Coming attractions

Here are some of the titles that I’ll be reviewing in the next couple of weeks:

Koppel. Investing and the Irrational Mind
Bigalow. Profitable Candlestick Trading
Michalowski. Attacking Currency Trends
Cohen & Malburg. Surviving the Bond Bear Market
Marston. Portfolio Design
Elder. The New Sell & Sell Short
Byers. The Blind Spot
Knuth. Trading Between the Lines

So stay tuned.

The secret of success

From this month’s Despair, inc. calendar: What is the secret? Pretend you’ve already achieved it—then offer to sell the secret to others.

Sound familiar?

Arnett, Global Securities Markets

It’s unclear to me who the intended audience is for Global Securities Markets: Navigating the World’s Exchanges and OTC Markets (Wiley, 2011) by George W. Arnett III. The flap describes the book as a complete Global Investing 101 course (in about 150 pages), but this is definitely not the case. The author, a lawyer, is primarily concerned with the legal structures, regulatory environments, and safeguards of financial markets. Contrary to the book’s title, the U.S. financial system receives the most extensive coverage.

Rather than write about market structure (exchanges and their associated depositories), the history of U.S. regulation, or issues surrounding margin, derivatives, short selling, and prime brokerage—all topics covered in Arnett’s book, I decided to share an interesting case study of how money can move around the world despite governmental constraints.

In 2003 Hugo Chavez imposed currency controls to restrict the flow of U.S. dollars into and out of Venezuela. A Venezuelan national or company that wanted U.S. dollars had to apply to a government agency under the jurisdiction of the Ministry of Finance. The process was lengthy and cumbersome and the kinds and sizes of approvable transactions were limited. Naturally, enterprising souls found a way to introduce “a parallel unofficial exchange regime.” (p. 129) Enter the process of permuta (swap). It’s far more expensive (6.5 to 7 bolivars to the U.S. dollar as opposed to the official change rate of 2.15 to 1), but it gets the job done. Here’s how it works.

The Venezuelan national or company takes the first step by depositing bolivars in the bank account of a local broker-dealer and using the deposited funds to buy a bond denominated in bolivars. The broker-dealer transfers this bond to an offshore entity that typically it has set up itself for the purpose of permuta. The favorite sites are Panama, the Netherlands Antilles, the Cayman Islands, and the British Virgin Islands. In the next step of the transaction the bolivar-denominated bond is swapped for a U.S. dollar-denominated bond held at a second offshore company, and this dollar-denominated bond is sent to the original client. The second offshore entity, which usually has an account at a U.S. bank or broker-dealer, then buys the bond from the client at a predetermined price and wires the proceeds to the client’s U.S. account. And, finally, it sells the Bolivar-denominated bond into the U.S. market. (p. 130)

The process is lawful even if not transparent. At least, it is normally lawful. An exception may arise if the second offshore entity conducts its activity in a U.S. account. “If the sale of the U.S. dollar-denominated bonds is to effect a permuta transaction whereby a U.S. dollar-denominated instrument is converted into U.S. dollars for the express purpose of moving funds from one place to another on behalf of a third party without any market risk to the participants, then the offshore company, if not licensed in the U.S. to provide money transfer services, may be acting as an unlicensed money transmitter under U.S. regulations.” (pp. 131-32)

Although financial firms can help foreign nationals and companies convert their money, even if the task sometimes requires activity bordering on skullduggery, many countries, including the United States, draw a line in the sand when it comes to helping foreign clients evade taxes in their home country. Recently, for instance, the Argentine government cracked down on transactions to and from tax havens. It was trying to stop the flow of so-called blue money and black money, neither reported for tax purposes, to offshore accounts. The tax evaders cannot turn to U.S. firms for help in masking their identities as their money wends its way to a proscribed tax haven. As Arnett writes, “A U.S. financial firm could run afoul of U.S. law if it knowingly assists Argentinian nationals to evade taxes through the knowing facilitation of intermediary transfers. In 2005 the U.S. Supreme Court decided a case called United States v. Pasquantino that established that a plot to defraud a foreign government of tax revenues (in this case, Canadian customs duties on alcohol) that has a U.S. nexus (use of the telephone in the United States) is a federal crime. The ruling overturned established law that one country would not look to enforce the tax laws of another country.” (pp. 139-40)

Gutmann, The Very Latest E-Mini Trading,2d ed.

Michael J. Gutmann, a frequent contributor to Futures Magazine, straddles the worlds of discretionary and automated trading. His trade entry setups, though well structured, are discretionary whereas his trade management system is more automated. In The Very Latest E-Mini Trading: Using Market Anticipation to Trade Electronic Futures, 2d ed. (2010) he explains both why he has adopted a hybrid system and what the ingredients of his system are.

Let’s start with the automated side of trading, which is designed to prevent the trader from taking profits prematurely. As Gutmann writes, “We can talk all we want about the importance of trading with the trend and achieving winning runners, but it seems that without some external, automatic mechanism as a guide … , we just can’t not take certain profits. Perhaps what’s important is to recognize this fact and then find the right tools to deal with it.” (p. 247)

Gutmann, using NinjaTrader, employs a three-tiered strategy for trading ES—an initial 10 tick stop loss for all targets, two defined targets (4 and 6 ticks), and a third target that will be trailed with Invivo.Stops. If the market accommodates, the trade will be managed mechanically. There are, however, two occasions on which the trader can override the trailing stop. First, if indicators (the author is particularly fond of his statistical MACD) point to a reversal, the trade can be closed manually before the stop-loss triggers. Second, if the market is trending strongly, the stop may be moved farther away than the software would dictate.

In placing trades as well as in managing them Gutmann stresses the importance of market architecture. What kind of a day is it? Is it, to use the terminology of market profile theory, a non-trend, normal, neutral, double-distribution, or trend day? Where is price relative to the session’s first hour price range or to the point of control? What is volume (Gutmann relies on his cumulative ticks indicator) telling us? Are there any discernible price patterns? What time of day is it?

Answering these questions helps the trader anticipate price movement. And anticipation, the author argues, is essential to success. “Anticipating the market rather than chasing it means using orders set ahead of the market (Limit or Stop Market) to open positions, and at prices that are predefined by the day’s architecture of price action.” (p. 262)

Gutmann packs his book with trade examples complete with charts, which is great. Unfortunately, since he is not a wordsmith, he uses acronyms to identify his trade setups and market conditions. For instance, MML is momentum move with ledge, BOP is breakout pullback, IB RE is initial balance range extension, and RBS is resistance becomes support. For me, at least, it was something of a chore to remember the acronyms; I often had to refer back to the earlier text.

The Very Latest E-Mini Trading is not a book for those who want instant gratification. On the contrary, it demonstrates the necessity of experience, analysis, trial and error, creativity, testing, more experience, more analysis—and the beat goes on. But there is a lot of useful material in this book to help the trader along the way. The developmental and statistical work Gutmann himself undertook will save the trader time (I particularly appreciate his trade management directed graphs), the sample playbook is an excellent guide, and the discussion of market architecture brings home the importance of context. It may not be the easiest book to read, but then who ever said that learning to trade well was easy?

Masonson, All About Market Timing, 2d ed.

“If you were in a leaking boat,” Leslie N. Masonson writes, “you’d have three choices: 1. Stay in the boat and stop the leak = Go short. 2. Get out of the boat = Switch to cash. 3. Go down with the ship = Buy-and-hold.” (p. 60) In this second edition of All About Market Timing: The Easy Way to Get Started (McGraw-Hill, 2011) Masonson explains why market timing is superior to buy-and-hold and describes some timing strategies that have been profitable in the past.

Most people, I assume, would prefer market timing to buy-and-hold—if it really were a viable strategy. The main argument against timing is that it can’t be done. The investor will end up being out of the market on the best days, in on the worst days, and poorer for his efforts. Better just sit there, say the critics, take your lumps in bear markets, and trust that the market will eventually power ahead, taking you along with it. Unfortunately the market can be very slow to recuperate from downdrafts, as the author documents in several tables.

Masonson presents five familiar market timing strategies: the best six months, presidential cycles combined with seasonality, simple moving averages, the Value Line 3 and 4 percent, and the Nasdaq Composite 6 percent. These strategies are best pursued using ETFs rather than individual stocks or mutual funds.

Performance summaries for each of these strategies (and variations on them—for instance, using daily versus weekly data, leveraging, and tweaking the seasonal approach) are included. Some of the summaries are updated through 2010, and some come with equity curves for the more visually oriented.

Where the performance of a particular strategy has degraded over time, Masonson offers an alternative. The Value Line 4% strategy, which triggers a buy signal when the Value Line Composite Index rises 4% from its last market low and a sell signal when it declines 4% from its last market top, performed well for quite a spell but then turned in mediocre results (although it still beat buy-and-hold). Between January 28, 2000 and January 12, 2001 the weekly strategy signaled 15 trades, of which 14 were losers; the daily strategy over roughly the same time period experienced 18 losers out of 20 trades. A 3% weekly strategy would have outperformed dramatically. Of course, this is 20/20 hindsight, and we don’t know how well a 3% strategy will deliver in the future.

In the book’s final chapter Masonson highlights some market timing newsletters, web sites, and advisors. Most of these are by subscription only—no free lunch, it seems, in the market timing world.

All About Market Timing is an introductory text, but it’s an excellent place to start to weigh the pros and cons of trying to time the market.

Dormeier, Investing with Volume Analysis

In addition to his “real” job managing money, Buff Pelz Dormeier develops technical indicators. He shares some of the fruits of his—and his noteworthy predecessors’—labor in Investing with Volume Analysis: Identify, Follow, and Profit from Trends (FT Press, 2011).

When I started reading this book I suspected that it would be like so many others: long on generalities and short on actionable ideas. The first hundred pages or so do indeed deal with general relationships between price and volume, and some of the material is familiar. But even the familiar material is often presented in an unusual way. Here’s one example.

Newton’s second law of motion, reinterpreted to apply to financial markets, analyzes “how much volume (force) is required to move a security (the object) a given distance (price change) at a given speed (acceleration/momentum). … Richard Wyckoff referred to this principle as the law of effort versus result, which asserts that the effort must be in proportion to the results.” (p. 47) As a corollary of this law, “if more volume (force) is required to produce less price change (acceleration), then the stock is becoming overly bought or sold.” (p. 85)

In apparent contradiction to Wyckoff’s law of effort is the rule of trend volume, according to which “more volume substantiates a stronger trend.” (p. 85) Can these two principles be reconciled? Dormeier suggests that they can, once we bring the notions of strong hands and weak hands into the equation. His discussion is too detailed to summarize here, but it is premised on how strong hands and weak hands play the game. As he writes, “Strong hands buy out of an expectation of capital appreciation. Weak hands buy out of greed and the fear of missing out on an opportunity. Weak hands sell from the fear of losing capital. Strong hands sell to reinvest in better opportunities (which does not have to be other equities).” (p. 87)

Dormeier really hits his stride when he turns “general volume principles into indicators with numerical values.” (p. 113) These indicators have a dual mandate—to lead price and to confirm price. But they don’t all work the same way; they are “tools, each of which is designed to explain a distinct piece of the volume puzzle.” (p. 117)

The author differentiates seven types of volume indicators; put otherwise, “volume indicators provide information in seven different ways.” The types (or ways) are: pure volume, volume accumulation based on interday price change, volume accumulation based on intraday price change, volume-price range indicators, price accumulation based on volume, tick volume, and volume-adjusted price indicators. He devotes brief chapters to each of these types of indicators, acknowledging their creators, describing their construction, and judging their usefulness. Perhaps the most bizarre are the price-volume charts created in the 1950s by Benjamin Crocker; they form “lines that resemble a toddler’s drawings on an Etch-a-Sketch.” (p. 124)

Dormeier’s own contributions lie in the realm of volume-weighted price indicators. Most notably, volume-weighted moving averages, volume-weighted MACD, the trend thrust indicator, and the volume price confirmation indicator. He has also devised a trailing stop that combines the VPCI with Bollinger Bands. And, to resolve the “significant disconnect between the relationship of the price index to the index’s volume totals,” (p. 227) he introduces the reader to cap-weighted volume. He explains how to construct each of these indicators.

The returns for Dormeier’s indicators are impressive. The only problem is that he developed them some time ago and tested most of them on data from the 1990s and the early 2000s. He did not update the backtests for this book, so I have no idea what kinds of results they would have produced over the last five years or even the last year.

Some people argue that volume analysis is really a thing of the past now that we have high-frequency trading adding substantially to volume totals. The author thinks not. “Non-directional trading,” he writes, “does not directly affect volume analysis” (p. 302) and the secular growth in volume will have virtually no impact on short- and intermediate-term volume analysis.

Investing with Volume Analysis is an important work for anyone who wants to incorporate volume indicators into a trading system or systems. Dormeier explains the theory, offers indicators for testing, and even describes some interesting ways to segment market data for purposes of testing. For those who think that volume bars at the bottom of the chart say everything there is to say on the subject, this book will be an eye opener.

Bennett, Day Trading Grain Futures

At the core of David Bennett’s Day Trading Grain Futures: A Practical Guide to Trading for a Living (Harriman House, 2009) is a single breakout strategy. It’s a strategy that incorporates not only entry rules but also position sizing, risk management, and exit rules. In page after page, chart after chart, the author drills the reader on his strategy and its fine points—and how to use Interactive Brokers platform to execute the trades. (Since the IB platform is ever evolving, this book should not be used as a TWS manual.) The result is one of the clearest examples I’ve encountered of how a trader plies his craft.

Bennett is an Australian resident who fights time zones to trade the U.S. grain markets—corn, beans, and wheat. The market session for the grains is from 9:30 to 13:15 CST, which means that show time in Australia is after midnight. Bennett interrupts his sleep to make at most a single trade.

As a breakout trader, the author stalks support and resistance ranges. One end of the range is the breakout level. The other end of the range has to be determined by a rule. In the case of a long trade, it is “the low of the last candle which had a lower low and lower high than its immediately preceding candle.” (p. 51) The range (r) is used to set a stop loss and profit target—for example, a stop at somewhere between 0.5r and 1r and a profit target between 1.5r and 3r.

As a day (or night) trader who values his sleep, Bennett enters not only a stop order and a profit taking order; in case neither one triggers, he also enters a “good after time” order to make sure he is flat at the end of the session. Of course, these three orders have to be grouped (one cancels all). So, if he drifts off to sleep, his orders are resting in the market or at his broker; he will either be stopped out, reach his profit target, or the trade will be closed just before the end of the session.

Bennett devised an Excel spreadsheet calculator (which he sells on his web site but which even I could easily recreate). Once the user has entered the stop factor (say, 0.5), the profit factor and the entry price, the spreadsheet automatically calculates the stop and the target levels as well as the potential profit and the trade risk in dollars. And, assuming that the trader uses a fixed risk model, the spreadsheet will calculate the maximum number of contracts the trader should buy or sell. There’s more data in the spreadsheet, most notably the daily limit for the traded product and the required margin, but you get the idea. As Bennett explains, “Once a trading session starts, … I don’t want to be in a position of writing down ranges, calculating stop and target levels by hand, or manually working out how many contracts I can take.” (p. 63)

Some might view Bennett’s trading plan as overly simplistic, but I don’t think the author would consider this to be a valid criticism. As he writes, “The trading style presented in this book is not sophisticated, but it is nevertheless built from strong bricks.” Moreover, he continues, “Trading is the constant repetition of a relatively simple process, striving for perfect implementation. It is a case of doing the same, simple thing really well, day after day after day.” (p. 146) Day Trading Grain Futures is an exemplary account of this approach to trading.