Humility

An Exercise in Humility (Photo credit: Wikipedia)

Humility is one of the most important characteristics a trader must have. Being humble is to be free from self deception.

“There are two ways to be fooled: One is to believe what isn’t so; the other is to refuse to believe what is so.”

…Søren Kierkegaard

Question your analysis, question your capital allocation strategy, question every aspect of each trade that you make. Never get to the point to where you have so much confidence in your trading ability that you take any aspect of it for granted.

As they say pride cometh before the fall….

To be a skeptic is to increase the chance that you are free from self deception. In doing so you increase the probability that you will not end up on the wrong side of a trade.

 

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• Day of Distinction – Humble or Humiliated a Fine Line or an Echoing Abyss? (dancingthroughlifewithspirit.com)
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• Humility vs. Self-deprecation (thoughtsfromdeepwater.wordpress.com)
• Success must bestow Humility (makpathan.wordpress.com)
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Inefficient Markets, Noise Traders and Technical Analysis

Image via Wikipedia

I plan to write a series of blog entries addressing Market Efficiency, Technical Analysis and Noise Traders. I felt inspired to write this series of entries upon re-reading “ A Non Random Walk Down Wall Street” by Andrew W. Lo and Craig MacKinlay.
Here are a few quotes that I would like you to consider as I work on my next entry:
“Perfectly information ally efficient markets are an impossibility, for if markets are perfectly efficient, the return to gathering information is nil, in which case there would be little reason to trade and markets would eventually collapse. Alternatively, the degree of market inefficiency determines the effort investors are willing to gather and trade on information; hence non-degenerate market equilibrium will arise only when there are sufficient profit opportunities, i.e., inefficiencies, to compensate investors for the cost of trading and information gathering. The profits earned by these industrious investors may be viewed as economic rents that accrue to those willing to engage in such activities.” This quote is attributable to Grossman,S., and J. Stiglitz, 1980, “On the impossibility of Informationally Efficient Markets,” American Economic Review, 70, 393-408.
Who are the providers of these rents?
Black (1986) gives us a provocative answer: noise traders, individuals who trade on what they think is information but is in fact merely noise. More generally, at any time there are always investors who trade for reasons other than informational for example, those with unexpected liquidity needs – and these investors are willing to pay up for the privilege of executing their trades immediately.”
Wikipedia has the following definition for Noise Traders:
A noise trader also known informally as an idiot trader, is described in the literature of financial research as a stock trader whose decisions to buy, sell, or hold are irrational and erratic. The presence of noise traders in financial markets can then cause prices and risk levels to diverge from expected levels even if all other traders are rational.
In finance, noise obtained a formal definition in a 1986 paper by Fischer Black: “Noise in the sense of a large number of small events is often a cause factor much more powerful than a small number of large events can be.”
A more academic definition of a noise trader goes as follows:
Irrational noise traders with erroneous stochastic beliefs both affect prices and earn higher expected returns. The unpredictability of noise traders’ beliefs creates a risk in the price of the asset that deters rational arbitrageurs from aggressively betting against them. As a result, prices can diverge significantly from fundamental values even in the absence of fundamental risk. Moreover, bearing a disproportionate amount of risk that they themselves create enables noise traders to earn a higher expected return than do rational investors.
I will close with a quote from an intellectual giant:
“If the reader interjects that there must surely be large profits to be gained… in the long run by a skilled individual who… purchase[s] investments on the best genuine long-term expectation he can frame, he must be answered… that there are such serious-minded individuals and that it makes a vast difference to an investment market whether or not they predominate… But we must also add that there are several factors which jeopardize the predominance of such individuals in modern investment markets. Investment based on genuine long-term expectation is so difficult… as to be scarcely practicable. He who attempts it must surely… run greater risks than he who tries to guess better than the crowd how the crowd will behave.”
—John Maynard Keynes (1936), p. 157

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• “Something structural has changed in current fundamentals” (ftalphaville.ft.com)

Put Calendar Spread FAS July/Aug 30

Today I would like to walk thru a trade I made using TD Ameritrade’s Think or Swim platform. I entered into a calendar spread on FAS, a triple leveraged ETF that tracks the Russell 1000 Financial Services Index. I bought the July 30 Put @ $3.40 and sold the Aug 30 Put @ 3.90. This resulted in a credit to my account in the amount of .50 per contract.
I entered the trade as a limit order which means that my order would only be filled if it met my requirements which in this case was that my trade result in a .50 net credit to my account.
My outlook on FAS is neutral to bearish in the short-term as it is trading near resistance in a downward sloping channel.

Moving Averages: The 5, 10, and 20 day are bullish.

MACD: Fast MA is bullish, while the slow MA is somewhat neutral.
 Stochastics: The 9, 14, and 20 day are all above 80% which is strongly bullish.
Relative Strength: The 9 day RSI is bullish. The 14 day RSI is technically bullish but is indicating weakness. The 20 day RSI is strongly bearish.
Money Flow Indicator: The 9 and 14 day MFI is still technically bullish but is indicating weakness. The 20 day is still bullish, but given the weakness in the shorter time intervals we can expect the 20 day to follow the trend.
Volatility: The Average True Range for the 9 and 14 day are identical while the 20 day is a little lower but they show bearish sentiment.
In total the technicals are slightly bullish but show weakness. For that reason I chose not to get into a trade that was extremely sensitive to direction.
Fas is trading in a range of $22.26-28.65 in the past 30 days and doesn’t look like it will break out of that range . It looks like FAS is headed toward the lower end of that range.

By entering the calendar spread I was looking to benefit from a near term increase in implied volatility, the benefit of time decay and price movement with my July put having a higher sensitivity to price movements due to the likelihood that my option expires at or near the current price.
My risk on the trade is limited to the credit I received ($500.00) as long as I cover my short before expiration of my long contract. My profit on the trade is dependent on how I decide to unwind the trade. I can choose to get out of both trades at the same time or I can cover my short and let my long ride. If I were to do that then time decay stops working in my favor and starts working against me. I also increase my risk to  the price action of the underlying.

With calendar spreads you should always cover the short option prior to the expiration of the long option. This is just simple risk management. And depending on your account type your brokerage may not allow you to do otherwise. I plan to close both contracts by Friday. I have a near-term price targets on the downside of 25.50 and 24.21. On the upside I will exit the trade if FAS crosses 28.41.

Related articles

• Market After Last Week’s Rally 07-05-2011 (benzinga.com)
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• Going Into July with a Boom 07-01-2011 (benzinga.com)
• Trading Wrap-Up for Thursday 6/30 (nasonresearch.wordpress.com)
• http://calendarspread.option-training.com/2011/05/01/trading-option-option-greeks-vega

Gambling and Speculation (via Piedmont Trader)

Very interesting blog on a topic relevant to all traders.

One recurrent topic in trading is differences and similarities between gambling and speculation. After having reads quite a few ideas on this I came up with the following definitions that work fine for me. Both gambling and speculation share the same common ground and this is risk. Risk in turn has to do with the uncertainty of the outcome of future events so basically both gamblers and speculators have in common that they take risk with the obje … Read More

via Piedmont Trader

The Protection Trade

Cover via Amazon

I am going to touch on a topic that has been made popular over the past few years as a result of the wildly successful book by Nicholas Nassim Taleb “The Black Swan“. I found his  fooled by randomness to be much more interesting, but both are must reads to anyone interested in the market and how we perceive everyday events. The author has a few detractors in finance, academia and the media. You shouldn’t let these deter you from what he has to say as he has yet to  experience the failure that some of his most vocal detractors have.

Nicholas Nassim Taleb must be thought of first as a pursuer of intellectual truth and knowledge, second as a trader and financial commentator. I share with him a desire for independence and freedom from authority and believe that trading can offer that. His most profitable trades have arisen due to misconceptions about risk and chance. Two topics of vital interest to traders.

A “Black Swan” event is the occurrence of a highly improbable event that has extreme implications. Black Swans are the outliers on a data set. If you were to ask where a black swan would show up on a Bell-Curve it would be to the extreme left or right. The two tails of the curve. They are often times the most ignored, yet most important aspects of a data set.  So a black swan trade would be to trade an event that is highly improbable of occurring, but in the case that it does, results in a large or even immense payoff.

The exact opposite of a black swan trade would be to trade an event with a high chance of occurring with a small payoff. An  example of this is given in another great book When Genius Failed by Roger Lowenstein in which he highlights the implosion of Long-Term Capital Management. LTCM was a fund created by some of the most elite and revered names in finance. Their trading style was to find high-probability, low payoff events, leverage the trade by on average 20:1 and hope that the black swan never crossed their path. Well as is often the case in matters of trading, the black swan decided to make its presence known. What resulted wasn’t on the scale our most recent economic crisis, but the fed had to step in with its strong-arm tactics forcing Wall Street’s major players to bail out a group of academic legends.

If you chose to become a black swan trader you will experience bouts of depression and self-doubt as most of your trades end up as losers, if you are able to withstand the psychological assault that this style provides then at the end of the day you will have achieved the independence and freedom from authority that we all pursue. If you chose the LTCM path and many of you will, you will experience a life of satisfaction, but be forewarned that it is a life lived on borrowed time.  For the Black Swan comes swiftly and witthout warning.

Isoalpha isn’t the proper forum for me to offer advice on trades that you should make, my goal is to make you aware of mistakes that can be made. To become a successful trader you have to be aware of your biases and how they affect the decisions you make while trading. You must be willing to look at the data in a different light and constantly question your rationale for making a trade. Just because you can backtest a strategy and found that it has been successful using historical data, doesn’t guarantee that it will be successful tomorrow. It doesn’t mean that you shouldn’t execute it, just be aware of the consequences that will occur if your theory isn’t valid in tomorrows market. If those consequences are bearable then by all means make the trade.

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Education of a Speculator

Cover of The Education of a Speculator

A word on Victor Neiderhoffer –

Education of a Speculator was the first real investment memoir I had the pleasure of reading. It wasn’t the first book written by a former fund manager I had read, that credit goes to Peter Lynch and his One up on Wall St. Upon completing that book I felt that I could trade stocks successfully. However at the time my interest in the market was developing, being a long-term investor just didn’t make sense, nor did it fit in with my goals of creating mountains of cash over the next couple of months. That’s where Education of a Speculator comes in. To think that I came across it unintentionally, and wouldn’t have read (and re-read) it had I not been intrigued by the title.

Backtesting

Prior to any investment or speculation you should challenge your rationale for putting that money at risk. This was a radical concept to me. It didn’t matter that I didn’t have a MonteCarlo simulator or access to the CRSP (Center for Research into Stock Price  at Graduate school of Business University of  Chicago) I started to sit and contemplate possible scenarios that would present pricing anomalies and then go and look for the data to prove my theory. As a scientist first comes up with a hypothesis and then tests that hypothesis to find truth, a trader no matter what he’s trading must if they want to survive, backtest their basis for investing.

Understanding Market Dynamics

The best way to understand how the market works is to go to your local zoo and go to the big cat exhibit at feeding time, ou will see that the lil kitty who looked so warm and cuddly just 2 minutes earlier is now ready to battle to the death for his piece of the pie. Same is true of fund managers.
There are a million reasons for a seller to sell and a buyer to buy, most of these reasons fail to take into consideration that the involved is supposed to be maximizing his expected utility, and as a result the product being bought or sold has its true value distorted just a little while longer.But there exist in every market no matter how liquid or illiquid extremely rational and ruthless participants who are there to take your savings and your soul while leaving you thinking that they did you a favor. It’s evolution on a micro-scale. The strong survive and the weak well the weak continue to give their earnings to the real players in the form of 401K contributions.

Understanding that the  person on the other side of the trade is there to basically take your money should motivate you to make sure that your trade is as close to a sure things as possible.

Random or Non-Random

So if the market is indeed random and the Efficient Market Hypothesis (E.M.T.) is accepted as if it came down from on high, how can one profit, state with any certainty that something is highly probable or improbable. That’s always been my problem, it would make it easier as a trader if we had the answer to these questions. But this is a debate for academics. As a trader it is your duty to come up with a road map that will lead you to profitability. At the end of the day what really matters is how much money you have in the bank not whether you were on the right side of an academic debate. The only way to increase your time in the market and the amount of money you have in the bank is to trade high probability events. The only way to do guarantee that outside of inside information is to  back test your theories. Do not try to make the data fit to your hypothesis unless you want to be stuck listening to Cramer instead of trading against Cramer.

Depth

I didn’t go as in-depth into some of these topics as I really wanted to. I really wanted to touch on Brownian Motion, Fractals, and Hemline analysis (it’s based on a theory that you can gauge the market based on the length of a woman’s skirt). I will in future posts my goal here is to ease you in to understanding the intricacies of the market and the debates among participants.

http://www.dailyspeculations.com/wordpress/,

http://www.wiley.com/WileyCDA/WileyTitle/productCd-0471249483.html,

http://en.wikipedia.org/wiki/,

http://blogs.wsj.com/financial-adviser/2010/02/25/ten-things-i-learned-while-trading-for-victor-niederhoffer/

 

Leverage (beta)

Leverage often misunderstood, often misused. When used properly it can effectively manage risk and achieve alpha.
Leverage is the lifeblood of a speculator. But it can also benefit the conservative trader.
Here’s an example, say you have $10,000 that you want to put to work for you in the market. You can go all in or you can reduce your risk profile and put 1/3 in a triple leveraged ETF, the remainder in an interest earning account.

Your return will go from: R = I x 1+a

to: R = (3)I x 1+a 

Where R= Amount of capital post trade, I= Amount in the trade and a= the amount traded. You can plug numbers into those equations and see what you come up with. You add 1 to a as a  will be in percentage terms

There will be a small difference after you take into account the costs of the trade. While trading leverage is more expensive than not it will likely be a nominal difference due to the size of the trade. The proliferation of ETF’s you will allow you to gain exposure where you want it.
If 3:1 doesn’t suit your needs you can employ more complex strategies using derivatives and structured products. I will touch on what some of these are and how to effectively use them this afternoon.
What you want to avoid doing is actually leveraging your account. There is a point and time when doing so is in your best interest. But they are few and far between.
With a little bit of research you will see that the graveyard of once high-flying hedge funds is filled with victims of leverage. Understandably so, it’s catnip to a trader. Now that financial engineering has been demystified and made available to the masses you can become a victim too. If you choose that route I hope that you’ll enjoy yourself while it lasts.

How advanced is your mathematical understanding?

A lot of potential traders never reach their full potential because of a poor understanding of market dynamics, financial products, portfolio management,   capital management and the psychology of trading. It’s not necessarily because they are lacking in intellect, natural ability, or desire to learn. A lot of times they just aren’t able to overcome the knowledge barrier to entry.

If you have time go to Google Scholar, type in: leverage trading capital open the first link (http://finance.wharton.upenn.edu/~rlwctr/papers/8936.PDF).

It’s a paper titled Optimal Dynamic Trading With Leverage Cnstraints. The paper is an attempt to solve the problem that most traders have, a limit on the capital they have to trade, the inability to borrow an unlimited amount of capital and the risk aversion that comes with those limits. The authors also explore limitations a pension fund has and  a risk neutral position. My goal is not to analyze or explain the paper in this post ( however if you would like me to do that leave a comment and I will) but to show that there is a barrier to entry. The authors use advanced mathematics to support their findings and solution on how to overcome capital restraints when formulating a trading strategy.

The flip side of this is the oversimplification of what is in fact a serious undertaking. Let’s take Jim Cramer. We’ve all heard the name, and we all hav an opinion on him. We can’t deny that he is a successful individual at what he does: entertain. But the majority of viewers don’t understand that he is now an entertainer, not an advisor. So when he  pumps his latest pick they’ll put in their market orders, get filled 10% above what they thought would be their purchase price and sell when three days later the stock is down 6-10%.

Finding a middle ground

TO BE CONTINUED

 

 

 

 

The Business Press

We cannot avoid the onslaught of financial advice and entertainment
in today’s society.  Some good comes of
it, we get to experience Schadenfreude when the latest corporate executive is haled
of in hand cuffs. But much of what is on CNBC, FOX Business, and their  ilk is of no real value to you as a trader.
Every once in awhile you will see, read or hear something that you feel will
benefit your trading day, but once we hear it has about, the likelihood that
you will be able to realize a return on investment that can be specifically
attributable to that piece of news is highly improbable.

I don’t advocate that you disregard everything that you hear
outside of a boardroom or trading floor, just don’t use it as justification to
put your capital at risk. If you have a disregard for money there are millions
of other ways for you to show that disregard that will bring both you and the receiving
party more satisfaction than following another one of Cramer’s trades.

I have had the fortune (some would say misfortune) to read a large
number of memoirs by current and former traders. While I felt that I was able
to take something from each book I read, I can honestly say that the memoirs of
Victor Niederhoffer http://en.wikipedia.org/wiki/Victor_Niederhoffer  and Nicholas Nassim Taleb http://en.wikipedia.org/wiki/Nassim_Nicholas_Taleb had by and far the most
qualitative and quantitative affect. If you choose to read my blog with any
regularity you will become as familiar with their personal philosophies and
professional trading styles as I have.

I won’t delve too deep into who they are, what they have
accomplished and why they matter. I have included a couple of links in case you
are the inquisitive type like myself and must know now. I can safely say that
their trading styles are as different as night and day. However they do agree
on the fact that you will gain absolutely nothing, and will in fact increase
the probability that you will have a losing trade,  if you base your trade off of something in
the financial press.

One thing you must remember whether you are trading or investing
is that financial journalists do not have their jobs because of their ability
to analyze the market. (Then again the same can be said of some fund managers!)
If you must rely on someone else for trading ideas and you don’t have the
ability to have your money manager at an address in Greenwich CT. you’re better
off asking someone who has absolutely no exposure to the markets, than someone
with superficial knowledge.

Trading as Psychological Warfare

Trading isn’t for everyone. But it might be for you. If you have the ability to follow a rules based trading system you can become a successful trader. There are a lot of people who feel that they can follow a set of rules, and they may be right. Following a set of rules when you are trading isn’t as cut and dry as following the instructions in an owners manual.
Let me be clear: TRADING IS PSYCHOLOGICAL WARFARE.  As a trader you will experience a variety of intense emotions that  reduce your ability to make decisions, well that’s not neccessarily the case, you will make decisions, they just might not be the right decisions for the right reasons. This is often overlooked by most people (and I’ve yet to hear Erin Burnett mention it).                                                                                                                                          I will touch on this subject more so than any other subject because it’s a silent killer of traders. I will help you to better understand why you experience the emotions that you do while trading and how to use them to your benefit.                                                                                                                                       Trading will help you to gain a better understanding of who you are as an individual, what intellectual and emotional strengths you posses and what triggers you emotions. If you can experience this while at the same time making your money work for you, you will have truly become a successful trader.

Introduction

Hello, I would like to welcome you to my blog isoalpha. I will be focusing on the trading of financial products, why you should do it, how to do it succesfully and the impact that being a market participant has on the individual.