Monday, October 16, 2006

Honorary veterinarian for a day

My veterinarian-student girlfriend, Crystal, and I were walking up to my apartment this morning when we both heard a scratching sound coming from a pinched closed gutter pipe running down the side of a nearby building. At first I didn't think anything about it, but it came unmistakably from the gutter pipe a second time. Crystal said, "that sounds like a squirrel trapped in the gutter." It sounded that way to me too, so we quickly devised a plan to free it from certain doom in that diabolical pipe. It gives me claustrophobia just thinking about it. The poor animal may have been in there all night, or perhaps days.

I grabbed my toolbox while telling Crystal where to find a pair of gloves for protection in case the animal became aggressive while we tried to free it. Our plan was to pull the bottom of the gutter open with my biggest pair of plyers.

Unfortunately we were forced to change our plan on two accounts. First, opening the bottom of the gutter would drop the animal right into a second drainpipe that went straight down into the ground, and second, the plyers were bending the pipe in ways that could have crushed the trapped animal. We used tape from my toolbox and a nearby piece of plastic to cover the hole in the ground below the pipe, but our makeshift lid crowded around the gutter that we needed to somehow manipulate open.

Crystal observed that the gutter was old and flimsy, so I asked her if she thought tinsnips would cut it. She said yes, they probably would. It was slow going, I was standing next to the building holding the pipe while she made small clips out of the bottom of the pipe. It was very noisy and traumatic for the animal inside, which we found out when it crapped on my tinsnips! It was bird poo, which was a relief because birds don't bite like squirrels might.

After quite a bit of careful cutting, Crystal was able to see feathers, and then a dangling leg on the left side of the gutter. We could hear it shifting itself inside the gutter. At that time we thought it was a good idea to cut away on the right side of the pipe to make sure we didn't accidentally maim the bird. Minutes later we paused to re-evaluate the next place to cut when a big red head poked out of the pipe and started looking around! We backed away and the bird wiggled out of the pipe, which we had cut in such a way that there were no jagged edges.

That bird jumped around on the ground for a minute, and then flew up to a bush to join a few other birds, and they all flew off. I don't know if those other birds were watching us save their mate, or just hanging out on some branches, but I felt pretty amazing when I saw our rescued bird take flight.

Crystal and I have been together for almost 5 years, and the whole time she's had her focus on becoming a vet but I never really knew what gave her the drive. Today was the first time I got to feel the gratification that comes with making a life-saving intervention for an animal, and I feel like I know Crystal a little bit better because of it. She wants to have the knowledge and position to do this kind of thing every day. I will never have that knowledge, but today was my chance to do it in a small way. I was so proud of what we did that she agreed it would be okay that I could be an honorary veterinarian for a day!

Wednesday, October 11, 2006

Watch lists, ads, and vendors

Jimmy, over at Trend Following with CANSLIM wrote a piece on trader watch lists that reflects my own opinion about bloggers posting stock watch lists. He says, "I sometimes find watch lists funny... Most people who post up lists will point out all the great stocks they posted up. 'If you bought X stock when I posted it, you would have a XXX% gain!' They don't mention the losses, 'If you bought X stock when I posted it, you would have had a margin call!'" Interestingly, a few people with ads on their sites are getting pretty defensive in the comments section of Jimmy's post.

There's nothing wrong with having ads, but realize that as soon as you put them on your site, you're more than just a trader, you're also vendor. Ads can make a site look more authentic, but they can also be a red flag. I know enough to filter out the good content from the bad, but there are a lot of impressionable people who visit our blogs and websites that don't.

I wonder if traders look at the ads on their own sites? Most of the ads I've seen on trading and finance related sites link to pyramid schemes or aggressive vendors that could be a mismatch for the reader, or worse, outright fraud. I would never dream of posting a link in the body of one of my blog posts to just about any ad destination I've ever seen based on the merit of its content. I don't believe in protecting people from themselves, but when they come to me to learn in good faith, I'm not going to point them in the wrong direction.

There's a relevant discussion going on over at Trader Mike's blog. Michelle says:
  • Other criticism directed at trading blogs is they do not say anything these critics do not already know, that you can get valuable information only if you are willing to pay, and if these bloggers were good at what they do, they wouldn’t be blogging. Apparently these critics have not considered perhaps the reason why a trading blogger writes is because he has something to write that has merit to someone, and he has a generous spirit, but nothing to sell — he is already making a good living.
I would disagree with the statement that blogs with ads aren't selling anything. Regardless of whether or not there are ads on a blog, I do feel that most highly read blogs add value because inevitably there will be readers who are being introduced to the content for the first time.

In the comments over at Jimmy's blog, No Doodahs points out a trader's cost of not being some kind of vendor:
  • If a "good trader" could make 40% annual and needs to take 10% off the top to pay for living expenses, or that same trader could make 40% annually and defray those expenses by having adverts and/or selling merchandise, which is smarter? Which will get that "good trader" retired faster? By the way, 10 years of 40% gives you equity that is twice as much as 10 years at 30%.
I guess my counterpoint is that if our hypothetical trader cares about the difference between having $7mil and $14mil at some fixed point in the far-away future, he would be better off managing accounts and collecting the fees and performance incentives over that time period.

About a year ago an old friend of mine had heard that I was knowledgable about trading. He called me up and started asking me very basic questions about options. I knew he was beating around the bush, and sure enough I found out what this was about. He asked if I would go with him to an Optionetics seminar, mentioning that he had 2 tickets. I told him not to even bother with it, that it was crap. He argued that he had went to the same seminar a few days ago and was interested. He wanted me to tag along and look for anything suspicious and share my general opinion about it. I agreed since it was only an hour long and I didn't have anything else planned that evening.

A few days later I arrived at the seminar. The hotel conference room was full of probably 30 people, with at least half looking like they had been invited in off the street to fill up seats. My friend warned me that the guy giving the seminar was a slick salesman, and as soon as I got a look at him I almost laughed at how slick he looked. As he pointed at slides and moved around on the stage, he kept rousing the audience and asking us rhetorical questions to invoke a peer pressure crowd response. It was obvious that many people in the crowd had practice with this sort of thing on Sunday mornings, and that slick guy worked it. He stopped looking at me when he would rally his audience because I wasn't joining the hype, and my friend was probably too embarassed to get into it like he probably would have if I wasn't there.

The worst part that sticks out in my mind was when this slick guy told everybody that people who bought stock were suckers. He claimed they had a 1 in 3 chance to make money because stocks could, A) go up, B) go down, or C) stay flat. These uninformed masses were just giving away their money because they only profited when stocks went up. If you took the optionetics course he was selling, you would learn how to make money no matter what stocks did.

This premise is completely false. I've won free lunches and all kinds of change from people by playing a similar game. It works like this: after buying in for a 3:1 jackpot payout, the buyer flips a coin and I flip a coin. The jackpot pays out if both coins land heads-up. There are 3 possible outcomes to this game, let's look at them for a $1 buyin:
  • Two heads land. I keep the buyin and give the $3 jackpot, so -$2 for me.
  • One lands heads and one lands tails. I keep the buyin, so +$1 for me.
  • Two tails land. I keep the buyin, so +$1 for me.
When negotiating the game, it should be pitched this way so as to represent a game of pure chance with 3:1 payout on 3 possible outcomes. However, the probability of the outcome with one coin landing heads and the other one tails is actually twice high as the probability of the other two outcomes, giving me an edge. People who buy US stocks usually have a similar edge: the market's natural upward drift. Unless, of course, they trade too frequently thus reducing portfolio correlation to market direction and large transaction costs to crowd out the edge, or fail to diversify enough for the edge to materialize.

So anyway, after the seminar, I spoke with my friend about all kinds of reasons I thought it was crap. But he still wanted to do it. Even after what I told him, he asked me to reduce the cost of the course by signing up with him and getting a two person discount! Unbelievable. I said, no way, and to watch me go verify these suspicions with the slick guy who gave the seminar.

I waited my turn to speak with him, and the first thing he asked me was, "So are you going to sign up today?" He was kind of smiling. As soon as I asked my first question, he stopped smiling. I asked him about the hedge fund he mentioned that was run by Optionetics founder, George Fontanillis. I pointed out that the hedge fund could potentially be on the other side of a lot of the trades recommended in the course, and how could I be sure that wasn't going to happen. You know what he told me? "I'm not even supposed to mention the hedge fund. That's all I'm saying." He was threatened, and my friend could see it by the way this slick guy was frowning at me. I wasn't going to let him off that easily though. I kept grilling him until he just stopped responding to my questions.

There's more to the story, but we'll leave it at that. The point of that story was to show that there are harmful vendors out there who are selling it as hard as they can to whoever they can. There are also curious and well-intentioned people like my friend, who didn't know enough to see that what was being sold at the seminar was just hopes and dreams. That kind of mistake can cost an aspiring trader years to make up for.

Monday, August 21, 2006

MNG chart

I haven't posted a chart in a while and I thought this one looked good enough to post. Notating it is left as an exercise for the reader.

Tuesday, August 08, 2006

Winning entry to the writing contest

This is the winning entry for the writing contest. As you can see, it is quite a production. Thanks to everybody who participated!


Risk management

By Terry Zink

“You get paid for taking risks.” This one phrase is critically important to understand if we want to make money in the stock market.

What do we mean when we say we get paid for taking risks in the market? I believe we can understand it thusly: buy before you are certain and sell before you are sure. To put it another way, our returns our better if we act before all uncertainty has cleared.

Risk and uncertainty are two terms that are often used interchangeably. When we say that we are paid for taking risks we are usually referring to uncertainty. Uncertainty is the probability that an investment we make will work out positively for us. If we make an investment whose outcome is uncertain, we will typically expect a higher rate of return. If the outcome cannot be predicted with a high degree of certainty then it makes sense to look elsewhere where the outcome is more predictable. However, if the potential payout is higher, then some investors are willing to overlook that uncertainty in order to maximize return.

Logically, it makes sense that the more uncertain the outcome, the more potential return we ought to expect. If we have to pay a price for uncertainty then we should expect to get more if it works out. In the bond market, long-term bonds have (or should have) higher rates of return than shorter term bonds. The reason is that longer term bonds ties up a person’s money for a longer period of time, and a lot of stuff can happen in that longer time period. It becomes more and more difficult to predict what might happen as the passage of time progresses. Thus, the price of tying money up longer is a higher rate of return.

In real terms, how might we quantify uncertainty? It is unfortunate that risk and uncertainty are often used interchangeably, for while risk is measurable, uncertainty is not. So, how might we go about measuring risk? In practical terms, I believe we can define risk as the most amount of money we are likely to lose in the case that trades or investments do not proceed the way we planned. For example, if we were to invest in a stock, we might define the maximum amount of money we will allow ourselves to lose is $500 before closing our position. We would then call this our risk, or to put it another way, we risk $500. If we invest in real estate, we might say that the most we will be willing to lose on the property is $10,000 before we sell. In either case, the amount we risk is the most we would be willing to lose before closing our position and cutting our loss.

Risk is closely correlated to reward. In all investments we must always ask the question “What is the risk/reward ratio?” The risk/reward ratio, conceptually, is evaluating how much money we think we can make versus how much money we will allow ourselves to lose. If we believe that our potential reward is considerably greater than our potential risk then we have a favorable risk/reward ratio and the investment is probably a good one. How favorable the risk/reward ratio ought to be depends on the individual investor, but in any event, it had better be less than 1.

Using this concept of defining risk, the phrase “you get paid for taking risks” might be better stated as “your payouts are better when you act before all uncertainty has cleared.” We use various tools to guide us in our decision about whether or not to act, including fundamental or technical analysis, or a combination of the two.

The risk/reward ratio is one of the most important ideas in investing, because an analysis of the risk/reward ratio often answers the question of whether or not a potential investment ought to be made. It also can help eliminate the uneasiness associated with uncertainty. When it comes to uncertainty in the market, an investor will often want to predict whether or not the investment will work out. By analyzing the risk/reward ratio the investor need not predict whether or not an investment will work out, he (or she) can weigh the facts and a decision will naturally present itself.

Let me create an example. Suppose an investor is trying to decide whether or not to take a position in a stock. They really don’t know if the stock will go up or down. Let us assume that the stock has been trading in a range between $40 and $50 per share for two years. The stock is now at $48 per share. Should the investor buy the stock? We know the stock usually hits $50 and bounces down, that means it has $2 to go before it probably turns around and trends down. There is not a lot of room on the upside, but plenty of room on the down side. We could only let the stock go down to $46 for a risk/reward ratio of less than 1. That is not a lot of downside room. A tighter stop might be $47 for two-to-one odds, or $47.50 for four-to-one odds, but that is not a lot room as stocks can fluctuate that much in a single day. Indeed, this is not a great risk/reward ratio. If the stock were trading at $41 or $42, we now have a lot of upside room and we can still set a $1 or $2 stop that gets us out. Note that in this case, we didn’t need to worry if the stock will break out of its trading range, the risk/reward ratio ruled out the first case but left the door open for the second.

What are some real life examples of taking risks in the market? One is taking action in a potential head and shoulders top before the change in trend has been confirmed. Figure 1 is an example of a stock in an uptrend, bouncing up along the trend line along subsequent rallies and pullbacks. However, at point 1, it pulls back and breaches the trend line it had always successfully held. It makes a successive rally at point 2 but fails to attain the high of the previous rally. At point 3, it closes below the low point of the preceding pullback. This is a confirmed change in trend from up to down. At that point, traders might decide to close their existing positions or go short on the stock.

Figure 1 - Confirmed change in trend

Note that we must wait for the stock to close below the previous pullback low. Is this the optimal time to close the position? While the trend has confirmed a change from up to down, we have given up a good proportion of our potential gain. After trading costs, commissions and slippage, waiting for consummation of the down move can wipe out a significant portion of our potential profit.

Instead, we might decide to go short around the peak of a right-shoulder in a potential head and shoulders top. If we can see that an uptrend has been violated and the successive rally fails to clear the high from the previous one, we can act before we are sure that the trend has reversed. All uncertainty has not cleared, the previous pullback support level has not been violated but the return will be greater if we capture as much of the move as we can. This is illustrated in Figure 2. The up trend has been violated at point 1 and the subsequent rally at point 2 has failed to carry up to the high of the head. At point 2 we have a potential head and shoulders top and we can take action by closing an existing position or going short. We do not know if the trend will be confirmed but our return will certainly be greater by acting sooner rather than later. We then minimize our potential loss by clearly defining how much we are willing to lose before we conclude we are proven wrong. We might incorporate some technical analysis that will prove us wrong, or use a volatility reversal against our position, but in any case, we manage uncertainty by defining our risk.

Figure 2 - Possible head and shoulders top

Another example is at the end of bear markets, fear is rampant and investors are hesitant to go long in the market for fear of losing more money. This is a justifiable fear; nobody likes to lose money and the reason we buy stocks is because we expect them to go up. However, even bear markets come to an end. There are numerous systems that produce signals to get back into the market, and the earlier we get into them, the better our potential gains. The problem is that hesitation can come into play for fear of the market reversing again and shaking us out of our positions, netting us another loss. We can wait for the market to provide us a clearer signal but by the time that occurs our potential returns have been reduced. Again, adding in commissions and trading fees, not to mention slippage, our potential returns are shrinking the longer we wait. We must act before we are certain, and we manage our risk by clearly defining how much we are willing to lose.

In trending markets, we must keep in mind that the longer a trend has been in existence, the closer it is to its end. Thus, we need to have faith in our market analysis when it is telling us to get back into the market and we then manage our risk to keep us in the game in the event we are proven wrong.

This illustrates the concept of minimizing our risk vs. managing our risk. Minimizing our risk would certainly guarantee the probability of a positive outcome but that outcome would be quite small. By comparison, managing our risk is accepting that we don’t know for sure how an investment will turn out, we accept that fact, but we go ahead and do the investment anyways because we can potentially make a substantial positive return; we will close that position if we lose money according to a predefined condition.

There are several systems of managing our risk, one of which is diversification. Diversification is the practice of investing in numerous different industry groups; when one industry group goes down the losses are offset by the gains in another. Thus, a large loss in one can be counter-balanced by another. Diversification is not limited to investing in a broad number of industry groups, however. A smaller concentration of industry groups may be invested in with a specific amount of total capital risked for each trade, say 1%. A method that concentrates in high performing industry groups but limits itself to a few individual positions manages risk by avoiding overexposure to a major downturn in any one group and protecting total trading capital. Indeed, the protection of initial capital is crucial to managing risk; it takes a larger proportional gain to make back what you lost. For example, if your capital drops 10%, it requires an 11% gain to break even. If your capital drops 25%, it takes a 33% gain to break even. Thus, selecting strategies that protect trading capital is a method of risk management that is imperative for any speculator to make use of. Note that we have not necessarily dispelled any uncertainty but we have minimized our potential loss if conditions move against us.

Of course, no system of risk management is perfect. Acting before we are sure has its downsides, as markets can quickly reverse with little to no warning. Sometimes the moves that we anticipate would happen don’t happen after all. Fundamental news changes can drastically alter the decisions we would have made had we had access to that news. If we buy a position in a stock and plan to get out if we lose 5% of our original position, that assumes that we actually can get out before the 5% has elapsed. What if we buy the stock and the next day the company declares bankruptcy and the stock goes to zero overnight? What if we are short the stock market and the Federal Reserve decides to cut interest rates from 5% to 1%? What if we buy a California-based home builder and the next great earthquake hits and California breaks off from the continent and submerges into the sea? Indeed, all of these sudden changes in market conditions can hurt us much more than we planned. Our risk management system breaks down.

But even in these cases, it is not as bad as it sounds. While these sudden changes are possibilities, they are not probabilities (except for perhaps a sudden change in policy from the Federal Reserve or political decisions by government). It is a possibility every day that we may get into a car accident but most people still drive cars to go to work. We can get food poisoning from contaminated food but most of us rarely think about this in the food we buy from the supermarket. They are possibilities but not probabilities. We make decisions based on the most probable outcome and take the necessary steps to minimize our risk. In the case of a car accident, we can fasten our seatbelts and buy cars with airbags. With supermarket food, we can buy canned goods and wash our vegetables. In the market, we can allocate only a portion of our trading capital to any one position and define our exit criteria. None of these will protect against the absolute worst case but it manages risk and, in this case, reduces it. It is a matter of taking steps to minimize the damage in the event that we what we don’t expect to happen, happens.

Risk management, then, does not involve eliminating risk but instead managing it by accepting what might go wrong and how to prevent damage that can occur. It is a matter of making intelligent decisions on how to allocate capital and taking action before certainty becomes completely known. Any mediocre trader can become an excellent trader by incorporating risk management into his or her methods.

Monday, August 07, 2006

Watch list for week of 8-7-06

If you look at the weekly charts of these stocks in addition to the daily charts it will become a lot more clear why I found them interesting. There appears to be long term bottoming patterns happening on a lot of them, but they aren't in the clear yet. I may enter small long positions in a few this week and add shares if they break out.

Also, it seems like the NYSE is getting all the action lately. Today it had far more new highs than the naz. Not really my kind of market, but it does show an underlying strength that gives me the incentive to place a few longs.

Tuesday, August 01, 2006

Breaking Off A Piece: Part 1

Here's the blueprint for one of the more interesting basic pyramidding campaigns that you can do in a stock. This is nothing original, I'm just throwing it out there for discussion because it is useful and the numbers work out nicer than many of the other variations.

The strategy can be used when two conditions exist: a) the stock is strongly trending up, and b) you want to own shares. For your campaign, you must identify up front the amount of "risk capital" for your operation. If your campaign is successful, you will have a block of stock, and have converted all of your "risk capital" back to cash for use in the next campaign.

Say we want to break off a $5k block of stock. For this specific campaign you will need 3 times that amount in risk capital, so $15k. After carefully identifying a good risk:reward entry point using your favorite technical analysis or tape reading, 1/3 of the risk capital ($5k) is committed.

If the stock moves in your favor 10%, commit another 1/3 of the risk capital ($5k). You will have committed $10k of risk capital and are carrying $10,500 of stock.

After the position moves in your favor another 10%, commit the final 1/3 of your risk capital. You will have committed the full $15k of risk capital and are carrying $16,550 of stock.

A limit order is placed to sell 3/4 of your shares 21% higher than your final entry. After the stock has advanced 21% from your final entry point, your position will be worth $20,025.50. If your limit order fills completely, you will have reclaimed your entire $15k of risk capital, and have a $5k block of stock.

At no point are you excessively exposing your capital to great risk. As the position moves in your favor, you will gradually be enabled to reclaim most or all of your risk capital if you stop out. If the position moves against you from the start, you will only take a loss out of 1/3 of your risk capital. What you have done is taken shares from people who are not managing the risk as well as you are. By managing risk in ways similar to this, a trader can break off quite a lot of stock over the years.

Here's a spreadsheet recap of the strategy:

Risk capitalPercentage multiplierPosition size

These numbers are just used as an example, there are all kinds of variations that can be used in different scenarios. A variation of this strategy can even be adapted for use by market makers to build inventory by adjusting the percentages way down.

Monday, July 24, 2006

Watch list for week of 7-24-06

The stock charts I looked at were pretty dismal this weekend, but I've listed the best ones I saw above.

I expect to be able to announce the winner of the writing contest this week. Although only one entry can win, I would like to publish all of the articles on this blog because each writer had a unique and insightful perspective.