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Book Review -The Risk of Trading by Michael Toma

  
  Education
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 Michael Toma’s The Risk of Trading: Mastering the Most Important Element in Financial Speculation (Wiley, 2012)

If I had to choose the two key sentences in this book they would be: “Risk management is not limiting losses. It is the art of maximizing profits for a given optimal risk.” (p. 173) That is, contrary to commonly-held views, risk management goes far beyond placing stops or calculating position size. It also goes beyond the purely mathematical, even though it would still behoove traders to be familiar with the seminal works of Ralph Vince (The Mathematics of Money Management, 1992) and the many books and papers that followed in a similar vein.

Toma, a corporate risk manager and the author of Trading with Confluence, offers a simple, math-free analysis. (Well, here and there a spreadsheet comes in handy.) He is at his best when discussing how to track performance.

One recommendation that I consider especially sound is that the trader track opportunity risk. “Auditing ‘opportunity risk’ is equally as important as measuring your actual trades. … In all the risks associated with trading, I find opportunity risk, whether in the form of unexecuted trades or pretarget exits, to be the difference between traders who reach that much-talked-about top 10 percent in the profession and those who remain in the novice pool, struggling to keep their heads (and P&L) above water.” (p. 126) If you were presented with a valid trade setup in your plan and you sat on your hands, track that trade. Are you actually skilled at overriding your system or should you, as Toma argues, take advantage of every opportunity that your plan presents?

Toma recommends that every trader construct his own key performance indicator (KPI) dashboard. Keep it simple, sticking to five to eight measurable items initially. And keep it balanced in scope. “The indicators should represent a balanced monitoring synopsis of performance, compliance, and business metrics. A common gap in KPI programs is that it is completely dominant in trade result metrics. A measure that detects rule breaking is far more indicative of trading success than a KPI that measures current win percentage over a small time period.” (p. 133)

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Top ten reasons you know China has a financial bubble on its hands

  
Analysis, Economy, Education
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Edward Chancellor, author of the seminal book on financial speculation and manias “Devil Take The Hindmost,” is now turning his eyes to China.  He sees a number of red flags which point to excess in China.

Chancellor writes:

In the aftermath of the credit crunch, the outlook for most developed economies appears pretty bleak. Households need to deleverage. Western governments will have to tighten their purse strings. Faced with such grim prospects at home, many investors are turning their attention toward China. It’s easy to see why they are excited. China combines size – 1.3 billion inhabitants – with tremendous growth prospects. Current income per capita is roughly one-tenth of U.S. levels. The People’s Republic also has a great track record. Over the past thirty years, China’s Gross Domestic Product has increased sixteen-fold.

So what’s the catch? The trouble is that China today exhibits many of the characteristics of great speculative manias. The aim of this paper is to describe the common features of some of the great historical bubbles and outline China’s current vulnerability.

Everyone knows there is extreme levels of excess. The latest report from Andy Xie on local governments shows that governments are now depending on asset prices for revenue, much as they did in places like California during America’s housing bubble.

How can we identify a speculative mania? Chancellor says:

bubbles can be identified ex ante, as the economists like to say. There also exists an interesting, if rather neglected, body of research on leading indicators of financial distress. A few years ago, many of these indicators were pointing to rising economic vulnerability in the United States and other parts of the globe. Today, those red flags are flying around Wall Street’s current darling, The People’s Republic of China.

James Rickards thinks this is the greatest bubble in history. Even Sino-enthusiast Stephen Roach is pointing to a bubble in China. He just thinks the government will be able to prevent its dragging down the real economy.

That’s because Beijing was vigilant in preventing asset and credit bubbles from spilling over into the real side of the Chinese economy. This was very different from the Japan endgame of the late 1980s, where the confluence of equity and property bubbles led to a massive overhang of excess capacity.

Roach’s confidence sounds an awful lot like blind faith in the Chinese authorities to me – exactly the opposite of what Roach’s former colleague Andy Xie is saying.

Chancellor includes this blind faith in the 10 signposts of manias and financial crises (very reminiscent of Kindelberger, by the way).

  1. “Great investment debacles generally start out with a compelling growth story.”

     

    100% yes. Check.

  2. “Blind faith in the competence of the authorities.”

     

    See Roach’s comments above or read Goldilocks is not sleeping in America anymore; she’s now in China. Check.

  3. “A general increase in investment is another leading indicator of financial distress. Capital is generally misspent during periods of euphoria. Only during the bust does the extent of the misallocation become clear.” (more…)
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