Thursday, October 27, 2011

Tuckett, Minding the Markets

In 2007 David Tuckett, a British psychoanalyst, interviewed 52 asset managers in the U.S., U.K., and Singapore in an effort to understand the context of their decision-making and, subsequently, to make sense of the financial crisis and to offer ways to make markets safer. Minding the Markets: An Emotional Finance View of Financial Instability (Palgrave Macmillan, 2011) explores such core concepts as phantastic objects, divided states of mind, and groupfeel.

In this post let’s look at a single dichotomy: the integrated state of mind vs. the divided state of mind. The former is “marked by a sense of coherence, which influences our perception of reality, so that we are more or less aware of our opposed ambivalent and uncertain thought and felt relations to objects.” By contrast, the latter is “an alternating incoherent state of mind marked by the possession of incompatible but strongly held beliefs and ideas; this inevitably influences our perception of reality so that at any one time a significant part of our relation to an object is not properly known (felt) by us. The aspects which are known and unknown can reverse but the momentarily unknown aspect is actively avoided and systematically ignored by our consciousness.” (pp. xi-xii)

The divided state of mind may be advantageous in certain circumstances—“the single-minded pursuit of a goal in battle with no thought for the consequences, or creative endeavour with little thought for consensus thinking.” Generally, however, “the pursuit of reward is tempered by the fear of loss, producing anxiety, which is a signal of danger.” (p. 63)

Tuckett argues that the financial marketplace accentuates rather than mitigates the human potential for developing divided states of mind. (p. 71) For one thing, there is undue emphasis on short-term returns. Even if a fund’s investment horizon is three to five years, there is pressure to perform short-term. Short-term results are also key in handing out bonuses.

Moreover, firms “may disproportionately select excessive risk-takers and predispose markets to gambling, based on –K [anxiety] thinking, rather than balancing risk and reward, based on K [real enquiry].” Tuckett reasons as follows: “[M]y respondents had to buy and hold stocks in a situation of quality uncertainty and information asymmetry, made particularly powerful by the fact that they were often making claims to have seen things that others had not. It is not surprising that this created a conflicting emotional experience. While it could be faced within an integrated state of mind, it is easy to see how it might be quickly and ‘dirtily’ dealt with in the short run by denial and a divided state of mind—in which case we would say that the dependent ambivalent relationship necessarily formed with assets is governed by –K rather than K. In –K decision-making anxiety about uncertainty is set aside. There is no longer an emotional incentive to desist from risky decisions. It creates the possibility that the attitudes and behaviour of many asset managers (particularly in a rising market and when there is pressure on them to perform exceptionally) will be excessively risky and that those who are successful will be rewarded so that it is people in a divided state who dominate the market. Those who make decisions in a divided state, if their gamble comes off, will perform better both than those who gamble and lose and those who are cautious.” (pp. 165-66)

Tuckett also found that “managers did not seem to approach failure in an integrated state of mind using their capacity for enquiry (K) to work through and learn from their mistakes. They did not mourn failure, so to speak, rather they sought to move on and fortify themselves for the next battle. This is what divided states enable human beings to do…. By and large the explanations my respondents gave for failures were not ones it would be easy to translate into successful decisions next time.” (p. 167)

Tuckett’s thesis requires some fine tuning, but I’m sure we can all recall those occasions on which we threw caution to the wind. Our wins, of course, resulted from our own careful enquiry (and genius); our losses from the vagaries of outside forces over which we had no control. And what did we learn that could make us better traders/investors? Nada.

Tuesday, October 25, 2011

Ranadivé and Maney, The Two-Second Advantage

The Two-Second Advantage: How We Succeed by Anticipating the Future—Just Enough (Crown Business, 2011) by Vivek Ranadiv√© and Kevin Maney explores how our brains predict future patterns and what this might mean for predictive software technology. Here I’ll limit myself to a couple of insights about our predictive abilities. Yes, you may have read most of this before, but it bears repeating.

The hero of the book is Wayne Gretzky, the 170-pound “weakling” who developed “an exquisite hockey brain.” I assume you know the famous line: “he doesn’t skate to where the puck is—he skates to where it’s going to be. Commentators would often say that Gretzky seemed to be two seconds ahead of everyone else.” (p. 5)

In fact, the authors claim, “most successful people are really good at making very accurate predictions—usually about some particular activity—just a little faster and better than everyone else.” (p. 8) How do people develop predictive skills? Some people are born with them, others acquire them through extensive deliberative practice.

Talented people have “an unusual ability to focus the brain’s resources on one task. … They seem to start up their mental models, quiet everything else, and open channels between regions of the brain. They run their minds so efficiently that time seems to slow down, possibly because they’re actually perceiving the world faster than the rest of us—which helps them get their predictions out ahead of the rest of us.” (p. 70)

Talented people also have a heightened sensitivity to weak signals, even to missing signals. They “make predictions based on a lack of events. This means they catch the notes that didn’t get played because someone in the orchestra missed them or recognize the deal that didn’t happen or the move an opponent didn’t make. It’s much more subtle than processing the things that do happen and takes a greater level of knowledge and a higher level of thinking.” (p. 46)

Let me conclude with a takeaway that applies to business management. Ben Horowitz, whose credentials go all the way back to being an “unheralded” product strategist at Netscape and who with his old Netscape boss launched the venture capital firm Andreesen Horowitz in 2009, believes that “there are two types of people in the top ranks of companies:” ones and twos. “Ones are predictive. Twos have to rely on mountains of data to figure out what they think. Ones should be CEOs, and twos should not.” (p. 24) Steve Jobs, of course, was the quintessential one; Steve Ballmer is a two.

Monday, October 24, 2011

Stock Trader’s Almanac 2012

The leaves are falling, Halloweeners are readying their costumes, and a new Stock Trader’s Almanac (Wiley) has arrived. The 2012 edition marks the 45th year of this annual publishing tradition. Jeffrey A. Hirsch, Yale Hirsch, and their team at the Hirsch Organization have once again produced an attractive spiral-bound desk calendar chock full of updated statistical data.

This volume follows the standard format. The calendar section takes up about 60% of the book; the rest is devoted to tables, statistical analyses, and personal record keeping.

In the calendar section recto pages are the actual calendar entries, complete with coding for each day. A witch icon appears on options expiration days. A bull icon “signifies favorable trading days based on the S&P 500 rising 60% or more of the time … during the 21-year period January 1990 to December 2010.” A bear icon uses the same parameters to identify unfavorable trading days. To provide even more granularity, beside each date are numbers indicating the probability of the Dow, S&P 500, and Nasdaq rising using the same lookback period. At the bottom of each entry is a quotation. There’s about a five-square-inch space in which to write.

Verso pages provide seasonal data, beginning with vital statistics for each month. Among the wealth of other data analyzed are the January barometer, market performance during presidential election years, market behavior three days before and three days after holidays, the best six months switching strategy, and Wall Street’s only free lunch.

Each almanac highlights the best investment books of the year. This year the top award goes to Ed Carlson’s George Lindsay and the Art of Technical Analysis, which I reviewed in September. The editors are major fans of Lindsay, whom they describe as “a brilliant market prognosticator who made numerous bold and uncannily accurate predictions. He was an intense student of history, market cycles, and repetitive price patterns. From memory, George could reproduce a chart of stock market prices for every one of the previous 160 years prior to his death in 1987.” (p. 114)

Every investor or trader who believes that history provides a guide to the future will do well to have the Stock Trader’s Almanac 2012 on his desk.

Thursday, October 20, 2011

Brown, Red-Blooded Risk

If you read only one finance book this year, Aaron Brown’s Red-Blooded Risk: The Secret History of Wall Street (Wiley, 2012) would be a good bet. Despite its title and subtitle, it is not a tell-all book and it would make a lousy movie. Instead, it challenges the reader to rethink the way she looks at commonly accepted financial principles. The experience can sometimes be intense, so to give the reader a break Brown intersperses chapters on quant history—and even here he rewrites the history we thought we knew.

This is a no-math-required book. But it is decidedly not a no-brains-required book. It reads easily, indeed enjoyably. At almost every turn, however, it offers an uncommon perspective. Take a concept as basic as risk. First, Brown differentiates risk from both danger and opportunity. Among other differences, risks are two-sided and measurable. As something of a corollary, he contends that risk is good. This does not mean that “risk must be accepted in order to improve expected outcomes. That makes risk a cost, something bad that you accept in order to get something good.” (p. 21) Those who treat risks as costs confuse risk with danger.

Brown, currently risk manager at AQR Capital Management, describes the principles and practice of risk management. The key principles are risk duality (the normal and the abnormal), valuable boundary (think VaR), risk ignition (Kelly’s optimal amount of risk that leads to exponential growth, though only within the VaR limit), money, evolution, superposition, and game theory. The practice, and Brown describes it from its infancy to its current state, depends on where you’re sitting—front-office, middle-office, or back-office. All, of course, involve intense quantitative analysis; the requisite people skills vary.

One of the jobs of the front-office risk manager is to analyze trading performance. Since independent traders are their own front-office risk managers, here’s an insight from someone who has monitored innumerable (well, probably not) trading results. First, two definitions to set the stage. “The accuracy ratio is the fraction of trades that make money. The performance ratio is the average gain on winning trades divided by the average loss on losing trades.” And second, the critical paragraph. “In principle, there is a trade-off between these two. If you cut losers faster and let profits run longer, you’ll have a lower accuracy ratio but a higher performance ratio. In practice, it very often seems to be true that the two are not closely related. The trader can pick a performance ratio, the market gives the accuracy ratio. Attempting to increase the accuracy ratio by sacrificing performance ratio seldom works. Therefore, the usual advice is to target a specific performance ratio, adjusting your trading if necessary to get to that target, but only to monitor accuracy ratio. When accuracy ratio is high, bet bigger, when it’s low, bet smaller or even stop trading until the market improves for your strategy.” (p. 221)

Who should read this book? Those who are interested in the battle between statistical frequentists and Bayesians and possible paths toward reconciliation. Those who aspire to be risk managers or who just want to know what they do and what their role was in the financial crisis. Those who are convinced that they know exactly what happened in tulipmania (read the fascinating chapter “Exponentials, Vampires, Zombies, and Tulips”). Those who have a passion for money—that is, its past and future (derivatives?). Those who want to pick the brain of a top poker player during the 1970s and 1980s, not for poker but for risk tips. Those who are tired of dull ideas expounded by drab people.

Here are a few disconnected closing thoughts about Brown’s book. Red-Blooded Risk is a heavy book, and I mean that in the old-fashioned sense of the word. It weighs in at two pounds for 415 pages. It is a book that makes you think. I highly doubt that you’ll agree with all of Brown’s ideas, but they are worthy of serious debate. It has comic strips provided by manga artist Eric Kim. It has a wonderful bibliography. And it extols those red-blooded risk takers “who are excited by challenges, but not to the point of being blinded to dangers and opportunities.” (p. 4) I have to admit, however, that I felt a sense of camaraderie with Paul Wilmott who wrote on the dust jacket: “His blood is considerably redder than mine, which is looking rather pink after reading this book. I’m not sure I’ve got the nerve to follow all of his advice, but then again I like quiche.”

Tuesday, October 18, 2011

Pestrichelli and Ferbert, Buy and Hedge

Long-term investors are faced with a host of difficulties. As a strategy, “buy and hold” has been a dud over the last decade. Diversification sometimes helps, but when it’s most needed it usually doesn’t. Jay Pestrichelli and Wayne Ferbert offer an add-on in Buy and Hedge: The 5 Iron Rules for Investing Over the Long Term (FT Press, 2012). As the title indicates, they suggest that investors use options to hedge their stock positions.

The basic premise is both simple and sound. Risk is the input to your portfolio, return is the output. This means that you can control risk, not return. Put another way, risk is what you buy, return is what you hope for.

The authors hammer this point home over and over, and they’re wise to do so since investors invariably focus on the potential reward of their position, not on the actual risk they are incurring. Yet they might just as easily be pinning their hopes on Enron as on Apple. Stock picking is tough.

And so, the authors argue, the solution is to define risk. Ideally, every investment should be hedged. Alternatively, the portfolio as a whole can be hedged. The authors outline a range of strategies, from married puts, collars, and ITM options to vertical and diagonal spreads, to accomplish this goal.

Since for the most part the authors view options as hedging vehicles, not speculative instruments, the focus is on risk management. They boil risk management down to four metrics, all of which should be used in analyzing a portfolio: capital at risk, volatility, implied leverage, and correlation.

Implied leverage may be an unfamiliar concept, so let me describe it briefly. First, what it is not: it is not using margin to buy stock. Rather, it focuses on the power of options to create leverage for a portfolio. That is, if an investor uses options to create exposure to equities and ETFS, he likely uses less capital than if he had bought or shorted the equity or ETF directly.

The authors offer the following example. “Suppose an S&P 500 ETF is trading at exactly $100 per share. You open an account with $100,000 in cash. Then you purchase ten Options contracts that are calls with a $90 strike price that expire six months from today…. The price of these Options is $11 per share…. Since a contract has 100 shares, the total price is $11,000. And with these ten contracts, you control 1,000 shares….” (pp. 81-82) The $100,000 portfolio is comprised of $11,000 in the SPY call options and $89,000 in cash. The implied leverage in this case is 1.0, calculated by using the formula (total market value of nonderivative securities + implied equity value for each derivatives position) / (total portfolio value – borrowed money).

If you add 2,000 shares of MSFT trading at $25 a share, your $100,000 portfolio now has an implied leverage of 1.5 because it controls the $100,000 of implied equity value plus $50,000 worth of MSFT. The numerator is now $150,000, and the denominator doesn’t change. The portfolio with the higher implied leverage gains more in an up market and loses more in a down market. If, for instance, SPY and MSFT both increase by 10%, the first portfolio will be worth about $109,750 and the second portfolio $114,750. If they both decrease by 10%, the first portfolio will be worth $91,000 and the second $86,000.

The authors conclude that “too much leverage increases your portfolio’s volatility by increasing the portfolio’s rate of change. The recommendation from Buy and Hedge is to avoid all excess leverage. Your implied leverage should always be 1.0 or lower. Your traditional leverage should always be 1.0 also.” (p. 85) Advanced investors who are looking for specific risk trades will end up with implied leverage well past 1.0, but the authors are trying to steer investors away from taking on speculative options risk. They are first and foremost hedgers.

Throughout the book the authors offer advice for long-term investors. For example, in the chapter “Harvest Your Gains and Losses” they identify when to reset your hedge in an investment that has an unrealized gain. Their suggestion is that once the unrealized gain of an investment is at least 50% of the total capital at risk for that investment, you should consider resetting the hedge to lock in gains.

Buy and Hedge is an eminently practical book for the long-term investor—and there are mighty few such books around these days.

Thursday, October 13, 2011

Trester, Understanding ETF Options

Remember the student (of course it wasn’t you) who, faced with an assignment for a ten-page paper and with nothing much to say, resorted to wide margins, triple spacing, and—if he had a computer—a large font size? Kenneth R. Trester goes even further in Understanding ETF Options: Profitable Strategies for Diversified, Low-Risk Investing (McGraw-Hill, 2012). He pads his 233-page book with lots of readily available lists. For instance, he spends about 50 pages listing ETFs, MLPs, and REITs. Another 40 pages is devoted to normal (fair) value listed call and put tables. That leaves 143 pages for large-print text.

Trester describes option basics and recommends computer simulation to “tell you what your true odds of profiting are.” (p. 106) Not surprisingly, Trester touts his own simulation programs and, later, his newsletter.

What secrets does Trester impart? If you’re buying options (either calls or puts) you “should avoid buying options on ETFs, as most ETFs neutralize volatility.” Instead, “bet on explosive, unstable, small stocks” and “go for the home run.” (pp. 110, 113)

But the “hidden path to profits” is option writing. If you want to buy stocks and ETFs at lower prices and sell them at higher prices, “write naked puts and covered calls. This strategy forces you to buy stocks and ETFs at lower prices and sell stocks and ETFs at higher prices. This is the investor’s ideal.” (p. 134)

“In order to buy stocks and ETFs at low prices, you should write put options that will expire 80 percent of the time worthless without needing to buy the stock. Then you will get the stock at low enough prices and, of course, earn a lot of income as you wait to try to buy the stock. … Of course, the question is how do you know if your written puts will expire as worthless 80 percent of the time? The answer is computer simulation.” (p. 138)

To sum it up, and ratchet up the numbers, “The financial regulators do not believe you can win 90 percent of the time, but you can when you write puts (using a simulator to make sure you have a 90 percent chance of winning). You can win 90 percent of the time, and the remaining 10 percent will get you the underlying stock or ETF at an attractive price. This is the Holy Grail of investing. This is the secret weapon. Add diversification, and you have the perfect game plan.” (p. 177)

Would that life were so simple.

Monday, October 10, 2011

Half-price book sale

Once again, my bookshelves are spilling over, so it’s time for a major fall housecleaning.

Here’s the deal. I will sell the books listed below for half the current official Amazon U.S. price plus the cost of domestic media mail—figure $3 for a single title, less per book for multiple titles. (I’m willing to ship outside the U.S., but shipping charges can be prohibitive.) They are officially used because, yes, I read them. But I have one of the tiniest “book footprints” on the planet; my used books look better than most new books at the local bookstore. No dog ears, no coffee—or, in my case, tea—spills, no visible fingerprints.

In deference to the publishers who so kindly supply me with review copies, I am not offering anything I have reviewed in the last three months.

If you would like to buy any of these books, please email me at My preferred method of payment is PayPal. I’ll fill “orders” on a first come, first served basis.

I'll update this list as I receive payment for individual titles.

Anson et al., The Handbook of Traditional and Alternative Investment Vehicles
Bhuyan, Reverse Mortgages and Linked Securities
Biggs, A Hedge Fund Tale of Reach and Grasp
Caliskan, Market Threads (stamped “review copy not for resale” on bottom edge)
Caplan, Profiting with Futures Options (paper)
Fischer, Trading with Charts for Absolute Returns
Fullman, Increasing Alpha with Options
Isbitts, The Flexible Investing Playbook
Kaufman, Alpha Trading
Koesterich, The Ten Trillion Dollar Gamble
Kolb, Financial Contagion
Koppel, Investing and the Irrational Mind
Kroll, The Professional Commodity Trader
Kroszner & Shiller, Reforming U.S. Financial Markets
Kurzban, Why everyone (else) is a hypocrite (stamped “review copy not for resale” on bottom edge)
Labuszewski et al., The CME Group Risk Management Handbook
Leibovit, The Trader’s Book of Volume
Light, Taming the Beast
Marston, Portfolio Design
Martin, A Decade of Delusions
Meyers, The Technical Analysis Course
Phillipson, Adam Smith
Shover, Trading Options in Turbulent Markets
Sklarew, Techniques of a Professional Commodity Chart Analyst
Sorkin, Too Big to Fail

Thursday, October 6, 2011

Columbus Day sale

Mark your calendars! Monday is the opening day of my second half-price book sale. The list is long, and there are lots of goodies. First come, first served.

I’ll provide more how-to details in Monday’s post.

International readers should probably window shop only since shipping charges to destinations outside the U.S. tend to be steep. Books, after all, are heavy, and there’s no international media mail rate.

Wednesday, October 5, 2011

Corbitt, All About Candlestick Charting

If you haven’t read the last dozen or so books on candlesticks, Wayne A. Corbitt’s All About Candlestick Charting (2012), the most recent volume in McGraw-Hill’s “All About” series, is a good place to start. The author is writing for the neophyte who can benefit from a primer on charts (candlestick and its cousins) as well as technical analysis.

In the first third of the book Corbitt describes the major candlestick reversal and continuation patterns. He then explains how to complement these patterns by using western techniques, both chart reading (trends, support and resistance) and technical momentum indicators. He then adds volume to the mix, including in his analysis the “convenient” yet, as he is the first to admit, problematic candlevolume charts. (I personally can’t understand why anyone would use candlevolume charts instead of, for instance, more granular and informative tick charts.) The final section of the book describes three-line break, renko, and kagi charts.

The book is clearly written and has plenty of illustrative figures and charts. For the most part it is a derivative work, which is fine for a primer. One original contribution is the author’s smoothed volume percentage indicator (VPI), which is akin to the on balance volume indicator. It is used to analyze the cumulative volume of the top stock holdings of ETFs to determine whether an ETF trend is likely to continue or reverse.

All About Candlestick Charting may not belong in the library of a seasoned trader, but it’s a worthy addition to McGraw-Hill’s “easy way to get started” series.

Monday, October 3, 2011

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

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.