Thursday, August 25, 2011

Trahan and Krantz, The Era of Uncertainty

The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground by Fran├žois Trahan and Katherine Krantz (Wiley, 2011) is a thoughtful, thoroughly researched book. Its main thesis is that macro matters—a thesis that has been amply demonstrated in recent market movement. An investor can be right in his bottom-up analysis, but if he gets the macro picture wrong he’s most likely doomed: historically 71% of equity returns are explained by macro trends.

“Macro,” of course, covers a wide array of forces “that dictate how the world unfolds around us.” The authors identify ten major macro themes that will matter for investors: globalization, the internet and the technology revolution, the implications of the credit bubble, the rise of China and its emerging consumer class, a change in worldwide demographic trends, Americans’ evolving relationships with credit and debt, fiscal crises in the developed world, troubles for the euro and/or the dollar, the Federal Reserve’s dual mandate and its shortcomings, and the changing face of “greed” on Wall Street. (p. 4)

The authors pay particular attention to the business cycle and how it can be understood using leading economic indicators—those with shorter lead times (e.g., Philly Fed index and ISM new orders/inventories ratio), those that are intermediate-term (e.g., consumer prices and emerging Asia equity markets), and those with longer lead times (e.g., changes in global short interest rates and the yield curve). For the investor it is critical to know where we are in the cycle, whether LEIs are accelerating or decelerating. Data from 1950 to 2009 make this clear. During this period annualized equity returns during the early expansionary phase were 34.5%, in late expansion 15.8%, in early contraction, 1.2%, and in late contraction -14.3%. The investor can further improve his returns by choosing those sectors that outperform the broader market in any given phase.

Another mandate for the savvy investor is to recognize and stay clear of bursting bubbles—“with little help from either Wall Street or Washington, D.C.” (p. 50) Trahan, who was chief investment strategist at Bear Stearns and one of the first on Wall Street to sound the alarm on the housing bubble (he left Bear Stearns before its untimely demise), shares some of his research that showed that “the housing bubble was predictable and avoidable.” (p. 67) For instance, home sales prices were far more stretched than rental prices, the ratio of the value of new homes for sale to employee compensation was at a level not seen since the late 1970s, the housing boom was geographically widespread, and the supply of new houses was skyrocketing while “the rate of home non-ownership—in other words, potential demand—was declining sharply.” (p. 70)

Where are we now? And where are we going? The authors are no fans of the policies of the Bernanke Fed. Their criticisms are laid out carefully, with special emphasis on dollar weakness, high commodity prices, and income disparity. And although there are too many variables to predict exactly where we’re headed, the authors suggest that “the global inflationary pressures resulting from the Fed’s weak-dollar policy will likely result in a growth slowdown and a future disinflationary, if not deflationary, period.” (p. 134)

After presenting a detailed account of inflation in the United States and a summary of some of the global economic tensions, the authors offer strategies for investing in both inflationary and deflationary environments complete with supporting charts and figures. The book concludes with some policy suggestions for a better economic future.

The Era of Uncertainty is a model of strategic thinking and often imaginative research. It is well written, its charts are based on the proprietary work of Wolfe Trahan & Co., and its theses are thought-provoking. It’s one of those books to which I’m sure readers will return as events unfold down the road.

Tuesday, August 23, 2011

T3 Live, The Modern Trader

Although The Modern Trader: Wall Street Traders Reveal Their Formula for Success (Marketplace Books, 2011) is clearly a promotional piece, it’s a good read nonetheless. The five partners in T3 Live, an online education platform for traders, recount how they came to be traders and offer advice on surviving and thriving in the trading business. Admittedly, they’re not simply traders. They have a second revenue stream: if trading falters, educating traders just might pick up the slack. And don’t mock the strategy: it’s savvy entrepreneurial diversification.

And these guys are entrepreneurs, through and through. Sean Hendelman, the CEO of T3 Live and a partner in the T3 Trading Group, claims that “trading is the most entrepreneurial business in the world.” (p. 113) This implies first and foremost that a trader must be proactive. “[T]o be an entrepreneur, … you have to go out and take what you want. A ‘take no prisoners’ approach can lead to limitless success if combined with a sound business plan and thorough preparation.” (p. 114) Being proactive also involves never settling for where you are. “The value of change should never be underestimated and its inevitability cannot be ignored. Circumstances and goals will always change, but the important thing is that you always push forward to learn the necessary lessons for success.” (pp. 121-22)

Don’t expect to find information on developing trading setups or systems in this book. It seems that each partner has his own approach to trading—from black box to discretionary manual order entry. What they have in common is enthusiasm for their business. They brim with self-confidence and optimism. They exhibit discipline. They work hard. Sounds to me like a pretty good model for the successful trader.

Monday, August 22, 2011

Dickson and Knudsen, Mastering Market Timing

Given the recent market volatility and the conflicting calls over whether we are carving out a short-term market bottom within an ongoing primary uptrend that began in 2009 or whether the market is rolling over, I was hesitant to review Mastering Market Timing: Using the Works of L. M. Lowry and R. D. Wyckoff to Identify Key Market Turning Points by Richard A. Dickson and Tracy L. Knudsen (FT Press, 2011). But then I decided that perhaps this is indeed the best time to share this work, written by two senior vice presidents at Lowry Research.

First of all, it’s important to note that the authors focus on major market tops and bottoms. Although they accept the notion that market patterns are fractal in nature, they acknowledge that “the probabilities of wrong timing are likely greater on a short-term basis when brief periods of market volatility can upset the most thorough analysis.” (p. 193) They analyze the tops of the 1966-1969, 1970-1973, 1975-1976, 1980-1981, and 2003-2007 bull markets and the bottoms of the 1968-1970, 1973-1974, 1981-1982, 2000-2003, and 2007-2009 bear markets.

Starting with Wyckoff’s models of market tops and market bottoms, they add Lowry’s proprietary indicators--the buying power and selling pressure indexes—to help quantify Wyckoff’s insights. Their calculation takes into consideration daily up/down volume, total volume, points gained, and points lost. Add to the mix the concept of 90% up and down days, introduced by Paul Desmond (the current principal at Lowry Research), and you have the basic ingredients for making major market calls. By the way, I should note in passing as the authors do that a 90% up or down day must include both price and volume; that is, a 90% up day occurs when up volume is 90% or more of the total up and down volume and points gained is 90% or more of the total points gained plus points lost for the session. (p. 25) Desmond’s 2002 Dow Award-winning paper is available online.

To give a sense of the authors’ work, here’s a marked-up chart of the final phase of the 2007 DJIA market top which includes Wyckoff, Lowry, and Desmond notations.

In the second part of the book the authors introduce additional tools for identifying market tops and bottoms: point and figure charts, the NYSE advance-decline line, and the percentage of NYSE issues trading above their 30-week moving average.

Mastering Market Timing will be valuable to anyone wanting to learn more about Wyckoff’s method. Since the Lowry indicators are proprietary, investors will have to be creative in coming up with something that approximates the buying power and selling pressure indexes. In the final analysis, will investors who read this book become better forecasters? I don’t know, but I consider it a boon to have so many charts of market turning points collected in one book.

Wednesday, August 17, 2011

Mea culpa

I know, I know, I’ve been a slouch. In my defense, I’m not the only one. Authors haven’t been prolific either, so I haven’t received a lot of books to review. Call it August.

But slowly this blog will come back to life. Keep the faith.

Friday, August 5, 2011

DeRosa, Options on Foreign Exchange

David F. DeRosa’s Options on Foreign Exchange, 3d ed. (Wiley, 2011) is a book for quants (or perhaps more precisely quantlets), which means that I’m ill equipped to review it in a meaningful way. Instead, I’ll simply outline its contents to give a heads up to anyone who is interested in trading forex options either speculatively or as a hedger and who doesn’t have an aversion to plowing through lots of equations, most of which are admittedly pretty straightforward.

After some basics about the foreign exchange market and options, the author moves on to the meat of the book: valuation of European currency options, European currency option analytics, volatility, American exercise currency options, currency futures options, barrier and binary currency options, advanced option models, and non-barrier exotic currency options.

There’s far more prose than math, and the prose is clear.

And, with that, I’ll abruptly end this post with my sincere apologies to the author. He deserved much better.

Wednesday, August 3, 2011

Passarelli, The Market Taker’s Edge

Options traders who have progressed beyond the basics would do well to read Dan Passarelli’s The Market Taker’s Edge: Insider Strategies from the Options Trading Floor (McGraw-Hill, 2011). Passarelli, a former market maker, shares a few war stories and explains how the stay-at-home trader (the potential “market taker”) can profit from learning what market makers actually do.

The author highlights one difference between “them” and “us” with a story about interviewing applicants for a job to work as an options instructor. All of the applicants had to be current or former professional traders. “Upon arrival at the job interview, traders were given a test that included a few questions that required them to draw at-expiration diagrams for various options strategies. Unexpectedly, more than a fair share of market makers couldn’t complete that part of the test! … Why couldn’t many of the market makers draw these simple diagrams? They are not in the habit of doing so: they don’t need to do so.” (p. 26) They rarely have to deal with absolute, maximum risk since they don’t hold trades until expiration. By contrast, expiration graphs are drummed into the heads of retail traders, and it is only later that they learn that those gorgeous iron condor expiration graphs are a lot less impressive earlier in the trade.

Passarelli spends time on topics most options books ignore, such as order entry (including middling the market), the usefulness (and most often uselessness) of stops on spreads, gamma scalping, synthetics, and position risk thresholds.

Here are a couple of takeaways.

Market makers try to avoid delta bets because “delta is generally a much bigger risk than the risks associated with volatility.” And volatility is, according to academic studies, more predictable than directional price movement. Passarelli continues: “Market makers hedge option trades to eliminate the haphazard directional risk in favor of being left with only the two volatility risks of vega (implied volatility) and gamma/theta (realized volatility). In fact, market makers would generally prefer to also eliminate volatility risk in favor of the arbitrage-like scenario of buying bids and selling offers and going home flat each night. However, positions usually cannot be completely eliminated because each individual option is not liquid enough to day trade and end each day with no position in any series. Thus options must be spread to reduce the impact of vega, gamma, and theta.” (p. 161)

The philosophies of market makers and market takers are radically different. “Market takers make a living selling options (or option positions) at a higher option premium than that at which they buy. Market makers make a living by selling at a higher volatility than that at which they buy. Though … they may be trading the opposite sides of the exact same options, their differing trading perspective makes for a symbiotic relationship.” (p. 210)

To end this review on a lighter note, as Passarelli ends his book, what did pit traders do doing the down times on the trading floor? There was a lot of competition, from how long you could hold your breath to how many eggs you could eat. Passarelli elaborates: “In the pit in which I traded, we would do brain teasers, ask each other what a certain number was in another base—for example, ‘What’s 32 in base 7?’ Game theory questions and obscure trivia always passed the time as well. For a while, we had a Scrabble board set up. You really learn to play Scrabble strategically when you’re playing against traders. And, always, when the Price Is Right came on, we changed the channel to watch.” (p. 222)

Monday, August 1, 2011

Covel, The Little Book of Trading

The latest addition to the “little book big profits” series, Michael W. Covel’s The Little Book of Trading: Trend Following Strategy for Big Winnings (Wiley, 2011) looks at the financial world through the eyes of successful trend traders. In eleven chapters Covel shares insights and life stories from the principals of Sunrise Capital (Gary Davis, Jack Forrest, and Rick Slaughter), David Druz, Paul Mulvaney, Kevin Bruce, Larry Hite, David Harding, Bernard Drury, Justin Vandergrift, Eric Crittenden and Cole Wilcox, Michael Clarke, and Charles Faulkner. And although Ed Seykota doesn’t get his own chapter (except for the lyrics to “The Whipsaw Song”—if you’re not familiar with it, the YouTube video is available at, he is a frequent presence in the discussions of others.

Covel, author of Trend Following, The Complete TurtleTrader, and the recent Trend Commandments, is an unabashed advocate of systematic long-term trend following trading. He doesn’t get into the nitty-gritty of how to develop a trend following system although he references the breakout system of the original turtles, a system I assume most trend traders these days have moved well beyond, and shares some general principles about devising a robust system. That’s okay because each trader really has to come up with his own system in which he believes wholeheartedly; there is no single template for trend trading.

What Covel stresses throughout the book are the accompanying principles that make trend following viable: stick to your plan and manage your risk through diversification, stop placement, and position sizing. These are important principles for any kind of trading, but for trend following they are critical. After all, trend following has a low win percentage and is subject to long stretches of flat to negative performance. As a result it’s easy for a trader to start doubting his system. And for the same reason it’s lethal for a trader to risk too much on any one trade.

Trend traders have to be contrarians in the sense that they have to cut their losses quickly and let their gains run, which “is in fact going against human biology.” We’re “designed to think that what we lose is going to come back,” whether it be the dog who “disappears in the morning but is outside the kitchen door by evening” or our car keys. A trend trader who believes that his unrealized losses will eventually be transformed into real profits won’t be trading for long. Similarly, a trader who accepts the premise of mean reversion—for instance, a trader who “believes he has found a mispricing in an extended market and expects a return to normal prices (whatever normal is)”—as many hedge funds do, will find that “it never works in the long run. That kind of thinking blows up with regularity.” (p. 115)

Covel also rails against buy-and-hold investing and index funds. In the chapter entitled “Study Hard and Get an A+” he recounts a conversation that Justin Vandergrift had with a doctor who kept talking about index investing in the S&P 500.

“When you went to medical school did you ever want to graduate with a C average?” The doctor said, “No.” Vandergrift replied, “Do you want to send your kids to a C school?” He said, “No.” Vandergrift countered, “Then why are you doing that with your money? The S&P is an average. It’s an average of the 500 largest companies in the United States. … It’s a C index. Why would you want to invest to get average returns?” (p. 129)

Successful trend following traders try to capture the outliers, the really big moves that more than compensate for the many small losses they take. This goal requires traders to have confidence in their systems and confidence in themselves. By introducing the reader to successful trend traders, Covel believes that some of their “magic” just might rub off.