Wednesday, September 28, 2011

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.

Monday, September 26, 2011

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.

Wednesday, September 21, 2011

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.

Monday, September 19, 2011

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)

Wednesday, September 14, 2011

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.

Monday, September 12, 2011

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.

Sunday, September 11, 2011

An image of global markets?

From the Washington Post:

A seemingly intoxicated moose is discovered entangled in an apple tree in Goteborg, Sweden. Per Johansson, 45, says he heard a roar from his vacationing neighbor's garden in southwestern Sweden late Tuesday and went to have a look. There, he found a female moose kicking about in the tree. The animal was likely drunk from eating fermented apples.
Per Johansson / AP

Thursday, September 8, 2011

Capra, Trading Tools and Tactics

For me Greg Capra’s Trading Tools and Tactics: Reading the Mind of the Market (Wiley, 2011) is a trip down memory lane. Back ever so many years ago when I first became interested in trading I took advantage of Pristine’s free online offerings. My own trading strategies have since evolved, but I remain grateful for the education I received. It certainly wasn’t the worst place to start.

In this book Capra distinguishes between objective and subjective trading tools—a distinction which is admittedly difficult if not impossible to sustain. His claim is that technical indicators are subjective because, as derivatives of price, they are open to interpretation. The same holds true for trend lines and Fibonacci levels: you can draw them from a variety of plausible points and get radically different support and resistance levels. Price, by contrast, is objective: “prices are directly observable in the real world and tell us what we need to know.” (p. 6) Among other things, they tell us where support and resistance are. Perhaps, but I’d wager to say that twenty traders would mark up the same price chart in at least ten different ways.

Capra wants to convince the reader to start becoming a winning trader by simplifying his charts. To begin with, by focusing only on candlestick bars and learning their “tells”. Learning, for instance, that “a pivot on a smaller time frame will show up as a tail on a larger time frame” or that a “cluster of bars may reverse prices and show up as a pivot on a larger time frame.” (p. 39) Bar-by-bar analysis and pattern analysis form the core of objective trading.

Once Capra has a clean candlestick price chart he adds volume at the bottom and overlays on prices something he had preciously condemned as being subjective—this time, however, done the “right” way: moving averages. What moving averages the trader uses is largely irrelevant since they are meant only as a guide to determine trend analysis, not entry points. “With that being said, since we do have to pick one or two moving averages to use, I like to pick ones that most traders will be using…. Because when an MA does work as an actual support level, it is due to a subjective method based on a self-fulfilling prophecy.” (p. 60) Capra chooses the 20 and 40 trendsetting moving averages and the 200 as “a line in the sand.” (p. 62)

According to Capra, “for the most part, technical analysis really is one big self-fulfilling prophecy.” (p. 111) But self-fulfilling prophecies should not be dismissed out of hand. Retracements to Fibonacci levels, for instance, may be subjective, but “virtually every trader has retracement concepts in mind. What tends to work well is when these subjective measures line up with objective measures.” (p. 111)

Other tools the trader can profitably use are market internals and, for stock traders, relative strength. But the basic tool remains price charts. Fleshing out this theme, Capra devotes a chapter to gaps, another to the concept of multiple time frames, and a third to pattern failure.

On balance, Trading Tools and Tactics is a very good book for the beginning trader and a wake-up call for the trader who focuses on a mishmash of indicators to the exclusion of price.

Wednesday, September 7, 2011

McCullough, Diary of a Hedge Fund Manager

Diary of a Hedge Fund Manager: From the Top, to the Bottom, and Back Again (Wiley, 2010) by Keith McCullough with Rich Blake is now available in paperback. McCullough, a global macro strategist, is CEO of Research Edge, a firm he founded in 2008.

McCullough’s career in the hedge fund world was not extraordinary. He was never truly at the top nor at the bottom, although he was fired from his last job pre-financial crisis (good call, too early = losses). He got his feet wet at CSFB and then ran money at Dawson-Herman’s Millennium Fund and Carlyle-Blue Wave. He also launched his own fund, later integrated into Magnetar Capital. These days, from his New Haven, CT office, he provides independent research to portfolio managers, analysts, and traders.

Perhaps because McCullough was more a plodder than a superstar and comes across as somewhat naïve compared to the usual Wall Streeter his insights into the hedge fund world are all the more valuable. He doesn’t have that self-aggrandizing, self-censoring instinct.

We read about the old boy network, in this case the Ivy League jock network. McCullough, a Yale hockey recruit from Canada, both benefited from his hockey ties and befriended other former hockey players. There are lots of references to hockey throughout the book. My favorite: when Tiger Williams compared “I-bankers to figure skaters and hedge fund managers to hockey players.” (p. 64)

Recognizing that not everyone on Wall Street came from a high-society background and that some of the junior staff needed help carrying out their new wine-and-dine role with aplomb, the folks at CSFB hosted an in-house wine seminar: “the event could have been called How to Order Fine Wine Without Looking Like a Moron.” (p. 52) McCullough’s practical takeaway: just order something expensive.

McCullough recounts some of his “research” misses and the lessons he learned: “One, stocks don’t lie. People do. And two, if you just go along with what everybody else thinks, if you confuse popular consensus for an honest research process, you’re setting yourself up for failure.” (p. 73)

The book can occasionally be deliciously catty. Back in 2006 McCullough routinely shorted Coach and for the most part got squeezed as “that darling of luxury brands” kept climbing. “Call me bitter, but to me, Coach was emblematic of hype-fed investing. … Its CEO Lewis Frankfort guided the Street about as skillfully as any executive ever has, delivering on growth quarter after quarter. Frankfort had a son who was in equity sales at Bear Stearns. If you were part of Frankfort’s circle, you knew that. You believed his story, and he did not disappoint.” McCullough steadfastly refused to believe the story. “Once a division of the Sara Lee Corporation, Coach went public in October 2000 on the idea that boiled down to women of all ages and income brackets, from Palm Beach to Sri Lanka, needing at least one $250 handbag per year, if not several, possibly one for each season. The idea that the company’s whole entire revenue growth outlook relied on women buying four expensive Coach handbags per year boggled my mind. Sure some might buy four, but all from Coach? And listening to Lew Frankfort talk about ladies’ accessories in a thick New York City accent was comical on a whole other level. He’d be riffing on charm bracelets and the sweet spot between modest and luxurious, speaking in the tones and cadence of a Jets fan calling into a sports talk radio show.” (pp. 133-34) If you’ve ever heard an interview with Frankfort, you know what McCullough means.

McCullough is up front about his calls, both good and bad—in fact, he tends to focus on the bad. In the epilogue he describes a Research Edge morning call that started out: “Okay, so we got our doors blown off.” Then, “with the uncomfortable admission behind me, I continue on with my morning macro overview, delivering in rapid-fire succession a barrage of facts and factoids, takes and observations, glancing at my notebook now and again, but the material pours out because it’s burned on my brain and needs to come out. I cover currencies, countries, commodities—gold is a buy today if it’s down, but long-term I’m selling if it goes over $1,000….” (pp. 197-98) Not the best call, with GLD trading at 93.71 the day before his early morning call on June 2, 2009 and only a slight pullback before gold started its parabolic climb to over $1900. But it stayed in the book.

Diary of a Hedge Fund Manager is a sometimes overly honest, in-the-trenches account of Wall Street and hedge funds between 1999 and late 2007. It makes for good reading.

Tuesday, September 6, 2011

Lehman and McMillan, Options for Volatile Markets

We live in volatile times. Long gone is the decade that saw the first plastic Coke bottle, an immunization vaccine for polio, and passenger jets. The historical 100-day volatility on the S&P 500 index “is now running at almost double the average volatility of the 1950s.” What’s an individual investor or a portfolio manager to do? In this second edition of Options for Volatile Markets: Managing Volatility and Protecting against Catastrophic Risk (Bloomberg/Wiley, 2011) Richard Lehman and Lawrence G. McMillan offer a variety of strategies that can be easily executed and managed and that help mitigate portfolio (as well as individual stock or ETF) risk.

After a brief introduction to the basics of options in general and covered call writing in particular the authors move on to the meat of the book—when to put on and how to manage strategies that can smooth out portfolio returns and sometimes even augment those returns.

The first set of strategies is the family of covered call writing and advanced call-writing. Covered call writing can be an incredibly easy, set it and forget it, strategy: at expiration the call either expires worthless or is exercised. Or the investor can monitor his position and make decisions prior to expiration: he can close part or all of the position or can roll the short call up, down, or out. In the “smart people can sometimes do stupid things” department the authors warn against selling the stock and hanging on to a naked short call position. This warning might seem to be unnecessary, but I heard about a Connecticut family that ended up in the hospital because, in the wake of Hurricane Irene, they ran a generator inside their house. They seem to have been oblivious to the dangers of carbon monoxide poisoning.

The authors provide one of the best accounts of covered call writing I have come across, although those who are familiar with their New Insights on Covered Call Writing (2003) will recognize it as an updated and condensed version of the material presented in their earlier book. They offer tips on choosing strike price and expiration month, they identify potential traps and risks, and they outline basic tax rules for anyone not trading in an IRA.

Going beyond basic covered calls, the authors describe such strategies as the margined covered write; partial, mixed, and ratio writing; and the “call-on-call” covered write or what most of us know as calendar call spreads or diagonal spreads. They also discuss put writing which is, of course, the synthetic equivalent of covered call writing.

Since covered calls can expose the investor to substantial downside risk, what alternatives does the investor who wants to manage risk have? There’s the basic put hedge and more flexible and less costly hedging counterparts such as debit spreads, ratio spreads, butterflies, and calendars. Collar strategies, even those that are passive, can outperform stock-only portfolios. A study looking at performance over 122 months, from April 1999 through May 2009, compared the QQQ to a simple passive collar strategy. The collar outperformed handily on the metrics of return, standard deviation, and maximum drawdown. The authors are encouraged by the results: “if the strategy is effective as implemented in a totally automated manner, just imagine how much we may be able to enhance the results through additional refinements and an overlay of active management.” (p. 151)

Another set of versatile strategies uses VIX options. The authors devote only one chapter to a very complicated subject, but they do an excellent job of sorting things out. They suggest two strategies. First, a perpetual long OTM call strategy on VIX which made money between 3/21/2006 and 6/15/2010 (though its beginnings were not promising). “This,” they write, is “a unique finding, as we are not aware of a single other entity on which a call purchase executed month after month would generate a profitable result over time." (p. 199) The second strategy is to protect a stock portfolio with VIX calls rather than, say, SPX puts. Their reasoning is compelling.

Lehman and McMillan put a lot of flesh on the bones I’ve laid out here. I consider this an important book for anyone who’s finally starting to think about how to manage volatility and protect his portfolio against risk.

Saturday, September 3, 2011

Hurricane Irene and me

Sorry for the long hiatus, but I had no electricity from Sunday morning until Friday night (9/2) as a result of Hurricane Irene. I did, however, get a lot of reading done, so I'll be back in full force shortly.

I tried to hand write reviews but soon enough discovered that I'm an inveterate self-editor: the reviews became illegible scrawl. It turns out that I need electricity not only for light and water (no city water in these parts) but for writing as well. We get spoiled so quickly.