Archive for June, 2011

Cover of "The 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.


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.


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.,,,



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+

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 (

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






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  and Nicholas Nassim 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 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.


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.