score is essential to get the feedback that improves accuracy. So often in human judgment, there is no objective measurement of success. Good Judgment Open uses a scoring system that allows forecasters to learn how the accuracy of their forecasts differs from the crowd.

2. Small improvements in forecasting add up.

3. Forecasting is a skill that can be best cultivated in dedicated forecasting tournaments (demonstrated by the work of Dr. Phil Tetlock, co-founder of GJI and co-author of “Superforecasting: The Art and Science of Prediction”)

4. The 25 economics and finance questions will offer experts in the broader business community an opportunity to leverage their expertise to forecast questions relevant to their work.

To participate in the “CFA Society Los Angeles 2017 Finance & Economic Challenge,” please go to gjopen.com/cfa and register for the Challenge to begin forecasting.

Champ, Going Public

Norm Champ spent almost 20 years in the private sector practicing law and serving as general counsel of a hedge fund before opting to join the SEC. Going Public: My Adventures Inside the SEC and How to Prevent the Next Devastating Crisis (McGraw-Hill, 2017) recounts his five years (“adventures” is a stretch) in government.

My initial reaction to this book was negative since it focused so much on the petty. But then, upon reflection, I decided that it was undoubtedly an accurate, if limited, account of how people function, and don’t function, inside government agencies. And for this reason was worth reading.

When Champ began his first job at the SEC, heading up investment management exams in New York, he assumed that the SEC was “a typically dysfunctional bureaucracy that needed to fix what had been broken.” Instead, he found that “there were parts of it that had never been built.” For instance, there were no internal guidelines on how to do the examinations of financial firms; “employees were more or less left to use their best judgment.” And some of the procedures “were slanted toward what was best for government workers—not enforcement of the federal securities laws. Examiners at Madoff’s firm actually drafted a letter asking the options exchange for records of his trading, but the examiners appear to have decided not to send the letter because it would pull in too many records that would have taken a long time to review. If those examiners had had procedures requiring them to verify at least some trading, they would have sent the letter and Madoff might have been unmasked because he did not trade at all—on the exchange or anywhere else.” And lest you think these investigators were swamped with work, on average they completed only a little more than two exams per person per year.

Civil service protections and union grievance procedures make it nearly impossible to fire SEC employees. The one case Champ cites in which an employee was actually let go involved a supervisor who had not shown up at the office in about five years (and who nonetheless got his standard annual raise). A new manager succeeded in having him terminated.

Another commonplace in the SEC and throughout the federal government is the anonymous complaint. Since employees have such strong job security, they can send the inspector general and others anonymous grievances without fear of consequences. “Those opposed to change use anonymous notes to protect the status quo.” During Champ’s tenure at the SEC, these nameless complaints appeared constantly. It cost him thousands of dollars in legal fees to help navigate the investigations.

Champ initiated reforms where he could, first in examinations and then as the top federal policymaker for investment management, also known as the wax museum when he arrived because it was frozen in time and place. IM has three major responsibilities: “it writes the rules regulating the investment management industry, provides guidance to industry and government on how those rules are applied in practice, and reviews documents that mutual funds use to sell their shares to investors.”

Champ’s account of the state of affairs in the wax museum is chilling. He introduced changes, including upgrading antiquated technology and hiring a math geek squad. But, even though he praises the efforts of many of his colleagues who “work so hard for investors,” one has the feeling that the SEC remains a work in (very slow) progress. Of course, as financial regulations get rolled back, it may have more time to improve its own infrastructure.

Yamarone, The Economic Indicator Handbook

Richard Yamarone, a Bloomberg senior economist, has written a book that, as he himself admits, “is overwhelmingly related to economics as seen from the Bloomberg terminal.” For those of us who don’t have access to such a luxury, The Economic Indicator Handbook: How to Evaluate Economic Trends to Maximize Profits and Minimize Losses (Wiley, 2017) can here and there be a frustrating read. The first chapter, for instance, describes the kinds of data available on the Bloomberg terminal, complete with screen captures: the economic calendar, economist estimates and expectations, the Bloomberg economic surprise index, the events calendar, the economic statistics table, the economic workbench, the Bloomberg orange book of CEO comments, treasury and money market rates, and the Bloomberg financial conditions monitor and its financial market conditions index. Some of this information is available elsewhere but not so conveniently packaged.

Having done his duty to his employer, Yamarone proceeds to discuss in eleven chapters the business cycle, GDP, labor market and employment, retail sales, NFIB small business economic trends, personal income and outlays, housing and construction, manufacturing, prices and inflation, confidence and sentiment, and the Federal Reserve. Most of the data come from publicly available sources.

Yamarone’s descriptions of the various economic indicators are perhaps the clearest I’ve seen anywhere. He explains what the indicators measure, how they are constructed, how they can be used, their strengths and weaknesses, sometimes how they can be tweaked to improve their ability to forecast changes in the economy.

For example, some economists chart the spread between two subsets of the Conference Board’s Consumer Confidence Index: the Present Situation Index and the Expectations Index. “The reasoning behind this strategy is simple: If the expectations index is less than the present situation index, generating a negative spread, the implication is that people are happier with where they are now than with where they see themselves in the near future. Conversely, a positive spread implies a belief that greater prosperity lies just around the corner, a good sign for spending and the economy. The wider the spread in either direction, the drearier or dreamier future conditions are expected to be relative to the present.” This spread has often been a good leading indicator. It “generally bottoms out just before a recession begins and peaks just after it ends.”

Yamarone slices and dices economic indicators, looking for their most predictive elements. He claims, for instance, that perhaps the single most important sentiment indicator is the trending behavior of the Conference Board’s 35-54 age group.

The Economic Indicator Handbook is useful both as a book to read cover to cover and as a reference book. That it comes with a lot of Bloomberg Terminal eye candy—beautiful charts and graphs—only adds to its value.

Lidsky, Eyes Wide Open

At the age of 13 Isaac Lidsky learned that he was beginning to go blind; by the age of 25 he had lost his sight entirely. His initial reaction was, naturally, to be fearful since his future seemed dark, both literally and figuratively. In Eyes Wide Open: Overcoming Obstacles and Recognizing Opportunities in a World That Can’t See Clearly (TarcherPerigree/Penguin Random House, 2017), expanding on his popular TED talk, he recounts how he embraced his blindness and “gained a life richer in understanding, connection, and success.”

Lidsky, now 37 years old, has had a life that many would envy—if, that is, they could skip the “being blind” part. He was a child actor, starring as “Weasel” on NBC’s sitcom Saved by the Bell: The New Class. He graduated from Harvard at the age of 19 with a degree in mathematics and computer science and proceeded to found an internet advertising technology company. When it was finally thriving, he left to attend Harvard Law School. After three years as a U.S. Justice Department attorney, he became a Supreme Court law clerk, working for Justices Sandra Day O’Connor and Ruth Bader Ginsburg. He then put aside his legal career to acquire a struggling construction company, growing it tenfold in five years.

Eyes Wide Open is an intellectually sophisticated, uplifting book that I highly recommend. Yes, it includes advice that you’ve undoubtedly heard before, but the context makes that advice all the more compelling.

For this post I’m going to share two short excerpts that traders might find especially applicable to their endeavors. First, the paralyzing effect of fear.

“Fear narrows your focus and tunnels your vision. … When you confront the unknown, you face the greatest need to look outside yourself, to see beyond your mental database, to broaden your perspective and to think most critically. But fear produces the opposite effect. It beats a retreat deep inside your mind, shrinking and distorting your views. It drowns your capacity for critical thought with a flood of disruptive emotions. … Similarly, fear often emerges when you face a compelling opportunity to take action, to evolve, to make progress, to overcome, to transcend. But fear can be paralyzing. Its inertia is massive. Like its sibling denial and its cousin pride, fear clings to the status quo. Fear thrives in the fictitious minutiae of the mental images it inspires. It immerses you in those images, lulls you into inaction, and invites you to passively watch its prophecies fulfill themselves.”

Second, the devastating message of your inner critic and the response of the strong man.

“You will never be good enough, he says. Don’t bother trying. … What remains to be done is vast compared to that which you have achieved. You require far more resources than those already marshaled. … Success is an island fortress, hazy and remote. The critic is obsessed with that fortress, the outcome, the destination, the final product. … You are on a fool’s errand, he says. This is hopeless.”

By contrast, “The strong man values effort, struggle, momentum, growth. He finds none of these things in perfection and thus has no use for it, in concept or in application. … For the strong man, the ‘best’ is a fallacy. He assesses the quality of the effort expended, not the results obtained. … What next? he asks. It is his mantra. Just keep moving.”

You’ll be amazed what you can achieve. Lidsky threw out the first pitch at a Marlins-Cubs baseball game to promote Hope for Vision—and it was a strike. All it took for a blind man to learn to throw a regulation pitch was three or four hours of practice.

Damodaran, Narrative and Numbers

Even as flagging, high-profile hedge funds are looking for salvation in the quant world, academics are raising a red flag. Perhaps we’ve gone overboard in our efforts to reduce all financial activity to a set of numbers. For instance, Robert J. Shiller, in his presidential address delivered at the annual meeting of the American Economic Association at the beginning of this year, extolled the virtues of studying (admittedly quantitatively) popular narratives to understand economic fluctuations.

In Narrative and Numbers: The Value of Stories in Business (Columbia University Press, 2017) Aswath Damodaran, professor of finance at New York University Stern School of Business and a self-avowed numbers man, delves into the role of storytelling in the context of valuing businesses and making investments. Valuation, he claims, is a bridge between numbers and stories. “In effect, valuation allows each side to draw on the other, forcing storytellers to see the parts of their stories that are improbable or implausible, and to fix them, and number crunchers to recognize when their numbers generate a story line that does not make sense or is not credible.”

In the early chapters Damodaran looks at storytelling in general and business storytelling in particular. At issue is whether the stories a business tells (or the investor creates) are possible, plausible, or probable. Damodaran admits that “the lines between the possible, plausible, and probable are not always easy to draw.” He suggests instead thinking about the distinction between the impossible, implausible, and improbable, laying them out on a continuum of skepticism. “Impossible and improbable are quantifiable, the first because you are assigning a zero probability to an event happening and the latter because you are attaching a probability (albeit a low one) that an event will happen. Implausible lies in the muddled middle, since proving that it cannot happen is not feasible and attaching a probability judgment to it is just as difficult.”

Since Damodaran argues that “stories without numbers are just fairy tales and numbers without stories to back them up are exercises in financial modeling,” the core of his book deals with the process of connecting a plausible story to value drivers, using value drivers to estimate value (and, in reverse, extracting stories from existing valuations), and then, in a feedback loop, improving and modifying the narrative.

Damodaran illustrates his points in some detail using the examples of Uber, Ferrari, Amazon, and Alibaba.

The intended audience of Narrative and Numbers includes both entrepreneurs (and managers) and investors. With both groups the goal is to prevent wishful thinking from becoming expectation. Damodaran has carefully and convincingly developed an antidote to that financial poison.