Friday, December 31, 2010
Wednesday, December 29, 2010
Lien, The Little Book of Currency Trading
I am not a forex trader, nor do I aspire to become one. Nonetheless, I am interested in currencies, so I decided to read Kathy Lien’s The Little Book of Currency Trading: How to Make Big Profits in the World of Forex (Wiley, 2011). This is the sixteenth volume in Wiley’s “little book” series.
Lien covers a lot of ground, from the basics of forex trading to one of her favorite trade setups, from trade management to identifying scams, from having a trading plan and a contingency plan to the top ten mistakes traders make (including, my personal favorite, becoming a demo billionaire). Often she proceeds by way of analogy. For instance, she highlights the difference between a trader and an investor by analyzing the behavior of those New York City taxi cab drivers who pay medallion owners a fixed sum per week for the right to drive a 12-hour night shift: some speed down city streets looking for as many “lower value” fares as possible, others wait patiently at JFK for the few “higher value” fares.
Since readers are always searching for ways to make outsized gains in the markets, I’m going to accommodate today. Well, that’s a gross overstatement. More accurately, I am going to share two practical suggestions that Lien makes on “how to make big profits in the world of forex.”
First, she describes her Double Bollinger Band Method, where the bands are set to one and two standard deviations above and below the 20-period moving average. These double bands, Lien argues, “can be used for identifying whether the currency is in a range or trend, if and when a trend has exhausted, where to find value within the trend, and how to get into a new trend.” (p. 108) I’m not going to steal her thunder. I assume that anyone who is savvy in technical analysis can hypothesize the outline of some of her tactics, if not their details.
Second, she disputes the common claim that traders must maintain at least a 2 to 1 reward to risk ratio. “An overly ideal risk to reward ratio encourages traders to try and take more from the market than is being offered and may encourage scalpers to use excessively tight stops.” (p. 100) Instead, she advocates trading with a negative edge, entering with a double lot and scaling out in two steps. Why adopt a mathematically inferior strategy which needs to be successful at least 60 to 70 percent of the time? Because, she writes, “it is psychologically more palatable, and trading at its core is always more psychological than it is logical.” (p. 103)
The Little Book of Currency Trading emphasizes the practical over the theoretical. Although it’s written for forex traders and investors, much of it is applicable to traders and investors in other markets as well. It’s a quick, lively read; it’s informative and concrete. It may not be a classic, but it’s definitely worth a look.
Lien covers a lot of ground, from the basics of forex trading to one of her favorite trade setups, from trade management to identifying scams, from having a trading plan and a contingency plan to the top ten mistakes traders make (including, my personal favorite, becoming a demo billionaire). Often she proceeds by way of analogy. For instance, she highlights the difference between a trader and an investor by analyzing the behavior of those New York City taxi cab drivers who pay medallion owners a fixed sum per week for the right to drive a 12-hour night shift: some speed down city streets looking for as many “lower value” fares as possible, others wait patiently at JFK for the few “higher value” fares.
Since readers are always searching for ways to make outsized gains in the markets, I’m going to accommodate today. Well, that’s a gross overstatement. More accurately, I am going to share two practical suggestions that Lien makes on “how to make big profits in the world of forex.”
First, she describes her Double Bollinger Band Method, where the bands are set to one and two standard deviations above and below the 20-period moving average. These double bands, Lien argues, “can be used for identifying whether the currency is in a range or trend, if and when a trend has exhausted, where to find value within the trend, and how to get into a new trend.” (p. 108) I’m not going to steal her thunder. I assume that anyone who is savvy in technical analysis can hypothesize the outline of some of her tactics, if not their details.
Second, she disputes the common claim that traders must maintain at least a 2 to 1 reward to risk ratio. “An overly ideal risk to reward ratio encourages traders to try and take more from the market than is being offered and may encourage scalpers to use excessively tight stops.” (p. 100) Instead, she advocates trading with a negative edge, entering with a double lot and scaling out in two steps. Why adopt a mathematically inferior strategy which needs to be successful at least 60 to 70 percent of the time? Because, she writes, “it is psychologically more palatable, and trading at its core is always more psychological than it is logical.” (p. 103)
The Little Book of Currency Trading emphasizes the practical over the theoretical. Although it’s written for forex traders and investors, much of it is applicable to traders and investors in other markets as well. It’s a quick, lively read; it’s informative and concrete. It may not be a classic, but it’s definitely worth a look.
Monday, December 27, 2010
Digging out, very slowly
The to-do list that started to be checked off before dawn: There are huge sand dunes around my car, except they’re white. And then there’s the area where Delta, the geriatric basset hound, stretches her legs and relieves herself. Not to mention the walkway to the heating oil and propane tanks. I leave the driveway to the professional, who plows when he’s finished his “important” clients. After which, if I don’t shovel, the driveway remains impassable. And it’s a very long driveway. Well, you get the idea.
Unlike many people in my Connecticut town, I didn’t lose power. Which was a godsend, because no electricity also means no heat and no water. Unfortunately the cable connection was down more than it was up, so it was a frustrating day.
The best I can offer you today is a link to a Harvard Business Review blog post by Tony Schwartz from August: "Six Keys to Being Excellent at Anything." It doesn’t break new ground, but it might inspire some New Year’s resolutions.
Unlike many people in my Connecticut town, I didn’t lose power. Which was a godsend, because no electricity also means no heat and no water. Unfortunately the cable connection was down more than it was up, so it was a frustrating day.
The best I can offer you today is a link to a Harvard Business Review blog post by Tony Schwartz from August: "Six Keys to Being Excellent at Anything." It doesn’t break new ground, but it might inspire some New Year’s resolutions.
Thursday, December 23, 2010
Santa reading “The Holy Grail of Trading”
In case you didn’t notice, the page is blank.
The happiest of holidays to all my readers.
Wednesday, December 22, 2010
Durbin, All About Derivatives
All About Derivatives (McGraw-Hill, 2011, a fully revised second edition) is a curious book, and I don’t say that unkindly. It’s just odd that in a book in the “All About” series, touted as “the easy way to get started,” you find such a lengthy discussion of options pricing. But then Michael Durbin is, among other things, a financial technology consultant specializing in high-frequency trading of financial derivatives, and he has helped numerous Wall Street firms develop derivative pricing and trading systems.
The structure of this book is straightforward. After an overview chapter, the author devotes a chapter each to forwards, futures, swaps, options, and credit derivatives. He then looks at using derivatives to manage risk, pricing the various derivatives, hedging a derivatives position, and derivatives and the 2008 financial meltdown. In three appendices he investigates interest, swap conventions, and binominal option pricing.
Even though this book would be a fine introduction to the subject of derivatives, it often goes beyond the elementary. For instance, Durbin points out the subtle pricing differences between warrants and options. Moreover, the book is laced with interesting tidbits. I didn’t know, for example, that Enron issued a series of credit-sensitive notes in 1998 that offered a coupon rate inversely tied to its credit rating.
For options traders who want to delve a little more deeply into pricing models, Durbin offers a gentle account in the text, coupled with a more mathematical description in an appendix. He explains why Black-Scholes cannot be used to determine the value of every type of option. Yes, it was meant to apply to European-style options, and there are other choices for American-style call options. But, he writes, “for American puts, Black-Scholes is simply not a choice. You must use a binomial tree method because an analytical method for pricing an American put option simply does not exist. An analytical solution is one in which you plug factors into a function and get a result. A nonanalytical method is more of a brute-force or trial-and-error approach, which the tree method really is.” It seems that the absence of an analytical solution to pricing American-style puts is an example of a “free boundary” problem. “These things,” Durbin continues, “are hard, like trying to predict precisely where water will flow when poured from a bucket onto a flat surface.” (p. 172)
All About Derivatives is a survey of a world that nearly everybody caught a glimpse of after 2008, but Durbin gives it structure and some mathematical clarity. It is a how-it-works book, not a how-to book. The trader in search of a quick buck will be disappointed. I was not.
The structure of this book is straightforward. After an overview chapter, the author devotes a chapter each to forwards, futures, swaps, options, and credit derivatives. He then looks at using derivatives to manage risk, pricing the various derivatives, hedging a derivatives position, and derivatives and the 2008 financial meltdown. In three appendices he investigates interest, swap conventions, and binominal option pricing.
Even though this book would be a fine introduction to the subject of derivatives, it often goes beyond the elementary. For instance, Durbin points out the subtle pricing differences between warrants and options. Moreover, the book is laced with interesting tidbits. I didn’t know, for example, that Enron issued a series of credit-sensitive notes in 1998 that offered a coupon rate inversely tied to its credit rating.
For options traders who want to delve a little more deeply into pricing models, Durbin offers a gentle account in the text, coupled with a more mathematical description in an appendix. He explains why Black-Scholes cannot be used to determine the value of every type of option. Yes, it was meant to apply to European-style options, and there are other choices for American-style call options. But, he writes, “for American puts, Black-Scholes is simply not a choice. You must use a binomial tree method because an analytical method for pricing an American put option simply does not exist. An analytical solution is one in which you plug factors into a function and get a result. A nonanalytical method is more of a brute-force or trial-and-error approach, which the tree method really is.” It seems that the absence of an analytical solution to pricing American-style puts is an example of a “free boundary” problem. “These things,” Durbin continues, “are hard, like trying to predict precisely where water will flow when poured from a bucket onto a flat surface.” (p. 172)
All About Derivatives is a survey of a world that nearly everybody caught a glimpse of after 2008, but Durbin gives it structure and some mathematical clarity. It is a how-it-works book, not a how-to book. The trader in search of a quick buck will be disappointed. I was not.
Monday, December 20, 2010
Schreiber and Stroik, All About Dividend Investing
What’s all the fuss over dividends? Do they really make that big a difference? In All About Dividend Investing, 2d ed. (McGraw-Hill, 2011) Don Schreiber, Jr. and Gary E. Stroik argue that they make a huge difference. In a classic dividend story they compare the portfolios of twins who were each given $10,000 in 1944 to invest in companies that made up the Dow Jones Industrial Average. The twin who spent his dividends each year had a portfolio worth $767,000 in 2009; he spent more than $370,000 in dividend income from 1944 through 2009.The conscientious twin reinvested his dividends until he retired in 1984 and needed his dividend income to help support his lifestyle. By the end of 2009 his portfolio was worth more than $4.7 million, and since 1984 he had collected more than $1.7 in dividends. So the first twin realized a little over $1 million from his initial gift; the second, about $6.5 million.
Dividend stocks are often recommended in down cycles. In the particular cycle the authors picked (or cherry-picked) $100,000 invested in the DJIA Index in 1966 would have declined to $90,275 by 1981. Had a person reinvested dividends, thereby acquiring more shares as prices were falling, the account would have been worth $186,661 in 1981. And had he taken his dividends in cash, he would have received $64,978 over those years; instead of losing $10,000 he would have netted about $50,000.
In bull markets dividend-paying stocks may underperform the more speculative non-dividend-paying growth stocks (in 1999 the NASDAQ gained 85% while the DJIA advanced only 25%). But with dividends reinvested the return would have increased substantially. An investment of $100,000 in the DJIA in 1982 would have been worth $1,302,760 at the end of 1999; with dividends reinvested, the value would have been $2,056,109.
The authors are writing for the relatively uninformed investor. They offer basic advice on how to screen for stock candidates and how to rank them. They outline alternatives to individual stocks such as folios, ETFs, and mutual funds. They explain simple risk management techniques and write about the current tax treatment of various kinds of dividends.
All About Dividend Investing is a good book for investors who are planning for their retirement needs, although it may not take the place of a financial planner. It offers a model portfolio: 70% dividend payers, 14% tactical choices, 14% noncorrelators, and 2% cash. Within the dividend payers segment the allocation is equally divided into five slices: value, growth, quality, yield, and overall best. But then the reader has to get down to work to find the right stocks to plug into these slices. Otherwise, he can use what he learned to find the right advisor for his needs.
Dividend stocks are often recommended in down cycles. In the particular cycle the authors picked (or cherry-picked) $100,000 invested in the DJIA Index in 1966 would have declined to $90,275 by 1981. Had a person reinvested dividends, thereby acquiring more shares as prices were falling, the account would have been worth $186,661 in 1981. And had he taken his dividends in cash, he would have received $64,978 over those years; instead of losing $10,000 he would have netted about $50,000.
In bull markets dividend-paying stocks may underperform the more speculative non-dividend-paying growth stocks (in 1999 the NASDAQ gained 85% while the DJIA advanced only 25%). But with dividends reinvested the return would have increased substantially. An investment of $100,000 in the DJIA in 1982 would have been worth $1,302,760 at the end of 1999; with dividends reinvested, the value would have been $2,056,109.
The authors are writing for the relatively uninformed investor. They offer basic advice on how to screen for stock candidates and how to rank them. They outline alternatives to individual stocks such as folios, ETFs, and mutual funds. They explain simple risk management techniques and write about the current tax treatment of various kinds of dividends.
All About Dividend Investing is a good book for investors who are planning for their retirement needs, although it may not take the place of a financial planner. It offers a model portfolio: 70% dividend payers, 14% tactical choices, 14% noncorrelators, and 2% cash. Within the dividend payers segment the allocation is equally divided into five slices: value, growth, quality, yield, and overall best. But then the reader has to get down to work to find the right stocks to plug into these slices. Otherwise, he can use what he learned to find the right advisor for his needs.
Friday, December 17, 2010
Dion, The Ultimate Guide to Trading ETFs
The Ultimate Guide to Trading ETFs: How to Profit from the Hottest Sectors in the Hottest Markets All the Time by Don Dion and Carolyn Dion (Wiley, 2011) is a workmanlike account of the benefits and pitfalls of investing in ETFs, many of which have been amply documented in the financial press and on blogs. The authors, however, give structure to the tidbits that the investor can pick up from other sources. The result is (contrary to the subtitle) a well-organized, balanced book that should serve the ETF investor well.
Although most investors know the advantages of ETFs over mutual funds, they are undoubtedly less aware of some of their potential disadvantages. The authors begin with the basics: appropriateness, liquidity, and concentration. Consider liquidity, for instance. The authors explain that ETFs have both primary and secondary liquidity. Primary liquidity refers to the liquidity of the fund’s underlying basket of securities whereas secondary liquidity refers to demand for the ETF itself. If either primary or secondary liquidity is lacking or dries up, the ETF “will tend to trade at a noticeable premium or discount” to its NAV. (p. 9)
Domestic, international, and derivative-based ETFs each come with their own sets of complications. International ETFs can become disconnected from their underlying equities because of time-zone differences; futures-based funds can trade at significant premiums to their NAV when position limits are imposed or threatened.
I appreciate a book that exposes the underbellies of trading vehicles since too many investors have a decent investing idea (hedge a winter’s supply of heating oil with an ETF, circumvent the short-selling restriction in an IRA by buying short ETFs, increase leverage with the 2X and 3X ETFs, gain exposure to an individual country with an ETF) without truly understanding the product they are using to execute their idea. How closely does it track the underlying? Is it best used for short-term trading or investing?
The authors stress again and again that the investor has to educate himself. For example, “there is a world of difference between … iPath Dow Jones-UBS Platinum Subindex Total Return ETN (PGM), which is based on platinum futures contracts, and ETFS Physical Platinum Shares (PPLT), which is backed by a physical stockpile of platinum. The word ‘platinum’ is the only thing these two funds have in common. The ways they provide exposure to that market are diametrically opposed.” (p. 152)
The book also has useful appendixes. One ranks all U.S.-listed ETFs and ETNs (as of April 30, 2010) on a scale of 1 to 5, a scale which is intended to be a guide to their complexity. A second is a tax guide for ETF investors. Yet another appendix offers sample portfolios for various trader/investor types.
The Ultimate Guide to Trading ETFs is not a revolutionary book. But any ETF investor who is not familiar with all of the material included in it is bound to stumble.
Although most investors know the advantages of ETFs over mutual funds, they are undoubtedly less aware of some of their potential disadvantages. The authors begin with the basics: appropriateness, liquidity, and concentration. Consider liquidity, for instance. The authors explain that ETFs have both primary and secondary liquidity. Primary liquidity refers to the liquidity of the fund’s underlying basket of securities whereas secondary liquidity refers to demand for the ETF itself. If either primary or secondary liquidity is lacking or dries up, the ETF “will tend to trade at a noticeable premium or discount” to its NAV. (p. 9)
Domestic, international, and derivative-based ETFs each come with their own sets of complications. International ETFs can become disconnected from their underlying equities because of time-zone differences; futures-based funds can trade at significant premiums to their NAV when position limits are imposed or threatened.
I appreciate a book that exposes the underbellies of trading vehicles since too many investors have a decent investing idea (hedge a winter’s supply of heating oil with an ETF, circumvent the short-selling restriction in an IRA by buying short ETFs, increase leverage with the 2X and 3X ETFs, gain exposure to an individual country with an ETF) without truly understanding the product they are using to execute their idea. How closely does it track the underlying? Is it best used for short-term trading or investing?
The authors stress again and again that the investor has to educate himself. For example, “there is a world of difference between … iPath Dow Jones-UBS Platinum Subindex Total Return ETN (PGM), which is based on platinum futures contracts, and ETFS Physical Platinum Shares (PPLT), which is backed by a physical stockpile of platinum. The word ‘platinum’ is the only thing these two funds have in common. The ways they provide exposure to that market are diametrically opposed.” (p. 152)
The book also has useful appendixes. One ranks all U.S.-listed ETFs and ETNs (as of April 30, 2010) on a scale of 1 to 5, a scale which is intended to be a guide to their complexity. A second is a tax guide for ETF investors. Yet another appendix offers sample portfolios for various trader/investor types.
The Ultimate Guide to Trading ETFs is not a revolutionary book. But any ETF investor who is not familiar with all of the material included in it is bound to stumble.
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