The stock market, just like life, can change on a dime. In the market, just as in life, we must learn to adapt to change. What separates the great trader from the rest of the crowd is his or her ability to change based on current market conditions. In other words, NO EGO ALLOWED. Mark Douglas, in his first book entitled The Disciplined Trader writes,
“There must be a difference between these two types of traders-the small majority of winners and the vast majority of losers who want to know what the winners know. The difference is that the traders who can make money consistently on a weekly, monthly, and yearly basis approach trading from the perspective of a mental discipline. When asked for their secrets of success, they categorically state that they didn’t achieve any measure of consistency in accumulating wealth from trading until they learned self-discipline, emotional control, and the ability to change their minds to flow with the markets.”
We trade the current market conditions as they unfold with a plan to trade one way or the other. To do otherwise would be to fight an undefeated foe.
Archives of “Business_Finance” tag
rssGreyserman and Kaminski, Trend Following with Managed Futures- Book Review
Trend Following with Managed Futures: The Search for Crisis Alpha (Wiley, 2014) by Alex Greyserman and Kathryn M. Kaminski is an academically rigorous book with a practical bent. Although on the surface it appears to have a narrow focus, in reality it covers a broad spectrum of important but often overlooked investing concepts. Even readers who have no real interest in managed futures can learn a great deal from it, especially if they have some familiarity with financial statistics.
The authors start with an 800-year historical perspective and then discuss trend following basics, theoretical foundations, trend following as an alternative asset class, benchmarking and style analysis, and trend following in an investment portfolio.
Here I’ll simply highlight a couple of ideas that are central to the book’s thesis.
Let’s start with the notion of crisis alpha. “Crisis alpha opportunities are profits that are gained by exploiting the persistent trends that occur across markets during times of crisis.” (p. 145) Viewed in the context of the adaptive market hypothesis set forth by Andrew Lo in 2004, “for both behavioral and institutional reasons, market crisis represents a time when market participants become synchronized in their actions creating trends in markets. It is only the select (few) most adaptable market players who are able to take advantage of these ‘crisis alpha’ opportunities.” (p. 73)
What is a ‘Zero-Sum Game’?
Zero-sum games are the total opposite of win-win situations – such as an agreement that creates value between two counter-parties – or lose-lose situations, like war and mutually destructive relationships for instance. In real life, however, things are not always so clear-cut, and winners and losers are often difficult to quantify. New traders get confused and do not understand that in trading, profits come from the people on the other side of your trade that are making the wrong decision. The reason that trading is difficult is because you have to out smart someone to get their money, how you do this is what gives you your edge if you are profitable. In all financial markets buyers and sellers are always equal and the time frame in which they are trading determines if their decision was the right or wrong one at the time of their trade. Your entry is someone else’s exit and your losses are in some one else’s account as profits.
A zero-sum game is a situation where one person’s gain is always equivalent to another person’s loss, so the total wealth for the players and participants in the game is always a net change of zero as a whole. The financial contract markets of futures and options are a zero-sum game with several million players. Zero-sum games are found in game theory, but are less common than non-zero sum games. Poker and gambling are popular examples of what a zero-sum game is since the sum of the amounts won by some players equals the combined losses of the others. The money at a poker table at the start of the game does not grow it is just redistributed to the winners from the losers by the end of the game. All of the casino’s profits come from the gambler’s losses and all the gamblers profits are taken from the casino. Games like chess and tennis also fit this model becasue there is one winner and one loser they are always equal. In the financial markets, option contracts and future contracts are examples of zero-sum games, excluding transaction costs, for every long contract their is someone short the same contract. Some one has to sell a contract to create open interest and someone has to buy it, there has to be a winner and a loser at all times, one long and one short. Brokers and market makers disrupt the perfect balance of winners and losers by taking commissions or profiting from the bid/ask spreads. But, for every person who profits on a contract’s value going in their direction, there is a counter-party who loses who is on the other side. (more…)
A Review: “Two Centuries of Trend Following”
The paper “Two Centuries of Trend Following” by Lemperiere, Derenble, Seager, et al of Capital Fund Management purports to show that trend following has been profitable, over a wide range of markets, consistently over 200 years. It deserves to be reviewed as it represents a case study of the statistical practices, and armchair explanations that are sometimes used to justify a system that in the most recent five year period has lost its mojo. Rocky has asked me to review it.
The amazing thing is that the authors seem to know how to compute hyperbolic tangent regressions, and compute the duration of a drawdown given a sharpe ratio, yet they seem completely unaware of the problem of multicollinearity, overlapping observations, and lack of independent observations.
In a nutshell, they compute hundreds of thousands of means, and they combine them and measure how far away from randomness they are. Recall that the average of two random observations is about 0.7 times as variable as one observations. The average of 100,000 observations is about 1/320 as variable as 1 observation. (more…)
What Ray Dalio and Art Cashin think of the latest market moves
Two articles are doing the rounds. The first is a letter from Bridgewater hedge fund titan Ray Dalio, who has long believed the world is in a great deleveraging. He doubles down today and says the next ‘big’ Fed move will be more QE.
Here’s the crux:
the ability of central banks to ease is limited, at a time when the risks are more on the downside than the upside and most people have a dangerous long bias. Said differently, the risks of the world being at or near the end of its long-term debt cycle are significant.
That is what we are most focused on. We believe that is more important than the cyclical influences that the Fed is apparently paying more attention to.
While we don’t know if we have just passed the key turning point, we think that it should now be apparent that the risks of deflationary contractions are increasing relative to the risks of inflationary expansion because of these secular forces. These long-term debt cycle forces are clearly having big effects on China, oil producers, and emerging countries which are overly indebted in dollars and holding a huge amount of dollar assets-at the same time as the world is holding large leveraged long positions.
While, in our opinion, the Fed has over-emphasized the importance of the “cyclical” (i.e., the short-term debt/business cycle) and underweighted the importance of the “secular” (i.e., the long-term debt/supercycle), they will react to what happens. Our risk is that they could be so committed to their highly advertised tightening path that it will be difficult for them to change to a significantly easier path if that should be required.
Next is NYSE floor veteran Art Cashin at UBS. Some of his comments are mute because he talks about the potential for China to cut rates and that’s already taken place. He says to watch high yield closely and Jackson Hole.
Vice-Chair Stanley Fischer will be speaking later this week at the Jackson Hole conference. I think he will be addressing the problem of inflation and that it’s not growing in the pace they want it. That will give the world a hint that the Fed is not quite ready to raise interest rates.
12 Market Wisdoms From Gerald Loeb
1. The most important single factor in shaping security markets is public psychology.
2. To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come.
3. Accepting losses is the most important single investment device to insure safety of capital.
4. The difference between the investor who year in and year out procures for himself a final net profit, and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.
5. One useful fact to remember is that the most important indications are made in the early stages of a broad market move. Nine times out of ten the leaders of an advance are the stocks that make new highs ahead of the averages. (more…)
The PROPER Use Of Hope and Fear
If you’ve been involved in the markets for any length of time you will no doubt have heard of the twin pillars of market psychology, Hope and Fear (or sometimes Greed and Fear).
In fact, if you’ve ever been involved in an endeavour where you have something on the line – a business, a wager, a job, or even a date – you will have experienced Hope and Fear in some form and the devastation it can play on your psychology.
Experiencing Hope
For most traders, Hope looks like this:
They’ve just bought a stock or commodity, and they hope that it goes up. Of course, this is the name of the game, we all hope it goes up if we are buying! But then the stock starts to fall, and instead of selling out, the trader holds on with the hope that it will rise again. The more the stock falls, the more they hope and pray that it will rise.
But they don’t realise – Hope does not equal Action. And only our Actions make money in the stock market.
Experiencing Fear (more…)
How To Become A Better Trader
Find the people who most consistently come up with the most original and useful observations and ideas, study their thought processes (how they’re generating those ideas), replicate those ways of thinking for yourself, and take the time to begin thinking like them. Imagine doing that across many virtual mentors over time so that you begin to integrate the best thinking of the best people. That is how imitation turns into innovation.
Take a look at who you’re following in social media. If you’re spending much time reading material from those you don’t want to internalize, you’ll wind up with little cumulative development.
5 Trading Frustrations and Solutions
Top Trader Frustrations
- I cannot trade my plan!
- You need to develop the skill to execute your trading plan under duress.
- Use visualization exercise to see yourself successfully executing your trading plan during the day. The greater level of detail a trader uses in their visualization exercise the greater its effectiveness.
- I cut my winning trades too early!
- Have profit targets
- Take partial profits
- Measure each day the missed profits that you could have obtained if you didn’t miss a setup, or if you didn’t cut your winning trades too early.
- I am not consistent with my trading
- Establish a playbook with setups that work for you, and setups that don’t work for you.
- Define the risk that you should take in setups based on whether they are A+, B, C setups (based on risk/reward and % win rate).
- Track the amount of risk that you are taking on similar trades, so that the results can be properly analyzed. Risk 30% of your intraday stop loss on a A+ setup, 20% on a B setup, 10% on a C setup, 5% on a Feeler trade.
- Do a trade review
- Did I trade the best stocks today?
- Did I recognize the market structure?
- Did I push myself outside the comfort zone?
- Things I did well
- Things I could improve
- I cannot find a profitable trading system
- Trading is a probability game, setups don’t work all the time, so don’t keep trying and throwing away trading setups without thoroughly testing them.
- Get exposed to lots of different setups and trade the setups that make the most sense to you and works best for you.
- I lack the confidence to take trades
- Have a detailed trading plan, place orders in advance in possible.
- Put on feeler trades with 5-10% of the risk that you normally put on. Once you start to become more comfortable you can then put on your regular trades again.
OVERCONFIDENCE in Trading
It is common for traders to complain of a lack of confidence in their trading, but very often it is overconfidence that does them in. Overconfidence results from a lack of appreciation of the complexity of markets and an underestimation of the challenges of trading them successfully. In a sense, overconfident traders lack respect for the markets. They think that reading about a few setups or buying the newest software will prepare them to make money. Overconfident traders don’t want to work their way up the trading ladder: they resist the idea that screen time is the best teacher. They also chafe at the idea of growing their account. Rather than start with one contract and wait until they’re profitable before trading larger size, they want big positions—and profits—right away. Because they’re so eager to make money—and so sure they can make it—overconfident traders generally trade impulsively. They won’t wait for the setup to form; they’ll jump the gun—and get whipsawed in the process. Instead of being patient and waiting for short-term patterns to align with longer-term patterns, they will take every trade, enriching their brokers in the process. (more…)