Archives of “Financial economics” tag

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Berkshire Hathaway’s Willingness to Kill

  
Analysis, Education
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I’m poring over the just-release 2014 annual letter to Berkshire Hathaway shareholders today and, as usual, I’m finding nuggets of wisdom on every single page.

One really interesting bit I wanted to pass on concerns a crucial benefit that their conglomerate structure offers. In countering the idea that Berkshire should break itself up or spin off some businesses to “unlock shareholder value”, Warren Buffett explains a key advantage that his collection of companies offers – beyond the obvious ability to self-fund.

He reminds his shareholders that being able to channel capital across opportunities and be willing to walk away from a dying industry is critical to the corporation’s longevity. He laments the twenty years between 1965 and 1985 that he allowed the legacy New England textile assets to decay before finally pulling the plug. He talks about the conflicts that a more singularly-focused corporation might have when its central line of business goes into secular decline.

One of the heralded virtues of capitalism is that it efficiently allocates funds. The argument is that markets will direct investment to promising businesses and deny it to those destined to wither. That is true: With all its excesses, market-driven allocation of capital is usually far superior to any alternative. Nevertheless, there are often obstacles to the rational movement of capital. As those 1954 Berkshire minutes made clear, capital withdrawals within the textile industry that should have been obvious were delayed for decades because of the vain hopes and self-interest of managements. Indeed, I myself delayed abandoning our obsolete textile mills for far too long. A CEO with capital employed in a declining operation seldom elects to massively redeploy that capital into unrelated activities. A move of that kind would usually require that long-time associates be fired and mistakes be admitted. Moreover, it’s unlikely that CEO would be the manager you would wish to handle the redeployment job even if he or she was inclined to undertake it…

…At Berkshire, we can – without incurring taxes or much in the way of other costs – move huge sums from businesses that have limited opportunities for incremental investment to other sectors with greater promise. Moreover, we are free of historical biases created by lifelong association with a given industry and are not subject to pressures from colleagues having a vested interest in maintaining the status quo. That’s important: If horses had controlled investment decisions, there would have been no auto industry.
 
 

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10 Characteristics of Successful Traders

  
  Education
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1) The amount of time spent on their trading outside of trading hours (preparation, reading, etc.);
2) Dedicated periods to reviewing trading performance and making adjustments to shifting market conditions;
3) The ability to stop trading when not trading well to institute reviews and when conviction is lacking;
4) The ability to become more aggressive and risk taking when trading well and with conviction;
5) A keen awareness of risk management in the sizing of positions and in daily, weekly, and monthly loss limits, as well as loss limits per position;
6) Ongoing ability to learn new skills, markets, and strategies; (more…)

Universal Lessons

  
  Education
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What follows are some of the most well-known investment disciplines along with a lesson or two from each that every investor should be able to use in their own strategy.

Focused Value Investing: Buying stocks that are underpriced in relation to their intrinsic value.
Lesson(s): It’s important to invest from the perspective that stocks represent an ownership interest in a business. You get your share of corporate profits from the stocks you own and over the long-term the value of the business should be reflected in the stock price.

Quantitative Investing: Using a systematic, mathematical approach to make buy and sell decisions within a portfolio.
Lesson(s): A rules-based, objective approach to investing is a great way to take out the emotions which can trip up so many investors and introduce biases into the investment process. Automating good decisions can reduce costly mistakes.

Technical Analysis: Studying charts, past prices and volume for security and market analysis by using patterns.
Lesson(s): An understanding of the history of the financial markets is extremely important to be able to define your tolerance for risk and gain the correct perspective on what couldhappen in terms of gains and losses. And at the end of the day markets rise and fall because of supply and demand.

Index Investing: Owning the entire market/index at a low cost.
Lesson(s): Beating the market is hard. Keeping your expenses, activity and turnover to a minimum is a prudent way to earn your fair share of the market’s return over time. (more…)

10 Options Trading Pitfalls To Avoid

  
  Education
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  1. The first question to ask in any option trade is how much of my capital could I lose in the worst case scenario not how much can I make. You can lose a high percentage of the capital you have in an option trade so keep it small in comparison to your total account size. I suggest never risking more than 1% of your trading capital on any one option trade.
  2. Long options are tools that can be used to create asymmetric trades with a built in downside and unlimited upside. The leverage is already there, if you position size correctly based on the normal amount of shares you trade you will stay out of a lot of trouble with losing a lot of money.
  3. Options should only be sold short when the probabilities are deeply in your favor that they will expire worthless, also a small hedge can pay for itself in the long run creating a credit spread instead of a naked option with unlimited risk exposure.
  4. Understand that in long options you have to overcome the time priced into the premium to be profitable even if you are right on the direction of the move.
  5. Long weekly deep-in-the-money options can be used like stock with much less out lay of capital to capture intrinsic appreciation in the underlying stock.
  6. The reason that deeper in the money options have so little time and volatility priced in is because you are insuring someone’s profits in that stock. That is where the risk is: the loss of intrinsic value, and that risk is on the buyer of the option contract.
  7. When you buy out-of-the-money options understand that you must be right about direction, time period of move, and amount of move to make money. Also understand this is already priced in.
  8. When trading a high volatility event that potential price move will be priced into the option, after the event the option price will remove that volatility value and the option value will collapse. You can only make money through those events with options if the increase in intrinsic value increases enough to replace the Vega value that comes out. This is why it is so hard to make money when holding options through earnings, the move is already priced in and that extra value is gone the next morning the options open for trading.
  9. Only trade in options with high volume so you do not lose a large amount percentage of money on the bid/ask spread when entering and exiting trades. You have to find those few option chains that have the liquidity to trade with spreads measured in cents not dollars. A $1 price difference in the bid/ask spread will cost your $100 to get in and out of a trade on top of commissions. Also be aware that the best liquidity is in the front month at-the-money options and option chains get more illiquid as they go deeper in-the-money or out-of-the-money this has to be considered in a winning trade because you might have to roll the option to a more liquid contract. Most options chains can’t be traded due to the fact that they are just not liquid enough.
  10. When used correctly options can be tools for managing risk by limiting capital at risk exposure and capturing huge trends, used incorrectly they can blow up your account.

10 Trading Mistakes

  
  Education
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  1. Are you trading without a plan? Trading without a plan makes you emotional and a gambler.
  2. Do you ever trade too big for your trading account size? Big trades are bad trades for the emotional engagement and risk of ruin that they entail over the long term.
  3. Do you risk losing more if you are wrong than you will make if you are right? The biggest driver of profitability in your trading will be big wins and small losses. Big losses and small wins is a sure path to losing your trading capital.
  4. Have you traded without studying charts to see what has happened historically with similiar price patterns? If you do your homework you can make money understanding possibilities and probabilities from past patterns. Trading your own opinions will usually put you on the wrong side of the market. 
  5. Did you trade a system before you back-tested it?Or are you just trading blindly?
  6. Have you ever exited a trade due to fear instead of due to hitting your stop loss or trailing stop? The right exit is what determines your profitability and whether your win is a big one or your loss is a big one.
  7. Have you ever entered a trade becasue of greed without an entry signal? Chasing a trade after the trend is over is a great way to lose money consistently and quickly.
  8. Have you ever copied someone else’s trade not knowing their time frame or position size? Ultimately you have to trade your own system and your own method that matches your own personality and risk tolerance. Only you can make yourself profitable with faith in yourself and your method.
  9. Are you that person that loves to short during market up trends and miss a whole up move?The easy money is on the side of the trend in your time frame going against the trend is a great way to lose money.
  10. Are you that knife catcher that keeps going long at the worn time in a down trend? When everyone is exiting a market that is the worst time to be getting long as wave after wave of holders are leaving. 

Psychology & Risk Management For Traders

  
  Education
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PSYCHOLOGY

  1. I keep Blue Channels turned off while trading.
  2. I do not care about others opinions I care only about price and chart action.
  3. I do not try to predict, instead I trade in accordance with the chart.
  4. I am not trying to prove I am right I am trying to make money.
  5. I am not trading for ego gratification I am trading for money.
  6. I am not trying to be the genius who calls a top I am the trend follower who follows a trend all the way up until it ends.
  7. I admit freely to my losing trades along with my winning trades.
  8. I do not get emotionally attached to each price movement through out the day.
  9. I have faith in my rules, methodology and system.
  10. I understand it that it is the market conditions and not me that creates profits.

RISK MANAGEMENT

  1. I never add to a losing positions.
  2. I carefully control position sizing to limit risk based on volatility.
  3. I attempt to never lose  more than 1% of my capital on any one trade.
  4. I trade smaller when volatility is high.
  5. I sell positions with volatility stops when daily ranges double in the wrong direction.
  6. I have stale stops and sale positions that do not trend in four days after entry.
  7. I quickly sell losing trades when my stop is hit.
  8. I sell stocks when they close in the bottom of the days range.
  9. I never expose more than 6% of my capital to possible loss at any one time.
  10. Risk is priority #1, profits are #2.

Michael Lewis’ Flash Boys: A Wall Street Revolt -A Remarkable Read

  
  Education
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Michael Lewis has a spellbinding talent for finding emotional dramas in complex, highly technical subjects. He did it for the role of left tackle in American football in The Blind Side (2006), and for the science of picking baseball players in Moneyball (2003). In Flash Boys, he turns his gaze on high-frequency computerised trading in US stock markets.

In terms of sheer storytelling technique, Flash Boys is remarkable. High-frequency trading, although often in the news when things go wrong, as in the 2010 “flash crash”, is hard for a specialist to understand, let alone the average reader. It is as if a violinist, bored with the repertoire, opted to play Paganini right-handed as a challenge.

Lewis reaches a stark conclusion: US stock markets are now rigged by traders who go to astonishing lengths to gain a millisecond edge over their rivals. As the innocent investor presses a button to buy shares, they leap invisibly into electronic markets to profit from the order and thousands of others, siphoning off billions of dollars a year.

The rise of high-frequency trading (HFT) was encouraged by a regulation passed in 2005, which aimed to open large exchanges such as the New York Stock Exchange and Nasdaq to stiffer competition. The idea was to make trading fairer; it instead unleashed, in Lewis’s view and that of other critics, a tidal wave of algorithmic front-running by traders whose superfast connections to stock exchanges allow them to react to buying and selling before others can. (more…)

Warren Buffett’s Biggest Losses

  
Analysis, Education
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Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.” – Warren Buffett

A good starting point to gauge investment performance is to compare your results against a simple buy and hold portfolio.

While there are certainly ways to improve the performance of buy and hold, there are many more ways to make it much worse.  You have to determine if the effort and actions you take with your portfolio strategy are worth it when compared to this simple (but not easy) alternative.

Investors generally fare much worse than buy and hold so this is an important decision for the average investor to consider.

When you hear about the average long-term gains of 9-10% in the stock market you must remember that those returns contain every single type of market environment. That means high valuations, low valuations, high interest rates, low interest rates, high inflation, low inflation, bubbles, recessions, booms, busts and everything in-between.

It’s an all-inclusive number that contains the good and the bad. (more…)

6 One Liners For Traders

  
  Education
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  • Its psychologically comforting to construct a system that looks good in the past
  • Learn from your losses
  • Emotions do nothing for your trading
  • It’s just another trade out of the next 1000
  • System->Risk Management/Volatility Control->Trading Psychology
  • “You have to enjoy trading, because if trading is a source of negative emotions, you have probably already lost the game, even if you make money.”

5 Vital Sins of Trading

  
  Education
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Image result for 5 sinsHubris: A foolish amount of pride or overconfidence. No matter how good of a trader you think you are, the market is always bigger. You will not win an argument with its price action no matter what.

Fear: Cutting winners short because of unwarranted fear eliminates all the big wins. Being afraid to take a good entry creates loss of a potential profit. Thorough trading methodology study is required to trade confidently.

Ego: The desire to be right more than the desire to make money leads to losing a lot of money. The ego causes traders to hold losers far too long. The best traders are slaves to the market’s price action.

Laziness: Seeking to be given trades instead of doing the work to develop a system leads to failure. Trades only have meaning when they are executed within a robust system complimented by discipline and risk management.

Greed: The greedier a new trader is, the higher the probability and speed at which they lose their whole trading account. There is significant risk in going for trades with big position sizes, because the losses can be huge if when wrong.

Money is made in the market through self-discipline and trade management. If a trader does not manage risk and position sizing, their winning trades are meaningless because they will eventually give it all back. Without overcoming the sins of hubris, fear, ego, laziness, and greed, a trader is unlikely to make it at a professional level.

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