Monday, February 27, 2012

Deemer, Deemer on Technical Analysis

Don’t tune out. This is not yet another technical analysis primer. Walter Deemer, who logged almost half a century as a technical analyst, has joined forces with Susan Cragin, who knows how to put words and sentences together. The result, Deemer on Technical Analysis: Expert Insights on Timing the Market and Profiting in the Long Run (McGraw-Hill, 2012), is a thoughtful overview of some concepts that inform technical analysis and that the longer-term investor can employ advantageously.

The book includes only a handful of charts, even though Deemer was once described as a person “who regards his charts the way an expert horticulturist might regard a bed of prize geraniums.” (p. 280) His basic stock chart displays price, a 50-day EMA, and in a separate panel “the all-important relative-strength line—which is simply the stock price divided by a broad market index such as the Standard & Poor’s 500 Index.” (p. 84) Deemer also presents charts that look at markets more obliquely. For instance, the ratio of median single-family home prices to the price of gold (1963-2011).

Although this book is part memoir, taking the reader back to the time that “state-of-the-art technology” was 3’ x 3’ loose-leaf binders designed to display four charts (a one-point point-and-figure chart, a long-term point-and-figure chart, a daily chart, and a weekly chart) on facing pages, the bulk of the book is devoted to explaining how to read the tea leaves.

The savvy technical investor, Deemer writes, “always has certain broad indicators in his back pocket, ready to review at a moment’s notice. He knows where the market is within the Kondratieff and four-year cycles. He knows where in the interest-rate and dividend-yield cycles he is. He knows where the last major bottoms and tops are. He knows whether current market sentiment is extremely optimistic or pessimistic. He knows what the current chart pattern looks like. And that’s what he starts with.” (p. 158)

What else can the technical investor call upon to improve his market timing skills? Deemer describes indicators that worked well over time—until they didn’t. A case in point was the ratio of the amount of money in Fidelity’s select money-market fund compared with the amount of money in its sector funds as a whole. (For those who weren’t trading in the 1980s, Fidelity’s sector funds were designed for active traders and were priced every hour.) It was a contrary indicator, with cash very low at market highs and very high at market lows.

He also introduces a promising new indicator based on the ISEE index, a call-put ratio that measures only “opening buy” transactions by the public.

In addition to learning how an experienced technical analyst thinks about investing, the reader can profit from Deemer’s words of wisdom, which he calls “advice for the perplexed” and “rules to live by.” A single example: “Document each buy or sell decision that you make. … Once every six months, prepare a summary report and explain your investment decisions to another human being. (Not your dog—another human being.) Just knowing that you will have to do this will make a big difference in how you operate.” (p. 258)

A footnote: In his brief bibliography Deemer recommends The Intelligent Chartist by John W. Schulz (1962), calling it “the most intellectual discussion of and reasoning behind technical analysis ever written.” (p. 299) I have already filled out an inter-library loan request. If successful (there seems to be only one copy in all of the Connecticut libraries that are willing to lend), I’ll share my thoughts on it in a future post.

Wednesday, February 15, 2012

Brooks, Trading Price Action Reversals

The third and final volume of Al Brooks’s series is Trading Price Action Reversals: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012). A trader does indeed have to be serious to read all three volumes because, according to the author himself, the task is daunting: some 570,000 words.

Only half of the final volume is about trend reversals. The rest deals with day trading, the first hour (the opening range), and putting it all together, including 78 trading guidelines, some of which you may not have encountered elsewhere.

This volume is the most accessible of the three, but then my very tired eyes did a lot of work before getting here. It would be difficult to skip the first two volumes and expect to understand the third.

Brooks himself is not primarily a reversal trader. As he writes, “I prefer high-percentage trades, and my most common trades are pullback entries and trading range fades. I especially like breakouts because when they are strong the probability of follow-through is often more than 70 percent. I look less often for reversal trades, because most reversal attempts fail, but I will take a strong reversal setup.” (p. 463)

Trading a reversal can be tough. “Since traders are expecting a large move, the probability of success is often 50 percent or less. In general, when risk is held constant, a larger potential reward usually means a smaller probability of success. This is because the edge in trading is always small, and if there was a high probability of success, traders would neutralize it quickly and it would disappear within a few bars, resulting in only a small profit.” (p. 73)

Brooks both categorizes the various kinds of reversal patterns and explains what to look for in taking a reversal trade—as always, with ample chart illustrations.

He then turns to day trading, his bread and butter. He warns traders who are not yet consistently profitable against taking small scalps. “A new trader should focus primarily on swinging only the best two to five entries each day, which are usually second entries in the form of reversals at new swing highs and lows on nontrending days (maybe 80 percent of days), and spikes and pullbacks on trend days. Once a trader is consistently profitable, the next goal should be to increase the position size rather than adding lower-probability entries.” (p. 262)

Brooks suggests that the notion of ‘always in’ “might be the single most important concept in trading.” It is part and parcel of swing trading, even though not all swing traders are always in the market. As Brooks explains, “If you had to be in the market at all times, either long or short, the always-in position is whatever your current position is.” (p. 293) There are, of course, many variations on always-in trading—from trying to catch many small swings to scaling into a position in the direction of the trend.

Let me close with two of Brooks’s guidelines.

“The single most important thing that you can do all day is talk yourself out of bad trades.” (p. 529)

“Too early is always worse than too late. Since most reversals and breakouts fail, an early entry will likely fail. Since most trends go a long way, entering late is usually still a good trade.” (p. 532)

Monday, February 13, 2012

Wagner, Trading ETFs

In this second edition of Trading ETFS: Gaining an Edge with Technical Analysis (Bloomberg/Wiley, 2012) Deron Wagner describes a tried and true method for trading ETFs, at least when markets are behaving reasonably well.

Wagner uses a top-down strategy, first determining the direction of the broad market trend and then looking to buy relative strength in an uptrending market and short relative weakness in a downtrending market. He supplements this top-down strategy with some chart patterns and simple technical indicators.

Following chapters on entry and exit techniques, the author turns to examples of actual trades from the years 2005 to 2007—ten long and ten short, not all successful. He explains his rationale for taking each trade, his trade management plan, and how the trade worked out.
To get a feel for his approach, let’s look at a single successful trade, long PBW at $21.44 on September 18, 2007. Okay, I cherry picked this trade because, were an investor still holding onto PBW, he would be looking at a substantial loss. The PowerShares Clean Energy Fund closed last Friday at $6.20. Ouch!

Wagner entered the trade on a breakout above the convergence of both its 50-day moving average and intermediate-term downtrend line. The rationale for the entry was that “the more levels of resistance that converge in one point, the more powerful the breakout will be if it comes.” Moreover, the trading range had tightened up (within the context of a symmetrical triangle) and, as Wagner explains, “tight ranges during periods of consolidation increase the odds of a breakout ‘sticking,’ meaning the breakout holds above the prior level of resistance instead of drifting right back down.” Price moved rapidly, and Wagner decided to sell into strength, exiting just shy of a previous high. On a four-day hold the trade netted a quick 6.6% gain.

Wagner concludes Trading ETFs with ideas for custom-tailoring your approach and some additional pointers.

Veteran traders are unlikely to learn much from this book, except perhaps that outsized returns do not require overly complex systems. On the other hand, investors who want to be more active in managing their portfolios—that is, those who want to morph from being buy and hold investors into swing traders—would do well to read Wagner’s book. The strategies he lays out are relatively simple to follow and tend to outperform as long as markets are not range bound or erratic.

Wednesday, February 8, 2012

Kaplan, Frontiers of Modern Asset Allocation

Frontiers of Modern Asset Allocation (Wiley, 2012) could be subtitled “the collected essays and interviews of Paul D. Kaplan, quantitative research director for Morningstar Europe.” In 27 chapters, most previously published as journal articles in the last decade, Kaplan analyzes a range of issues that both academics and practitioners have found worthy of debate.

The book is divided into four parts: equities; fixed income, real estate, and alternatives; crashes and fat tails; and doing asset allocation. Some of the chapters, such as “Updating Monte Carlo Simulation for the Twenty-First Century” and “Markowitz 2.0” are technical and require quantitative skills. Others, such as those dealing with indexing, will be of interest primarily to academics and those who structure products. Still others are accessible to both financial professionals and investors with some background in statistics. The interviews with such noted figures as Roger Ibbotson, George Cooper, Benoit Mandelbrot, Harry Markowitz, and Sam Savage combine serious—mainly quantitative—discussion and debate with the occasional personal anecdote.

Let’s look very briefly at a 2000 paper written by Roger G. Ibbotson and Kaplan, “Does Asset-Allocation Policy Explain 40 Percent, 90 Percent, or 100 Percent of Performance?” for which the authors received a Graham and Dodd Award of Excellence. The authors raise three questions: “How much of the variability of return across time is explained by asset-allocation policy; how much of the variation among funds is explained by the policy; and what portion of the return level is explained by policy return?” (p. 257) They examined ten years of monthly returns of 94 U.S. balanced mutual funds and five years of quarterly returns of 58 pension funds. Fast forwarding to their conclusion: “asset allocation explains about 90 percent of the variability of a fund’s returns over time, but it explains only about 40 percent of the variation of returns among funds. Furthermore, on average across funds, asset-allocation policy explains a little more than 100 percent of the level of returns.” (p. 265)

Kaplan’s book will not appeal to the average individual investor. However, for those whose job it is to think seriously about asset allocation—whether theoretically or in practice—it offers a wealth of information.

Monday, February 6, 2012

Brooks, Trading Price Action Trading Ranges

The second of Al Brooks’s three-volume magnum opus, Trading Price Action Trading Ranges: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012), focuses on that area where markets spend the majority of their time—in trading ranges. He looks at trading ranges themselves, breakouts from ranges (transitions into new trends), and pullbacks (trends converting to trading ranges). The other two parts of the book deal with magnets (support and resistance) and orders and trade management.

In keeping with Brooks’s general style, the 600-page Trading Price Action Trading Ranges is a detailed and necessarily somewhat repetitive book. After all, if patterns didn’t repeat, technical analysis would be completely bogus.

I, on the other hand, don’t want to repeat myself. Since I reviewed the first volume in December, I’m going to take a different tack this time around and share a couple of points Brooks makes about trading ranges and trade management that I think might be of general interest.

First, on the relation between pullbacks and trading ranges. Brooks writes: “All pullbacks are small trading ranges on the chart that you are viewing, and all trading ranges are pullbacks on higher time frame charts. However, on the chart in front of you, most attempts to break out of a trading range fail, but most attempts to break out of a pullback succeed.” (p. 183)

Second, on so-called reversal patterns: double tops and bottoms and head and shoulders tops and bottoms. “Since trends are constantly creating reversal patterns and they all fail except the final one, it is misleading to think of these commonly discussed patterns as reversal patterns. It is far more accurate to think of them as continuation patterns that rarely fail but, when they do, the failure can lead to a reversal.” (p. 319)

And third, a description of trading ranges in terms of trends. “Every rally in a trading range is essentially a bear flag and every selloff is effectively a bull flag. Because of this, traders trade the top of the range the way they trade a bear flag in a bear trend. … They expect that attempts to break above the trading range will fail, that the bear flag breakouts will succeed, and that the market will soon reverse down and test the bottom of the range.” (p. 331)

Finally, just one of many thoughts on protective and trailing stops. “Traders can use wide stops when they are fading breakouts in stairs patterns or on trending trading range days. If the average range in the Emini is about 10 to 15 points and there is a breakout that runs about five points, a trader might fade the breakout and risk about five points to make five points, expecting a test of the breakout. In a typical situation, this trade has better than a 60 percent chance of success and therefore has a positive trader’s equation.” (p. 523)

Brooks, who believes that “trading is entirely about math,” (p. 437) offers examples of trades with a probability of success of 70%, 60%, 50%, 40% or less, and 40-60%. Naturally, he also describes the reward: risk ratio necessary to break even on each of these types of trades.

As for risk management, he writes graphically: “If you are 60 percent confident that the market will go up, that means that in 40 percent of the cases it will instead go down, and you will lose if you take the trade. You should not ignore that 40 percent any more than you would dismiss someone 30 yards away who is shooting at you, but who has only a 40 percent chance of hitting you. Forty percent is very real and dangerous, so always respect the traders who believe the opposite of you.” (p. 442) Amen.

Friday, February 3, 2012

Williams, Long-Term Secrets to Short-Term Trading

Larry Williams is a legendary commodity trader, author, and educator, probably best known for his blow-out performance (a 11,000% return in 12 months) in the 1987 Robbins World Cup trading contest. In this long overdue second edition of Long-Term Secrets to Short-Term Trading (Wiley, 2012; the first edition appeared in 1999) Williams incorporates some of his more recent reflections on trading.

First, what this book is not: it is not a day-trading manual. In fact, contrary to the title of the book, Williams writes that “You will never make big money until you learn to hold on to your winners, and the longer you hold, the more potential you have for making a profit. … Thus short-term traders, by their very definition, are limiting their opportunities.” (pp. 60-61)

Second, what this new edition doesn’t and does do: it doesn’t update any of the backtests of Williams’ trading “secrets” from the first edition. Fair enough, because as Williams readily admits, systems “work for a while, work really well and then fall apart.” (p. 86) In the second edition he offers some new ideas coupled with “a little common sense and testing.” (p. 95) Nonetheless, traders who are looking for the latest and greatest money-making systems will be disappointed in this book. The systems have (think the music industry) a vinyl quality—regarded by aficionados, largely cast aside by the mainstream and the cutting edge. For better or worse, most quants are pursuing a different path and Williams’ systems seem a bit dated. Then again, as he writes, “you’ll catch more fish with worms and hoppers on a bent pin than any fly ever tied.” (p. 245)

To my mind, the real strength of this book lies in Williams’ thoughts on what it takes to be a successful trader (which is very different from being a trading contest winner—think money management). He writes about fear and greed (and why “there is a lot more to fear than fear itself”). He illustrates how stop placement is critical to a system’s results. And he explains why even successful traders who have no additional income stream may not be able to pay their bills month in and month out.

Long-Term Secrets to Short-Term Trading should be required reading for every new, and even not so new, trader. It imparts the wisdom of the battle tested.

Wednesday, February 1, 2012

Mysak, Encyclopedia of Municipal Bonds

Never having invested in municipal bonds, I had only a passing acquaintance with their structure and history. And, I confess, when I requested a review copy of Joe Mysak’s Encyclopedia of Municipal Bonds: A Reference Guide to Market Events, Structures, Dynamics, and Investment Knowledge (Bloomberg/Wiley, 2012) I anticipated a slow, dull read. How wrong I was!

Joe Mysak is a journalist who has covered the muni market for thirty years—and he knows how to tell a good story. In this so-called encyclopedia he both defines terms and recounts some high and even more low points in municipal bond history. The result is a surprisingly compelling, informative read.

The definitions in this book are not the one-liners we are accustomed to. Consider, for instance, “All bonds go to heaven.” Mysak writes that “This is an old market axiom describing how municipal bonds are bought and held, and rarely trade, after they are sold in the new-issue market.” Mysack provides data to support this axiom. Moreover, he writes, “This also helps explain why prices on outstanding municipal bonds rarely react to news in the way stock prices do.” (p.3)

Or, to take another example, this time from the law, the term ‘ultra vires’ “meaning ‘beyond the power of men’ is used to describe bonds that have been invalidly issued. Municipalities often used such claims to repudiate debt in the nineteenth century, particularly in the Reconstruction South and in the railroad-mad West, which led to the growth of the bond counsel business. In modern times, the Washington Public Power Supply System default in 1983 was caused by a judge ruling that a majority of the participants in the system had entered into contracts without the specific authority to do so, thus invalidating the bond payments and causing the largest default, $2.25 billion, in the history of the municipal market.” (p. 197)

The three-page entry on ‘tourist attractions’ begins “No, no, no, no, no, no, and no. Aquariums, theme parks, glorified rest stops, and zoos have a checkered history in the municipal market, and have left behind a trail of defaults and heartbroken investors.” (p. 191) The lead sentence for ‘Convention centers’ is “Stop the madness!” (p. 36)

Naturally, Orange County, California, rates a lengthy entry, but so does the concept of escrowed to maturity. We read about bid rigging, Chapter 9, garbage, bond insurance, pay-to-play, the 11 Deadly Sins, and Jefferson County, Alabama.

Everyone who invests in municipal bonds should read this book. I would highly recommend it as well to those who simply want to broaden their knowledge of the financial markets. I personally learned a great deal and had fun doing it.