Page, Diversity and Complexity

As long-time readers of this blog know, I’m a big fan of Scott E. Page’s work. Some time back I devoted two posts, imaginatively labeled part 1 and part 2, to The Difference: How the Power of Diversity Creates Better Groups, Firms, Schools, and Society. Page is back with a new book, Diversity and Complexity (Princeton University Press, 2011), that has a more sweeping task even though it is styled as a primer: to elucidate the role of diversity in complex adaptive systems ranging from biological to social (including financial) systems.

One reason that Page is so enjoyable to read, even when he is writing about complicated subjects, is that he has a knack for finding imaginative examples. To illustrate the effects of variation and diversity on complexity, for instance, he conjures up a cakewalk involving nine-year-olds. And, no, it’s not the kind of cakewalk that Debussy’s “Golliwogg” did. To address the sample problem he looks at recipes: “Over what set of recipes do we test whether quality improves with diversity?” If the sample includes all theoretically plausible recipes “diversity does not always increase quality. … Peanut butter-watermelon-squash enchiladas drenched in chocolate sauce doesn’t sound tasty.” (pp. 47-48)

It is difficult to unravel separate threads of this book without doing a disservice to its sophistication and logical rigor. But here’s a topic that is both timely and to me always intriguing—negative and positive feedbacks in systems. “[I]n systems with negative feedbacks, variation produces stability, and in systems with positive feedbacks, variation can make systems more prone to tip.” (p. 160)

As the author writes, “A negative feedback exists when increases in the propensity of an action decrease the benefits from taking that action.” Take the case of 1000 people going to the beach on Saturday. They have a common threshold, let’s say 400, where they all say that the beach is too crowded and they’re not going the following week. If 300 people go to the beach on the first Saturday, all 1000 will go the next Saturday. Oops, too crowded, so no one goes the next week, everyone goes the following week, and the yo-yo effect continues.

Page admits that this is a pretty lame example, but it sets up the problem of maintaining a comfortable temperature in a bee hive. “Bees have an internal mechanism that determines when the hive is too hot or too cold. When it’s too hot, they fan out. When it’s too cool, they huddle together. A hive of genetically identical bees will all get hot and cold at the same temperature.” If, however, there is variance in their temperature thresholds, then as the temperature rises only a few bees will feel the need to fan the hive. “Those few will fan out and reduce the temperature until some of them begin to feel comfortable, at which point those bees will stop fanning and the temperature will equilibrate.” (p. 161)

With positive feedbacks, by contrast, “variation in thresholds leads to an increase in the probability of large events.” Imagine a crowd milling around during a time of social upheaval, with each individual trying to decide whether to riot. “By comparing two scenarios,” Page writes, “I can show how variation leads to big events. In the first, each of one thousand people has a threshold of twenty. Any person who sees at least twenty people rioting will join the riot. The result of this distribution of thresholds will be that no riot occurs. In the second scenario, assume that ten people have threshold zero, ten people have threshold ten, ten have threshold twenty, ten have threshold thirty, and so on. This crowd of people is not nearly as angry as the first crowd. Their average threshold is approximately five hundred. And yet, in this scenario, a riot erupts. This is because, initially, ten people riot (those with threshold zero), and then ten more do, and so on, and so on. The variation in thresholds allows the system to tip.” (p. 162) And, Page continues, makes riots (and, I would add, financial outliers) notoriously difficult to time.

Diversity and Complexity is a fascinating book with obvious ramifications for the financial markets. Read it and you too may come up with some instances of horizontal transfer, which happens “when an idea or solution jumps from one domain to another.” (p. 15)

Rachev et al., Financial Models with Lévy Processes and Volatility Clustering

My quant skills aren’t up to reviewing this book, but I thought I should bring it to the attention of my more math-savvy readers. The core of the book is an analysis of discrete option pricing models with volatility clustering.

Have a great weekend.

Leibovit, The Trader’s Book of Volume

Mark Leibovit believes that volume analysis is “the closest thing we have to a real working ‘crystal ball’” in the markets. (pp. 425-26) In The Trader’s Book of Volume: The Definitive Guide to Volume Trading (McGraw-Hill, 2011) he outlines the fundamentals of volume analysis and introduces the reader to a broad range of volume indicators and oscillators.

We have all heard the mantra that volume precedes price. As Leibovit writes, “Market price trends do not happen in a vacuum; rather, it is the behavioral or programmed responses of traders and managers that result in the volume shifts that precede a price move. As the crowd mobilizes, as reflected in the volume numbers, its size and conviction will determine the direction and strength of the price movement. As the conviction of the crowd falters and the volume numbers pull back and diminish, so too will this impact the timing and direction of the trend.” (p. 24)

In analyzing the relationships between price and volume under various market regimes Leibovit pays particular attention to divergences where volume doesn’t confirm price action and signals a possible trend change. But he doesn’t rely solely on easy-to-spot divergences. He also introduces the reader to volume overlays, including moving averages, MACD, and linear regression. These overlays can help the trader see volume trends over a longer time frame.

And, of course, there is the plethora of indicators and oscillators, some 33 in all. Thirteen apply to the broad market; the rest can be used in the analysis of individual securities. In each case Leibovit explains the indicator’s or oscillator’s formulation, its use in trend confirmation, its potential divergence with price, and its use with other indicators. He also illustrates its practicality with a sample trade setup and entry. He closes each section with trader tips.

Throughout the book the author stresses that there is no “one size fits all” solution to selecting the appropriate volume indicators and oscillators. Volume analysis is an art, not a science. It depends on the instrument being traded as well as the trader’s time frame.

But The Trader’s Book of Volume goes a long way toward taking the mystery out of volume analysis. In roughly 450 pages, amply illustrated with MetaStock charts, it offers concrete ways to use volume to improve trading results.

Given, No-Hype Options Trading

For the options spread trader, especially the non-directional trader, who is looking for strategies and trade management ideas No-Hype Options Trading: Myths, Realities, and Strategies that Really Work by Kerry W. Given, aka Dr. Duke (Wiley, 2011) might be just the ticket. The book (for those who care about the sometimes dueling camps in the options world) reflects some of the techniques taught by Dan Sheridan, who was one of the author’s mentors.

Options trading can be daunting, in large measure because “the risk-adjusted return of any options strategy will tend toward zero over time.” (p. 16) It doesn’t matter whether a person engages in high-probability or low-probability trading, whether the spread of choice is an iron condor or an out-of-the-money vertical spread. Without robust risk management the options trader will over time end up with a huge goose egg in his account for all his efforts.

The author focuses on calendars, double diagonals, butterflies, and condors. His analyses don’t follow a standard pattern, but generally speaking he discusses trade structures, the rationale for various positions, and ways to enter and manage trades, including adjustments. At the conclusion of each chapter is a set of exercises to test the reader’s understanding of the material. Answers are provided at the end of the book.

Here I’ll sample his chapter on butterflies. The first important distinction is between at-the-money and out-of-the-money butterflies. An ATM butterfly, especially on a broad market index, is “a delta-neutral income generation trade.” An OTM butterfly is normally a speculative directional trade; it is an inexpensive, low-probability, high-risk trade. But an OTM butterfly can also be used as a “what if I’m wrong” trade. Let’s say the trader expects a stock to trade higher and has opened an appropriate bull call spread. But, in case the stock doesn’t trade as expected, an OTM put butterfly below the stock’s current price can serve as an inexpensive hedge.

The author outlines two ways to manage an ATM butterfly, a simple and a more advanced. The simple technique has eight steps. Here are a few of them. Sell the ATM options and buy one option at one standard deviation OTM and one option at one standard deviation ITM. Buy extra calls and/or puts on the wings to get as close to a delta neutral position as possible. Close the trade when you are down 20%. Close half of the contracts and take your profit if you are up 25% or more. Close the trade on the Friday before expiration week. (pp. 103-105)

No-Hype Options Trading is a practical book for the trader who has a modicum of knowledge about options but needs help with delta-neutral strategies. Whether this book will enable him (with lots of practice) to generate steady monthly income, the alleged goal of non-directional trading, is another matter. Markets don’t always accommodate the delta-neutral trader. Strongly trending markets present significant challenges and highly volatile markets are “the worst-case scenario.” (p. 153)

Rosenbloom, The Complete Trading Course

Corey Rosenbloom’s The Complete Trading Course: Price Patterns, Strategies, Setups, and Execution Tactics (Wiley, 2011) is an excellent introduction for the beginning trader. Unfortunately it has little to offer the more advanced trader that isn’t readily available elsewhere. But as a Trading 101 course, it succeeds in synthesizing a great deal of material into a coherent, easy-to-follow text.

We read about foundational principles (trend, momentum, price contraction and expansion), strategies and tools (candlestick charts, price patterns, Fibonacci tools, Elliott wave theory), and finally execution and trade setups (including two that the author developed). For those who want more, there’s an extensive bibliography. And, of course, the author’s popular blog Afraid to Trade.

The couple of points I’m extracting from the book for this post are both historically based. First, from an SMB Capital training blog comes the recognition of “two radically different schools of traditional technical analysis,” one stemming from the work of Richard Schabacker and the other from the writings of Richard Wyckoff, both dating to the early 1930s. Schabacker believed that one could learn to trade by studying thousands of patterns and their variations. Wyckoff, by contrast, focused on understanding “why the market was doing what it was doing, … how the motivation of buyers and sellers showed itself in the patterns of price and volume.” Not surprisingly, Rosenbloom comes down on the side of Wyckoff, writing that “We as traders must realize that price patterns are not magic, and what’s important is supply/demand factors, as well as the underlying context in which the pattern forms.” (p. 114)

The author also appeals to Wyckoff in discussing the life cycle of a price move. Wyckoff recognized four stages: accumulation, mark up, distribution, and mark down. In transitioning to an explanation of Elliott wave theory Rosenbloom overlays Elliott’s waves on the Wyckoff stages. The result: “In simplest comparison, Elliott’s Waves 1 and 2 represent [the] Accumulation stage, Wage 3 represents the … Mark-up stage, and Waves 4 and 5 mark the start of the Distribution stage.” The A-B-C pattern represents the Mark-down stage. (p. 177)

The Complete Trading Course provides a solid foundation for the aspiring trader. It covers not only basic techniques of technical analysis and position management but also issues of matching trading style to personality. Those new to trading would do well to read it.

Ward, High Performance Trading

Last week Steve Ward was the guest presenter in Linda Raschke’s winter lecture series. The webinar is archived on the home page of the LBR Group site.

Ward, a performance coach to both athletes and traders, is the author of High Performance Trading: 35 Practical Strategies and Techniques to Enhance Your Trading Psychology and Performance (Harriman House, 2009). The strategies and techniques are sorted into three categories: (1) planning and preparing for trading success, (2) decision-making, discipline and flawless execution, and (3) evaluation, analysis and improving and sustaining performance.

Ward’s book focuses on the practical. For instance, he writes that it is important to be able to recognize when you are at your best, in your ideal trading state. Trading “when you are in such states—or at least as close as possible—is important to achieving consistency in your performance. When you trade in states that are not conducive to trading it is not that you cannot make money or won’t make money, but that the chances of you trading well are reduced; and, importantly, your risk profile has increased.” (p. 99) So the trader should “check in” regularly—that is, rate himself on a scale of 1 to 10 to assess his current trading state. Good times to check in are “as part of your preparation before trading, after a significant loss or win, after a string of winners or losers, on returning to trading after a break for any reason, after making an error, [and] throughout the afternoon when tiredness and fatigue may become more prevalent.” (pp. 100-101)

Most of Ward’s advice is commonsensical but worth repeating nonetheless: traders have a penchant for flaunting common sense. Consider the case of increasing size. He writes: “Most traders I have worked with look at increasing size as a key performance measure, and (I would have to say) as a key bragging right! The important thing with increasing size, though, is to make sure that you are using it as a growth factor on top of your improving trading performance capabilities, and not instead of such progress.” (p. 263) And, he continues, when increasing size, “it is important to move from the comfort zone into stretch and not panic. … Let’s say you are trading four contracts and decide to double to eight. Imagine a typical loss but with eight contracts, and now imagine a string of losses with eight contracts—how does that feel? If a bit uncomfortable, then that is to be expected—if you want to throw up, then that is feedback! How about with six contracts? Five? Through using this process you can begin to get a feel for what trading size may be best—whenever in doubt, go for the smallest increment you can.” (p. 264)

Throughout the book Ward asks the reader to answer questions and perform exercises. A couple of examples: Can I raise my performance by focusing on and utilizing my strengths more effectively? Can I raise my performance level by developing my weaknesses? Or, Which feelings detract from your trading performance? How often do you experience these emotions? How do you deal with them?

Ward’s book is not revolutionary, but that’s okay. Traders don’t need to make revolutionary changes to improve their performance. A behavioral change here and there, freeing up a frozen mindset, keeping things in perspective. All can help.

Those traders who don’t have the luxury of a professional performance coach can still profit from second-best: informed self-coaching. Ward’s book (along with others such as Brett Steenbarger’s The Daily Trading Coach) is an inexpensive way for traders to learn to coach themselves to better performance.

Watson: a death knell for discretionary traders?

Watson was a resounding success. I wouldn't want to trade against "him" or his money machine successors. I suspect we ain't seen nothing yet. Here's a link to The Economist's take.