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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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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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/