Amazon links

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

Haslett, Risk Management

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

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

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

Hirsch and Person, Commodity Trader’s Almanac 2011

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

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

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

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

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

Jankovsky, Time Compression Trading

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

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

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

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

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

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

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

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

Kaminsky, Smarter Than the Street

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

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

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

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

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

Augen, Trading Realities

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

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

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

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

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

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

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

Bill Gross

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

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