Archives of “Financial economics” tag

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Diagnosing trading problems.

  
  Education
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A good physician knows that, before cure comes a diagnosis. You cannot treat a problem before you identify what that problem is.

All too often, traders assume that their performance problems are due to a single cause: trading the wrong chart pattern or indicator, having the wrong mindset, etc. As a result, they seek out one trading guru or coach after another, only to see their P/L head steadily south.

The reality is that there are quite a few reasons why trading might be unprofitable. Figuring out which might apply to you is the first step is getting the right help.

Here’s a fourfold scheme that I have found helpful in conceptualizing trading problems:

1) Problems of training and experience – Many traders put their money at risk well before they have developed their own trading styles based on the identification of an objective edge in the marketplace. They are not emotionally prepared to handle risk and reward, and they are not sufficiently steeped in markets to separate randomness from meaningful market patterns. They are like beginning golfers who decide to enter a competitive tournament. Their frustrations are the result of lack of preparation and experience. The answer to these problems is to develop a training program that helps you develop confidence and competence in identifying meaningful market patterns and acting upon those. Online trading rooms, where you can observe experienced traders apply their skills, are helpful for this purpose.

2) Problems of changing markets – When traders have had consistent success, but suddenly lose money with consistency, a reasonable hypothesis is that markets have changed and what once was an edge no longer is profitable. This happened to many momentum traders after the late 1990s bull market, and it also has been the case for many scalpers after volatility came out of the stock indices. Here the challenge is to remake one’s trading, either by retaining the core strategy and seeking other markets with opportunity or by finding new strategies for one’s market. The answer to these problems is to reduce your trading size and re-enter a learning curve to become acquainted with new markets and methods. Figuring out how you learned the markets initially will help you identify steps you need to take to relearn new patterns.  (more…)

Loss Size versus Win Size When Trend Following

  
  Education
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Too many seek to have high win to loss ratios. This is a mistake. The key is to “try” to keep your losses small when trend following. You can always have gaps or limit moves but one of the best ways to mitigate big losses is to trade smaller. In a trend following program, win percentage can be among the lowest of all primary strategy types at 35-40%. Compare this with the options selling that has the highest win percentage at 74.25%. Option sellers have buried more traders than I can count. One of the reasons that some ” unique and small number” of consistent trend followers have survived for decades is that they attempted to focus on loss size and have tried to keep them small. One of the main statements of trend followers is Cut your losses and let your profits run. Easier said than done for most. This is where the psychology comes in and must be enforced.

Trend following success is not based on systems or methods…it is based on thought processes. Even with the correct thought processes…it is never easy…and there are always losing periods…

Past performance is not indicative of future performance

Is The Market Always Right?

  
  Education
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George Soros likes to joke that market has predicted seven of the past two recessions. And he is right. Since the market is forward looking, it will sometimes discount fundamentals that will never become a reality.

Prices reflect people’s expectations about the future, mostly about the near-term future. To say that the market is always right means to assume that people’s expectations about the future always come true. We all know that this is not the case. No one has a crystal ball. People are often wrong.

Is the market always right?

No, but this does not stop people who follow price trends to make a lot of money. The market could remain “wrong” (irrational) for a very long period of time and even become “wronger”. (more…)

CHANGE IS ESSENTIAL

  
  Education
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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.
 

External and Internal rules for Traders

  
  Education
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Assuming you use rules in your trading, here’s an exercise that can bring new insight into analyzing your trade metrics. The next time you review your trade history (you do review it, right?) focus on the rules of the trade. Specifically, ask yourself how you responded to the rules.

For this exercise we will use two types of rules—external and internal. An example of an external rule would be one generated from your trading system. Let’s use a simple moving average cross as a buy order. An example of an internal rule would be discretionary in nature. Usually we can find these in statements like “I told myself that I’d trade smaller ahead of my vacation so I wouldn’t have to worry about positions and truly relax.”

Take a piece of paper and divide it into two columns; one for external and one for internal. Now process your prior trades to see which types of rule you followed and didn’t follow. Take it a step further to see which type of rule had larger profits or losses over time. See if there’s a correlation between length of trade and type of rule. Perhaps there’s a common thread between losing trades and not following your internal rules. If so, this would suggest a lack of discipline on your part which can be fixed by creating an external rule to avoid or lessen losses in the future. Have fun with the exercise but approach it with the intent to improve your trading. (more…)

12 Things said by Jesse Livermore

  
  Education
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1. “An investor looks for safety… The speculator looks for a quick profit.” Livermore is saying that what differentiated him and other speculators from investors was: (1) a willingness to make bets with short duration and (2) not seeking safety.  Anyone reading about Livermore must remember that he was not a person who often/always followed his own advice. He eventually shot himself leaving a suicide note which included the sentence: “I am a failure.”

2. “A professional gambler is not looking for long shots, but for sure money…Since suckers always lose money when they gamble in stocks – they never really speculate…”  Livermore believed he was not a gambler since he only speculated when the odds were substantially in his favor (“sure money”).   Livermore’s statement reminds me of a quotation from Peter Lynch: “An investment is simply a [bet] in which you’ve managed to tilt the odds in your favor.” Livermore’s statement also reminds me of the poker player Puggy Pearson who famously talked about need to know “the 60/40 end of a proposition.”  When the odds are substantially in your favor you are not a gambler; when the odds are not substantially in your favor, you are a sucker.

3. “I trade in accordance to my means and always leave myself an ample margin of safety. …After I paid off my debts in full I put a pretty fair amount into annuities. I made up my mind I wasn’t going to be strapped and uncomfortable and minus a stake ever again.”  Livermore is not referring here to seeking a Benjamin Graham style “margin of safety” on each bet but rather to this: once you establish a big financial stake as a speculator, setting aside enough money so you don’t need to “return to go” financially is wise.  Livermore wanted a margin of safety in terms of safe assets so that he would always have a grubstake to start over in his chosen profession of speculation. On this point and others, he failed to follow his own advice.

4. “Keep the number of stocks you own to a controllable number. It’s hard to herd cats, and it’s hard to track a lot of securities.” There is only so much information a single person can track in terms of stocks whether you are in investor or a speculator. By focusing on a smaller number of stocks you are more likely to (1) know what you are doing (which lowers risk) and (2) find an informational advantage you can arbitrage.

5. “Only make a big move, a real big plunge, when a majority of factors are in your favor.” Only bet when the odds are substantially in your favor. And when that happens, bet in a big way.  The rest of the time, don’t do anything. (more…)

What is a ‘Zero-Sum Game’?

  
  Education
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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”

  
  Education
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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

  
Analysis, Education
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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.

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