Reading the Markets

Brooks, Trading Price Action Reversals

2012-02-15T05:12:00.000-05:00

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)

Wagner, Trading ETFs

2012-02-13T05:32:00.000-05:00

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.

Kaplan, Frontiers of Modern Asset Allocation

2012-02-08T05:31:00.001-05:00

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.

Brooks, Trading Price Action Trading Ranges

2012-02-06T05:41:00.001-05:00

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.

Williams, Long-Term Secrets to Short-Term Trading

2012-02-03T05:18:00.000-05:00

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.

Mysak, Encyclopedia of Municipal Bonds

2012-02-01T05:32:00.000-05:00

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.

Oxley, Extreme Weather and Financial Markets

2012-01-30T05:29:00.000-05:00

Living in Connecticut, I rarely experience extreme weather. Last year was an outlier. The winter was brutal, then came the remnants of Hurricane Irene (not in itself extreme but nonetheless a week-long power outage), and finally the freak Halloween snow storm (and, yes, another week without electricity). Although there was undoubtedly a spike in generator sales, let’s face it: no investor is going to make much money betting on Connecticut weather.

In Extreme Weather and Financial Markets: Opportunities in Commodities and Futures (Wiley, 2012) Lawrence J. Oxley takes us to where weather is genuinely extreme and where real money can be made. Wending his way through the various commodities and ways to trade them, he focuses on five potential global climate shocks: excess snow and ice; flooding mines; farmland droughts, floods, and frost; hurricanes and tornadoes; and timberland fires.

Let’s take a look at a single commodity, which the author says “may well be [his] favorite weather-based investment”—platinum. Platinum enjoys strong global demand, the supply side is highly concentrated geographically (South Africa accounts for 76% of total platinum mine production), and these geographies have the potential for politically rooted supply shocks.

Assume there is a flood in South Africa. Who are the biggest winners? First, platinum futures, followed by ETFs and the stocks J. Matthey and Stillwater. If the flood is in Montana, the biggest winners are still platinum futures and ETFs. The same holds true if the flood is in Russia. “At this point you might be wondering why ‘platinum futures’ and exchange-traded funds (ETFs) in platinum are ranked higher than all of the publicly traded stock winners. The futures market and the ETF market do not care where the global climate event occurs. All they care about is the price of platinum. It makes life a bit easier if you do not have to worry about which names in the stock market are the winners and losers, but instead simply focus on the extreme weather events and the price of platinum.” (pp. 71, 75)

Oxley does not, however, confine his analysis to trading commodity futures. He gives examples of pairs trading in equities and explores opportunities in the bond and forex markets.

Event-based trading is notoriously difficult because everybody is responding to the same information. Think, for instance, of the recent run-up in orange juice after a cold snap threatened Florida’s crop, the FDA detained shipments of oranges imported from Brazil in which they found traces of an illegal fungicide, and Mexico’s crop faced damage from drought. Even with this perfect storm trading was still not easy. For instance, on January 10, when news of Brazil fungicide fears broke, orange juice surged 11%. The next day, as investors awaited more news from the FDA, orange juice futures fell 9.5%. Here’s the 30-day chart.

Oxley offers some tips for event-based trading, including when to sit on your hands. For example, if sugar spikes—which means that soda and chocolate are negatively affected, he recommends avoiding (not shorting) Hershey and Coca-Cola stock. And he cautions not to “buy excessively in the municipal bond market in hurricane regions during hurricane season.” (p. 179)

Oxley’s book is a worthwhile read for commodity investors, novices as well as the more experienced, who are in search of opportunities. It is also a cautionary tale for those who want to protect their portfolios. No one should trade commodities without understanding the impact extreme weather can have.

Palicka, Fusion Analysis

2012-01-26T05:35:00.001-05:00

Fusion Analysis: Merging Fundamental, Technical, Behavioral, and Quantitative Analysis for Risk-Adjusted Excess Returns (McGraw-Hill, 2012) is based on a course V. John Palicka offered at the New York Institute for Finance. As the subtitle indicates, the book advocates a multi-pronged or, perhaps better put, a blended approach to investing.

Palicka’s general approach is not new. Many stock screeners and investment services score stocks using a variety of inputs. For the investor who wants to do it himself, however, it’s not always obvious what kinds of inputs make the most sense—and potentially the most dollars. It’s also not intuitive what the theoretical underpinnings of the various approaches are. For instance, in a somewhat philosophically muddled chapter that touches on faith, physics, and time travel the author argues that determinism (here most frequently contrasted with free will) is the basis for technical analysis.

Palicka throws a lot at the reader in this book. He blends Elliott Wave analysis with the fundamentals of real estate within the context of determinism. He studies gold trading and business cycles, describes buy and sell decisions using Gann analysis, outlines measures for risk-adjusted excess returns (Sharpe, Treynor, Jensen Alpha, and the Information Ratio), and explains how to use swaps for market timing.

Fortunately Palicka provides a case study (Steve Madden—SHOO) to illustrate how the fusion process works. He uses a scoring system to determine a rating but cautions that “my actual and proprietary system may differ from that illustrated for confidentiality reasons.” (p. 374) In his illustration he incorporates five categories—short-term return, price/book, expected P/E divided by the expected P/E on the S&P 500, price/cash flow, and technical (a weighted average of MA, support/resistance, MACD, OBV, market relative strength, and Fibonacci). The categories are weighted—in this case between 10% and 35%--and each category gets a rating. So, to determine the total rating you simply take each individual rating times its weight and sum the products. Then you compare the summed rating to a table which correlates ratings (buy, buy/hold, hold, sell/hold, sell) with points. If, for instance, in this example the total rating is under 1.5, the stock gets a buy rating.

Of course, in the investing world nothing is cut and dried, and Palicka’s book makes that patently obvious. Backtesting helps, numbers are critical, but ultimately fusion analysis relies on market experience, the integration of disparate fields of study, and the touch of an artist. Even though I doubt that the author would find this an apt description of his method, I intend it as a compliment.

Brown, Technical Analysis for the Trading Professional, 2d ed.

2012-01-24T05:17:00.001-05:00

When I requested a review copy of this book, I forgot how much I disliked the first edition. Either I’m getting soft or Constance M. Brown has substantially improved the second edition. Probably a little bit of both. By the way, for those aspiring to be certified in the Chartered Market Technician program it is required reading.

Technical Analysis for the Trading Professional: Strategies and Techniques for Today’s Turbulent Global Financial Markets (McGraw-Hill, 2012) is still not a book that I would turn to for core trading strategies. On the fringes, however, it can be useful. And this is important because, as I have argued before on this blog, it is often by making even minor changes at the periphery that returns are substantially improved.

Brown relies primarily on Fibonacci projections, Gann analysis, and the Elliott Wave Principle for her trading. She also adds a couple of oscillators to her charts, including her Composite Index, for which she now provides the formula.

At practically every turn Brown offers a twist on commonly accepted tenets of technical analysis. Take something as seemingly simple as trend lines. She devotes an entire chapter to the argument that dominant trend lines are not always from extreme price highs or lows. Her trend lines sometimes look like the ones I draw (which, of course, make them ever so smart). At other times it’s difficult to follow her logic; the choice of pivot points seems idiosyncratic.

Or, to offer another example, she wrote in the first edition and quotes the passage here: “By the end of Part 3, you will feel certain that no conventional indicator is safe in my hands. I will invert it, smooth it, compound it, disassemble it, superimpose it, and even imbed it—all in an effort to understand it.” (p. 357)

Brown’s book is definitely not for the novice trader. Without a solid foundation in classical technical analysis (and here I include Fibonacci, Gann, and Elliott) the reader would be utterly lost in the twists and turns of Brown’s original work.

The author’s earlier writings were often shrouded in mystery, aka “teasers.” In this book, by contrast, Brown makes an honest effort to share the ideas she has honed over the years. I always figure that if I get one good idea from a book it was worth the read. Technical Analysis for the Trading Professional over-performed.

Trading on steroids

2012-01-23T05:03:00.003-05:00

Some days I simply can’t stay focused, and Saturday was one of them. I watched the snow accumulate. I thought about what I really want to do when I “grow up,” a theme that recurs about as frequently during the day as do my dreams of approaching graduation a credit short or walking into the final exam of a course I never attended. In my dreams, by the way, I am not so much the panicked student as the unprepared brash risk taker who skates by. Enough said.

But perhaps not enough said, and this brings me to a book that is scheduled to be published by Penguin Press in June—The Hour between Dog and Wolf: Risk Taking, Gut Feelings, and the Biology of Boom and Bust by John Coates. Well, clearly, I don’t have a copy of the book, but I took a look at the papers Coates published a few years back. For those who care about credentials, I’ll quote from Penguin Press’s summer catalogue: “Coates is a senior research fellow in neuroscience and finance at the University of Cambridge. After completing his Ph.D. Coates worked for Goldman Sachs, Merrill Lynch, and Deutsche Bank in New York, where he observed the powerful emotions driving traders. He returned to Cambridge in 2004 to research the effects of the endocrine system on financial risk taking.” His Cambridge faculty page has links to four short papers available online in .pdf format.

Coates’s key thesis is that “contrary to the assumptions of the rational expectations hypothesis, financial market equilibria may be influenced as much by traders’ biological traits as by the truth of their beliefs.”

Coates sampled male traders in the City of London, analyzing their steroid hormone levels. Among his findings, “a trader’s morning testosterone level predicts his day’s profitability, … a trader’s cortisol rises with both the variance of his trading results and the volatility of the market.” “[A]cutely elevated steroids may optimize performance on a range of tasks; but chronically elevated steroids may promote irrational-risk-reward choices.”

Interesting stuff, definitely worth a quick read. If the publisher is generous, I’ll have more to say on the topic this summer.

Cofnas, Trading Binary Options

2012-01-20T05:21:00.001-05:00

For the directional trader with a small trading account binary options might be an attractive opportunity. The Chicago-based Nadex (North American Derivatives Exchange), for instance, will open an account with no minimum funding, and to trade a single contract one needs no more than $100. Of course, depending on the structure of the trade, that money might disappear in the blink of an eye since for those trades held to expiration (which might be intraday, daily, weekly, or event-based) winning contracts are worth $100, losers worth nothing.

Before retirees rush to deposit their Social Security checks with a binary option broker and stay at home buying cheap out-of-the-money calls instead of going to Atlantic City and shooting their wad on a one-armed bandit they—and, naturally, all other traders—should learn a great deal more about binary options. Abe Cofnas provides a good introduction to this instrument and also offers insights on directional trading in Trading Binary Options: Strategies and Tactics (Bloomberg/Wiley, 2012).

Those traders who have shied away from options because they seem complicated may be relieved to learn that understanding the Greeks is not essential in the world of binary options. Yes, market makers use them to price the binaries and Cofnas even introduces the reader to volatility smiles, but the trader’s major decisions are whether to buy or sell binary options and at what strike price. How much does he think the market will move in a given length of time and in what direction? At expiration he will either be right or wrong and will either collect his $100 or lose whatever he paid to put on the trade.

We all are familiar with the “no free lunch” principle. In this case, the speculative trader who opts for the simplicity of binary options has to be very good at predicting and timing market direction. (Hedgers can of course also use binary options, but this book is written primarily for the retail speculator.) Cofnas devotes four chapters to tools the binary options trader can use to improve his skills: sentiment analysis, macroeconomics and the currency markets, technical analysis, and volatility tools.

He then fleshes out the five basic binary option trading strategies—in-the-money, deep-in-the-money, at-the-money, out-of-the-money, and deep-out-of-the-money—using examples from the Agora newsletter he writes. The trades were in gold, the DAX, crude oil, currency pairs, and the S&P 500. Some were sentiment based, others event driven. He devotes an additional chapter to strategies for analyzing event risks.

The book concludes with chapters on risk management, evaluating and improving trading performance, algorithmic approaches to binary option trading, and a 50-question quiz.

Cofnas’s book should be useful to anyone considering adding binary options to his trading portfolio. A beginner can understand it, an intermediate trader can profit from it.

Fabozzi, The Handbook of Fixed Income Securities, 8th ed.

2012-01-18T05:22:00.001-05:00

You thought War and Peace was daunting? The original edition of Tolstoy’s masterpiece was a mere 1,225 pages. The text of the eighth edition of The Handbook of Fixed Income Securities, edited by Frank J. Fabozzi with the assistance of Steven V. Mann (McGraw-Hill, 2012) is 1,810 pages long. When you add the thirty pages of front matter, you end up with a five-pound book.

The previous edition of this handbook was published seven years ago. To catch up with the changing times, this edition adds 31 new chapters and about 300 more pages. Subsequent handbooks will probably best be published as two-volume sets.

As you might well imagine, I did not read the book in its entirety before writing this review. But, having dipped into it, I consider reading the whole to be a worthwhile project. If I proceed at the rate of a couple of chapters a day, I will have devoured it in about a month and figure I will have a pretty solid understanding, at least on an elementary level, of the fixed income market.

The book is divided into ten parts: background, government securities and corporate debt obligations, securitized products, term structure of interest rates, valuation modeling, credit risk, multifactor risk models, bond portfolio management, derivatives, and performance evaluation and return attribution analysis. Although some of the authors of the 71 chapters are academics, most are practitioners.

The book is written for those who want a broad overview of the bond market without getting bogged down in the math on which the bond market depends. Investment professionals (especially those on the equity side whose knowledge of the bond market is weak), financial advisors, and individual investors could all profit from it. There may be more in this book than most people would ever want to know, but there is definitely a lot that they should know.

Shull, Market Mind Games

2012-01-17T05:19:00.001-05:00

Denise Shull, founder of the risk and performance advisory consulting firm ReThink Group, argues that traders and investors will improve their bottom lines if they better understand their emotions. Numbers, she writes, “look you in the eye and lie.” Both rationalism and empiricism come up short. The key to market success lies in leveraging emotional introspection and analysis into informed trading behavior—first and foremost, risk management.

In Market Mind Games: A Radical Psychology of Investing, Trading, and Risk (McGraw-Hill, 2012) Shull argues that we would “be able to extract a powerful advantage if we spent more time logically analyzing what the numbers cannot tell us.” (p. 20) Quantitative analyses are merely clues, not answers to what all traders are trying to figure out—other players’ future perceptions.

As it turns out, we all can predict (some admittedly better than others—perhaps an explanation for those seemingly natural born traders) what other people are going to do. This “pattern recognition of likely human behavior” is called “theory of mind,” or ToM. It is “the key to accurately reading markets.” (p. 63)

Looked at from another perspective, trading is a case study in dealing with uncertain scenarios (as opposed to risky situations). A 2005 study found that the brain handles risk and uncertainty differently; confronted with risk, blood takes a different route through the brain than it does when dealing with uncertainty. The researcher “proffered the idea of an ‘uncertainty circuit’ or the idea that a sort of red flag went up saying ‘more information needed.’”

Shull argues that this research undercuts “maybe the second most repeated rule of trading—‘plan the trade and trade the plan.’ … This supposed truism assumes a computer model of thinking. In practicality, it leaves very little room for context and certainly none for a warning flag that more information must be obtained. Traders try to do exactly what they planned while their brain fights them to find more information or to scramble in the face of a clear, but maybe only subconsciously perceived, threat.” (p. 77) That is, although it is important to start with the right type of game plan, “good judgment on the fly will be ultimately what wins the game (remember your brain when faced with uncertainty will make judgment calls whether you ask it to or not.)” (p. 117)

To be a successful trader it is not enough to read the markets. Traders must also read themselves to figure out (not control) what feelings, physical and emotional, are fueling their judgment calls.

Feelings should be viewed as data to be captured and then analyzed. “Just like if you had any new data set to work with, first you would try to get the scope of it, look at it from different angles to get a sense of what you were dealing with, and then go about ways to monitor, track, and categorize.” (p. 125) Knowing yourself and knowing how you feel (your emotional contexts) at any given time will give you a risk management edge. It will help you avoid those “What was I thinking?” moments.

Shull spends several chapters describing some of the most common emotions traders bring to their decisions. For instance, she asks the reader to determine where he is on the spectrum between the fear of losing money and the fear of missing out.

In summary, as Shull writes in her afterword, “once you become familiar and hopefully facile with consciously contextualizing or curating market information in terms of who is or will be taking the other side of your trade, once you give up on finding ‘the (nonexistent) facts,’ the mind game of the markets is in your mind—and nowhere else. … Everything will fall prey to your ego and your unconscious, unless you make both conscious. You can leave the unconscious where it is, but that will be your biggest risk factor. Sooner or later it will burn you.” (p. 235)

Shull offers some practical suggestions, from getting enough sleep to recording what you’re feeling as you trade. She may be a little too eager to have traders unload their psychological baggage on their parents, but it’s easy enough to opt for an alternative psychological theory to understand and deal with emotional problem areas. And we all have them.

Admittedly, Market Mind Games repeats what others have said before—that the market is in your head. But now neurological research is providing a scientific basis for taking this claim seriously. And Shull’s foray into epistemology offers the outline of a systematic framework for making sense of it. All in all, a provocative read.

Morris, Candlestick Charting Explained Workbook

2012-01-09T05:08:00.001-05:00

My hunch is that most people who use candlestick charts simply find them more user-friendly than bar charts. No squinting required to figure out a bar’s open and close. For Gregory L. Morris, however, candlestick charts are more than clean graphics. “Candlestick charting gives a deeper look into the mind-set of investors, helping to establish a clearer picture of supply/demand dynamics.” (p. 9)

Morris, the author of Candlestick Charting Explained, the third edition of which was published in 2006, has now written a companion workbook, Candlestick Charting Explained Workbook: Step-by-Step Exercises and Tests to Help You Master Candlestick Charting (paperback, McGraw-Hill, 2012). Although I assume both author and publisher hope that the publication of the workbook will revitalize sales of the original text, the workbook can stand on its own.

In general, I’m not a fan of workbooks. But perhaps because I don’t have the Urtext on hand I found Morris’s workbook exceedingly well crafted. It describes and gives chart examples of reversal and continuation patterns—from such well-known ones as the bullish and bearish engulfing patterns to the more obscure (and rare), such as the concealing baby swallow.

There are frequent tests. I will confess that I started with the tests, figuring that I knew a fair amount about the intricacies of candlestick charting. “Knew,” past tense, is probably the operative word. If I had charted my performance, I wouldn’t have been the star of the class. Well, that was a bummer, so I had to go back and actually read the book. But it was a good read, so I didn’t feel that I was doing penance for a failed memory.

Does a chartist have to know all the candlestick patterns to be successful? Of course not. Can a trading method based on candlestick patterns alone be profitable? Perhaps, though with major caveats. Morris himself claims that trading solely on candle patterns is not wise. He advocates combining candle patterns with momentum indicators, at the very least. In fact, his MetaStock add-on scores patterns using a range of inputs.

In whatever way traders decide to use candlestick patterns, Morris’s workbook is both a good introduction and a quick refresher course.

Standard & Poor’s 500 Guide, 2012 Edition

2012-01-04T05:38:00.000-05:00

It’s commonplace for authors to write revised editions of their books. But book reviewers are not supposed to serve up revised editions of their reviews. The former are billed as new and improved; the latter seem nothing more than warmed-up fare. The problem is that sometimes it’s difficult to start from scratch when reviewing a book that, while completely new, is also identical in structure. Such is the case with the 2012 edition of the Standard & Poor’s 500 Guide. So, with apologies, herewith a revised edition of last year’s review.

* * *

This is a very big paperback—8 ½” x 11”, more than 1000 pages, and weighing in at about 4.5 lbs. With so much information available online, why would anyone need this book? I can think of several compelling reasons.

First, a personal preference: I enjoy flipping through pages, making serendipitous discoveries. I don’t have the same kind of experience online since I normally am looking for something specific, not just seeing what comes my way.

Second, the two pages devoted to each company in the S&P 500 are jam-packed with data, including ten years of company financials (per share data, income statement analysis, and balance sheet and other financial data), five years of revenue and earnings per share, and the four most recent dividend payments. The summary of the company’s business is also more analytical than the run-of-the-mill online fare.

Third, and taking up almost half of the space allocated to each company, is proprietary S&P information, ranging from analysts’ reports to the famous five-star system of investment recommendations. I complained last year that the analysts’ reports were not especially timely; some dated back to July and the most recent were from October. This year’s edition has remedied that problem. Most analyses and business summaries were written in November; closing prices for stocks are from late November.

Other data include S&P’s qualitative risk assessment, its quantitative evaluation, and each company’s relative strength rank. For each stock there is also a price chart from June 2008 through November 2011 overlaid with S&P proprietary metrics.

For the reader who cannot live without stock screens, the book provides lists of companies with five consecutive years of earnings increases, stocks with A+ rankings, rapid growth stocks, and fast-rising dividends.

The book is somewhat unwieldy to handle (it’s definitely best read on a desk, which I personally find awkward), but this is a small price to pay for the amount of information available. It will find a place on my shelf next to last year’s edition.

Lack, The Hedge Fund Mirage

2012-01-03T05:19:00.001-05:00

In The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True (Wiley, 2012) Simon Lack draws on a long career in the hedge fund industry. The result is a chatty, personal history of hedge funds and a critical look at what they offer (and mostly don’t offer) investors.

The very first sentence of the book is a stunner: “If all the money that’s ever been invested in hedge funds had been put in treasury bills instead, the results would have been twice as good.” Contrast this stark reality with the money earned by hedge fund managers. In 2009 the top 25 hedge fund managers collectively earned $25.3 billion. No wonder one of Lack’s chapters is entitled “Where Are the Customers’ Yachts?” referencing the classic book of that title.

Lack set up JPMorgan’s incubator funds that provided early stage funding, or seed capital, to new hedge fund managers. Typically, they would offer $25 million of capital in exchange for 25 percent of the business. “The business share would come, not through a direct equity stake in the manager’s company, but through carving off 25 percent of the fees earned from all the other clients.” (p. 40) That is, they would earn a share of the top line, before expenses, and be at least in part protected from investing losses.

Even JPMorgan occasionally suffered from hedge fund practices that, though presumably legal, are detrimental to investors. Transaction costs, for instance, can be substantial when the fund invests new money. Some hedge funds claim to value their holdings on the bid side to be conservative. But “this should be false comfort because it also means that new investors come into the fund at a ‘conservative’ (which means low) NAV. Since the new capital received will have to be deployed, the manager will either have to buy more of the securities already owned, incurring transaction costs shared by all the investors, or use the cash for new opportunities which has the effect of diluting the existing investors’ share of current holdings at the bid side of the market. In effect, existing investors sell a pro-rata share of their holdings to the new investors at the bid side of the market.” (p. 110)

Moreover, Lack encountered a firm that played fast and loose with the valuation of its portfolio. When Lack’s group decided to exercise its escape clause in the face of a deteriorating convertible bond market and withdraw half of its capital, the fund switched from valuing its holdings at mid market to using the “Bid NAV.” The group felt they’d been had. “Fortunately,” Lack writes, “we were able to turn the trick back on them two months later” when the fund managers artificially boosted their performance as the market bounced back by using the “Ask NAV” to value their bond portfolio. Lack’s group cashed out the rest of its holdings at the higher valuation.

In this book Lack names names—the good, the bad, and the slouches. He offers pointers on how to invest wisely in hedge funds, his best idea being to opt for a small, new hedge fund. And, of course, do lots of due diligence.

Lack’s experience shines through on every page of The Hedge Fund Mirage. Hedge fund investors, and anyone who is even contemplating investing in a hedge fund, would do well to take advantage of it.

Merry Christmas

2011-12-23T05:27:00.003-05:00

What do you do with all those books you bought and now consider useless?

Following up on my 2009 post on unusual Christmas trees but becoming increasingly lazy, this year I direct you to a site that pictures twelve Christmas trees made out of books.

Cortés, Against the Herd

2011-12-21T05:12:00.001-05:00

Those of you who watch Fast Money on CNBC (I don’t) are undoubtedly familiar with Steve Cortés since he’s one of the regulars. He is also the founder of Veracruz, a market research firm. In Against the Herd: 6 Contrarian Investment Strategies You Should Follow (Wiley, 2012), itself a fast-paced book, he shares some of the fruits of his and his firm’s research.

The themes are (and with one exception I won’t be a spoiler and tell you which way he positions himself) China, Japan, gold, the housing market, market volatility, and the U.S.

Here I’ll share Cortés’s take on Japan. In a chapter entitled “Dolls Are Meant for Children” he predicts a “severe demographic and fiscal implosion” for Japan, arguing that the country’s problems “are utterly terminal [and] there is literally no escape from the death spiral.” (p. 35) The chapter’s title, by the way, refers to the doll Yumel, which serves “as a fake grandchild for the massively growing legions of lonely, geriatric, grandchildless Japanese.” (p. 34)

In the 1980s Japan seemed unstoppable economically. The Nikkei reached a closing high of 38,916 in 1989 and eight of the ten largest companies in the world by market cap were Japanese. Super-low rates and a strong yen created “the tinder for a classic bonfire of reckless investment.” (p. 41) As we know, the bubble popped. The Nikkei declined over 80% to a 2009 low of 7,055, in the early 1990s values of commercial real estate fell 87%, and deflation set in.

Japan is now in an “inescapable” bond trap, with a debt-to-GDP ratio over 200% and a debt-to-private GDP ratio at 240%. For the past 20 years Japan has been able to sell its bonds to domestic insurance companies, individual Japanese savers, and public pension plans. “But the famously thrifty Japanese are fast drawing down savings and the trajectory is certain and points toward an aging nation of net spenders, not savers. Japan began the two lost decades with a savings rate at 16 percent. It has slowly dipped to 2 percent and will soon likely head to negative territory.” (p. 46)

If Japan has to tap the international fixed income market, rates will have to rise. “According to hedge fund titan Kyle Bass, every 1 percent increase in the Japanese government’s cost of capital will consume an astounding 25 percent of total government revenue. He states, ‘For context, if Japan had to borrow at France’s rate, the interest burden alone would bankrupt the government.’” (p. 48) Japan would have to roll out its printing presses and devalue its currency.

Cortés offers some ideas on how to capitalize on Japan’s impending doom, the simplest being shorting the yen and buying the U.S. dollar.

Cortés’s writing is fine in small doses, formulaic for the length of a book. He tries to ease the reader into investing concepts by invoking pop culture images. For instance, in the chapter on gold, he starts with MC Hammer, moves on to John Travolta, then the Bible (well, I guess that wouldn’t qualify as pop culture), Richard Simmons, John L. Sullivan, Three’s Company, and finally A Man for All Seasons. This goes on chapter after chapter after chapter after chapter…. It starts to wear thin pretty quickly.

But for those who like to think in macro terms Cortés’s book offers six contrarian (or semi-contrarian) theses supported by well-reasoned arguments and sufficient though not overwhelming data.

My picks of the year

2011-12-18T10:17:00.000-05:00

Last year I wrote a post in which I highlighted some books that I personally found valuable. One of my readers requested a 2011 update. So here it is—my brief, admittedly very idiosyncratic list presented in alphabetical order. Clicking on the book title will with any luck take you to my review.

Aaron Brown, Red-Blooded Risk: The Secret History of Wall Street

William Byers, The Blind Spot

Emanuel Derman, Models.Behaving.Badly

Scott E. Page, Diversity and Complexity

Among the books that deal more directly with investing I almost always enjoy titles in the “little book” series. Here are two, both particularly useful for value investors: Aswath Damordaran, The Little Book of Valuation and Vitaliy N. Katsenelson, The Little Book of Sideways Markets.

Lots of runners-up this year, but I’ll stop for now. I may need to pull them out of the hat for next year’s picks.

Brooks, Trading Price Action Trends

2011-12-15T05:22:00.005-05:00

In 2009 Al Brooks wrote Reading Price Charts Bar by Bar, a book I struggled with, as I explained in my review. It seems I was not alone. Brooks therefore re-engineered his project instead of simply writing a second edition. The result is a three-book series, of which Trading Price Action Trends: Technical Analysis of Price Charts Bar by Bar for the Serious Trader (Wiley, 2012) is the first volume. The other two, forthcoming in January, will deal with trading ranges and reversals.

Trading Price Action Trends is still no spine-tingling thriller, but it’s a tremendous improvement over Brooks’s first effort. For starters, the prose is cleaner and the charts are larger. And instead of merely describing bars, individually and as parts of patterns, he explains what they may reveal about the intentions and expectations of traders, both bulls and bears.

Brooks himself trades primarily off of 5-minute e-mini S&P 500 candlestick charts using only price action—no indicators (with the exception of a 20-bar EMA and hand-drawn trend lines), news, or multiple time frames. He sees everything “in shades of gray” and thinks “in terms of probabilities.” (p. 12) He recognizes that “everything can change to the exact opposite in an instant, even without any movement in price.” (p. 37) When he looks at a chart, he is “constantly thinking about the bullish case and the bearish case with every tick, every bar, and every swing.” (p. 39) He dissects bars but also realizes that ultimately they have meaning only contextually. If he were dealing with animals instead of charts he would be both an anatomist and an ecologist.

About half of this volume is devoted to the fundamentals of price action, the other half to trends. Of course, there is no clear demarcation line between the two. It’s impossible to write about the fundamentals of price action without discussing trends. At the level of individual bars, for instance, Brooks differentiates between trend bars and dojis (where the bulls and bears are in balance).

Who should read this book? Novices who think that trading is easy; this book should definitely dissuade them and perhaps prevent yet another account from being blown out. Serious traders, as Brooks himself suggests—and I would add serious traders with a penchant for detailed analysis who are willing to log thousands of hours of screen time and after-hours study in order to stand a chance of becoming a successful discretionary trader.

Trading Price Action Trends is a tough book to absorb. One pass is certainly not enough. But even on the first pass I found some extremely useful pointers. So it goes on to the shelf awaiting a second read.

Smith and Shawky, Institutional Money Management

2011-12-14T05:18:00.001-05:00

Institutional Money Management: An Inside Look at Strategies, Players, and Practices, edited by David M. Smith and Hany A. Shawky (Wiley, 2012) is the most recent addition to the Kolb Series in Finance. As is the custom with books in this series, it includes contributions by both academics and practitioners and is designed for professionals in the field as well as those aspiring to enter the field. It is a well-edited volume that anyone with a modicum of market experience should have no difficulty reading.

The book has four main themes that are explored in 22 chapters: market regulation, performance evaluation, and reporting; key individuals to the investment process; major investment approaches; and types of institutional investors.

In this post, rather than attempting an overview, I’m going to zero in on a single point that I think is potentially important for the individual investor.

The editors, in their chapter “Investment Buy and Sell Decision Making,” analyze data from Informa’s plan sponsor network (PSN) database, which is updated quarterly through surveys of money managers. They examine 5,410 equity portfolios and 1,494 fixed income portfolios from 1979 to the November 2009 release.

What criteria, they ask, do portfolio managers use when buying equities? About 60% reported using a bottom-up method. The next most popular criteria were quantitative/research (14%), fundamental analysis (11%), computer screening/models (4%), and top-down/economic analysis (4%). Only 20 portfolios of the 5,410 relied on technical analysis although, as the authors note, “the criteria most closely related to technical analysis—quantitative analysis, computer screening, and momentum—also enjoy widespread usage by portfolio managers.” (p. 125)

As we know, the more important question is usually when to sell. The PSN database recognizes six sell-discipline criteria: down from cost, up from cost, target price, valuation level, fundamental deterioration overview, and opportunity cost. The most popular among managers was fundamental, followed by valuation level; target price came in third.

The authors analyze returns by equity class (and the overall average) for each of these sell-discipline criteria. The best-performing criterion was down from cost, followed by target price. The worst performance, by a large measure, was logged by those who used no sell-discipline criterion. Here are the overall average numbers for the arithmetic average benchmark-adjusted returns (percent annualized): fundamental 2.17%, valuation level 2.00%, target price 2.47%, opportunity cost 1.76%, down from cost 2.59%, and none 1.22%.

There’s a lesson here.

McDowell, Survival Guide for Traders

2011-12-13T05:14:00.001-05:00

So you want to become an independent trader, either to supplement your income or eventually to have trading be your sole source of income? Bennett A. McDowell has written Survival Guide for Traders: How to Set Up and Organize Your Trading Business (Wiley, 2012) for the novice who wants to get started but doesn’t quite know how to go about it. If the wannabe trader doesn’t feel quite ready to plunge into the markets after reading this book, McDowell is more than ready to sell him a range of pricey products on his website TradersCoach.com.

Like all start-up businesses, trading is difficult and prone to failure. What will give the novice a shot at being successful? McDowell offers six pointers: (1) understand it will be a lot of work, (2) get adequate financing, (3) plan, plan, and plan some more, (4) start your business for the right reasons, (5) be resilient and persevere, and (6) create a model that can be profitable. And, he adds, reduce your expenses because with taxes a penny saved is closer to a penny and a half earned.

McDowell covers a lot of territory in this book, from how to choose the best data feed, broker, and front-end platform for your needs to money management and financial psychology. He offers a detailed business plan template. He lists some technical analysis signals and tools (those included in his own software are at the top of the list) and five popular scanning tools (again, his scanner heads the list).

What is the holy grail of trading? McDowell suggests that is perseverance: “those who survive and prosper for the long term are the traders who can persevere through thick and thin and just keep going with new solutions and strategies.” (p. 132)

Survival Guide for Traders is a good primer with an abundance, sometimes an overabundance, of information, but of course the reader won’t go from “See Spot run” to “Sleep that knits up the ravelled sleave of care” in one fell swoop. There’s a lot of work and practice in between.

Stoken, Survival of the Fittest for Investors

2011-12-12T05:08:00.001-05:00

Over the past few years, as academics have come to view markets as complex adaptive systems, Darwin’s ideas have worked their way into the mainstream financial literature. In Survival of the Fittest for Investors: Using Darwin’s Laws of Evolution to Build a Winning Portfolio (McGraw-Hill, 2012) Dick Stoken explores both the theory and practice of Darwinism as it applies to the individual investor.

Free markets, Stoken explains, use the same algorithm as evolution—search through potential designs, select the few that are good enough, then replicate or amplify them. Free markets are “littered with errors,”, but “each error, along the way, provides feedback so as to formulate a new trial until a solution is found.” (pp. 29-30) Moreover, similar to prey/predator models, “free markets fluctuate…. During the exuberant phase of the cycle, errors become embedded into the system and, at some point, interfere with its ability to self-regulate. Reversals are necessary to flush enough of the errors out so that the system can regain its former vitality.” (p. 31)

Stoken analyzes bubbles at some length and argues that the errors in the most recent financial crisis were not man-made. “If only X had done Y” is a misplaced criticism. The errors “were of the kind that living systems, operating via a trial-and-error process, typically make. Therefore, they could not, in an ordinary sense, be man-fixed.” The real error, he contends, was “in not allowing for error. … Our wealth-generating machine lowered its margin of safety drastically, leaving little room for anything to go wrong.” Stoken continues: “The more complex a system becomes, the greater the number of errors. Bubble time is also peak complexity time. The particular error doesn’t matter so much, as all roads lead to system failure. Much like Hercules in his battle with the nine-headed serpent Hydra, when Hercules cut off one head, two more would sprout; if we fixed one error, the problem shifted and another and more potent accident soon popped up.” (pp. 106-107)

What is an investor who accepts this view of the market to do? Of course, he has to adapt. Stoken offers several concrete options, from a passive diversified portfolio of alternative investments to a levered actively managed “combined assets” portfolio, from annual rebalancing to using a breakout system for buy and sell signals. He includes basic backtesting results for each strategy.

Survival of the Fittest for Investors is one of the “fittest,” best written investment books I’ve read in some time. The investor who is searching for a way to boost returns would do well to add it to his must-read list.

A daily chart advent calendar

2011-12-10T05:54:00.000-05:00

As usual, I'm late to the game. On November 30 The Economist published a daily chart advent calendar, a collection of the 24 most popular maps, charts, data visualisations and interactive features on their site this year plus a new chart for Christmas day. Not just the routine stuff. The first graph is the street price of cocaine in rich nations and adult usage in these countries. We're now on day ten; you're not allowed to peek ahead.

Schmitt, 401(k) Day Trading

2011-12-08T05:18:00.000-05:00

Over the past couple of weeks I have reviewed several books that meticulously explore the viability of various investing and trading strategies. Richard Schmitt’s 401(k) Day Trading: The Art of Cashing in on a Shaky Market in Minutes a Day (Wiley, 2011) does not fall into this category.

Schmitt argues that the investor with unconsolidated 401(k) accounts can outperform buy-and-hold returns by trading part of his retirement portfolio once every day. How, you may ask, can he do this given the restrictions on frequent trading imposed by most mutual funds? It’s simple. He has two commission-free stock fund accounts, one for buying stock and the other for selling stock, and a cash fund. And here’s the strategy. “You use one account for transfers just before the market close from a stock fund to a cash fund whenever the stock market is advancing for the day. In the other account, you transfer from a cash fund to a stock fund when the market is declining for the day.” (p. 220)

The investor doesn’t swap out his total buying or selling account each day. Instead, he determines how much to exchange based on the S&P 500’s daily change (not the daily range) multiplied by a constant calibration factor. “Under normal conditions, you could use a calibration factor of one thousandth of the initial amount of your retirement savings portfolio you decide to subject to day trading.” (p. 194) So, if the investor had a $100,000 portfolio, the S&P moved 10 points, and his calibration factor was $100, he would exchange $1,000.

Schmitt provides very little statistical information about his backtesting of this method. He compares only the differences in returns between the $100,000 day trading portfolio and the $100,000 S&P 500 portfolio. To “accommodate the market volatility experienced during the decade ended December 31, 2010,” the backtested day trading portfolio used a calibration factor of $75 for each daily one-point change in the S&P 500 index. (I assume this figure was optimized in hindsight, warning flag #1.) The day trading portfolio outperformed the index portfolio over the ten-year period (120 vs. 95.3) and a five-year timeframe (115.1 vs. 100.7). In 2010 itself, however, the index portfolio outperformed 112.8 vs. 107.3. We have no data on portfolio drawdowns.

The author acknowledges that “a comparison of alternative asset management strategies relies heavily on the measurement period selected for use in computing the strategies’ investment returns” (warning flag #2). “A 20-year comparison of alternative strategies becomes a bit more interesting.” (p. 207) We don’t know how badly Schmitt’s strategy would have performed over that time frame. Suffice it to say that the author acknowledges that “day trading is a strategy of the times, but not for all times. It may perform well in a volatile stock market with little or no net change over time but does not fare as well by comparison in a rapidly increasing or decreasing stock market.” (p. 208) So, warning flag #3 is that the investor has to be able to read the tea leaves of the market environment, present and near future.

Schmitt’s book provides a lot more information about 401(k) plans than I have shared in this review, and to that extent I have been unfair. But before investors with 401(k) plans get all excited about a way to earn excess returns with very little work they should step back a bit and think it through.

Hassett, The Risk Premium Factor

2011-12-07T05:23:00.000-05:00

In The Risk Premium Factor: A New Model for Understanding the Volatile Forces That Drive Stock Prices (Wiley, 2011) Stephen D. Hassett sets out to provide a model for estimating the equity risk premium (and hence the cost of capital) and for solving the equity premium puzzle.

Hassett begins with the CAPM equation for the cost of equity: risk-free rate + beta x equity risk premium (ERP). For the market as a whole, the cost of equity is the risk-free rate + ERP. The problem is how to calculate ERP. Enter Hassett’s risk premium factor (RPF) model, which proposes that “the equity risk premium (ERP) is a simple function of the risk-free rate.”

“Conventional theory would hold that if the equity risk premium (ERP) were 6.0 percent and 10-year Treasury yield were 4.0 percent, then investors would expect equities to yield 10 percent, but if the 10-year Treasury were 10 percent, then investors would require a 16 percent return—a proportionately smaller premium.” By contrast, Hassett argues that ERP is not fixed but “varies directly with the level of the risk-free rate in accordance with a risk premium factor (RPF).” For example, “with an RPF of 1.48, equities are expected to yield 9.9 percent when Treasury yields are 4.0 percent and 24.8 percent (10 + 1.48 x 10 = 24.8) when they are at 10 percent to provide investors with the same proportional compensation for risk.” (p. 19)

To calculate the RPF Hassett ran regressions on annual data between 1960 and 2008 and quarterly data from Q4 1986 to Q4 2008. He found two shifts in the RPF—in 1981 and September 2002. (The causes of these shifts, the author admits, are still not fully explained.) The RPF values for the annual data sets were 1.24 between 1960 and 1980, 0.90 from 1981 through 2001, and 1.51 for 2002 through 2008.

Hassett acknowledges that the RPF can be discerned only in hindsight and cannot be projected, but he still considers his method superior to other methods for determining risk premiums. For instance, “if the RPF changed just two times over 50 years, one might argue that in any year there is a 96 percent chance … that the RPF will remain constant over the next year.” (p. 28)

The RPF model is also brought to bear on the equity premium puzzle, the inability to reconcile the observed ERP with financial models. The authors of a 1985 paper found that on average short-term Treasuries produced a real return of about 1% over the long term and equities yielded 7%. This, the authors maintained, would require a puzzling coefficient of risk aversion on the order of 40 or 50 to justify the 7% ERP. Haslett invokes his model in conjunction with the notion of loss aversion to tackle the puzzle.

Hassett uses his model to explain major market gyrations. He also explains how it can be used to value an acquisition or project.

For most investors the model is most applicable in valuing the overall stock market. Hassett argues that when trying to decide whether the market is over- or undervalued the analyst should focus on the two drivers of valuation—earnings and interest rates (interpreted through the lens of the RPF model).

I am not equipped to pass judgment on Hassett’s model. It’s certainly a simple model, not one of those complex quant models that have come under attack of late. It also seems plausible. Is it useful? Perhaps.

Triana, The Number That Killed Us

2011-12-06T05:19:00.001-05:00

Pablo Triana, a professor at ESADE Business School (Spain), is a man on a mission: to rid modern finance of complex mathematical models. In The Number That Killed Us: A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis (Wiley, 2012) his target is one of the most widely used models, VaR (Value at Risk).

Triana’s thesis is fairly straightforward, although he spends over 200 pages fleshing it out. VaR is fundamentally flawed because it relies on historical data, viewing the past as prologue; it assumes a normal probability distribution; and it doesn’t differentiate among kinds of assets. Moreover, since VaR is the key metric invoked to determine leverage, traders can use it to game the system. They can put together portfolios with ostensibly low risk profiles and hence be eligible to use more leverage, an exercise that sometimes masks reckless behavior.

VaR, Triana argues, was the “top miscreant” in the financial crisis. “Without those unrealistically insignificant risk estimates, the securities that sank the banks and unleashed the crisis would most likely not have been accumulated in such a vicious fashion, as the gambles would not have been internally authorized and, most critically, would have been impossibly expensive capital-wise.” (p. 3)

Triana wants to get rid of VaR. What should replace it? “Going forward, let’s do less mathematical financial risk analysis, please. Softer sapience based on traders’ war scars, experience-honed intuition, historical lessons, and networking with other players will not only typically beat quant sapience when it comes to understanding and deciphering exposures (we humans can’t be that bad!), but most crucially should be far more effective in preventing obviously lethal, chaos-igniting practices.” (pp. 44-45)

Financial risk, he contends, “is a simple discipline. Or rather, a discipline that ought to be based on fairly simple tenets: Financial risk is not measurable or forecastable, the past is not prologue, battle-scarred experience-honed intuitive wisdom should be accorded utmost notoriety, certain assets are intrinsically riskier than others, too much leverage should be avoided, and too much toxic leverage should be banned.” (p. 213)

The book closes with a brief Q&A with Nassim Taleb and an essay by Aaron Brown that presents a more balanced view of VaR.

I’m certainly no expert on VaR or on the risk management practices of investment banks, but from the little I know Triana does justice to neither. Considering that he doesn’t want to reform quantitative risk management but either to abandon it or to keep a simplified version of it on a tight leash, I suppose fine points are irrelevant. Triana paints with broad, impassioned brushstrokes.

In my opinion supplementing VaR in particular and quantitative models in general with a large dose of human wisdom is a laudable goal. Maintaining a healthy margin of safety is important even if it means diminished profits during good times. Keeping models as simple as possible is undoubtedly good practice. On the other hand, chucking math and replacing it with so-called “battle-scarred experience-honed intuitive wisdom” is not. For one thing, behavioral finance has taught us that, despite our best intentions, we can be terrible bunglers. We humans really are that bad! For another, what masquerades as wisdom often turns out to be an oversized ego. Just think of …. Well, I’m sure you can easily fill in the blanks.

Twomey, Inside the Currency Market

2011-12-05T05:16:00.000-05:00

For those who are intellectually curious and who want to know more about the currency market than they’ll ever need to become a halfway decent trader Brian Twomey’s Inside the Currency Market: Mechanics, Valuation, and Strategies (Bloomberg/Wiley, 2012) is a fascinating if sometimes overwhelming book.

Twomey begins not with the definition of a pip but with an analysis of Bank of International Settlements (BIS) reports (which, by the way, are available online). The second chapter, entitled “Currency Trading Beyond the Basics,” lives up to its billing. It deals with such topics as margin in various countries, rollover rates and LIBOR, swap points, and purchasing power parity.

Twomey supplies formulas where necessary, charts where helpful as he takes the reader on a journey through trade weight indices, short-term interest rates and money market instruments, LIBOR, government bonds and yield curves, swaps and forwards, stock and bond markets, currency cycles and volatility. The journey is also geographical, encompassing markets in all the major crosses. And it includes a series of recommended trade strategies.

The final chapter is on technical analysis but, once again, not just the run-of-the-mill fare. He describes volume and open interest, COT reports, Bollinger bands, simple moving averages, Ichimoku, the Baltic dry index, the IMF and special drawing rights, pivot points, and currency correlations and trend lines.

This post is beginning to sound like a laundry list, but it’s the only way I can convey the breadth and the sometimes unexpected content of Twomey’s book. The book is definitely not for those who want a “dummies” introduction or who are looking for instructions on how to get rich quick in the forex market. It’s also not for those in search of some light reading for a rainy afternoon. Inside the Currency Market is for the serious student who wants to go beyond simple buy and sell signals to understand the range of market factors that influence currency prices.

Derman, Models.Behaving.Badly

2011-12-01T05:17:00.001-05:00

Models.Behaving.Badly: Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life (Free Press, 2011) is a wise book by a man who has thought deeply about his life, and not just as a quant on Wall Street. Emanuel Derman reminisces about his youth as a member of Habonim (a coeducational Zionist movement) in apartheid South Africa, his ordeal with myopic ophthalmological specialists, and his immersion in theoretical physics. He ventures into an unlikely corner of philosophy—not epistemology but Spinoza’s theory of emotions. He describes “the crooked paths that culminate in theories,” in particular classical and quantum electromagnetic theory.

Although these discussions have a life of their own, they serve to illustrate three fundamental ways of understanding the world: models, theories, and intuition. Intuition is “a merging of the understander with the understood”; “it emerges only from intimate knowledge acquired after careful observation and painstaking effort.” (pp. 96-97) Theory bears a close relationship to intuition. “[W]hen it is successful … it describes the object of its focus so accurately that the theory becomes virtually indistinguishable from the object itself. Maxwell’s equations are electricity and magnetism; the Dirac equation is the electron….” (p. 61)

Of the three, models are the most common and potentially the most troubling ways of understanding. “A model is a metaphor of limited applicability, not the thing itself.” (p. 54) It is an analogy which, although not unfounded, is partial and flawed. “Models project multidimensional reality onto smaller, more manageable spaces where regularities appear and then, in that smaller space, allow us to extrapolate and interpolate from the observed to the unknown.” (p. 58)

Since the financial markets do not obey the laws of science but are subject to the vagaries of human behavior, there can be no financial theories, only financial models. And, as Derman writes graphically, “When we make a model involving human beings, we are trying to force the ugly stepsister’s foot into Cinderella’s pretty glass slipper. It doesn’t fit without cutting off some of the essential parts.”

Models are not useless; indeed, they can be “immensely helpful in calculating initial estimates of value.” (p. 194) The best model in all of economics, Derman argues, is Black-Scholes. Although it is imperfect, it stands head and shoulders above CAPM: “an unkind way to look at CAPM is to say that it’s not very good.” (p. 182)

Reading Derman’s book is both an intellectually rewarding and a thoroughly pleasurable way to spend an afternoon. I recommend it unequivocally.

Fisher, Using Median Lines as a Trading Tool

2011-11-30T05:14:00.000-05:00

Median lines can sometimes be very useful in mapping out market structure and in identifying potential profit targets. One argument against them, however, is that they are subjective and that as a result no trading strategy that incorporates them can be backtested.

Greg Fisher of www.Median-Line-Study.com addressed this problem in a paper he wrote for an MBA independent study course and subsequently published in 2009 as Using Median Lines as a Trading Tool: An Empirical Study--Grain Markets 1990-2005. He also wrote a companion piece, Finding High Probability Lines. Both are brief works (70-some pages) and in part cover material available elsewhere. But his study of the grain markets is a serious attempt at backtesting median line principles.

The thorniest problem is the choice of pivot points. They are obvious in hindsight and somewhere between tough and impossible to identify in real time. Fisher uses Andrews’ definition of a trendline: “For an uptrend within the period of consideration, draw a line from the lowest low, up and to the highest minor low point preceding the highest high. The line must not pass through prices in between the two low points. Extend the line.” A pivot is “a reverse in price direction that reverses the previous trend by violating the previous trendline.” (pp. 13-14) Once a pivot forms, a median line and its parallels are drawn.

Fisher offers a flowchart of possible price action, starting with the most basic either/or: does price reach the median line or not?

And, among other things, he records the percentage of time price reached the median line as well as price action at the median line.

Fisher’s work is thorough and probably about as good as backtesting median lines can be. Yet, as he himself admits, it benefited from hindsight since he was working with historical data. “The study assumes all pivots were chosen correctly as it is based on known price data.” (p. 38) In real time trendlines are drawn and re-drawn. In fact, even in the figure Fisher provides to illustrate Andrews’ notion of trendlines there are obvious places to draw trendlines that misidentify the important pivot points.

This is no reason to reject median lines out of hand. Andrews’ method can be used in multiple ways, for multiple purposes. For instance, one doesn’t always have to rely on the most recent, still tentative pivot to draw median lines. Often the best sets are those that the market has already respected.

For readers who are unfamiliar with median lines Fisher’s books provide a good introduction. For those who want to subject the median line method to some Monday-morning backtesting Fisher offers a carefully thought out model.

Frush, All About Exchange-Traded Funds

2011-11-29T05:24:00.001-05:00

ETFs have been a major force in the markets for some years. It is perhaps a tribute to their success that a subcommittee of the Senate Banking Committee held a special hearing last month examining such topics as whether ETFs are contributing to volatility and posing risks to the financial system.

Scott Paul Frush writes for those who want, as the subtitle of every “All About” book reads, “the easy way to get started” in ETFs. All About Exchange-Traded Funds (McGraw-Hill, 2012) is a comprehensive introduction. Among other things it includes a brief history of ETFs, it identifies the players, it explains how ETFs come to market, it describes their internal workings, and in a hundred-page section it outlines the main types of ETFs (broad-based, sector and industry, fixed-income, global, real asset, and specialty). It even includes a list of ETF closures by year, through 2010.

In an early chapter Frush discusses the advantages and drawbacks of ETFs over mutual funds and individual stocks. Let me mention just three here. First, a plus for ETFs, they are not subject to style drift, “the tendency of a portfolio manager to deviate from his or her fund’s specific strategy or objective.” (p. 44)

Second, a plus for mutual funds, some ETFs suffer from dividend drag, “the implicit cost some ETFs incur as a result of the … SEC rules stipulating that certain ETFs cannot immediately reinvest back into the portfolio the dividends paid by companies held in the fund. Instead, some ETFs must accumulate the dividends in a cash reserve account and pay them to shareholders at periodic intervals—typically quarterly. This requirement differs for mutual funds, as they can reinvest dividends immediately.” (p. 45)

Third, ETFs are fully invested by nature—“and that’s a very good thing for investors.” Mutual funds, by contrast, must allocate part of their holdings to cash to satisfy shareholder liquidations. “If you were to build a portfolio of 60 percent equities and 40 percent fixed income and later discovered that many of your equity mutual funds hold 10 percent cash, you might not be too happy since that means that your actual portfolio allocation is closer to 54/46 percent equities to fixed income, respectively.” (pp. 46-47) Speaking of asset allocation, Frush devotes a chapter to the topic in the final part of the book on how to use ETFs.

All About Exchange-Traded Funds is a well-written, balanced introduction. Both individual investors and financial advisers could profit from reading it.

Zacks, The Handbook of Equity Market Anomalies

2011-11-28T05:14:00.001-05:00

Leonard Zacks, the founder of Zacks Investment Research, has edited a book that should appeal to serious investors who are trying to find an edge. The contributors to The Handbook of Equity Market Anomalies: Translating Market Inefficiencies into Effective Investment Strategies (Wiley, 2011) are mostly academics. They review literature from the past twenty years on market anomalies and draw practical implications for the individual investor.

After an introductory chapter on the conceptual foundations of capital market anomalies, the book highlights nine anomalies: the accrual anomaly, the analyst recommendation and earnings forecast anomaly, post-earnings announcement drift and related anomalies, fundamental data anomalies, net stock anomalies, the insider trading anomaly, momentum (the technical analysis anomaly), seasonal anomalies, and size and value anomalies. The editor then looks at anomaly-based processes for the individual investor, and an appendix covers the use of anomaly research by professional investors. As you might expect, each chapter includes an extensive bibliography. (The website that accompanies the book has abstracts of the referenced works and links to the original articles—some available at no charge.)

The authors explore strategies that worked, that still work, and—the toughest hurdle of all—that continue to produce excess risk-adjusted returns after all those pesky transaction costs are deducted.

Many of the anomalies can be attributed to psychological factors. To take perhaps the simplest case, sunshine has been linked to tipping and the lack of sunshine to depression and suicide. When the sun shines people feel good, are more optimistic, and “may be more inclined to buy stocks thus leading to higher stock prices.” (p. 255) Indeed, studies show, sunshine is strongly positively correlated with daily stock returns, especially the farther one is from the equator. Other weather conditions such as rain and snow are unrelated to returns.

A question that I found intriguing is whether aggregate insider trading can be used to predict market returns. (Studies suggest that insider trading as an individual stock picking strategy delivers superior returns over long investment horizons.) Insiders, it turns out, are contrarian traders; they sell after increases in the market and buy after poor performance. So far studies indicate that “aggregate insider trading is more successful in predicting forthcoming poor stock market performance, but it can also be used with moderate success to predict large stock market increases. Aggregate insider transactions have a promising potential to be used as a market-timing tool.” (p. 166)

Zacks suggests that research on these anomalies be used to create quant multifactor equity models. The investor can embrace that suggestion if she has some quant skills, can subscribe to a scanning service (Zacks Investment Research, of course, provides such a service), or can use select anomalies to supplement her current investing strategy. No matter what the choice, this book is a cornucopia of carefully researched investing ideas.

Happy Thanksgiving

2011-11-24T04:12:00.003-05:00

Martin, Benjamin Graham and the Power of Growth Stocks

2011-11-23T05:18:00.001-05:00

Most people asked to describe the difference between value and growth investing would stumble because these strategies are neither mutually exclusive nor collectively exhaustive. In fact, Warren Buffett argues that “growth is always a component in the calculation of value” and “the very term ‘value investing’ is redundant. What is ‘investing’ if not the act of seeking value at least sufficient to justify the amount paid?” Frederick K. Martin gives full form to this “joined at the hip” reality in Benjamin Graham and the Power of Growth Stocks: Lost Growth Strategies from the Father of Value Investing (McGraw-Hill, 2012).

Graham may be best known for his rigorous methodology for evaluating an investment, but “as his career progressed, he developed an appreciation for the long-term power of growth.” Later in his career he purchased a major stake in GEICO for $27 a share “and watched it rise over the ensuing years to the equivalent of $54,000 per share. … That single transaction, which accounted for about a quarter of his assets at the time, ultimately yielded more profit than all his other investments combined.” (p. 7)

Graham defined a growth stock as “one which has done better than average over a number of years and is expected to do so in the future.” In the 1962 edition of Security Analysis he devoted an entire chapter to analyzing and valuing growth stocks. “Brilliant in its common sense and simplicity, it was a landmark chapter in Graham’s illustrious career before it inexplicably disappeared from future editions of the book.” (p. 65) Martin reprints the “lost” chapter in this book—an important service in and of itself.

Martin expands on Graham’s growth ideas in seven chapters. Among the key principles is Graham’s valuation equation: value = current “normal” earnings x (8.5 plus 2G), where G is the average annual growth rate expected for the next 7 to 10 years. Martin also explains how to build a margin of safety for growth stocks and describes the characteristics of a great growth company. He hammers home the power of compounding and invokes Graham’s notion of “Mr. Market” to explain inefficiency in the market. And he gets down in the trenches, showing how to put Graham’s principles into action.

Benjamin Graham and the Power of Growth Stocks provides effective guidance for the long-term investor who wants to achieve above-average returns. Yes, the strategy requires work—and a lot of wasted effort, and this in itself “could be a deal killer for anyone who is not willing to be diligent in her investing practices. If she doesn’t enjoy the painstaking effort of poring through 10-K reports, analyzing balance sheets and cash flow charts, and making careful projections, she may be unable to execute Graham’s strategy effectively.” (p. 246) At least she doesn’t need to be a sophisticated quant. As the author argues, “higher-level math implies a level of precision that does not exist in the real world.” (p. 259)

Zacks, The Little Book of Stock Market Profits

2011-11-22T05:20:00.000-05:00

Mitch Zacks, senior portfolio manager at Zacks Investment Management and “the firm’s primary expert on quantitative investing,” is the latest contributor to Wiley’s “little book big profits” series. Not surprisingly The Little Book of Stock Market Profits: The Best Strategies of All Time Made Even Better (2012) describes some of the strategies that are inextricably linked with the Zacks name. The author also draws on academic findings summarized in Leonard Zacks’s Handbook of Equity Market Anomalies (to be reviewed on this blog in the very near future).

In eleven chapters the author discusses such topics as changes in sell-side analyst recommendations, smaller cap stocks, earnings estimate revisions, price momentum, piggybacking on the trades of insiders, net stock issuance (IPOs, stock buy-backs), quality of earnings, valuation metrics, post-earnings announcement drift, seasonal timing, and multi-factor models.

Despite the brevity of the book Zacks is careful to explain the conditions under which the strategies work, what can derail them, and whether they are effective as stand-alones. Let’s take a single example: price momentum.

“The data show two patterns that seem relatively stable, or about as stable as financial data ever become. These two patterns are short-term momentum and long-term reversals. In the short-to-medium term, roughly about a calendar quarter or two, stocks that have gone up in price substantially tend to continue to trend upward. However, over the long term, stocks that performed extraordinarily well over the last few years tend to become losers over the next three to five years.” (pp. 64-65) Even though momentum-based trading was profitable until 2000, the normal relationship between short-term momentum and long-term reversals then broke down, and it was not until 2005 that it was re-established.

Zacks explores specific momentum strategies such as a 12/3 split. “What this means is sorting the universe of stocks into deciles based upon how they performed over the past year, and then holding the portfolio for the next three months. It also looks like performance can slightly be increased if you lag the construction period by one week.” (p. 67) Other momentum strategies that can deliver excess returns are “buying stocks that trade near their 52-week highs and using traditional moving averages.” (p. 68)

Somewhat curiously, at least according to one study, “momentum seems to work better for mid-cap stocks than for either large- or small-cap stocks.” Other studies, however, indicate that “price-momentum-based studies are statistically stronger for stocks with lower analyst coverage.” (pp. 69-70)

Since individual investors, unlike institutional investors, tend to hold losing stocks too long and sell winning stocks too soon, and since these behavioral biases contribute to momentum returns, “we would expect to see stocks with low volume—which would be more likely to be held by individuals—to exhibit stronger momentum returns.” This is indeed the case: “a stock’s past trading volume is a good predictor of how strong the momentum effect is and the extent to which the momentum effect persists.” (p. 74)

Momentum-based returns also seem to be linked to broad-based economic strength. “Over the past seventy years, it looks like momentum based strategies only generate excess returns in periods of economic expansion. Even more interesting, momentum returns turn negative during a recession.” (p. 75)

The Little Book of Stock Market Profits can be used as something of a crib or pony by those who don’t want to spend countless hours reading the academic literature. It’s a fast read and offers useful advice for the active investor.

Ciana, New Frontiers in Technical Analysis

2011-11-21T05:14:00.002-05:00

For those of us without a Bloomberg terminal New Frontiers in Technical Analysis: Effective Tools and Strategies for Trading and Investing by Paul Ciana (Bloomberg/Wiley, 2011) is an idea book, not a plug and play manual. But even though some of the software tools described in Ciana’s book are not available on run-of-the-mill trading platforms (and where they are, they are available by subscription only) clever programmers may get inspired. Moreover, even without access to proprietary software the imaginative reader can add some new arrows to his quiver.

The six chapters in this book are written by six different authors: “Evidence of the Most Popular Technical Indicators” (Paul Ciana), “Everything Is Relative Strength Is Everything” (Julius de Kempenaer), “Applying Seasonality and Erlanger Studies” (Philip B. Erlanger), “Kase StatWare and Studies” (Cynthia A. Kase), “Rules-Based Trading and Market Analysis Using Simplified Market Profile” (Andrew Kezeli), and “Advanced Trading Methods” (Rick Knox).

Ciana provides some fascinating data about the preferences of those who use the Bloomberg Professional Service. For instance, Europe opts for log charts 47% of the time and Asia only 9% of the time. Asia prefers candlestick charts, the Americas bar charts. Worldwide the most popular technical indicators (excluding moving averages) are RSI, MACD, Bollinger bands (BOLL), stochastics (STO), directional movement index (DMI), Ichimoku (GOC), and volume at time (VAT). RSI is the clear winner, with a 44.4% worldwide preference; MACD comes in second at 22%. Some indicators have geographical ties. GOC has a 10.8% popularity rating in Asia as opposed to 2.5% in the Americas and 2.8% in Europe. VAT has a 5.3% rating in the Americas and only 1.8% in Europe and 1.6% in Asia.

VAT, for those who are unfamiliar with it, is something of a seasonal indicator. For instance, “from a historical perspective, VAT considers the volume that has occurred on that day over the past X years to create the average for that day. … From an intraday perspective, VAT creates an average of volume from the actual volume that occurred during that time-slice for the past X days. In both applications VAT can be projected into the future to get an idea of expected volume.” (p. 37)

The authors describe the proprietary technical indicators they have developed and give ample illustrations of them. Some of the indicators have been around for quite a while. For instance, there are Kase’s DevStops, which I always mean to study more carefully and somehow never do. And, of course, Market Profile is a well-known if not so well understood trading framework (hence the simplification proposed in this book).

For those traders always in search of the next best thing (and all traders should be open minded enough to recognize that regimes change and strategies must be adaptable) Ciana’s New Frontiers in Technical Analysis offers a lot of eye candy. Possibly addictive, perhaps not truly nutritious, but definitely fun to devour.

Fabozzi and Markowitz, eds., Equity Valuation and Portfolio Management

2011-11-17T05:22:00.000-05:00

Someday, I trust, markets will get a break from the relentless macroeconomic and political vicissitudes and investors will be able to focus once again on company and portfolio basics. In anticipation of that day Frank J. Fabozzi and Harry M. Markowitz have edited a very useful volume dealing with quantitative approaches to Equity Valuation and Portfolio Management (Wiley, 2011).

The book is broad in scope, as witnessed by the table of contents. Its 21 chapters include “An Introduction to Quantitative Equity Investing,” “Equity Analysis Using Traditional and Value-Based Metrics,” “A Franchise Factor Approach to Modeling P/E Orbits,” “Relative Valuation Methods for Equity Analysis,” “Valuation over the Cycle and the Distribution of Returns,” “An Architecture for Equity Portfolio Management,” “Equity Analysis in a Complex Market,” “Survey Studies of the Use of Quantitative Equity Management,” “Implementable Quantitative Equity Research,” “Tracking Error and Common Stock Portfolio Management,” “Factor-Based Equity Portfolio Construction and Analysis,” “Cross-Sectional Factor-Based Models and Trading Strategies,” “Multifactor Equity Risk Models and Their Applications,” “Dynamic Factor Approaches to Equity Portfolio Management,” “A Factor Competition Approach to Stock Selection,” “Avoiding Unintended Country Bets in Global Equity Portfolios,” “Modeling Market Impact Costs,” “Equity Portfolio Selection in Practice,” “Portfolio Construction and Extreme Risk,” “Working with High-Frequency Data,” and “Statistical Arbitrage.”

I can’t possibly do justice to the book in this brief post. Let me simply share a single idea that I found promising (and that can be sketched out in a couple of paragraphs).

It’s an approach for dealing with strategy failure. “Every investment strategy has three core properties: (1) the return that the strategy generates, (2) the volatility of that return, and (3) the correlation of that return with alternate strategies.” (p. 397) As we know, returns are fragile: “strategies fail despite the support of logic or history.”

To address this problem the authors, both from Nomura, suggest an alpha repair process. Essentially, what they do is to take a set of 45 factors (such things as 1-year price momentum, market cap, and ROE) and view each as an asset. “The objective is to own the portfolio of factors weighted to produce the highest Sharpe ratio.” They don’t want to include all 45 factors on the portfolio “team” because “while more factors could improve the Sharpe ratio by reducing risk, a diversified portfolio of many factors would likely produce lower returns than a concentrated portfolio of good factors.” (p. 403) Instead, they run their screens each month against a large pool of contending strategies and select three factors using optimization for next month’s “team.” The screens incorporate “the history of factor return, volatility, and correlation with other factor returns.” (p. 412)

The alpha repair strategy provides a framework for discarding a factor that seems to have lost efficacy and embracing one that seems to have become important. The procedure (which is of course a lot more complicated in its execution than in its bare outlines) has a targeted 100% annual turnover. It has outperformed the benchmark Russell 1000 in a consistently linear fashion—by more than 4% in the period January-August 2010, annually for the past five years, and annually for the past ten years.

O’Shaughnessy, What Works on Wall Street

2011-11-16T05:22:00.000-05:00

I can’t quite fathom how I missed the first three editions of this book, but James P. O’Shaughnessy’s best-selling What Works on Wall Street: The Classic Guide to the Best-Performing Investment Strategies of All Time (McGraw-Hill, 2012) is now in its fourth edition. It has been updated with new data covering the recent market turmoil, innovative strategies for investing success, and new material on sector analysis. One of the advantages of buying a book that has a large readership is that it is inexpensive—under $25 on Amazon for almost 700 oversized pages.

Backtesting investment strategies is an enterprise fraught with danger, and critics are only too ready to line up to shoot holes in the tester’s methodology, sample size or timeframe, or to decry the value of statistics in general. I, by contrast, am grateful that anyone undertakes a task for which I am ill equipped. For those who believe that history provides a guide to the future O’Shaughnessy’s massive work is an invaluable reference.

Confronted with such a large, data-heavy book, readers will be tempted to skip to the penultimate chapter: “Ranking the Strategies.” But this lazy approach will probably yield little because it is important to understand why certain strategies work better than others and why multifactor models, especially those that “marry both value and growth characteristics, … will go on to offer investors the best absolute and risk-adjusted returns.” (p. 470)

O’Shaughnessy analyzes all the popular metrics—among them, market cap, P/E ratios, EBITDA to enterprise value, price-to-cash flow ratios, price-to-sales ratios, price-to-book value ratios, dividend yields, buyback yield, shareholder yield, and accounting ratios. He looks at one-year earnings per share percentage changes, profit margins, return on equity, and relative price strength. He dissects the market leaders universe and the small stocks universe and describes the ratios that add the most value in each case. And he looks at how the factors he has examined perform on the sector level.

What Works on Wall Street is not a book you read straight through unless you are a possessed numbers wonk. Rather, it’s one you pick at—and the pickings are by no means slim—and put in a prominent place on your reference shelf.

Malz, Financial Risk Management

2011-11-15T05:15:00.002-05:00

Allan M. Malz, currently a senior analytical advisor in the Markets Group at the Federal Reserve Bank of New York and a faculty member at Columbia University and earlier a trader and risk manager, has written a thorough account of the principles of risk management and the challenges facing risk managers today.

Financial Risk Management: Models, History, and Institutions (Wiley, 2011) is a big book, over 700 pages. And for those who are not steeped in the basic math of risk management it is a difficult book. The fault, I am the first to admit, lies with the reviewer, not the author. I have a knack for getting in over my head when it comes to quant books.

Despite my obvious handicap, I learned a lot from this wide-ranging book. Start with macro/central bank issues such as the structure of the banking industry, stress tests, and financial regulation--especially in the wake of the most recent financial crisis. And since, lest we myopically forget, the world has experienced many financial crises, Malz devotes a chapter to the topic, analyzing such issues as panics, runs, and crashes; the causes of financial crises; and the behavior of asset prices during crises.

For those who are charged with managing portfolio risk Malz takes them through the ins and outs of VaR. Especially intriguing to me, albeit mentally tasking, was the chapter on nonlinear risks and the treatment of bonds and options. And, although I would like to believe it’s Monday morning quarterbacking but I know it’s not, we can read about credit and counterparty risk and structured credit risk.

Malz’s Financial Risk Management will never be a best seller. But those who need to know how to manage risk—and I would hope that their numbers are not limited to risk managers themselves--would do well to add this book to their must-read list.

Weissman, Trade Like a Casino

2011-11-14T05:10:00.001-05:00

Richard L. Weissman, the author of Mechanical Trading Systems (2004), has a new book out: Trade Like a Casino: Find Your Edge, Manage Risk, and Win Like the House (Wiley, 2011). It’s a well-balanced book that incorporates trading ideas, risk management, and trader psychology and that is appropriate for both beginning and intermediate traders.

Weissman contends that “the single most important tool in developing positive expectancy trading models is the cyclical nature of volatility.” (p. 73) Trendless, low-volatility environments resolve themselves into trending markets; trending, high-volatility markets cycle to low volatility. He discusses the leading volatility indicators, with Bollinger bands being his favorite, average true range following, and ADX rounding out the list. He offers coding for long and short entries and exits using these indicators.

Another tool he finds valuable is timeframe divergence, where the shortest timeframe diverges from longer ones. He discusses this tool at some length and provides ample chart illustrations.

The book proceeds at an easy gait despite the fact that Weissman recognizes that there are no simple, one-dimensional paths to successful trading. “All market behavior is multifaceted, uncertain, and ever changing.” (p. 191)The master trader, he writes, must be disciplined yet flexible, must reprogram himself to avoid the irrational cycles of euphoria and fear (taking partial profits helps in this endeavor) and instead be even-minded, and must learn to participate rather than anticipate. And, of course, must always practice good risk management.

Well, that doesn’t sound too hard, does it? It shouldn’t take all that much work to follow Weissman’s directives. Then comes the chapter on analyzing performance—in particular, the due diligence questionnaire that he advises each reader to complete. The questionnaire with explanations is a staggering 19 pages long and forces the trader to assess virtually every aspect of his business. Anyone who takes this questionnaire seriously should begin to understand how much work really is involved in setting up and running a successful trading operation. Weissman also offers tips on monitoring performance.

Trade Like a Casino won’t guarantee the reader a profitable trading career, but it provides a pretty complete outline of what it takes to win like the house.

Finding your own style

2011-11-10T05:19:00.001-05:00

Before I return Mehrling’s biography of Fischer Black to the public library I thought I’d touch on another theme. Herewith some lengthy quotations that may inspire you to find your own style.

Fischer spent the early 1970s at the University of Chicago’s Graduate School of Business “safe inside his office on the third floor of Rosenwald, with Myron Scholes on one side and Eugene Fama on the other.” There he “could be a maverick without bearing the costs that everywhere else are imposed on those who refuse to conform to societal norms. He loved it.

“The own downside was the obligation to teach. No one was ever better than Fischer at working one-on-one with a student, but the subject had to be one that he was interested in learning about himself. And the student had better be interested in solving the problem … and prepared to defend his proposed solution against alternatives, even alternatives that no one except Fischer was prepared to consider. For him, the whole point of academic life was to think new thoughts, and he was interested only in interacting with people who shared that commitment.”

“Standard classroom lecturing about matters that Fischer thought had already been resolved was simply a bore, and Fischer was lousy at it. He recalled: ‘I was terrible, judging by the ratings my students gave me. I thought lectures were a waste of time for me and for my students (especially when the material is in a book). I looked for every possible excuse to cancel classes. One thing I did was to fill some classes with reviews of past exams. That worked well, so gradually I started doing more of it. Eventually, I worked out the following system.

‘I handed out lists of questions and packets of readings at the start of each semester. In each class we would discuss three or four of the questions. They would give their views and I would give my views. The students liked it, and I liked it. My ratings went from the bottom to the top, and I’m sure they learned more than when I was lecturing.’ Students would recall of his ‘Fifty Questions’ course that every year the questions stayed the same, but the answers always changed. In effect, Fischer handled teaching, which he hated, by turning it into research and intellectual dialogue, which he loved.” (pp. 186-87)

* * *

“The way that Fischer worked was to use ‘recalcitrant experience’—the expression is Quine’s—to stimulate further refinement of his theory of how the world works. Indeed, he actively sought examples of recalcitrant experience for this purpose.”

“Inconclusive was fine with him. Better to know the extent of your ignorance than to waste time building theories on insubstantial empirical foundations. More generally, he favored simply exploring the data quite directly, without very much in the way of elaborate statistical apparatus. He was not testing theories or estimating coefficients, but rather searching for new knowledge.”

“Twenty-five years later, at Goldman Sachs, he ruminated about how best to manage traders: ‘Observing a puzzle is not enough. A crooked yield curve or an unexplained stock price move is suggestive, but I generally want to know why these patterns exist before I trade. Stories can be wrong, but I’m uncomfortable trading without one. I want to know what kind of supply and demand imbalance is creating the trading opportunity.’ Such is the long shadow cast by Fischer’s early encounter with Quine.” (pp. 117-19)

In praise of dilettantism, with a dash of madness

2011-11-09T05:37:00.001-05:00

I recently finished reading the Steve Jobs biography as well as Fischer Black and the Revolutionary Idea of Finance (2005) by Perry Mehrling. Both men had cancer and died young—Jobs at 56, Black at 57. In their short lifetimes both transformed their fields.

Those who don’t know the basic outlines of Steve Jobs’s life and his embrace of aesthetic and technological principles in the creation of Apple products have been living under a rock. So I’m not going there. Rather, I want to use Fischer Black’s years at Harvard to illustrate some of the powers of intellectual cross-fertilization.

As an undergraduate Fischer was initially infatuated with studies in social relations (“a conglomeration of sociology, anthropology, psychology, psychiatry, etc.”). On the side he took courses in mathematics and physics. “He seems to have had the idea that he could always return to physics for graduate school if nothing else worked out. In May 1957 he wrote to his parents that physics was not interesting to him but would lead to the kind of job he wanted, namely in research. ‘In social relations the subject matter would be more interesting and everything would be great if I could get the right kind of job, but I doubt if such jobs even exist. I’m now considering other fields, even economics.’ … Fischer spent the fall of 1957 trying out biology and chemistry as possible alternatives to physics [and, importantly, also took Van Quine’s course on deductive logic for his own interest] before he accepted the inevitable. … In May 1958 he switched his major to physics.” (p. 34)

He stayed on at Harvard for graduate school—the sole university to which he applied—but, once there, he took only one physics course and barely passed it. Instead, he became interested in computers, and eventually artificial intelligence, and petitioned “to switch officially from theoretical physics to applied mathematics.” He took a course on B.F. Skinner’s psychology of learning, but failed it. He was more comfortable with the cognitive approach to learning and took two graduate courses in this area.

Departmental authorities were concerned about Fischer—first because he failed the course in the psychology of learning and second because he was unwilling “to be tied down to a specific program of work. … [I]n his formal application for admission to the thesis-writing stage of the PhD, Fischer listed his proposed subject as ‘artificial intelligence or foundations of mathematics.’ Well, which was it to be? In February 1961, his adviser, Anthony Oettinger, wrote a note to the Committee on Higher Degrees: ‘I have reason to be concerned about his intellectual discipline so that, while recognizing his ability and his desire for independence, I am concerned lest he lapse into dilettantism.’” (p. 37)

“By spring 1962, his lack of progress toward a viable thesis was evident to everyone, and Oettinger graded his work unsatisfactory. In June he was officially informed that he would not be allowed to register in the fall.” (p. 39)

Undeterred, Fischer stayed on in Cambridge and described his life a month later: “I am studying modern art in summer school, taking guitar lessons, taking a speed reading course, working on my thesis, working at Bolt Beranek and Newman [a consulting firm], participating in psychological experiments on hypnotism.” (p. 40) In the spring of 1963, in an effort to learn “how natural language works in the hope that it might help him with the tricky problem of programming a computer to understand questions posed in natural language,” he sat in on courses at MIT in the grammar of English and in semantics. (p. 43)

Fischer’s work at BBN opened the possibility for a return to graduate school. “Over the next year, Fischer wrote a dissertation that was accepted for the PhD in applied mathematics in June 1964. The title of the dissertation was ‘A Deductive Question Answering System.’” Yet, “even as he was writing the thesis, he wrote to his parents: ‘I’m trying to decide what I want to do after I get my degree. The field is wide open. I don’t really like any of these labels: scientist, engineer, researcher. I’m not at all sure I want to stay in the computer field.’” (p. 44)

Mehrling concludes that Fischer Black’s work on artificial intelligence (the man-computer symbiosis) led to “an integration of the two sides of his character, the wildly creative and the ruthlessly logical. Thirty years later, a colleague would remember Fisher: ‘No one’s mind is, or will ever be, as fertile as Fischer’s was. No one is even close. He was crazy and logical at the same time. The force of his logic would push you into corners you didn’t like, or it could open vistas you had not imagined. The crazy streak freed him from conventional wisdom. He was intellectually fearless.’” (pp. 45-46)

Hirsch and Person, Commodity Trader’s Almanac 2012

2011-11-08T05:17:00.001-05:00

Now in its sixth edition, the 2012 Commodity Trader’s Almanac (Wiley) once again provides a treasure trove of price data and seasonal trading ideas. It belongs on the desk of everyone who trades commodity futures and U.S. dollar crosses as well as stocks, ETFs, and ETNs that are commodity based.

I bought the inaugural 2007 edition of this almanac and for purposes of this review pulled it off my shelf to compare it to its 2012 counterpart. My question was: Is it worth buying the almanac every year? Are the changes really that important to a trader’s bottom line? The brief answer is “yes.”

First of all, if there’s any place seasonal strategies work it’s in commodities. And the 2012 strategies are no rehash of those of 2007. The almanac switches around the commodities that are analyzed. For instance, the commodities that received a one-page analysis in June 2007 were coffee and crude oil whereas in the June section of the 2012 almanac we read about soybeans, sugar, beef, and corn.

The almanac follows the familiar Hirsch format. It’s spiral bound, which means it lies flat when open. About 60% of the volume has calendar entries with appropriate quotations on recto pages, analysis on verso pages. Then come contract specifications, a list of select ETFs, a series of potentially profitable trading patterns, and an extensive long-term data bank (annual highs, lows, and closes as well as near-term contract monthly percent changes) for the S&P 500, 30-year Treasury, crude oil, natural gas, copper, gold, silver, corn, soybeans, wheat, cocoa, coffee, sugar, live cattle, lean hogs, British pound, Euro, Swiss franc, and Japanese yen.

Every year the editors tweak the almanac to respond to trading trends. For instance, this time around they have added a brief section on options and spread trading. But the bottom line is that the Commodity Trader’s Almanac, like the Stock Trader’s Almanac, is a handsome, useful addition to a trader’s desk—especially those traders who believe, like Jesse Livermore, that “It isn’t as important to buy as cheap as possible as it is to buy at the right time.”

Knight, High-Probability Trade Setups

2011-11-07T05:14:00.001-05:00

Tim Knight, founder of Prophet Financial Systems (now part of the TD Ameritrade stable) and a well-known blogger (Slope of Hope), takes yet another look at pattern trading in High-Probability Trade Setups: A Chartist’s Guide to Real-Time Trading (Wiley, 2011).

The bulk of the book is devoted to nineteen patterns: ascending triangles, ascending wedges, channels, cup with handle, descending triangles, descending wedges, diamonds, Fibonacci fans, Fibonacci retracements, flags, gaps, head and shoulders, inverted head and shoulders, multiple bottoms, multiple tops, pennants, rounded bottoms, rounded tops, and support failure. In each case he defines the pattern, explains the psychology behind it, and provides examples.

The two shorter parts of the book provide an overview (a primer on chart setups and the author’s personal trading journey) and tips on setting stops and being a bear as well as a guide to real-life trading.

For those who are familiar with the literature on chart patterns there’s not much new in this book. The illustrative charts are, however, such a decided improvement over those in the classic Edwards and Magee volume, Technical Analysis of Stock Trends, which has seen multiple editions over the years, that it is worth adding to a reference library. Moreover, the examples are drawn primarily from recent price action. Given market volatility over the past few years it’s easy to find charts that graphically illustrate most patterns. For instance, all of the rounded top examples were drawn from the bear market from late 2007 through early 2009. “The reason is that the market conditions leading up to 2007 were so strong (although wavering in the summer of 2007) and the conditions following the peak gradually deteriorated into an unmitigated collapse. Thus the formation of the domes—the rounded tops—was just about perfect. … Under normal circumstances, formations this clean are infrequent.” (p. 278)

For those who are looking for a solid introduction to pattern trading Knight’s book is first-rate—clear descriptions and lots of ProphetCharts. For those who are old hands at chart patterns the book bears testament to the fact that sometimes profitable patterns really do stare you in the face.

Tuckett, Minding the Markets

2011-10-27T05:37:00.000-04:00

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.

Ranadivé and Maney, The Two-Second Advantage

2011-10-25T05:18:00.002-04:00

The Two-Second Advantage: How We Succeed by Anticipating the Future—Just Enough (Crown Business, 2011) by Vivek Ranadivé 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.

Stock Trader’s Almanac 2012

2011-10-24T05:05:00.002-04:00

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.

Brown, Red-Blooded Risk

2011-10-20T05:19:00.001-04:00

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.”

Pestrichelli and Ferbert, Buy and Hedge

2011-10-18T05:14:00.000-04:00

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.

Trester, Understanding ETF Options

2011-10-13T05:13:00.000-04:00

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.

Half-price book sale

2011-10-10T05:14:00.021-04:00

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 readingthemarkets@gmail.com. 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

Columbus Day sale

2011-10-06T05:36:00.001-04:00

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.

Corbitt, All About Candlestick Charting

2011-10-05T05:05:00.001-04:00

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.

Huddleston, The Vigilant Investor

2011-10-03T05:05:00.001-04:00

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 www.investorswatchblog.com.

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.

A link for epistemologically minded traders

2011-09-28T17:42:00.000-04:00

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.

Veneziani, The Greatest Trades of All Time

2011-09-26T05:12:00.000-04:00

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.

Rhoads, Trading VIX Derivatives

2011-09-21T05:16:00.001-04:00

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.

Carlson, George Lindsay and the Art of Technical Analysis

2011-09-19T05:11:00.001-04:00

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)

Schmidt, Financial Markets and Trading

2011-09-14T05:28:00.000-04:00

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.

Taulli, All About Commodities

2011-09-12T05:24:00.001-04:00

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.

An image of global markets?

2011-09-11T19:01:00.000-04:00

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

Capra, Trading Tools and Tactics

2011-09-08T05:09:00.001-04:00

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.

McCullough, Diary of a Hedge Fund Manager

2011-09-07T05:18:00.001-04:00

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.

Lehman and McMillan, Options for Volatile Markets

2011-09-06T05:15:00.001-04:00

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.

Hurricane Irene and me

2011-09-03T10:24:00.000-04:00

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.

Trahan and Krantz, The Era of Uncertainty

2011-08-25T05:13:00.001-04:00

The Era of Uncertainty: Global Investment Strategies for Inflation, Deflation, and the Middle Ground by François Trahan and Katherine Krantz (Wiley, 2011) is a thoughtful, thoroughly researched book. Its main thesis is that macro matters—a thesis that has been amply demonstrated in recent market movement. An investor can be right in his bottom-up analysis, but if he gets the macro picture wrong he’s most likely doomed: historically 71% of equity returns are explained by macro trends.

“Macro,” of course, covers a wide array of forces “that dictate how the world unfolds around us.” The authors identify ten major macro themes that will matter for investors: globalization, the internet and the technology revolution, the implications of the credit bubble, the rise of China and its emerging consumer class, a change in worldwide demographic trends, Americans’ evolving relationships with credit and debt, fiscal crises in the developed world, troubles for the euro and/or the dollar, the Federal Reserve’s dual mandate and its shortcomings, and the changing face of “greed” on Wall Street. (p. 4)

The authors pay particular attention to the business cycle and how it can be understood using leading economic indicators—those with shorter lead times (e.g., Philly Fed index and ISM new orders/inventories ratio), those that are intermediate-term (e.g., consumer prices and emerging Asia equity markets), and those with longer lead times (e.g., changes in global short interest rates and the yield curve). For the investor it is critical to know where we are in the cycle, whether LEIs are accelerating or decelerating. Data from 1950 to 2009 make this clear. During this period annualized equity returns during the early expansionary phase were 34.5%, in late expansion 15.8%, in early contraction, 1.2%, and in late contraction -14.3%. The investor can further improve his returns by choosing those sectors that outperform the broader market in any given phase.

Another mandate for the savvy investor is to recognize and stay clear of bursting bubbles—“with little help from either Wall Street or Washington, D.C.” (p. 50) Trahan, who was chief investment strategist at Bear Stearns and one of the first on Wall Street to sound the alarm on the housing bubble (he left Bear Stearns before its untimely demise), shares some of his research that showed that “the housing bubble was predictable and avoidable.” (p. 67) For instance, home sales prices were far more stretched than rental prices, the ratio of the value of new homes for sale to employee compensation was at a level not seen since the late 1970s, the housing boom was geographically widespread, and the supply of new houses was skyrocketing while “the rate of home non-ownership—in other words, potential demand—was declining sharply.” (p. 70)

Where are we now? And where are we going? The authors are no fans of the policies of the Bernanke Fed. Their criticisms are laid out carefully, with special emphasis on dollar weakness, high commodity prices, and income disparity. And although there are too many variables to predict exactly where we’re headed, the authors suggest that “the global inflationary pressures resulting from the Fed’s weak-dollar policy will likely result in a growth slowdown and a future disinflationary, if not deflationary, period.” (p. 134)

After presenting a detailed account of inflation in the United States and a summary of some of the global economic tensions, the authors offer strategies for investing in both inflationary and deflationary environments complete with supporting charts and figures. The book concludes with some policy suggestions for a better economic future.

The Era of Uncertainty is a model of strategic thinking and often imaginative research. It is well written, its charts are based on the proprietary work of Wolfe Trahan & Co., and its theses are thought-provoking. It’s one of those books to which I’m sure readers will return as events unfold down the road.

T3 Live, The Modern Trader

2011-08-23T05:12:00.001-04:00

Although The Modern Trader: Wall Street Traders Reveal Their Formula for Success (Marketplace Books, 2011) is clearly a promotional piece, it’s a good read nonetheless. The five partners in T3 Live, an online education platform for traders, recount how they came to be traders and offer advice on surviving and thriving in the trading business. Admittedly, they’re not simply traders. They have a second revenue stream: if trading falters, educating traders just might pick up the slack. And don’t mock the strategy: it’s savvy entrepreneurial diversification.

And these guys are entrepreneurs, through and through. Sean Hendelman, the CEO of T3 Live and a partner in the T3 Trading Group, claims that “trading is the most entrepreneurial business in the world.” (p. 113) This implies first and foremost that a trader must be proactive. “[T]o be an entrepreneur, … you have to go out and take what you want. A ‘take no prisoners’ approach can lead to limitless success if combined with a sound business plan and thorough preparation.” (p. 114) Being proactive also involves never settling for where you are. “The value of change should never be underestimated and its inevitability cannot be ignored. Circumstances and goals will always change, but the important thing is that you always push forward to learn the necessary lessons for success.” (pp. 121-22)

Don’t expect to find information on developing trading setups or systems in this book. It seems that each partner has his own approach to trading—from black box to discretionary manual order entry. What they have in common is enthusiasm for their business. They brim with self-confidence and optimism. They exhibit discipline. They work hard. Sounds to me like a pretty good model for the successful trader.

Dickson and Knudsen, Mastering Market Timing

2011-08-22T05:18:00.001-04:00

Given the recent market volatility and the conflicting calls over whether we are carving out a short-term market bottom within an ongoing primary uptrend that began in 2009 or whether the market is rolling over, I was hesitant to review Mastering Market Timing: Using the Works of L. M. Lowry and R. D. Wyckoff to Identify Key Market Turning Points by Richard A. Dickson and Tracy L. Knudsen (FT Press, 2011). But then I decided that perhaps this is indeed the best time to share this work, written by two senior vice presidents at Lowry Research.

First of all, it’s important to note that the authors focus on major market tops and bottoms. Although they accept the notion that market patterns are fractal in nature, they acknowledge that “the probabilities of wrong timing are likely greater on a short-term basis when brief periods of market volatility can upset the most thorough analysis.” (p. 193) They analyze the tops of the 1966-1969, 1970-1973, 1975-1976, 1980-1981, and 2003-2007 bull markets and the bottoms of the 1968-1970, 1973-1974, 1981-1982, 2000-2003, and 2007-2009 bear markets.

Starting with Wyckoff’s models of market tops and market bottoms, they add Lowry’s proprietary indicators--the buying power and selling pressure indexes—to help quantify Wyckoff’s insights. Their calculation takes into consideration daily up/down volume, total volume, points gained, and points lost. Add to the mix the concept of 90% up and down days, introduced by Paul Desmond (the current principal at Lowry Research), and you have the basic ingredients for making major market calls. By the way, I should note in passing as the authors do that a 90% up or down day must include both price and volume; that is, a 90% up day occurs when up volume is 90% or more of the total up and down volume and points gained is 90% or more of the total points gained plus points lost for the session. (p. 25) Desmond’s 2002 Dow Award-winning paper is available online.

To give a sense of the authors’ work, here’s a marked-up chart of the final phase of the 2007 DJIA market top which includes Wyckoff, Lowry, and Desmond notations.

In the second part of the book the authors introduce additional tools for identifying market tops and bottoms: point and figure charts, the NYSE advance-decline line, and the percentage of NYSE issues trading above their 30-week moving average.

Mastering Market Timing will be valuable to anyone wanting to learn more about Wyckoff’s method. Since the Lowry indicators are proprietary, investors will have to be creative in coming up with something that approximates the buying power and selling pressure indexes. In the final analysis, will investors who read this book become better forecasters? I don’t know, but I consider it a boon to have so many charts of market turning points collected in one book.

Mea culpa

2011-08-17T05:09:00.001-04:00

I know, I know, I’ve been a slouch. In my defense, I’m not the only one. Authors haven’t been prolific either, so I haven’t received a lot of books to review. Call it August.

But slowly this blog will come back to life. Keep the faith.

DeRosa, Options on Foreign Exchange

2011-08-05T05:17:00.001-04:00

David F. DeRosa’s Options on Foreign Exchange, 3d ed. (Wiley, 2011) is a book for quants (or perhaps more precisely quantlets), which means that I’m ill equipped to review it in a meaningful way. Instead, I’ll simply outline its contents to give a heads up to anyone who is interested in trading forex options either speculatively or as a hedger and who doesn’t have an aversion to plowing through lots of equations, most of which are admittedly pretty straightforward.

After some basics about the foreign exchange market and options, the author moves on to the meat of the book: valuation of European currency options, European currency option analytics, volatility, American exercise currency options, currency futures options, barrier and binary currency options, advanced option models, and non-barrier exotic currency options.

There’s far more prose than math, and the prose is clear.

And, with that, I’ll abruptly end this post with my sincere apologies to the author. He deserved much better.

Passarelli, The Market Taker’s Edge

2011-08-03T05:23:00.001-04:00

Options traders who have progressed beyond the basics would do well to read Dan Passarelli’s The Market Taker’s Edge: Insider Strategies from the Options Trading Floor (McGraw-Hill, 2011). Passarelli, a former market maker, shares a few war stories and explains how the stay-at-home trader (the potential “market taker”) can profit from learning what market makers actually do.

The author highlights one difference between “them” and “us” with a story about interviewing applicants for a job to work as an options instructor. All of the applicants had to be current or former professional traders. “Upon arrival at the job interview, traders were given a test that included a few questions that required them to draw at-expiration diagrams for various options strategies. Unexpectedly, more than a fair share of market makers couldn’t complete that part of the test! … Why couldn’t many of the market makers draw these simple diagrams? They are not in the habit of doing so: they don’t need to do so.” (p. 26) They rarely have to deal with absolute, maximum risk since they don’t hold trades until expiration. By contrast, expiration graphs are drummed into the heads of retail traders, and it is only later that they learn that those gorgeous iron condor expiration graphs are a lot less impressive earlier in the trade.

Passarelli spends time on topics most options books ignore, such as order entry (including middling the market), the usefulness (and most often uselessness) of stops on spreads, gamma scalping, synthetics, and position risk thresholds.

Here are a couple of takeaways.

Market makers try to avoid delta bets because “delta is generally a much bigger risk than the risks associated with volatility.” And volatility is, according to academic studies, more predictable than directional price movement. Passarelli continues: “Market makers hedge option trades to eliminate the haphazard directional risk in favor of being left with only the two volatility risks of vega (implied volatility) and gamma/theta (realized volatility). In fact, market makers would generally prefer to also eliminate volatility risk in favor of the arbitrage-like scenario of buying bids and selling offers and going home flat each night. However, positions usually cannot be completely eliminated because each individual option is not liquid enough to day trade and end each day with no position in any series. Thus options must be spread to reduce the impact of vega, gamma, and theta.” (p. 161)

The philosophies of market makers and market takers are radically different. “Market takers make a living selling options (or option positions) at a higher option premium than that at which they buy. Market makers make a living by selling at a higher volatility than that at which they buy. Though … they may be trading the opposite sides of the exact same options, their differing trading perspective makes for a symbiotic relationship.” (p. 210)

To end this review on a lighter note, as Passarelli ends his book, what did pit traders do doing the down times on the trading floor? There was a lot of competition, from how long you could hold your breath to how many eggs you could eat. Passarelli elaborates: “In the pit in which I traded, we would do brain teasers, ask each other what a certain number was in another base—for example, ‘What’s 32 in base 7?’ Game theory questions and obscure trivia always passed the time as well. For a while, we had a Scrabble board set up. You really learn to play Scrabble strategically when you’re playing against traders. And, always, when the Price Is Right came on, we changed the channel to watch.” (p. 222)

Covel, The Little Book of Trading

2011-08-01T05:14:00.002-04:00

The latest addition to the “little book big profits” series, Michael W. Covel’s The Little Book of Trading: Trend Following Strategy for Big Winnings (Wiley, 2011) looks at the financial world through the eyes of successful trend traders. In eleven chapters Covel shares insights and life stories from the principals of Sunrise Capital (Gary Davis, Jack Forrest, and Rick Slaughter), David Druz, Paul Mulvaney, Kevin Bruce, Larry Hite, David Harding, Bernard Drury, Justin Vandergrift, Eric Crittenden and Cole Wilcox, Michael Clarke, and Charles Faulkner. And although Ed Seykota doesn’t get his own chapter (except for the lyrics to “The Whipsaw Song”—if you’re not familiar with it, the YouTube video is available at www.seykota.com/tribe/essentials/index.htm), he is a frequent presence in the discussions of others.

Covel, author of Trend Following, The Complete TurtleTrader, and the recent Trend Commandments, is an unabashed advocate of systematic long-term trend following trading. He doesn’t get into the nitty-gritty of how to develop a trend following system although he references the breakout system of the original turtles, a system I assume most trend traders these days have moved well beyond, and shares some general principles about devising a robust system. That’s okay because each trader really has to come up with his own system in which he believes wholeheartedly; there is no single template for trend trading.

What Covel stresses throughout the book are the accompanying principles that make trend following viable: stick to your plan and manage your risk through diversification, stop placement, and position sizing. These are important principles for any kind of trading, but for trend following they are critical. After all, trend following has a low win percentage and is subject to long stretches of flat to negative performance. As a result it’s easy for a trader to start doubting his system. And for the same reason it’s lethal for a trader to risk too much on any one trade.

Trend traders have to be contrarians in the sense that they have to cut their losses quickly and let their gains run, which “is in fact going against human biology.” We’re “designed to think that what we lose is going to come back,” whether it be the dog who “disappears in the morning but is outside the kitchen door by evening” or our car keys. A trend trader who believes that his unrealized losses will eventually be transformed into real profits won’t be trading for long. Similarly, a trader who accepts the premise of mean reversion—for instance, a trader who “believes he has found a mispricing in an extended market and expects a return to normal prices (whatever normal is)”—as many hedge funds do, will find that “it never works in the long run. That kind of thinking blows up with regularity.” (p. 115)

Covel also rails against buy-and-hold investing and index funds. In the chapter entitled “Study Hard and Get an A+” he recounts a conversation that Justin Vandergrift had with a doctor who kept talking about index investing in the S&P 500.

“When you went to medical school did you ever want to graduate with a C average?” The doctor said, “No.” Vandergrift replied, “Do you want to send your kids to a C school?” He said, “No.” Vandergrift countered, “Then why are you doing that with your money? The S&P is an average. It’s an average of the 500 largest companies in the United States. … It’s a C index. Why would you want to invest to get average returns?” (p. 129)

Successful trend following traders try to capture the outliers, the really big moves that more than compensate for the many small losses they take. This goal requires traders to have confidence in their systems and confidence in themselves. By introducing the reader to successful trend traders, Covel believes that some of their “magic” just might rub off.

Feld & Mendelson, Venture Deals

2011-07-28T05:21:00.001-04:00

Brad Feld and Jason Mendelson wrote Venture Deals: Be Smarter Than Your Lawyer and Venture Capitalist (Wiley, 2011) primarily for the entrepreneur who’s thinking about taking his start-up to the next level—accepting venture capital. It’s a hands-on book that goes a long way toward leveling the playing field between entrepreneurs and VCs. And no, the entrepreneur can’t fire his lawyer after reading this book, but at least he doesn’t have to be obsequious.

The authors focus on the term sheet, which is a summary document in contemplation of a financing. It has two key elements: economics and control. That is, what is “the return the investors will ultimately get in a liquidity event, usually either a sale of the company or an initial public offering”? And how much control can the VCs have over the company’s business decisions?

These questions would appear to be straightforward, but of course they’re not. The subheads in the chapter on the economic terms tell part of the tale: price, liquidation preference, pay-to-play, vesting, employee pool, and antidilution. And, trust me, even if you think you understand the concepts in the subheads, it gets a lot more complicated as you drill down.

Although the term sheet gets the lion’s share of the book’s attention, including a sample term sheet in an appendix, the authors also explore other areas vital to entrepreneurial success, such as negotiation tactics and raising money the right way.

All in all, if you are thinking about looking for outside capital for your business, you should definitely read this book. If you are a wannabe VC, it’s also important. I, who fall into neither category, found it a fascinating read.

Toghraie, Trading on Target

2011-07-26T05:14:00.001-04:00

For those who are struggling with self-sabotaging problems that undercut trading profitability (and isn’t everybody?) Adrienne Toghraie’s Trading on Target: How to Cultivate a Winner’s State of Mind (Wiley, 2011) offers advice. The advice isn’t revolutionary, it’s often perfunctory, and I’m not even sure it’s always sound—at least not if one believes some recent psychological studies. But it is far-reaching, so the reader will most likely find out something about himself that he didn’t realize before, something that is holding him back from reaching his full potential as a trader.

The book is divided into five parts: obstacles to becoming a top trader, letting go of emotional states, taking right action, stretching and expanding yourself as a trader, and modeling top traders. Many of the discussions are illustrated with case studies. Let me start with my favorite, meant to lend color to the claim that “a detailed mental image is one of the most powerful tools that a trader can have. An individual with a clear vision of himself as a trader, with positive detail and without misgiving, is truly a trader.” (p. 217)

The author attended a party where the host’s children entertained the guests with piano performances. The oldest girl sat down at the keyboard with tremendous confidence, performed brilliantly, bowed, and identified the piece she had just played. Her younger brother went through the same motions and, although he was not the equal of his sister, played the best that he could. “The third child to entertain us was another girl, who was only four years old. She approached the bench with the same confidence as her older brother and sister. She paused before her performance and with focus that was equal to her older siblings, raised the pointer finger on her right hand and pressed the key of Middle C. Then, she stood up, bowed with a flourish and announced, ‘The name of my piece is “Middle C.”’ We all applauded her enthusiastically because she had also done the best she could.” The author continues: “The best for her was the knowledge that the picture she had in her mind would manifest itself in time.” (p. 214) Well, maybe yes and maybe no, but she sounds like a corker who will probably make her mark somewhere.

Toghraie's book addresses difficulties that traders at all levels of experience and competence face. Take “The Happy Monkey,” for instance. Rex (who really should have been given a different name) spent a long time developing a trading system and paper trading it before he finally committed money to it. Six months into his trading he was doing very well; two months later he was “second-guessing his system and losing money.” (p. 175) Rex the tinkerer was bored. He lamented that he felt like a mindless monkey who simply pulls the lever when the signal tells him to pull it.

The author suggests two paths for Rex. First, he can re-channel his need to tinker, either by working on an alternative system (presumably after trading hours) or finding some intellectually challenging outlet outside of trading. Second, he can become the happy monkey. That is, he can create a new internal model that redefines his role, goals, and rewards. “The new picture was of a person who had accomplished the tinkering in the past, but now had permission to follow his rules. The picture comes with the understanding that there is a prize out there for following his rules. That prize is that he will be the person who adds value when he has mastered his technique and can use his intuition as a new filter. Having permission to use intuition in his trading is a treasure, indeed, because it allows Rex the ability to use his mind again in a way that is constantly challenging and new each time. However, he cannot use the intuition filter unless he has mastered his technique and mastered his own psychology.” (p. 178) The trick, of course, is to differentiate between using intuition and second-guessing.

Adrienne Toghraie is a trader’s coach who, on her website (tradingontarget.com) advertises her home study course, seminars and workshops, and private coaching—all on the expensive side. For most traders who want access to her ideas, I suspect reading Trading on Target will suffice. For those in search of a coach, the book is an easy way to decide whether Toghraie belongs on the short list.

Bern, Investing in Energy

2011-07-25T05:19:00.001-04:00

I was looking forward to Gianna Bern’s Investing in Energy: A Primer on the Economics of the Energy Industry (Bloomberg/Wiley, 2011). My knowledge of the energy complex was haphazardly gleaned, so I thought a primer would be just the thing to pull all the fragmentary bits and pieces together. Ultimately, I was disappointed. Although the book is packed with information, the author’s disjointed, sometimes opaque, and often repetitive prose keeps getting in the way. I suspect that the author, who is the president of Brookshire Advisory and Research, simply knows too much and found it difficult to tell a simple, straightforward story.

The book covers crude oil and natural gas, the power sector (hydroelectric, nuclear, geothermal and wind, solar), and green energy (biofuels and ethanol, cleaner coal). Understandably, given its dominance in the energy markets, crude oil is the focal point of the book.

We read, for instance, about categorizing (not the highly technical task of measuring) reserves into the proven, the probable, and the possible. Proven reserves have a 90% certainty of being produced; probable reserves, a 50% certainty; and possible reserves, at least a 10% certainty. For some strange reason, the industry isn’t satisfied with this breakdown into P90, P50, and P10. Instead, it offers an aggregating typology: 1P reserves are proven, 2P reserves are the sum of proven and probable, and 3P reserves are the sum of proven, probable, and possible. “Why report 2P or 3P reserves if they are, by definition, unproven? Oil and gas producers report 2P and 3P reserves because they provide a picture as to future potential oil and gas reserve growth.” (p. 55)

Readers who thought they knew what the crack spread was will discover that, as is so often the case in the energy complex, nothing is definitive. The most familiar 3-2-1 crack spread “considers the theoretical profitability of refining three barrels of crude into one barrel of heating oil and two barrels of gasoline.” Since there are 42 gallons in a barrel, the formula is [(1 x HO price x 42) + (2 x RBOB price x 42) – (3 x crude price)]/3, where HO is the symbol for heating oil and RBOB for “Reformulated Blendstock for Oxygenate Blending base grade of gasoline.” (p. 91) (Sounds like a good Jeopardy question to me!) But since seasonal factors weigh on the relative demand for gasoline and heating oil, sometimes it makes sense to look at 1-1 spreads—the heat crack and the gas crack. And outside of the U.S., where diesel often takes the place of gasoline, other ratios—such as a 5-3-2 crack spread--are more commonly used.

The author covers a range of topics critical to understanding oil production, refining, and pricing. One of the more interesting chapters to me, since I’ve been following the ups and downs of the Hungarian oil company MOL, analyzes state-owned and mixed-capital oil companies. Successful examples of the latter are Statoil (Norway), Petrobras (Brazil), and Ecopetrol (Colombia).

Investing in Energy is a blend of information, analysis, and investing advice. It attempts too much and therefore fails as a primer. But for anyone who wants to know what he should know about the energy complex, it’s a good jumping-off point.

Beder and Marshall, Financial Engineering

2011-07-21T05:22:00.000-04:00

Financial Engineering: The Evolution of a Profession, edited by Tanya S. Beder and Cara M. Marshall (Wiley, 2011), is part of the Kolb Series in Finance and, like its predecessors, is a big book—some 600 pages long. It is a fascinating collection of 29 original papers written by both academics and practitioners.

Two articles outline career opportunities and educational programs for aspiring financial engineers. The rest of us can home school ourselves from the comfort of our own favorite reading nook. The curriculum? In addition to a brief history of financial engineering, the volume deals with such major themes as financial engineering and the evolution of major markets (fixed income, U.S. mortgage, equity, foreign exchange, commodity, and credit); key applications of financial engineering; case studies in financial engineering—the good, the bad, and the ugly (mostly ugly); and special topics in financial engineering.

Financial engineering may be the stomping ground for quants, but you wouldn’t know it from this book—at least not until the first appendix that describes some IT tools for financial asset management and engineering. The book has virtually no math in it; aside from a few figures, charts, and graphs, the authors rely on good old-fashioned prose, most of it quite lucid, to explain the many facets of financial engineering.

I tried to decide what to share in this review. I contemplated the piece on portable alpha because I was thinking just the other day about what ever happened to this once hot concept. (Apparently it may see a rebirth in a more robust and dynamic form.) I ruled out the chapters on quantitative trading in equities and systematic trading in foreign exchange because we’ve touched on these topics, at least in their general form, often enough on this blog. I finally decided to wade into new waters—financial engineering and macroeconomic innovation, a paper by Cara M. Marshall and John H. O’Connell.

We know that some U.S. municipalities are in severe financial straits, even if the situation is not as dire as Meredith Whitney would have us believe. Take the case of Harrisburg, which faced default on its incinerator bonds and had to be bailed out by the state of Pennsylvania. Given the cyclicality of the economy, why didn’t Harrisburg simply have a rainy day fund? The authors concede that “surpluses are hard to justify as they lead to pressure to either “(1) increase spending, (2) cut taxes, or (3) some combination of the two.” But, they suggest, “macroeconomic derivatives could easily represent a powerful, albeit partial, solution to this problem. Using historic data, a city like Harrisburg should be able to determine how changes in national or regional GDP growth impact its cash flows. Alternatively, it might do the analysis using the national or a regional growth rate in non-farm payrolls. The city could then enter into a GDP or non-farm payroll swap.” The goal would be to “keep the city’s budget balanced in all economic climates.”

Let’s say that the budget is balanced when real GDP grows at 2.7% and that a 1% change in GDP translates into $20 million of net cash flow (in or out) for the city. The city could enter into a 10-year GDP-swap with a macroeconomic swap dealer. In its simplest form, disregarding any spread, the deal could be structured in such a way that “the city pays the swap dealer the actual annual growth rate in GDP on notionals of $2 billion and the swap dealer pays the city an annual fixed rate of 2.7 percent on the same $2 billion of notionals.” Suppose the GDP increases to 3.7%. Then “the municipality would pay the dealer $74 million (i.e., 3.7 percent x $2 billion), and the swap dealer would pay the city $54 million (i.e., 2.7 percent x $2 billion). In a swap, only the net is exchanged with the higher paying party paying the lower paying party the difference. So, in this case, the city pays the swap dealer $20 million—which is precisely the size of its surplus for the year. On the other hand, suppose that the following year the economy sinks into a recession and GDP growth becomes negative, say -1.3 percent. Then, the swap dealer will pay the city $26 million on the GDP leg. (This is because the payment on the GDP leg is negative, so it goes in the opposite direction.) And the swap dealer also pays the city $54 million on the fixed leg. Thus, the city receives an infusion of $80 million from the swap dealer thereby offsetting its cash flow shortfall caused by the decline in GDP (i.e., the recession).” (pp. 301-302) Another solution would be to structure municipal debt offerings along the lines of inflation-indexed bonds with a floating coupon that would be tied inversely to the growth rate of the GDP.

There’s always room for financial innovation, and Financial Engineering offers its share of ideas. It also provides ample documentation of the unintended consequences of innovation gone awry. All in all, a thought-provoking read.

Sullivan, Clutch

2011-07-19T05:05:00.001-04:00

Paul Sullivan’s Clutch (Portfolio/Penguin) was published last year. Sullivan, a business columnist for The New York Times, looks at why some people thrive under pressure while others choke. He illustrates his points with well-drawn portraits of people who are “clutch.” Some of these clutch performers, such as Jamie Dimon and trial lawyer David Boies, are well known public figures; others, such as Sgt. Willie Copeland, are not. But all have demonstrated that they can perform exceptionally well in the most trying circumstances.

What traits do the clutch performers share? Sullivan identifies five: focus, discipline, adaptability, being fully in the present, and being driven by fear and desire.

Let’s look at some case studies. First, David Boies on “entering the bubble.” Boise prepares, prepares, and prepares even more for a trial. Once the trial begins he focuses. “In the courtroom, he said he not only has no idea how the trial is going on a broader level but he does not care. … If Boies stopped to congratulate himself on a particularly deft cross-examination or tried to tally up where he stood, he would lose his focus. … He is concerned more with tangible measures. Is the argument he is making working? Is it true and will it hold up under scrutiny from the opposing lawyer? … His focus does not make him myopic. It allows him to follow the tack that he or his opponent is taking at that moment and recalibrate his argument. That is what he can control.” (pp. 41-42)

Second, the importance of discipline and resilience in trading as related by William Mumma, global head of derivatives at Bankers Trust in the mid-1990s. “There were two reasons people got A’s at Harvard or became Navy Seals, and only one of those reasons made them good traders. Some prepared and studied harder, which would not necessarily help them. They did not expect to lose ever—in life, in school, in work. This was not possible in trading. But others [who got A’s after faltering along the way]… were innately better at pushing themselves to succeed. They didn’t fear failure; they hated it,” which, as Mumma was quick to point out, is different from disliking losing. “All traders lose at some point, but it doesn’t mean they failed. It means they lost on a particular day. The better traders figured out how to avoid losing strategies, those that not only lead to losses in a single day, but failure down the road.” (pp. 66-67)

Finally, the power of fear as a motivator. In 2007 researchers studied 281 students at the University of Bath, two-thirds of whom went to the gym regularly. They wanted to figure out what motivated some students to work out and others not to. The study was something of a thought experiment. The researchers “asked half of them to imagine themselves as overweight and unattractive. The researchers then further divided the sample by asking half of the group to imagine themselves failing at their workout regime—and thus becoming even less attractive—while telling the other group to see themselves succeeding wildly and in doing so becoming much more attractive. Over the course of the study, the researchers found that the group that was motivated by the fear of looking awful stuck to their workout better than the group that was doing it with the hope of looking better. The gap between the two groups was significant, with 85 percent who wanted to avoid becoming unattractive continuing their workouts when told they were failing compared to 65 percent who were told they were succeeding. Even if both groups started out going to the gym regularly, the ones that were doing it to look better than they already did dropped off, while those who felt, in essence, that they had to dig themselves out of a hole were the ones who continued.” (pp. 117-18)

The CRB Commodity Yearbook 2011

2011-07-18T05:15:00.001-04:00

Commodity traders, especially those who trade at least in part on fundamentals, recognize that the CRB commodity yearbooks are an invaluable resource. No, they don’t come cheap, and now that they are sold exclusively through the Commodity Research Bureau they are even pricier. But consider what you get for your money: 384 8 ½” x 11” pages, most filled with charts and tables (over 900 in all).

If I counted correctly, the yearbook covers 104 commodities, from aluminum to zinc. In addition to the exchange-traded commodities we’re all familiar with, there is somewhat perfunctory introductory information and data on such products as cassava, castor beans, eggs, honey, lard, plastics, rayon, and tallow and greases.

I happen to be fond of tapioca, whose primary source is cassava. So I was a tad distressed to learn that “one problem with cassava is the poisonous cyanides, which need to be destroyed before consumption.” At least we don’t eat castor beans (though there is the dreaded castor oil) since the potent toxin ricin is found naturally in them. But did you know that, according to the USDA, “a diet of whole milk and potatoes would supply almost all of the food elements necessary for the maintenance of the human body”? And those who think that onions add to the flavor of food paid for their culinary opinion last year: average onion prices in 2010 were up 108.3% over the 2009 level.

These tidbits of information are not actionable for a trader, but the massive amount of data in the yearbook, most covering the decade from January 2001 through December 2010, certainly should be. Where seasonal factors have an impact on commodity prices, there are monthly data. Otherwise the tables offer detailed yearly data.

Consider, for example, cotton, which was on a tear in 2010. The yearbook devotes eight pages to the commodity and provides the following tables (most covering a decade): supply and distribution of all cotton in the United States; world production of all cotton; world stocks and trade of cotton; world consumption of all cottons in specified countries; average spot cotton prices, C.I.F. Northern Europe; average producer price index of gray cotton broadwovens; average price of SLM 1 1/16”, cotton/5 at designated U.S. markets; average spot cotton, 1 3/32”, price (SLM) at designated U.S. markets; average spot prices of U.S. cotton, base quality (SLM) at designated markets; average price received by farmers for upland cotton in the United States; purchases reported by exchanged in designated U.S. spot markets; production of cotton (upland and American-pima) in the United States; cotton production and yield estimates; supply and distribution of upland cotton in the United States; average open interest of cotton #2 futures in New York; volume of trading of cotton #2 futures in New York; daily rate of upland cotton mill consumption on cotton-system spinning spindles in the United States; consumption of American and foreign cotton in the United States; exports of all cotton from the United States; U.S. exports of American cotton to countries of destination; cotton government loan program in the United States; production of cotton cloth in the United States; cotton ginnings in the United States; fiber prices in the United States. Whew!

Is the CRB commodity yearbook essential for those who trade technically? No. Could their trading be improved by including some fundamental data? Most likely. At the very least, the yearbook provides fodder for hypothesis generation. And for macro traders, even those who may not always be in the commodity markets, it’s a treasure trove of leads. It’s a book I know I will return to again and again.

Martinez, The Forex Mindset

2011-07-15T05:13:00.001-04:00

Jared F. Martinez’s The Forex Mindset: The Skills and Winning Attitude You Need for More Profitable Forex Trading (McGraw-Hill, 2011) is meant to be an uplifting book—part pep talk, part sermonette—that is directed at all traders. I think that Forex may be mentioned more often in the title and subtitle than in the text itself.

Much of the book is derivative, some of it is banal. We read such nostrums as “For every minute you remain angry, you give up 60 seconds of happiness.” (p. 122) Or “If we don’t stand for something, we have the potential to fall for anything.” (p. 93) Some quotations get badly mangled. For instance, C. S. Lewis wrote: “Humility is not thinking less of yourself but thinking of yourself less.” Martinez writes (p. 168): “Humility is thinking less of yourself rather than thinking of yourself less.” I don’t think so.

In fifteen chapters Martinez tries to help the reader with such things as finding a mentor in trading and in life, understanding how your head and heart work, the importance of change, dealing with frustration and anger as you trade, learning patience and self-control to avoid temptation, listening with humility, learning to trade with confidence, and achieving excellence at trading.

Here are a couple of his recommendations.

There are eight elements of excellence “that can guide you from the dream of excellence to the actual end result of daily applied excellence. 1. Work with purpose and with passion. … 2. First identify questions, and then find answers. … 3. Be clear about your purpose. … 4. Venture from your comfort zone. … 5. Strive for perfection, but aim for excellence. … 6. Take risks, and never give up your right to be wrong. … 7. Respect yourself and each other. … 8. Search for excellence as you strive to keep perfection in perspective.” (pp. 46-48)

“The biggest temptation most traders fight is the temptation to settle for too little. Some traders succumb to the temptation of settling for too little. … Every trader must find a balance between settling for too little and wanting too much.” (p. 158)

If you’ve never encountered a self-help book before, this might be a reasonable place to start. If you want to track down proverbs that aren’t referenced as such, it might be provide a few hours of diversion. (For instance, the author writes that “A handful of patience is far more valuable than a barrel of brains.” This didn’t sound like something he dreamed up, and—indeed—it turns out to be a Dutch proverb.) But The Forex Mindset is definitely not among the most useful books on trading psychology that I’ve read.

Free special issue of Expiring Monthly

2011-07-13T05:45:00.000-04:00

I wrote last month about the options journal Expiring Monthly. For those who like to sample before making a commitment, a special issue with highlights from volume one is now available for free download (and no form to fill out). Both Condor Options and Option Pit have the download link.

Bhuyan, The Esoteric Investor

2011-07-12T05:39:00.000-04:00

If you’re bored with the standard investing vehicles and want to cast a wider net (pun intended), Vishaal B. Bhuyan’s The Esoteric Investor: Alternative Investments for Global Macro Investors (FT Press, 2011) has three suggestions: demographics, fish, and water.

The author’s specialty is longevity and mortality risk instruments such as life settlements, reverse mortgages, and longevity reinsurance. He edited Reverse Mortgages and Linked Securities, which I reviewed earlier. In The Esoteric Investor he writes about the so-called life markets in the context of the looming demographic crises, with Japan being the poster child for potential demographic disaster.

I was most intrigued, however, with the second part of the book on tuna. I remember being stunned when I read a while back that a 754-pound bluefin tuna had fetched a record $396,000 at the world’s largest wholesale fish market in Tokyo. That’s a whopping $525 a pound! Talk about tunamania!

I didn’t know how these bluefish tuna went from being mere glints in their mother’s eye (actually, a mature female lays millions of eggs over a period of months—and a good thing because it has been estimated that fewer than one in a million survives) to a very high-priced course at a top Tokyo or New York restaurant. Here’s how tuna fishing and fattening goes in Australia, the prime supplier of high-end tuna to Japan.

Southern bluefin tuna are born in Indonesian waters. “For the next eight years, they leisurely work their way around the west coast of Australia, crossing the Great Australian Bight en route to the east coast.” The best-case scenario is that they will circumnavigate Australia and return to their birthplace to spawn and begin the cycle anew. “But many will not make it that far. They will pass unscathed through Western Australian waters and the Great Australian Bight, but then they will find that their migration route has brought them into the perilous seas off South Australia, where boatloads of fishermen with nets are dedicated to keeping them from completing their instinct-inspired journey.” (p. 88)

After spotter pilots locate schools of tuna and radio their location to the waiting “chum boats,” the fishermen on these boats throw baitfish into the school, “causing the tuna to become excited and follow the boat.” Then “a net is shot around the school of fish and the chum boat. The spotter pilot overhead directs the boat out of the net just before it closes, leaving nothing but fish behind. The net is pursed around the school, perhaps thousands strong.” The trapped tuna are then transferred to a net cage, similar to a floating corral, which tows the fish to one or more of 150 pens off Port Lincoln. Each pen contains from 20 to 50 tons of fish.

“These tuna are a precious commodity—which is exactly the right term—and they are pampered and coddled to an extent that would embarrass a purebred Pekingese. Every day of the year, the bait boats make the 5-mile journey to the pens around 6 a.m. and then return to the Port Lincoln marina to pick up another consignment of baitfish to feed the penned tuna. At 2 in the afternoon, they do it again. Stehr Group feeds 60 tons of pilchards a day to their tuna; over the season that adds up to 5,500 tons.” (p. 86)

The tuna are kept in these fattening pens for several months until they are big enough to be slaughtered. No need to go into the gory details here. And then off to the Tsukiji tuna auctions.

Well, I obviously got hung up on tuna—and I didn’t even write anything about the problems of overfishing and other ecological concerns—and have neither time nor space to do justice to the book as a whole. Perhaps at a later date I’ll do another post on it because it is an intriguing book. Most of the investing opportunities are not for the retail investor (water being the exception), but they’re interesting to read about nonetheless. Maybe someday we’ll get a fish ETF or futures contract in the U.S.; Norway’s fish exchange (FISH Pool ASA) launched a salmon futures contract back in 2007 and traded over 100,000 tons in 2010. The ticker FISH isn’t taken yet.

Baiynd, The Trading Book

2011-07-11T05:07:00.001-04:00

Anne-Marie Baiynd is a thoroughly engaging writer. The Trading Book: A Complete Solution to Mastering Technical Systems and Trading Psychology (McGraw-Hill, 2011) may not be the greatest thing since white bread, but it’s a darned good read.

As the subtitle indicates, the book moves between the nuts and bolts of a discretionary technical trading plan and—dare I go there?—the nuttiness of the unprofitable trader. She walks the reader through a series of trades that, in their full complexity, rely on analyzing candlesticks, moving averages, Fibs, and Bollinger bands. And she proves that one can actually describe trades in clear, cogent prose. The discretionary trader who uses some or all of these tools will learn their subtleties. The person who doesn’t know what tools to use will get a good sense of how to begin to structure trades, piece by piece.

In this review, however, I’ll focus on a couple of psychological takeaways from the book.

Let’s start with the trading journal—that thing that every trader knows he should keep and yet so few do. The author admits that initially she herself put the task of creating and using a trading journal on an “I’ll eventually get around to that” list. She writes: “I resisted the urge early on because it seemed like a lot of work that would actually interrupt my trading, then I resisted because I did not know what to write down, then because I felt a bit lazy, and then because the last thing I wanted to do was review horrifying trades to remind me about how bad I was.” Eventually she came to the realization that “what I had been doing had given me what I had gotten, and since I didn’t like the state I was in, writing a trading journal (as well as a lot of other changes) started looking really good to me.” (pp. 135-36)

She recalls that “the months of journal writings chronicling major defeat were gut-wrenchingly emotional, ramblings of a trader at her wits’ end, but every day I just kept coming back. About every six weeks, I’d break them out and read over the past trades, and though the queasy feeling stayed reading many of them, it was invaluable—like a road map in the dark and a chance to review actions with a mind no longer clouded by the emotions of that day. Reading my old trades and talking them out loud was critical to my advancement as a trader.” (p. 142)

One of the things that traders have to confront in their journals is the incredible difficulty of sticking to their system or plan. “Trading is a bit like this. We are playing a game where we have, let’s say, three doors from which to choose. Behind the first door is a man wearing a set of brass knuckles, and he’s waiting to deliver a shot to the face; the second door is our brokerage firm, which will take a transaction fee for simply opening then closing the door; and the third is a lovely knapsack full of Benjamins. Every time we open a door and close it, our items shift around between doors.” (And you thought we were simply dealing with the Monty Hall problem!) We have a system that is very reliable if well executed. So we put on our first trade, choosing door number one. We encounter “Knuckles”—definitely no fun. Our next trading signal sends us to door number one again. Do we really want to open that door again? Of course not. But we muster up the courage and open the door, unfortunately later than we should have—“and there’s Mr. Broker fleecing our pockets.” You get the picture.

Baiynd continues: “If we choose to day-trade or to swing-trade … , the scenario just described is a large measure of our daily existence, and how we fare has far more to do with our abilities to follow direction, address fear, and manage our exposure than any system out there.” (pp. 48-49)

Since we’re all to varying degrees flawed traders, reading some of the ways to confront our failings is an important first exercise. The Trading Book makes that exercise exceedingly palatable.

Happy birthday, blog

2011-07-10T05:14:00.002-04:00

Hard to imagine, but Reading the Markets has now been up and running for two years, with almost 600 posts. Some days I swear I’m going to shut it down because it is so much work, but then a publisher dangles an irresistible carrot of a book. . . .

By the way, I found the image on Deborah Melmon’s blog, Deb’s Art—lots of amusing illustrations.

Covel, Trend Commandments

2011-07-08T05:27:00.001-04:00

It’s time for a beach book, and Michael W. Covel’s Trend Commandments: Trading for Exceptional Returns (FT Press, 2011) fits the bill perfectly. The many, many “chapters” are bite-sized, and there are mighty few intellectual challenges to get in the reader’s way as he turns pages faster and faster. The thesis is familiar: trend following is the surest path to trading success. Very little how-to, lots of passion about trading and living an engaged, courageous life. And spiced up with swipes at the likes of Warren Buffett. As I said, a beach book—and therefore one that is difficult to review in a meaningful way.

So, instead, let me pull out three passages, not all Covel’s original ideas, that I think are worth quoting in part.

First, footnoted to Ed Seykota’s website but in Covel’s prose: “All trends are historical. None are in the present. There is no way to determine a current trend, or even define what current trend might mean. You can only determine historical trends. … [T]he only way to measure a now trend, one entirely in the moment of now, would be to take two points, both in the now and compute their difference.” (p. 39)

Second, on figuring out when to get out of a trade, compliments of Peter Borish: “You need a prenuptial agreement with the market.” (p. 75)

Finally, from the “chapter” on statistical thinking, “Trend following is about non-normality of market returns. You will never have, nor will you ever produce, returns that exhibit a normal distribution. You will never produce the mythologically consistent returns that many believe to exist. … Trend following’s alpha comes from letting winners run on the right-hand side of a fat tail and cutting losses short on the left-hand side. Eliminating losing positions and holding onto profitable positions puts you in the big game hunt for positive outliers. A normal distribution is simply worse than useless as a risk management tool.” (p. 137)

Fischer, Trading with Charts for Absolute Returns

2011-07-06T05:25:00.001-04:00

Robert Fischer, author of Fibonacci Applications and Strategies for Traders, The New Fibonacci Trader, and Candlesticks, Fibonacci, and Chart Pattern Trading Tools has a new book out: Trading with Charts for Absolute Returns (Wiley, 2011). In it he explains chart pattern recognition, especially Fibonacci and Elliott wave principles; trend channels and trend lines; and, his ultimate weapon, the PHI-ellipse. The PHI-ellipse must be computer generated and is available as part of Fischer’s Fibotrader software package (fibotrader.com). The software can be used free as long as the user is willing to import .ascii data manually.

Although the book clearly promotes the software package, it offers quite solid tips on how to work with support and resistance lines—and, among other things, use false breakouts to one’s advantage. The author identifies patterns such as support lines based on three valleys and a false breakout and its counterpart, resistance lines based on three peaks and a false breakout.

The PHI-ellipse is not a new trading tool (the author introduced it already in 2001), but it has taken Fischer time to develop trading rules based on it. So what is it? As you might imagine, it is an ellipse where “the ratio of the major axis divided by the minor axis of the ellipse is a member of the PHI series 0.618 – 1.000 – 1.618 – 2.618…. A circle, in this respect, is a special type of PHI-ellipse with a = b (ratio a:b = 1).” But, without tinkering with this ratio, there’s a problem. “PHI-ellipses with increasing ratios e_x = a:b of major axis to minor axis turn very quickly into ‘Havana cigars’—and … become so narrow that they can hardly be applied to charts as an analytical tool. … To make PHI-ellipses work as tools for chart analysis, the mathematical formula that describes the shape of the ellipse is transformed. The ratio of the major axis a to the minor axis b of the ellipse is still under consideration, but in a different way—in mathematical terms, e_x = (a:b)_x.” (pp. 142-43)

What makes the PHI-ellipse so special? It is a trend-following trading tool designed to keep the investor in the trending market as long as possible. It integrates price and time into a single tool and can dynamically adjust to price moves. On the downside, it cannot be part of a fully automated trading system.

Fischer takes the reader through the best peak/valley structures for drawing the PHI-ellipse and offers rules for trade entries. And he, of course, directs the reader to the companion web site. The software is free to download for a 15-day trial; afterwards, if you don’t pony up the subscription fee, it turns into an .ascii-only data program.

Light, Taming the Beast

2011-07-05T05:18:00.000-04:00

Larry Light’s Taming the Beast: Wall Street’s Imperfect Answers to Making Money (Wiley, 2011) is perfect summer reading fare. The author, a financial reporter and editor, is a skilled storyteller. In this book he explores a range of investment strategies and instruments, traces their development, and in the process profiles some of the best-known investors and academics.

He covers value investing (Benjamin Graham and Warren Buffett), stocks (Jeremy Siegel), indexes (John Bogle), bonds (Bill Gross), growth investing (Thomas Rowe Price), international investing (John Templeton), real estate (Donald Trump), alternatives, asset allocation, short selling (James Chanos), hedge funds (Alfred Winslow Jones and Steve Cohen), and behaviorism (Daniel Kahneman and his followers).

Light’s thesis is that “investing success does not come in one flavor” and that “the trick is to be sufficiently flexible to dip into any or all of [the approaches he describes], but by the same token, to know their limitations.” (p. 254) He does a good job of spelling out these limitations. Even for more experienced investors who are well aware of many of these limitations, Little’s prose is so quick-paced that the book should be read, not skimmed.

Take, for instance, the case of a $50 short gone bad. “Maybe XYZ’s rivals trip over themselves and the company’s management gets its act together. Amid joyous shouts on Wall Street, XYZ vaults to where the air is rare, hitting $100. Your broker will want you to put up more margin, often an extra 30 percent of the value. Worse, you have an unlimited liability. The damn XYZ stock could keep on levitating. The higher it flies, the more you are out of pocket to buy it back. For you, this is a real nightmare on Wall Street, with the broker playing the role of Freddy Krueger.” (p. 203)

Or take real estate, “a realm of cruel ironies.” Think back to the building frenzy in Dubai with the 2,717-foot-tall Burj Khalifa (its post-bailout name) viewed as the “crown jewel” of Dubai. Although this skyscraper was 90 percent sold, “other Dubai commercial structures stood forlorn. … That left the Burj as a massive mockery of the promise that real estate was a gift that kept giving forever.” (p. 140)

And, on a stroll down memory lane, think back to when Hillary Clinton “parlayed a $1,000 grubstake in cattle futures into $100,000 over 10 months. … When her trading success came to light in 1994, with the Clintons in the White House, there were dark mutterings that she must have cheated somehow. The editor of the Journal of Futures Markets was quoted as saying: ‘This is like buying ice skates one day, and entering the Olympics one day later.’ But no malfeasance was ever proved. Most likely, Hillary Clinton was preternaturally lucky.” (p. 169)

The cast of characters in this book is vividly described. “Known for his brightly colored bow tie and unorthodox enthusiasms” could refer only to Jim Rogers. And you may recall that Bill Gross “reacts to mistakes seriously. After a bad call on junk bonds, he took a sabbatical of several months to clear his head. His wife told the New York Times that he once recommended a Pimco fund to the owner of his local doughnut shop and, when it lagged for a while, ‘he could hardly go in the shop for his favorite coconut cake doughnut.’ “ (p. 97) I was surprised to read that he actually eats doughnuts.

All in all, Taming the Beast is a delight to read, especially in comparison to so many of its very dull competitors in the investing space.

Jagerson and Hansen, All About Investing in Gold

2011-06-29T05:06:00.001-04:00

The latest addition to McGraw-Hill’s “All About” series is All About Investing in Gold: The Easy Way to Get Started by John Jagerson and S. Wade Hansen, founders of the website Learning Markets. Earlier they wrote All About Forex Trading and Profiting with Forex.

The book is a bit of a jumble. There’s a lot of material in it aimed at a wide swath of investors and traders. It deals not only with topics specific to gold but with how to pick the right broker, technical analysis (with an emphasis on Fibonacci retracements, projections, and fans), and option strategies. Along the way there are useful pieces of information, some very useful indeed, but it’s left to the reader to sort things out. The reader who needs help avoiding a mail-order counterfeit gold scam is probably not the same person who is interested in the damage caused by contango in a futures-backed gold ETF.

The authors are active traders who were clearly chomping at the bit in the chapters that provide gold market background, identify the major players, and outline the fundamentals of the gold market. They wanted to get to the meat of the book: strategies for making money investing in or trading gold. Curiously enough, to my mind at least—and this cuts against “my” grain—these chapters (particularly the ones on the major players and the fundamentals) may be the most rewarding for the gold investor.

Although the authors believe that gold has a bright future, they acknowledge that over the very long term gold remains relatively flat. And yet this very ability to preserve value over the long haul and to reduce portfolio volatility makes gold a good asset for diversification purposes. For buy and hold investors the authors recommend allocating a “substantial” portion of the portfolio to ETFs such as GLD and GDXJ.

For long-term investors the authors also suggest the use of covered calls “to reduce volatility and increase profitability over the long term without significantly increasing risk” (p. 177) and protective puts “to reduce the risk of a significant drop in the price of gold.” (p. 181)

Active traders might consider trading the gold-to-silver ratio or using gold stocks and gold together. They could use the COT report as a trading tool. Or, if their accounts are large enough, they could sell naked puts or increase leverage with synthetic positions. The authors point out some of the substantial downsides of all these strategies.

Both gold and options are “hot” topics in the trading world, and novices are eager to sign on to both. It may be relatively easy to get started investing in gold products, but it is decidedly not easy to ratchet up profits using options. All About Investing in Gold should be read as a primer, not as a trading plan.

Lindzon et al., The StockTwits Edge

2011-06-27T05:15:00.001-04:00

How many really good ideas do we have? Aside from the brilliant insights I have in my dreams that quickly fade in the light of day, I’m no idea machine. So I set the bar quite low when I judge books: if I encounter at least one intriguing idea or one potentially profitable suggestion I consider the book a worthwhile read. By contrast, the editors of The StockTwits Edge--Howard Lindzon, Philip Pearlman, and Ivaylo Ivanhoff--aimed much higher. The subtitle of this new release from Wiley is 40 Actionable Trade Setups from Real Market Pros.

For those unfamiliar with StockTwits, it is a networking site for investors, “a global trading floor that collectively digests and shares prices, ideas, and news.” (p. 4) The editors are either principals or employees of StockTwits. Fortunately, the site needs little self-promotion; it has over 100,000 users. So, instead of being a blatant advertisement for the site, the book shares some of the site’s best ideas. For the book’s forty-six chapters (I don’t know whether the editors actually counted the number of trade setups and found six chapters wanting) the editors draw on the expertise of professional traders as well as traders who have attracted a following on StockTwits.

The chapters are necessarily brief (about eight pages each on average), but therein lies their strength. No rambling or boilerplate here. It seems that the authors were given a two-fold task: to recount how they came to embrace trading/investing as a life passion and to describe their favorite trade setup, preferably with illustrative charts. Several authors opted to add words of wisdom on topics ranging from preparation to risk management.

The book is divided into seven unequal parts: trend following, value investing, day trading, swing trading, options trading, forex trading, and the art of trading. Although the divisions make eminent sense, the reader shouldn’t pick and choose his way through this book. There are often insights in unlikely places.

Likewise, it is unfair to pull out particular setups or pieces of advice as illustrative of the book as a whole. But I’ll do it anyway. I particularly liked a task that Charles Kirk assigns new traders in his mentorship group: “to spend a month in a practice account with only two goals: (1) to lose everything in that account and (2) to lose as much money as they can as fast as they can. You will be surprised to learn what always happens. First, those traders initially often trade better and more profitably, and they soon learn and appreciate that it can often be as difficult to lose money as to make money, especially when you are trying to do it quickly. This exercise offers a tremendous learning experience and one that I highly recommend to all traders no matter their level of skill or experience. In fact, once you learn how to really lose money in the market, you learn how to improve and succeed even more. Also, this exercise will help you remove the fear of losing in your own approach. To trade well, you must learn how to use fear you feel and the fear of others to your own advantage.” (p. 307)

The normal trading book takes about ten solid pages of ideas and stretches them to two hundred or so. The advantage of The StockTwits Edge is that it is concentrated. There are lots of ideas to mull over and (presumably) forty setups to try or reject.

To close on a somewhat whimsical note, one of the subheads in the book reads “When elephants dance, they leave traces.” That brought to mind another ending to this sentence: “When elephants dance, it isn’t safe for the chickens.” I think both endings apply to the markets.

Half-price book sale

2011-06-22T05:22:00.009-04:00

I'll update this list as I receive payment for books. In a couple of cases I had two copies, so even though I've sold one the title still appears on the list.

My bookshelves can no longer accommodate, so it’s time for some serious housecleaning. My first instinct was to be charitable, but the local library is not the least bit interested in adding free investing/trading books to its collection.

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 six months.

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

Aldridge, High-Frequency Trading
Aldridge & Krawciw, The Quant Investor’s Almanac 2011 (paper)
Baschab & Piot, Outperform
Belveal, Charting Commodity Market Price Behavior
Bromma, How to Make Money in Alternative Investments
Caliskan, Market Threads (stamped “review copy not for resale” on bottom edge)
Caplan, Profiting with Futures Options (paper)
Caplan, The New Option Secret: Volatility (paper)
Carr, Smarter Investing in Any Economy
Collins, Market Rap (paper)
Collins, When Supertraders Meet Kryptonite
Crask, Options Strategies for Sophisticated Traders (paper)
Dalton, Mind Over Markets (paper)
Dion, The Ultimate Guide to Trading ETFs
Durbin, All About High-Frequency Trading (paper)
Fisher, Debunkery
Frishberg, Investing without Borders
Fullman, Increasing Alpha with Options
Harris, Short-term Trading with Price Patterns
Hooke, Security Analysis on Wall Street, 1st ed.
Isbitts, The Flexible Investing Playbook
Kotok and Sciarretta, Invest in Europe Now!
Kroll, The Professional Commodity Trader
Labuszewski et al., The CME Group Risk Management Handbook
Lo and Hasanhodzic, The Heretics of Finance
Marks, Aqua Shock
Marr and Reynard, Investing in Emerging Markets
Maxwell and Shenkman, Leveraged Financial Markets
Mazur, What’s Luck Got to Do with It? (stamped “review copy not for resale” on bottom edge)
McGuire, Hard Money
Millard, Channels & Cycles
Miller, Tradestream Your Way to Profits
Nyaradi, Super Sectors
Patel, Technical Trading Systems for Commodities & Stocks
Phillipson, Adam Smith
Rachev et al., Probability and Statistics for Finance
Rittereiser and Kochard, Top Hedge Fund Investors
Rotblut, Better Good Than Lucky
Saliba, Options Strategies for Directionless Markets (paper)
Sarna, History of Greed
Schwartz, Micro Markets
Schwartz et al., Mastering the Art of Equity Trading through Simulation (paper)
Shaffer, Profiting in Economic Storms
Shover, Trading Options in Turbulent Markets
Sklarew, Techniques of a Professional Commodity Chart Analyst
Sorkin, Too Big to Fail
Stevenson, Precision Trading with Stevenson Price and Time Targets
Underhill, The Handbook of Infrastructure Investing
Waltzek, Wealth Building Strategies in Energy, Metals, and Other Markets
Weber and Zieg, The Complete Guide to Non-Directional Trading (paper)
Whiddon, The Investing Revolutionaries
Wilkinson, Technically Speaking

My Rube Goldberg TV

2011-06-20T05:09:00.000-04:00

How can I read books when I’m creating a Rube Goldberg TV? Comcast is transitioning to all-digital in my area, which theoretically means I need a set-top box for the “main” TV and a DTA (ugly little box) for all other TVs.

Here’s my retro setup. I have two analog TVs. One occasionally keeps me company during the day, and it is happy with the tiny box and the huge looping white coaxial cables. The other TV (which I either watch while exercising or fall asleep on) is what Comcast considers the cash cow, for which I need their cable box. The problem is that I also have a series 2 dual tuner Tivo and a DVD recorder. After a lot of experimenting, it seems I will need a three-way splitter and two additional DTAs to make this combination work.

I’m allergic to inelegant solutions, and this is decidedly inelegant. And time consuming!

But stay tuned. On Wednesday I’m going to offer some books for sale at half the Amazon price (plus shipping) on a first-come, first-served basis. I’ve run out of book shelf space.

Coles and Hawkins, MIDAS Technical Analysis

2011-06-16T05:10:00.001-04:00

Anyone who trades using technical analysis would do well to read MIDAS Technical Analysis: A VWAP Approach to Trading and Investing in Today’s Markets (Bloomberg/Wiley, 2011) by Andrew Coles and David G. Hawkins. It’s not that the MIDAS method, pioneered by Paul Levine in 1995, is the holy grail. I recommend the book because the authors have done such a thorough job of explaining and, after extensive research, expanding on the notion of volume-weighted support and resistance curves. In the process they touch on a wide range of technical approaches to the market, some of which I suspect will be unfamiliar to the majority of readers.

Coles and Hawkins, like so many who end up in technical analysis and trading, have academic backgrounds. Coles earned a Ph.D. from the University of London with a dissertation on biological themes in philosophy and medicine in ancient Greece. Hawkins has an M.S. in physics from Brown and taught at the university level. And the original developer of MIDAS was a theoretical physicist with a Ph.D. from Caltech. “Overeducation” can sometimes result in overthinking a problem. Midas Technical Analysis exhibits its fair share of overthinking, but that doesn’t mean that it’s merely a theoretical study. Far from it.

The MIDAS method was a development of or variation on VWAP (volume weighted average price). First, Levine modified the original VWAP formula. Second, he thought it important to anchor his support and resistance curves at a point where there was a change in the underlying psychology. That is, “instead of ‘moving’ averages, one should take fixed or ‘anchored’ averages, where the anchoring point is the point of trend reversal.” (p. 11) And third, he believed the markets to be fractal.

Coles and Hawkins start from the basic MIDAS premises, but they set out to develop a full trading system, not just a forecasting method. The two authors work on different time horizons: whereas Coles trades intraday, Hawkins focuses on longer-term charts. And they presumably have different interests as well. So each chapter in the book has a single author.

The chapters cover a broad range of topics. For example, MIDAS curves and day trading; applying the topfinder/bottomfinder to investor timeframes; equivolume, MIDAS, and float analysis; standard and calibrated curves; MIDAS and FX; MIDAS and the Commitments of Traders report; a MIDAS displacement channel for congested markets; and MIDAS and standard deviation bands. Appendixed to the text is MetaStock code for the standard MIDAS S/R curves and TradeStation code for the MIDAS topfinder/bottomfinder curves.

The trading plan the authors present is discretionary. There are no hard-and-fast buy and sell rules, though Hawkins offers a set of directions. Judgment is required throughout: for instance, where to anchor a curve, how to interpret multiple timeframe curves, and what kinds of market data to consider in addition to what’s on the chart.

In this more than 400-page book Coles and Hawkins take the reader down highways and byways, describing the scenery all along the way. Some of scenery is Kansanian (with due apologies to any readers from Kansas), but much is intriguing. The book is, to shift metaphors, definitely several cuts above the standard technical analysis fare.

Eureqa

2011-06-14T05:24:00.001-04:00

As I was cleaning out my e-mail, I revisited an old (maybe 2009?) program from the Cornell Creative Minds Lab named Eureqa (and of course pronounced “eureka”). Well, “revisit” is the wrong word. Originally, I downloaded it, played with it briefly, and set it aside. And then when I had to reformat my hard drive recently—one of those incredibly annoying, time-consuming chores—I didn’t reinstall it. I can only play at being a geek, not actually be a geek.

Eureqa is, as described on its website, “a software tool for detecting equations and hidden mathematical relationships in your data. Its goal is to identify the simplest mathematical formulas which could describe the underlying mechanisms that produced the data.” And if past is prologue, can project into the future. Well, maybe.

For those of you with time on your hands and a penchant for data mining who somehow missed this piece of free software, you can download it here.

Little, Trend Qualification and Trading

2011-06-13T05:04:00.001-04:00

Unless markets are absolutely comatose they swing. There are swing points in uptrends, downtrends, and sideways movement. Ideally the short-term trader buys close to the low swing points and sells close to the high swing points. The savvy trend trader ignores the minor swing points; he simply has to identify when he is about to overstay his welcome. All this is patently obvious in hindsight, hellishly difficult at the hard right edge.

In Trend Qualification and Trading: Techniques to Identify the Best Trends to Trade (Wiley, 2011) L. A. Little offers what he calls a neoclassical model of trends that relies in large measure on defining and qualifying swing points. The classical model, developed and popularized by Charles Dow and his followers, has of late morphed into what one might call the reductionist classical model: “A trend is evident when two consecutive sets of higher highs and higher lows (uptrend) or lower highs and lower lows (downtrend) occur within any given time frame.” (p. 23) This reductionist model, Little argues, doesn’t work: for one thing, it triggers premature exits.

In its stead Little offers a neoclassical model of trend. “The neoclassical trend model no longer consists of black and white—up or down and nothing in between. It displays varying shades of trend. It qualifies trend on a more granular level; a level that allows the trader to make intelligent decisions based more on probability than supposed absolutes.” (p. 26)

For Little, trends should be qualified as suspect and confirmed. The two inputs necessary to differentiate between a suspect trend and a confirmed trend are swing point price and volume. In its most basic terms, “When the current price trades lower (downtrend) or higher (uptrend) than the previous swing point price and volume contracts, the trend is suspect.” “When the current price trades lower (downtrend) or higher (uptrend) than the previous swing point price and volume expands, the trend is confirmed.” (p. 28)

Of course, nothing is ever so simple in trading. First of all, it’s important to identify swing points, both potential and actualized. Any current bar whose high is higher than that of the preceding bar has the potential to be a swing point high. It does not become an actualized swing high, according to Little, until it has remained the highest high for six successive bars. “The time element,” Little writes, “can be optimized for differing markets and equities, but my research has shown that six bars tends to represent the optimal ‘wait time’ across most equities, sectors, and general market indexes.” (p. 31) This can be six days, six weeks, or six months.

Little offers numerous chart illustrations of potential and actualized swing points and of suspect and confirmed trends in a variety of market regimens.

Little admits that “although trend theory is a necessary condition to trading trends profitably, in itself it isn’t sufficient. It is necessary to take the theory and integrate it into a workable and profitable trading system….” (p. 109) The second part of the book therefore deals with preparing to trade, entering and exiting trades, reversals and price projections, time frames, the trading cube, and trading qualified trends. Among the key concepts are anchor bars, which “identify chart price areas where significance exists” (p. 156) (as opposed to swing points, which normally define areas where a price boundary exists), and price zones (not lines).

Naturally, some of the material in the second part of the book is familiar. We encounter, for instance, support and resistance (though viewed as zones, not lines), measured moves (AB = CD), and the usual catalogue of gaps. But Little integrates the familiar with his own contributions and illustrates his points with marked-up charts.

Trend Qualification and Trading is an intermediate-level book for chartists. The only things on Little’s charts are price bars, volume, and labeled lines and zones that go far beyond the standard trend lines. For those who like to mark up charts, this book will be a satisfying read.

Amazon vs. Connecticut: Losers, Us

2011-06-10T07:19:00.000-04:00

This morning I received the following letter from the Amazon Associates Team:

For well over a decade, the Amazon Associates Program has worked with thousands of Connecticut residents. Unfortunately, the budget signed by Governor Malloy contains a sales tax provision that compels us to terminate this program for Connecticut-based participants effective immediately. It specifically imposes the collection of taxes from consumers on sales by online retailers - including but not limited to those referred by Connecticut-based affiliates like you - even if those retailers have no physical presence in the state.

We opposed this new tax law because it is unconstitutional and counterproductive. It was supported by big-box retailers, most of which are based outside Connecticut, that seek to harm the affiliate advertising programs of their competitors. Similar legislation in other states has led to job and income losses, and little, if any, new tax revenue. We deeply regret that we must take this action.

As a result of the new law, contracts with all Connecticut residents participating in the Amazon Associates Program will be terminated today, June 10, 2011.

* * *

So I will no longer be picturing dust jackets and providing links to Amazon.

Martin, A Decade of Delusions

2011-06-09T05:37:00.000-04:00

Frank K. Martin, who founded Martin Capital Management in 1987, wrote long annual letters to his clients. In 2006 he published Speculative Contagion, a compilation of his annual communiqués from 1998 to 2004. His new book, A Decade of Delusions: From Speculative Contagion to the Great Recession (Wiley, 2011) incorporates his earlier work and takes the story up through 2009, with an epilogue entitled “This Time Is Different.”

Martin’s fund, headquartered in Indiana, has a value orientation. “[T]he long-term challenge for us as a small shop doing battle with the New York Yankees of the investment world is to use our minds (we don’t have the financial muscle) to do what Billy Beane does so extraordinarily: to find value where no one else can find value.” (p. 249) The fund, similar to most value funds, lagged during strong bull runs and excelled during sharp pullbacks. So it’s not surprising that Martin fretted as stocks got marked up way beyond what turned out to be their true worth.

A Decade of Delusions is a cautionary tale, exposing excesses and arguing for the road less traveled. Value investors should relish it. Those who respect history can learn from it. But it’s also a veritable Bartlett’s Quotations for the markets. I particularly like the oft-quoted Leibniz quotation (one that a good translator should revisit), but that bears repeating: “Nature has established patterns originated in the return of events, but only for the most part.” As Martin notes, “Leibniz’s conditional phrase ‘but only for the most part’ gave permanence to the presence of risk.” (p. 314)

Although Martin doesn’t quite rise to the level of the homespun humor of his idol Warren Buffett, about whom he writes extensively, he can occasionally be scathingly funny. Sometimes he is just scathing. Consider, for instance, two subheads: “The Malevolent Mathematical Mystery of Modern Money Management (a.k.a. MPT)” and “The Absurdity of the Collective Wisdom of Individual Irrationality.”

A footnote for fans of Jack Bogle: he wrote the foreword to this book.

A fixed broken link

2011-06-08T19:22:00.000-04:00

I was a slouch. Normally I check my links to make sure all is well, but today I didn't. And, guess what, the link was broken.

So, for those who want to get to the Expiring Monthly site, here's the correct link (now fixed on the original post as well): Expiring Monthly.

Expiring Monthly

2011-06-08T05:26:00.004-04:00

We can only hope that Expiring Monthly has no expiration date itself. With Bill Luby, Mark Sebastian, Mark Wolfinger, and Jared Woodard—names that should be familiar to all options traders—as featured contributors, a spate of well-known guest contributors, and interviews with notables in the field, Expiring Monthly is a valuable resource for those seeking a solid options trading education.

The monthly magazine, now in its second year, addresses traders at all stages in their education. Mark Wolfinger answers rookie questions and writes about basic issues. The other contributors tackle somewhat more complex topics, though nothing esoteric or quant-like. You would never mistake Expiring Monthly for Wilmott Magazine.

One column that traders at all stages of their education can profit from is “Follow That Trade,” in which a contributor walks the reader through a hypothetical trade (sometimes a really bad trade) and how he managed it (again, sometimes poorly). For instance, Mark Wolfinger tracks a disastrous RUT trade where he bought three iron condors per strangle, made a delta adjustment along the way, and stuck it out to the bitter end even though “proper risk management would have forced a much earlier exit.” All that was left was a prayer that went unanswered. Mark Sebastian shares a successful surgical strike SPX calendar entered during the Egyptian sell off as well as an OEX butterfly. Bill Luby describes a silver and gold pairs trade that went against him.

In addition to writing feature articles (such as “Why Black-Scholes Is Better Than We Think” or “Trading Ranked Volatility with Non-Directional Spreads”), Jared Woodard often ruminates in a back page column on topics ranging from living and dead history to why decision theorists and average investors are both right. Bill Luby tends to look at big-picture issues that underlie trading decisions: “What Is a Non-Trending Market?” or “Evaluating Volatility Across Asset Classes” or “Exploring Put to Call Ratios.” Mark Sebastian draws on his experience as a pit trader to write gritty articles like “Whose Bones Are You Eating?” and practical pieces like “Understanding Order Flow.”

And, of course, there are the interviews, some with corporate types such as the CEOs of OptionsXpress and TradeKing and others with authors of hot-off-the-press trading books. Over the course of the last four issues Ping Zhou (Trading on Corporate Earnings News), Michael Benklifa (Profiting with Iron Condor Options), and Jeff Augen (Trading Realities, among several other books on options) shared their thoughts. But authors of legendary books are not ignored. In the inaugural issue Sheldon Natenberg (Option Volatility and Pricing) was interviewed and, more recently, Larry McMillan (Options as a Strategic Investment).

All in all, a nice publication, cleanly laid out and with limited advertising. On the Expiring Monthly website you can explore the archives of back issues and, of course, subscribe.

Harrison, The Other Side of Wall Street

2011-06-06T05:12:00.001-04:00

Long-time readers of this blog may recall my rather lukewarm review of Barton Biggs’s novel, A Hedge Fund Tale of Reach and Grasp. By contrast, Todd A. Harrison’s The Other Side of Wall Street: In Business It Pays to Be an Animal, In Life It Pays to Be Yourself (FT Press, 2011) is a gripping autobiographical tale of reach and grasp. And, unlike Biggs’s novel, of self-styled redemption.

Harrison, the founder of Minyanville (the redemptive part of the tale), recounts his days at Morgan Stanley, the Galleon Group, and Cramer Berkowitz from 1991 through 2002. These were heady times, and Harrison eventually became a prime player—and, in the process, a fractured soul.

He started on the derivative desk at Morgan Stanley. “There I was—6’1”, 215 pounds of muscle, straight A’s in my back pocket, and so scared that I could barely move. It was precisely where I wanted to be, rubbing elbows with the big hitters who wore Armani suits and had fat wallets. I remember thinking that one day, that would be me; at whatever the cost and no matter the price….” (p. 29)

He didn’t wear Armani suits or have a fat wallet his first year. He got a base salary of $28,000 and no bonus. The second year was more of the same. At bonus time he was told that “this may not be the business for you.” (p. 39) Finally, in 1993, his third year, when he worked harder than he ever had before, the twenty-four-year-old Harrison made “more money than [he] knew what to do with”: $75,000. “Things had really started to come together. I built the bank’s pad into one of the biggest on the Street, and word quickly spread about the kid from Morgan with steely nerves and a penchant for making aggressive markets.” (p. 43)

What Wall Street gives it can just as easily take away. Harrison’s disastrous First Interstate trade, where he was on the wrong side of an eight-figure overnight swing, didn’t cost him his job but it certainly shook his confidence. He bounced back, however, and by the age of 26 became one of the youngest vice-presidents at Morgan with a $300,000 compensation package.

Harrison’s position at Morgan became tenuous when Mark Neuberger took over the equity derivative trading operation, and soon enough he left for Galleon. Life at Galleon was not smooth sailing. He managed the derivative risk for Galleon’s flagship fund and had his own small trading account. His compensation was based on the performance of his own account, and—as at Morgan--for two years in a row he received no bonus. The third year, when he was sure it was “his year,” he was expecting a huge bonus, a million or three. Instead, he got $50,000 and was told that he didn’t have what it took to be a partner in the fund. “I beat myself up pretty badly after that meeting, questioning why I wasn’t good enough, asking myself why I couldn’t take that final step to stardom. It would be years later before I realized that not making partner at Galleon was the single best ‘failure’ of my professional career.” (p. 71)

So on to Cramer Berkowitz in 2000, a much smaller fund, where Harrison would run the entire trading operation and would receive a “nice percentage of the profits.” (p. 73) And would reel when the towers fell and the market imploded.

Harrison writes with intense passion about his time at Cramer Berkowitz where he not only traded but wrote ten to twelve columns daily for TheStreet.com. “When I wasn’t trading, I wrote, and when I wasn’t writing, I thought about what to trade or what I should write.” Especially after 9/11 “I was emotionally terrorized, although at the time I had no idea how damaged I was. … I was sleeping three or four hours each night, if that, but given my persistent nightmares, I wasn’t sure that was a bad thing.” (p. 116) Those who follow Jim Cramer, for whatever reason, will be especially interested in this part of the book.

Todd Harrison, who was diagnosed with ADHD as a kid, now had a host of other problems to overcome. The fund remained positive in the wake of 9/11 but “the slow, steady grind of the fourth quarter took its toll, both on the fund and its stewards.” (p. 121) Harrison resigned from TheStreet.com. But soon enough he missed his column and “craved a new beginning—something, anything, to stop the intense pain that had suddenly consumed me.” (p. 122)

Enter Minyanville, home of Hoofy and Boo. “The specter of Minyanville rose like a phoenix from the scorched earth and rescued me from realities I didn’t want to face. … It was an escape, a corridor from a very painful place to a bright, animated world without terror or acrimony or politics or agenda.” (p. 125) And, finally, exit Cramer Berkowitz.

In his “easier and more relaxing existence” he would manage a smaller fund, build Minyanville, and run a foundation he had established. (p. 141) Naturally, life never accommodates. “The hedge fund that was supposed to underwrite the collective costs of my various endeavors instead lost large sums of money, and while I had some cash stashed away, most of it, including my entire retirement account, was at risk alongside my investors.” (p. 143) In the end, Harrison writes, “I closed the doors, returned the remaining money, and booked the largest loss of my professional career. … The road to recovery would be long and hard, and I had to power the engine with a small reserve fuel tank. If I ran out of gas, there would be nobody left to tow me home.” (p. 151)

Harrison didn’t run out of gas, though he was tested again and again. The Other Side of Wall Street is a tale of perseverance in the face of failure, of recalibration despite success. It’s one of those books you read in a single sitting (helped by the fact that it’s only about 170 pages long). A riveting story.

A brief hiatus

2011-05-31T05:37:00.002-04:00

I recently received three books to review, but I’m going to be a bit slower than usual because I have a lot of other things on my plate right now. I have not abandoned you!

Happy Memorial Day

2011-05-29T14:13:00.001-04:00

In a singularly non-patriotic post, here's an old Animal Planet video that I received via a basset breeder friend. It may be a tribute to problem-solving, canine style. Or more likely an example of clever training. Whatever the case, it’s funny.