Huddleston, The Vigilant Investor

It could never happen to me. Don’t be so sure. Pat Huddleston’s The Vigilant Investor: A Former SEC Enforcer Reveals How to Fraud-Proof Your Investments (AMACOM, 2011) details more kinds of investment fraud than you could ever conjure up in your wildest imagination. The author, a former enforcement branch chief at the SEC, now exposes financial scams (and, according to the FBI, they amount to a whopping $40 billion annually) on www.investorswatchblog.com.

The point of Huddleston’s book is to educate investors to be more diligent when confronted with a seemingly legitimate but in fact fraudulent deal. He suggests steps the investor can take. The simplest is to be familiar with scams of the past; most future scams will either be repeats or variations.

Huddleston may be on a mission, but his book is no homily. Instead, for the most part it reads like a cheap thriller—except for the fact that nothing comes cheap in scams. The cases are real; they range from the “I’d never fall for that” to the “I might just be this guy’s next victim.”

Remember Raffaello Follieri, who claimed to be a representative of the Vatican, sent to help the Catholic Church sell properties so it could settle child abuse cases? The same Follieri who dated Anne Hathaway (among other credits, The Devil Wears Prada)? And who conned supermarket magnate Ron Burkle into putting up capital for his phony real estate venture and then fleeced him for more than a million dollars? He’s now serving time in a federal prison but gets out next May at the ripe old age of 33. Prepare for a second act, warns the author.

In general, the religious are prime targets. Affinity fraud flourishes in certain Christian settings: prosperity theology claims that God rewards the faithful (particularly those who couple faith with outsized generosity) with material wealth. “In scams targeting the faithful, the affinity relates to something more significant than common ancestry; at the very least, it relates to a code of conduct that frowns on fraud. When investors meet an investment promoter who shares their faith, they believe that they understand things about that individual’s character that they cannot know about someone who does not share their faith. When the promoter promises a certain return and gives a personal guarantee that the investment will deliver as promised, the mark is tempted to believe that she has received a sort of divine blessing on the venture.” (p. 103) The author concludes: “Fraud aimed at religious groups is so virulent and effective that the only safe course is to refuse to consider any investment pitched by even a subtle appeal to your faith. Make it your Eleventh Commandment.” (p. 104)

For sheer moxie one of the most notable scams was “the origami airline,” perpetrated by Lou Pearlman (who was the mastermind behind ‘N Sync and the Backstreet Boys). Pearlman created Trans Continental Airlines, a charter airline service. “Its operations were impressive enough to convince a large German bank, Deutschland Invest und Finanzberatung (DIF), to take a major stake. Trans Continental’s balance sheet, audited by Coral Gables, Florida, accounting firm Cohen & Siegel, was impressive enough to convince the likes of Bank of America and Washington Mutual to extend $150 million in credit.” (p. 88) Alas, the company was flying paper airplanes; it was utterly fictitious. Moreover, neither DIF nor Cohen & Siegel was real. The losses that the banks and mom-and-pop investors suffered—more than $400 million—were the sole, painful reality.

Huddleston’s book is both a compelling read and a cautionary tale. It’s well worth a look.

A link for epistemologically minded traders

I have been playing catch-up on blog reading. Most are the standard yada yada yada posts, but here's one that really tickled my epistemological fancy. Jared Woodward at Condor Options wrote an intriguing piece on the distinction between delta one thinking and options thinking. It's definitely worth a read.

Veneziani, The Greatest Trades of All Time

Vincent W. Veneziani’s The Greatest Trades of All Time: Top Traders Making Big Profits from the Crash of 1929 to Today (Wiley, 2011) is not the greatest trading book of all time. The problem is that most of its material is readily available in greater detail elsewhere. For instance, if you want to read about John Paulson’s subprime short, the obvious source is The Greatest Trade Ever by Gregory Zuckerman. Or why read ten pages about Jesse Livermore when we have Reminiscences of a Stock Operator? The only original material comes from the author’s interviews with Kyle Bass and Jim Chanos.

For those who are new to trading, however, this book provides an introduction to some icons of the business and their winning trades. Featured, in addition to Livermore, Paulson, Bass, and Chanos, are Paul Tudor Jones, John Templeton, George Soros, David Einhorn, Martin Schwartz, and John Arnold. The final chapter deals briefly with Phillip Falcone, David Tepper, Andrew Hall, and Greg Lippmann.

Each chapter has a life of its own, but all conclude with very brief sections that recreate the person’s trading strategies and his top traits. For instance, we read that “Jones’s brazen utilization of Elliot [sic] wave theory is legendary.” (p. 43) Jones was not a wave counter; rather, he embraced Elliott’s notion of repeating cycles. The author shows a chart overlaying data from 1982-1986 on 1932-1936 data and notes the striking correlation. Jones “extrapolated a time period with a high correlation and began making investments as if he were living in the past with a roadmap to the future” (p. 38), a technique that was chronicled in the 1987 PBS documentary about him. (Despite the best efforts of Jones and his lawyers, the film is still available online.) Veneziani also notes that “Jones helped define the cliché Wall Street traits that much of the industry and its participants attempt to emulate today.” (p. 44) Among them: intensity, keeping a comprehensive viewpoint, and having a methodical approach.

The reader who doesn’t have hedge fund money behind him will be able to mimic very few of the great trades in this book. And some of the highlighted traits are primarily a product of the individual trader’s personality. But it’s still enjoyable to be a voyeur and more enjoyable yet to daydream about pulling off one of the greatest trades of all time.

A footnote for those who need a laugh. I don’t collect howlers from books, but here’s a good one: “The story of George Soros begins on the dreary streets of 1930s Budapest in what is now known as Hungary.” (p. 87) How was it known to English speakers in the 1930s? Oops, Hungary.

Rhoads, Trading VIX Derivatives

These days the markets are, as we all know, exceedingly volatile. So why not take advantage of the situation instead of throwing up during the roller coaster ride? In Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange-Traded Notes (Wiley, 2011) Russell Rhoads does a yeoman’s job of explaining a wide range of VIX products, including volatility indexes on alternative assets, and exploring some winning (and losing) strategies.

This book is not a page-turner, but what it lacks in literary flow it more than makes up for in data. For instance, Rhoads explores some strategies for using VIX futures as a tool in market forecasting. As one example, he looks at what happens on a day when the spot VIX index rises more than the S&P 500 lost but when the futures rise less than the S&P 500 lost. The day in question happened to be November 20, 2008, a short-term bottom for the stock market. “The S&P 500 index was up over 15 percent over the next four trading days following this divergence day….” (p. 120)

The author also provides data on hedging strategies. A portfolio invested in the S&P 500 index compounded monthly from January 2007 through December 2010 would have lost money; one that was 90% committed to the index and 10% invested in VIX futures would have come out just slightly ahead. Rhoads suggests that “as the VIX and VIX futures have gone through periods of high and low levels, an approach that dynamically hedges based on some sort of indicator or market analysis may result in stronger outperformance. This outperformance may be achieved through increasing or decreasing exposure to volatility based on some systematic approach.” (p. 146)

Rhoads cites a study that looked into whether allocating a small portion of a diversified 60-40 portfolio to VIX futures and options would have improved the overall portfolio performance during the financial crisis (August 1, 2008 to December 31, 2008). The most dramatic improvement came from buying out of the money VIX calls with strikes that were 25% higher than the VIX index. “[T]he fully diversified model portfolio lost 19.68 percent in value. Contributing 1 percent out of the money VIX calls to the portfolio resulted in a portfolio return of 17.70 percent. A 3 percent weighting of out of the money VIX calls resulted in a portfolio return of 97.18 percent.” The authors of the study cautioned, however, that “over the long term, exposure to the VIX for diversification purposes may result in underperformance.” (p. 147)

Traders can also, of course, speculate with VIX derivatives. Rhoads exhorts traders to pay attention to details, such as when VIX futures and options expire (a Wednesday that may vary from month to month) and how options are valued (using the underlying futures) versus how they are settled (in cash based on the VIX index).

Most of the speculation section is devoted to calendar spreads with VIX futures, with VIX options, and with a combination of VIX futures and options. Rhoads also discusses vertical spreads as well as iron condors and butterflies.

Trading VIX Derivatives may not be the quintessential “curl up in front of the fireplace” book, but it belongs in the library of every portfolio manager and trader who wants to learn how to profit from using VIX products. And I suspect more and more investors and traders will fall into this category.

Carlson, George Lindsay and the Art of Technical Analysis

Investors often look to technicians for signs that a market is either about to roll over or that a current downtrend is not simply a pullback but the beginning of a longer-term bear market. Among the technical patterns that portend doom are the direly-named Hindenburg Omen and the Death Cross. The Three Peaks and a Domed House pattern may not sound as menacing as the other two, but it too signals a severe market decline—at least when it occurs in the chart of the Dow Jones Industrial Average.*

In George Lindsay and the Art of Technical Analysis (FT Press, 2011) Ed Carlson introduces the reader to the “seemingly bizarre” discoverer of this pattern, as Louis Rukeyser described Lindsay. Among other things, he wore a bright red toupee, and his last face-lift “left him a bit strange in appearance as it pushed up his eyebrows so he looked perpetually surprised….” (p. 14) Lindsay had an advisory/forecasting service and wrote a weekly investment letter; he did not trade for his own account. Apparently many of his forecasts were spot on.

Lindsay’s sole book was The Other History, which he self-published. It was an attempt to describe temporal patterns in international events, what he called technical history. His technical studies of the stock market appeared only in his newsletters.

Lindsay made a bold claim for his most famous reversal pattern—that it “could be found at 60% of bull market tops and at the peaks of rallies in bear markets (cyclical bull markets).” (p. 41) (Thomas Bulkowski didn’t include the pattern in his Encyclopedia of Chart Patterns because he said he couldn’t find enough samples.) Lindsay, who introduced the Three Peaks and a Domed House concept in 1968, said he found inspiration in two patterns which began in 1893 and 1910.

In its idealized form it looks like this:

Carlson spends a great deal of time describing this pattern and its variations, such as the domed house coming before the three peaks.

He also explains how Lindsay calculated how far markets might fall after this formation appeared.

In general, only three points are needed for the calculation: F, G, and N. If(N-G)/(F-G)—the so-called swingover ratio—is less than 2, the calculated number is used as a multiplier; if it is 2 or greater, the multiplier is simply 2 (with one exception, not worth going into here). The number of points that the market is expected to fall from point N is [(N-G) x multiplier] – (F-G). Lindsay himself admits that not all three peak patterns can be used for this calculation. “Market history shows that a formation can be discarded (1) when it is supplanted by another pattern which precedes or follows it, (2) when it is short or imperfectly formed, or (3) when it occurs at a very low level, historically, in the average.” (p. 89)

Lindsay also had a triangulation timing model that was comprised of three elements: the 107-day top-to-top interval, the low-to-low-to-high interval, and the convergence of these two intervals, which gives a targeted top or high. (p. 95)

Lindsay’s work is complicated, which may be a virtue or a vice. I have described only a few of the timing models and observations that Carlson carefully analyzes.

I will leave my readers with one last takeaway from Lindsay: “I am amazed because few technicians recognize that the length of time that market movements last has always been much more nearly uniform than the number of points which the averages gain or lose. Perhaps it is because, at least in my version of it, I sometimes start counting from secondary highs and lows. But such counts are made comparatively seldom.” (p. 174) Readers who are interested in cyclical market analysis should profit from reading about Lindsay’s variations on the theme.
____

*Lindsay wrote: “Averages composed of a small number of blue chips have always had crisper chart patterns than all-inclusive indexes. It is largely because unseasoned stocks are in a state of flux: new ones are being added, old ones are dropped, and the number of shares is constantly changing. The Dow Jones stocks are more stable in composition. Talk of the Dow Jones Average as being unrepresentative is beside the mark. If you want to know the true level of ‘the market,’ look at the broader averages. If you want to predict the future, go by the Dow or the New York Times Industrials. Indeed, some technicians get the most reliable results by using an index of only ten or twelve sensitive and influential stocks. The NYSE Index of all stocks is nearly worthless in forecasting.” (p. 40)

Schmidt, Financial Markets and Trading

Anatoly B. Schmidt’s Financial Markets and Trading: An Introduction to Market Microstructure and Trading Strategies (Wiley, 2011) would never be subtitled “markets for poets.” (I wrote this lead sentence before I realized, double-checking Schmidt’s credentials, that an earlier book of his was entitled Quantitative Finance for Physicists.) Schmidt has a Ph.D. in physics, is a quantitative analyst, and teaches in the financial engineering program at Stevens Institute of Technology.

This book is not for the math shy. Most of the math is relatively straightforward, but there’s a lot of it. For instance, in the chapter on technical trading strategies Schmidt discusses some popular technical indicators and chart patterns, always with formulas prominently displayed. While I personally think it’s important to know how technical indicators are constructed, there are a host of other sources for this information.

For those who can read formulas as easily as sentences, Schmidt’s book offers a good survey of the academic literature on market microstructure (inventory models, information-based models, models of limit-order markets, and models of empirical market microstructure) and market dynamics (statistical distributions, volatility, and agent-based modeling) and describes some trading strategies (technical and arbitrage) and back-testing procedures.

Personally, I found the section on market microstructure the most intriguing—and since, I somewhat sheepishly admit, I skipped most of the math, I had mighty little to read. Here are a couple of takeaways.

A buyer (seller) is more likely to submit a market order if there is a thick limit order book (LOB) on the bid (ask) side. A buyer (seller) is more likely to submit a limit order if the LOB is thick on the ask (bid) side. (p. 52) (These points may seem intuitively obvious, but how many at-home traders adjust their order types according to supply and demand pressures?)

In the past, intraday U.S. equity trading volumes were U-shaped. Since 2008 the volume pattern has become closer to J- (or even reverse L-) shaped. (p. 59) That is, volume peaks at the end of day.

Readers who are comfortable in the world of quantitative finance will learn much more than I did. Not that this is a groundbreaking book. It is best viewed as a textbook for would-be financial engineers.

Taulli, All About Commodities

Over the past couple of years a lot has been written about commodities, as usually happens in hot markets. All About Commodities by Tom Taulli, the most recent addition to McGraw-Hill’s All About series (2011), is a bit late to the party, but even so a good primer is always valuable for the uninitiated.

Taulli’s book covers a wide swath of topics—for starters, fundamental and technical analysis, order types, contract specifications, U.S. and global exchanges, and options on futures. More interesting are the chapters on the commodities themselves. Little of that dry, mechanical prose you find in most surveys of commodities.

The author shares tidbits that might captivate a cocktail party audience (as long as it’s not a Wall Street crowd) for a couple of minutes. For example, do you think those folks standing around drinks in hand know that Keynes called gold the “barbarous relic”? Or that the spot price of gold is “based on the decisions of five committee members of the London Gold Market” who meet twice a day to set the price, a process known as the London Gold Fixing which has been in place since September 1919?

By the way, a sidenote. According to the Business Insider (September 8), the Pan Asia Gold Exchange (PAGE), owned and operated by the Chinese government, will open in the next couple of months. It is anticipated that PAGE “could pose a challenge to the near monopoly on gold price discovery currently held by the members of the London Bullion Market Association (LBMA) that include many large banks.”

Coffee drinkers might be interested to know that “the origins of coffee go back to the ninth century. The story is that in Ethiopia a goat herder saw that his herd got more energy when eating red berries from a tree. The town was called Kaffa, which became the name for coffee.” (p. 143)

First and foremost, though, the book is an introduction to the vast world of commodities and how the individual investor can profit from it. It’s an easy, enjoyable way to start out.