DRAWDOWN VS. SYSTEM DEATH p. 20
SYSTEM TEST: The 4-percent model p. 34 INTERVIEWS: Vitaliy Katsenelson on active value investing p. 38
NIGHT AND DAY TRADING in the E-Minis p. 16
Ari Kiev on handling trading stress p. 44
TREASURIES AND INFLATION PROTECTION: What you see isn’t what you get p. 28 GOLD AND COFFEE on the run pp. 60, 60. 57
$4.95 U.S. / CANADA
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CONTENTS: MAY 2008 • VOLUME 9, NO. 5
®
TRADING STRATEGIES FOR THE FINANCIAL MARKETS
9
Trading Strategies Night and day in stock index futures Find out what the overnight futures action really portends for the next day session in the E-Mini stock index futures. By Active Trader Staff
13
System death: When good systems go bad Autopsies of two trend-following systems offer clues about when to abandon a losing strategy. By Christian Smart, Ph.D.
20
Advanced Strategies TIPS, treasuries, and insurance Do TIPS really have any advantage over regular T-notes T-notes and T-bonds? By Howard L. Simons
24
Trading System Lab The 4-percent model Testing suggests “classic” system still has legs. By Volker Knapp
In every issue…
3 Editor’s Note 4 Contributors 5 Letters 6 Opening Trades
39 ETF Snapshot
52 Global Marketplace
Volume, volatility, and momentum statistics for exchange exchange-traded -traded funds.
40 Stocks & Futures Snapshot Volume, volatility, and momentum statistics for futures and stocks.
International market performance performance..
58 Trading Resources New products, services, and books.
60 Trading Calendar 62 Key Concepts 64 Upcoming Events
1
www.activetradermag.com • May 2008 • ACTIVE TRADER
Contents continued Contact Active Trader: Editorial inquiries:
[email protected]
28 Active Trader Trader Interview Vitaliy Katsenelson Katsenelson:: Market skeptic
Comments, suggestions:
[email protected] For advertising or subscription information, log on to: www.activetradermag.com
This portfolio manager and author of Active Active Value Investing explains how to survive a possible long-term range-bound market. By David Bukey
34
Q&A Ari Kiev on trading stress and leadership
The Economy
The fact that trading is a high-stress profession is no
54
U.S. economic briefing
secret, but there’s more to
Updates on economic numbers and how
understanding it — and
the market reacted to them.
controllin contr olling g it -— than you might might think. By Mark Etzkorn
Trading Basics
56 38
41
The Face of Trading
The maxi world of mini futures A review of the wide range of mini futures
Brushing up profits
contracts available to U.S. traders.
By Active Trader staff
By Steven Graubart
Inside the Market
Trade Diary
By Jeff Ponczak
65
Catching a ride on the gold express.
Rogue trader shredded in wheat market
67
“Overbought” moment in the market offers a
MF Global trader racks up $141 million
selling opportunity opportunity..
loss in wheat futures gambit. By Chris Peters
Other stories: Department of Justice advocates new futures clearing structure • Coffee perks up to multi-year high • Tempers Tempers flare over Wall Street arbitration • Gold keeps teasing the $1,000 mark • Managed money • Global Global news • Quick scalps
2
www.activetradermag.com • May 2008 • ACTIVE TRADER
Editor’s NOTE
Historic times Thank goodness there’s no inflation — if there
H
were, the U.S.’s flaccid uman beings can adjust
currency would only
to just about anything.
And all this after the commodity “bull” had supposedly hoofed it south for retire-
To wit, the price of
exacerbate the
ment. Gee, thank goodness there’s no
crude oil: When our
problem, probl em, having fallen
inflation — if there were, the U.S.’s flac-
most important fuel source — a linchpin
cid currency would only exacerbate the
of the global economy — costs 10 times
recently to new lows
problem, having fallen recently to new
more than it did a decade ago and darn
against most major
lows against most major currencies.
near twice what it did a year ago, you have to marvel at our ability to recalibrate
One of the most laughable aspect of
currencies.
inflation tracking is that the official statis-
our psyches, and thus our economies, to
that can explain its surge the past year or
tics remove the “volatility” energy and
such a sea change.
so. Nonetheless, it seems hell bent on
food components from the so-called
But psyches are such fragile things
reaching the $1K mark, although one can
“core” inflation numbers. No, you
(just ask the stock market). At least our
only guess at the tragicomedy that might
wouldn’tt want to food and energy to wouldn’
cars haven’t increased tenfold in price.
unfold after it does so.
muddy the picture — who spends money
Oil’s one thing, but gold’s history-in-
The grains — when was the last time
the-making run is something else. For the
they were the “it” commodity sector? —
time being, we’re really dependent on oil
are picking up 2008 where they left off in
— it’s it’s pretty difficult to completely erase
2007 (including rice!); ditto for the rest
your carbon footprint, regardless of how
of the metals. And the soft commodities
much you might like to — but there’s no
— coffee, cocoa, and sugar — have got-
industrial or commercial purpose for gold
ten in on the fun, too.
3
on that stuff? Maybe gold’s rally isn’t so crazy after all.
Mark Etzkorn, EditorEditor-in-chief in-chief
www.activetradermag.com
•
May 2008
• ACTIVE TRADER
This Month’s ®
For all subscriber services: Active Trader Magazine P.O. Box 567 Mt. Morris, IL 61054-0567 • (800) 341-9384 • www.activetradermag.com Editor-in-chief:
Mark Etzkorn
CONTRIBUTORS
Howard Simons is president of Rosewood Trading Inc. and a
strategist for Bianco Research. He writes and speaks frequently on a wide range of economic and financial market issues. Dr. Christian Smart is a mathematician, cost analyst, trading systems devel-
[email protected]
oper, and part-time trader. He develops and sells trading systems through his Web
Managing editor:
site, www.drsmarttrading.com. Dr. Smart has a Ph.D. in applied mathematics and
Molly Flynn
[email protected]
Senior editor:
Jeff Je ff Po Ponc ncza zak k jpon jp oncz czak ak@a @act ctiv ivet etra rade derm rmag ag.c .com om
is the author of numerous technical publications in mathematics, reliability engineering, cost analysis, and investing. He has presented the results of his latest research both in the U.S. and abroad.
Senior editor:
David Bukey
[email protected]
Asso As soci ciat ate e ed edit itor or::
Chris Peters
[email protected]
Contributing writers:
Thom Hartle, Howard L. Simons, Marc Chandler, Keith Schap, Thomas Stridsman, Robert A. Green, Jim Ji m Kh Khar arou ouf f Editorial assistant and Webmaster:
Kesha Green Artt di Ar dirrec ecto tor: r:
Thom Hartle (www (www.thomhartle.com) .thomhartle.com) is director of marketing
for CQG and a contributing editor to Active Trader magazine. In a Trader magazine. career spanning more than 20 years, Hartle has been a commodity account executive for Merrill Lynch, vice president of financial futures for Drexel Burnham Lambert, trader for the Federal Home Loan Bank of Seattle, and editor for nine years of T of Technical Analysis Analysis of Stocks & Commodities magazine. Hartle also writes a daily market blog called hartle & flow (www.hartleandflow.com).
Laura Coyle
[email protected]
President:
Phil Dorman
[email protected]
Publisher, Ad sa sale les s Ea East st Co Coas astt an and d Mi Midw dwes est: t:
Bob Dorman
[email protected]
Ad sa sale les s West Coast and Southwest only:
Alliliso Al son n El Elliliss
Volker Knapp has been a trader, system developer, and
researcher for more than 20 years. His diverse background encompasses positions such as German National Hockey team player, coach of the Malaysian National Hockey team, and president of VTAD (the German branch of the International Federation Fede ration of Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc. (www.wealth-lab.com), which he is still running.
[email protected]
Classified ad sales:
Mark Seger
Jim Kharouf is a business writer and editor with more than 10 years of experi-
[email protected]
ence covering stocks, futures, and options worldwide. He has written extensively
Volume 9, Issue 5 Active Trader is published monthly by TechInfo, Inc., 161 N. Clark Street, Suite 4915, Chicago, IL 60601. Copyright © 2008 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. Annual subscription rate is $59.40.
on equities, indices, commodities, currencies, and bonds in the U.S., Europe, and Asia. Kharouf has covered international derivatives exchanges, money managers, ma nagers, and traders for a variety of publications.
The information in Active Trader magazine is intended for educational purposes only. It is not meant to rec- ommend, promote or in any way imply the effective- ness of any trading system, strategy or approach. Traders are advised to do their own research and test- ing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past perform- ance does not guarantee future results. 4
www.activetradermag.com • May 2008 • ACTIVE TRADER
LETTERS
Diary of a hedge fund manager
Oscillator coding
My name is Ali Meshkati. I am currently rebuilding after having my macro hedge fund “blow up” at the end of 2005. I was formerly ranked no. 1 in my field (http://trackrecordlive.com/wpcontent/uploads/2007/12/sp32-20031106-114131.gif) I started my hedge fund with $1 million in 2002 and by the beginning of 2004 had over $10 million under management in my fund and in private managed accounts. While being small relative to other funds, I was on the fast track until I became enthralled by my own success and broke every trading rule in the book — the same trading rules that led to my success for more than a decade in the markets. I started a Web site www.trackrecordlive.com that will serve as a trading diary during my attempt to climb back, illustrating the combination of capturing large gains in the markets with a newfound approach that controls volatility and limits risk to the absolute minimum. On the site I have taken the pen name “Captain Ahab,” which I felt was very fitting fitting given that that Captain Captain Ahab in the the book Moby Dick sought revenge on the whale that destroyed his ship. Similarly, the market destroyed my vessel and took my leg — now I am seeking revenge. The market is my Moby Dick. Unfortunately for me, I had to suffer a fall from grace before these lessons became ingrained within me as a trader. Now that they are, I think the lessons and insights will be extremely valuable to all.
I have tried to match the results displayed in “The Aroon oscillator” oscillator” ( Active Active Trader , March 2008) with an Aroon oscillator I've put into TC2007. The author uses five bars as the [look-back] period. Can you tell me the exact settings your staff used to get these results, please? StockCharts.com StockCharts.com says the standard setting is 25 bars, and TC2007 asks for a smoothing average time period. —Bob Baron We don't know what the “smoothing average time period period”” is; it might might simply simply be the term term the program prog ram uses for look-ba look-back ck period. period. You’ll You’ll have to contact the software vendor directly on that one. At any rate, the only parameter we’re familiar with is the look-back period — i.e., the number of bars used in the indicator’s calculation. This num- ber, of course, is modifiable. No look-back period is carved in stone, although default settings might be suggested.
—Ali Meshkati
Everybody is a star I am very inspired by reading “The Face of Trading” section and am requesting to submit a short excerpt from my trading history and experiences.. I am a self-taught riences self-taught trader who who has branched branched into options, options, curcurrency, and futures. I have established myself as my own trading entity part time as I transition out of full-time [work] to become a stay-athome trader. Please advise on how I can submit a request to be featured. —S. Biddle
We always want to hear from traders. You can send information to
[email protected] — be prepared to document your trading with brokerage statements!
ACTIVE TRADER •
May 2008
•
www.activetradermag.com
5
OPENING Trades
Stocks: Status quo — to the downside
Gold fever: 1,000˚ and…?
Confounding bull holdouts and
Gold spent most of the first half of March
traders looking for at least a bounce,
consolidating and teasing traders by
in March the U.S. stock market broke
approaching the $1,000 mark — twice
down below its February consolida-
rallying above $990 — before pulling Source: TradeS TradeStation tation
tion and positioned itself to make a
back into the $960s and $970s, and
run at the January low.
finally leaping up to $1,001.00 on March 13.
After selling off to 1,270 on Jan. 23, the S&P 500 index (SPX) bounced back nearly
In response to feverish speculation in
10 percent to 1,396 by Feb. 1. After that it moved sideways, eventually falling 8.3 per-
gold prices, Deutsche Bank recently
cent from the Feb. 27 high to the March 10 low below 1,273.
introduced three exchange-traded notes
The picture around the globe was equally bearish; few major equity markets gained ground in 2008 through mid-March. Reviewing exchange-traded funds (ETFs) based
(ETNs) to let traders make leveraged,
on country stock indices revealed one ETF — the iShares MSCI Taiwan Index Fund
inverse, or inverse leveraged bets on
(EWT) — that was in positive territory intraday in the 20 trading days up to March
gold.
10, but it eventually closed the day in the red. However, the market roared to the upside on March 11 in response to the Fed’s latest liquidity injection. ETF
Sym
+/-
iShares Silver Trust
SLV
35.29%
StreetTRACKS Gold Trust
GLD
21.30%
iShares COMEX Gold Trust
IAU
21.26%
DB Commodity Index Tracking Fund
DBC
19.52%
iShares FTSE/Xinhua China 25
FXI
-23.95%
PowerShares Golden Dragon USX China
PGJ
-26.24%
The two weakest international ETFs were mainland China-based: the PowerShares
Source: TradeStation
All three ETNs — DB Gold Double
Golden Dragon USX China and the iShares FTSE/Xinhua China 25 were both down
Long (DGP), DB Gold Short (DGZ), DB
around 25 percent.
Gold Double Short (DZZ) — track the
In terms of U.S. sectors, the one area of unequivocal strength was metals. Three of
DB Liquid Commodity Index-Optimum
the four ETFs boasting double-digit 20-day returns on March 10 were gold and silver
Yield Gold by various percentages. The
based, and the fourth was a broader commodity index.
short ETN attempts to mimic the index’s inverse (-100 percent), while the other two represent either 200 or -200 percent
Bonds and notes soar
of its performance. For coverage of gold’s current run, see
Interest-rate futures continued to climb
“Gold express may lose steam above
as stocks continued to fall. The March
$1,000” on p. 49. Trader staff Disclaimer: Some Active Trader members had long positions in gold when this was written in mid-March .
10-year T-note T-note contract (TYH08) topped 120 on March 10 before reversing the next day as stocks rallied. The contract broke out of a week-long consolidation and easily surpassed the 11905/32 January high. 6
Source: TradeS TradeStation tation www.activetradermag.com • May 2008 • ACTIVE TRADER
Euro tops $1.5000 for the first time
Futures volume sets new records
The U.S. dollar’s respite from the 2007 meltdown that culminated in late
If last year was any indication, 2008
November proved to be short lived.
should be another record year for futures
The euro/U.S. dollar pair
trading volume.
(EUR/USD) catapulted above 1.500 on
Spurred by increasing demand for
Feb. 27, pushing above 1.5400 by March 7. The same day, the U.S. dollar
many commodities and record prices in
index (DXY) broke down to a new all-
many markets, 2008 has gotten off to a
time low of 72.46.
better start than 2007. And according to data released by the Futures Industry
For more currency analysis, including statistics on what the euro has
Association (FIA), 2007 global futures
done when it has made similar moves
volume was up 28 percent over 2006,
in the past, see the free March issue of
with more than 15 billion contracts trad-
Currency Trader magazine (www.currencytradermag.com).
ed. The FIA’s numbers are based on volunSource for both charts: TradeStation
tary submissions from 63 exchanges in more than 30 countries.
Oil $100: The new $30? After a weak January Jan uary,, energy prices regained
Gas ETF hits the road
momentum mid-February to trade at record highs — fueled in part by the U.S. dollar’s decline.
The U.S. gasoline fund (UGA) was
Oil first traded above $100 on Jan. 3 before falling to $85.42 a barrel within three weeks.
launched by Victoria Bay Asset
April crude oil futures f utures (CLJ08) broke above $100
Management and the American Stock
again on Feb. 19, but another week passed before
Exchange on Feb. 27. Unlike other ETFs,
the contract closed above the $100 mark. Crude
which track the moves of selected com-
then cracked its inflation-adjusted high of
panies within the energy sector, UGA is
$103.76 on March 3, closed above $105 three
based on the price of near-month gaso-
days later, and jumped above $110 on March 13.
line futures (RB) traded on the New York Mercantile Exchange (NYMEX).
Following oil’s lead, gasoline and heating oil
Other energy-related ETFs that follow
futures also climbed to all-time highs. April gasoline futures (RBJ08) climbed to a historic $2.7556
Source: eSignal
NYMEX futures include the U.S. oil fund
per gallon on Feb. 20, and April heating oil
(USO) and the U.S. natural gas fund
futures (HOJ08) jumped to $2.9863 a gallon.
(UNG), which also follow near-month contracts. Alternately, Alternately, the U.S. 12-month
Tit for tat
oil fund (USC) tracks the 12 monthly crude oil futures contracts.
News that New York Governor Eliot Spitzer had been allegedly taped arranging a tryst with a call girl was met with cheers from the floor of the New York Stock Exchange. Spitzer had aggressively aggressiv ely prosecuted corruption on Wall Street in his previous job as New York attorney general. ACTIVE TRADER • May 2008 • www.activetradermag.com
7
Opening Trades
continued
Volatility hits grains Grain prices became more volatile in February as wheat, corn, and soybean futures soared. May wheat (WK08) gained 14.9 percent in February, hitting an intraday high of $13.494 per bushel on Feb. 27. After several limit-down moves, the contract fell 21.7 percent to $10.56 on March 4. May soybeans (SK08) climbed 17.6 percent in February before dropping 14.4 percent from its $15.864 March 3 high. May corn futures (CK08) followed a similar pattern, sliding 4.2 percent from its $5.472 high set on the same day. Corn futures had rallied 34.7 percent over the previous three months. And don’t forget the forgotten grain — rice. Although it’s the staple food of billions of people, rice futures are a fairly low profile market in the U.S. Nonetheless, the May contract (RRK08) rallied from 14.250 to 18.550 from January to March 11 — a 3-percent gain, and a new all-time high.
Source: eSignal
An aftertaste in coffee, sugar, and cocoa? Like most commodities, coffee and sugar prices continued to rally in late February. In early March, however, both markets declined roughly 15 percent from their recent multi-year highs. In January, prices of Arabica and Robusta coffee were at their highest levels in more than a decade as January exports fell 9.4 percent compared to last year. But May coffee futures (KCK08) dropped to $1.5145 per pound on March 7. (See “Java jolt: Something’s brewing in coffee” on p. 46 for analysis of the coffee market.) Sugar futures gained 20 percent in February as the May contact (SBK08) reached a high of $0.1507 per pound on March 3 before slipping 15.3 percent within a week. The cocoa market was hot in January and February as May cocoa futures (CCK08) climbed 36.5 percent. After topping $2,845 per metric ton on March 5, the May contract slipped 5 percent by March 10. Political turmoil, harsh weather, and disease have
Source: eSignal
weakened West Africa’s cocoa output as of late, driving prices to record levels.
King cotton
Exercise those options
May cotton futures (CTK08) climbed
Retail options traders gave up profits by failing to exercise certain call options just
13.4 percent in the first three days of
before a stock pays dividends, according to a new study published in the Journal of
March to reach a record high of $0.9286 per pound. But those heights didn’t last
Financial Markets. The article, written by professors at Vanderbilt and Indiana University, estimates
long as the May contract plunged 17.6
individual options traders ignored $491 million in unrealized profits from January
percent by March 11. Cotton’s early
1996 to April 2006, most of which was captured by market makers through dividend
March spike followed a bullish February
arbitrage, a strategy that profits when call option holders don’t exercise deep in-the-
in which it rose 20.76 percent - the
money calls just before a dividend is issued.
largest monthly gain since last summer and the fourth biggest monthly increase in 12 years.
Although transaction costs are one reason retail traders forego exercise, they don’t completely explain why all these profits were left on the table. For more options news, strategies, and analysis, go to www.futuresandoptionstrader.com.
8
www.activetradermag.com • May 2008 • ACTIVE TRADER
Trading STRATEGIES
Night and day in stock index futures Forget about whether the futures are up or down before the morning bell. Analyzing Analy zing the the entire entire range of of the night night session session and putti putting ng this infor informatio mation n in the context of the previous day’s price action sheds more light on what will happen in the upcoming day session.
BY ACTIVE TRADER STAFF
A
lthough the E-Mini S&P 500 (ES) futures trade
New York Stock Exchange and Nasdaq; and the night session,
nearly 24 hours a day, most traders divide the
which is when the three aforementioned markets are closed.
market into two sessions: the day session, which coincides with pit trading in the full-sized S&P
500 contract (SP) as well as the regular trading hours of the
FIGURE 1: UP DAY AND NIGHT
Financial news stations typically report whether the stock index futures are up or down before the open of the day session, with the implication that strength or weakness in the futures has some predictive value. Traders know, know, however, the relationship between the pre-market futures and the regular day session is foggy, at best: Strength or weakness implied by the futures may play out in the opening minutes (or seconds) of the regular session, or not at all. Are there any useful usefu l patterns between the overnight session and the day session? Rather than simply observing whether the futures are up or down immediately before the day session, let’s analyze how the night session responds to exceptional strength in the preceding day session, and whether the night session’s subsequent behavior has any predictive value for the following day session. To get started, let’s define the overnight and regular trading sessions.
Night and day The E-Mini S&P 500 trading session begins at 3:30 p.m. CT for one hour, at which point the Globex electronic market closes for its daily 30-minute maintenance period. At 5:00 p.m. trading resumes and the market officially closes Strong day and night sessions tend to precede further bullish price action. Source: CQG Integrated Client
the next day at 3:15 p.m. For the purposes of this analysis (and in keeping with common trader practice), the day session open is 8:30 a.m. CT, which matches the beginning of the regular trading day
9
www.activetradermag.com • May 2008 • ACTIVE TRADER
FIGURE 2: NIGHT REVERSAL EXAMPLE
for stocks as well as pit-traded futures. The day session’s close is 3:15 p.m., 15 minutes after the close of the NYSE and the Nasdaq. Accordingly, the “night” session encompasses all trading between 3:30 p.m. CT and 8:29 a.m. the next day. The study compares the day and night sessions from Feb. 1, 2007 to Jan. 31, 2008.
Strength and weakness patterns Now we need to classify the behavior in the different trading sessions as strong or weak. Our goal is to characterize the market’s behavior in the day session and in the night session, and determine if the relationships between these two sessions indicate anything about the next day session’s performance. Here are the rules for day sessions: 1. Large day sessions: If the day session’s range exceeds the average range of the most recent five day-sessions’ ranges, the range is considered large. 2. Up close vs. down close: If the large session’s close
Large up-closing day sessions followed by down-closing night sessions were often followed by selling the next day. Source: CQG Integrated Client
is in the upper third of its range, the session is considered an up session. If the close is in the bottom third of the large session’s range, the session is considered to be a down session.
Notice this is
not
a comparison of how the night session
closed relative to the previous day session, but a measure of where the night session closed (at 8:29 a.m.) within its own
Next, we’ll check whether the night session closes strongly or weakly:
range. The large day session and strong- or weak-closing day session definitions were chosen because these moves usually occur in
1. If the night session’s close is in the
reaction to news. The research then sought to determine when
upper third of its range, it is
the subsequent night session perpetuated or reversed the
considered an up session.
momentum of these sessions. For example, after a large up-closing day session, did the night session follow suit by closing in
2. If the night session’s close is in the lower third of its range, it is considered a down session.
the upper third of its range, or did it switch gears and close in the bottom third of its range? First, the study measured the result after large up-closing day sessions were followed by up-closing night sessions: the net
3. If the night session’s close is in the
(close-to-close) change for the next day session was calculated
middle third of the range, the
(i.e., the change from the previous day’s 3:15 p.m. close to the
session is considered neutral.
current day’s 3:15 p.m. close). continued on p. 1 1
ACTIVE TRADER • May 2008 • www.activetradermag.com
10
Trading Strategies continued
TABLE 1: DAY AND NIGHT SESSION CLOSE IN SAME DIRECTION 6/8
E-Mini S&P traded after these different scenarios.
Large up-closing day + up-closing night
Average 8.44
Median
Max.
Min.
7.125
25.50
-2.00
Test results re sults The first column in each half of Table 1
3/6
contains a ratio. The denominator is the
Large down-closing day + down-closing night
Average -1.71
Median
Max.
Min.
number of times the condition occurred,
-3.375
29.00
27.50
while the numerator is the number of
While rare, instances of both the day and the night sessions’ closing boded well for the next day’s trading. However, a weak day session followed by a weak night session resulted in ambivalent (but slightly negative) price action.
times the subsequent day session closed in the same direction as the previous day session. For example, the top half of Table 1 shows there were eight large up-closing day sessions that were followed by up-
TABLE 3: NIGHT SESSION REVERSALS 5/17
closing night sessions, and the next day session closed up six times after these
Large up-closing day + down-closing night
Average -4.5
Median
Max.
Min.
events (Figure 1). The average and medi-
-3.5
32.25
-39.25
an close-to-close gains were 8.44 and 7.125 points, respectively respectively,, with a maxi-
2/14
mum gain of 25.50 points a worst loss of
Large down-closing day + up-closing night
Average 8.69
Median
Max.
Min.
8.625
27.25
-14
The largest and most reliable moves followed night sessions that reversed the momentum of the preceding day sessions — especially when a large down- closing day was reversed by an up-closing night.
-2.00 points. Even rarer were combinations of large down-closing day sessions followed by down-closing night sessions (bottom half of Table 1). This occurred just six times, and the subsequent day sessions were split 50-50 between gains and losses. The
TABLE 2: NEUTRAL NIGHT SESSION CLOSES 7/14
average and the median close-to-close
Large up-closing day + neutral-closing night
Average 0.0536
changes of -1.71 and -3.75 points, how-
Median
Max.
Min.
0.5
24.75
-19.25
ever, indicate a slight negative bias. Table 2 shows what the E-Mini S&P did after large up- and down-closing day
5/13
Large down-closing day + neutral-closing night
Average 3.8654
sessions were followed by neutral night-
Median
Max.
Min.
session closes (those that closed in the
9.5
24.75
-36.25
middle third of the night session’s range).
Neutral night sessions after strong up-closing up-closing day sessions did not exhibit much of a connection to the next day session’s session’s trading, but a down-closing day followed by a neutral night session tended to be followed by bullish behavior. behavior.
There were more examples for these conditions than those in Table 1. When large up-closing day sessions were followed by neutral night sessions (top half
The next portion of the analysis studied the opposite scenario:
of table), the next day session was essentially neutral as well:
what happened after large down-closing day sessions that were
gains and losses were split 50-50 and the average and median
followed by down-closing night sessions. Table 1 details how the
moves were both less than one E-Mini S&P point — incremen-
11
www.activetradermag.com • May 2008 • ACTIVE TRADER
tal gains of 0.0536 and 0.50, respectively. After the 13 combinations c ombinations of large down-closing day sessions and neutral night sessions, the next day session closed lower only five times — an indication that a neutral night session in these circum-
Related reading What’s the time? Active Trader, August 2003. Do markets have intraday price characteristics short-term traders can use to improve their strategies? We crunch some numbers to find out when the market is moving and when it’s snoozing. “
”
stances means the selling pressure might have come to an end. The average and median close-to-close moves were 3.87 and 9.5 points, which indicates a degree of bullishness. The final part of the analysis measured what happened after a large up-closing or down-closing day session was reversed by a night session that closed in the opposite direction (Table 3). These patterns had more total examples than the previous scenarios and also had more interesting results. Large up-closing day sessions followed by down-closing night sessions occurred 17 times, and the next day session closed higher only five times — meaning the market reversed and closed lower 12 of 17 times (70 percent). The average and median close-to-close changes were -4.5 and -3.5 points, respectively respectively.. The combination of large down-closing day sessions reversed by up-closing night sessions exhibited the strongest tendency of all the scenarios in the analysis (Figure 2). The E-Mini S&P closed lower the next day session only two of 14 times, which
Note: This article is also contained in the “Thom Hartle Trading Trading Strategy and Analysis collection, Vol. Vol. 1: 2001-2004,” a discounted set of articles packaged packaged in a single PDF file. Stock index futures: Numbers you should know Active Trader, March 2007. Before you design a trading system or place a trade, you need to understand how the market you’re trading behaves. Arm yourself with stats you can build on. “
”
Deciphering intraday price action Active Trader, June 2007. Reanalyzing the E-Mini S&P 500 with recent price data finds subtle shifts in short- term behavior. “
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Following through in the S&Ps Active Trader, December 2003. Strong closes and large ranges are often interpreted as signs of potential follow- through, but this study unveils another way to find out what today’s market action says about tomorrow’s. (Note: This article is also contained in the collec- tion below.) “
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Stock Index Futures Trading Collection Stock index futures traders: Futures on the S&P 500, Nasdaq 100, Russell 2000, Dow Industrials, and other benchmark stock indices are among the most actively traded contracts in the world. This collection of 16 Active Trader articles covers a variety of techniques for analyzing and trading these instruments. “
”
You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
means the market reversed the sell-off and closed higher 86 percent of the time. The average and median
sider results statistically valid. Analyzing more data and confirm-
close-to-close moves were gains of 8.69 and 8.625 points,
ing the results of this study would help validate its conclusions.
respectively.
Nonetheless, having these tables available and tracking the day session and night session comparisons are helpful for any
Watch for night reversals
intraday stock index futures trader. Overall, it appears night ses-
The one caveat of this study is the low number of occurrences of
sions that reverse a previous strong or weak day session are the
each setup. Generally, 30 or more examples are needed to con-
most promising signals.
ACTIVE TRADER • May 2008 • www.activetradermag.com
12
Trading STRATEGIES
System death: When good systems go bad A look at two two troubled troubled strateg strategies ies shows shows how to spot spot problem problemss in a trading system before losses really pile up.
BY CHRISTIAN SMART, Ph.D.
N
ot every trade can be a winner, and most traders endure losing streaks at some point. But if your trading system is losing money, how do you know if it is suffering just a brief drawdown or if the system is on its last leg? When a trading approach or system becomes too popular, it often stops working. If, for instance, too many traders use a trend-following approach, which buys (sells) the market after it reaches new highs (lows), the technique will eventually fail — at least temporarily. Increased slippage will occur as more traders rush into the market at obvious breakout points, and countertrend traders will begin to exploit trend followers’ predictable behavior by taking the other side of the trade, and trends will then fade shortly after they develop. But trend-following systems aren’t dead. In his book The Way of the Turtle (McGraw-Hill, 2007), Curtis Faith describes the “system death” phenomenon as cyclical, meaning systems live, die, and are reborn depending on market 13
conditions, popularity, popularity, and other factors. When popular systems suffer an extended period of losses, traders abandon them; but those shunned systems eventually begin working again. Handling drawdowns is difficult, but paying close attention to a system’s performance offers clues about whether you
When a trading approach or system becomes too popular, it often stops working.
should continue trading or abandon the technique before you lose too much. Dissecting the performance of two simple trend-following strategies uncovers some early warning signs of system death. (For more details about the following systems, see “Key concepts”
on p. 62.)
Trade rules for simple breakout system The idea behind breakout systems is price will continue to move in the same direction after it exceeds the highest high or lowest low of the previous N days (or weeks, or minutes, etc.). If, for example, price climbs to a new 60-day high, it may trend even higher, and if price drops to a new 60-day low low,, it could c ould drop further. The breakout system used here is a simplified version of one traded by the “turtles” — Curtis Faith and other students of Richard Dennis and William Eckhardt in the early 1980s. To catch bigger trends, the strategy enters the market on a longer-term breakout signal (55 days) and exits on a shorter-term signal (21 days): 1. Ent Enter er long long on a stop when today’s high exceeds the highest high of the previous 55 days. 2. Exi Exitt long long on a stop when today’s low is less than the lowest low of the previous 21 days.
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3. En Ente terr sh shor ortt on a stop when today’s low drops below the lowest low of the previous 55 days.
FIGURE 1: UPSIDE BREAKOUT IN THE EURO
4. Exit short on a stop when today’s low is higher than the highest high of the previous 21 days. Money management: The system uses fixed-fractional position sizing, risking 0.5 percent of recent volatility as defined by the 15-day exponential moving average (EMA) of a market’s average true range (ATR) on each trade. To calculate position size, use the following formula:
The breakout system bought the euro after it rose to a new 55-day high on Nov. 21, 2006 and exited with a small loss six weeks later.
Position size = (CE*%V) / (MV*PV) where,
CE = current account equity %V = percent volatility (percentage of current account equity to risk per trade) MV = market volatility (15-day EMA of ATR) PV = point value Suppose the Nikkei 225 index futures (NK) 15-day ATR is 250 and the account size is $1,500,000: Current account equity (CE) = $1,500,000 Percent volatility (%V) = 0.5% Market volatility (MV) = 250 Position size (number of contracts) = (1,500,000 * 0.005) / (250 * 5) = 6 contracts. Figure 1 shows a long trade example in eurocurrency futures (EC) in November 2006. Price broke above the previous 55-day high on Nov. 21, 2006
and the system went long the next day. Six weeks later later the euro fell to a 21day low on Jan. 5, 2007 and the system exited with a slight loss. The system was tested from Jan. 1, 1986 to Dec. 31, 2007 on a diversified portfolio of 12 futures markets: British pound (BP), cotton (CT), gold (GC), copper (HG), Japanese yen (JY), natural gas (NG), Nikkei 225 (NK), gasoline (RB), sugar (SB), soybeans (S), 10-year T-notes (TY), and 30-year T-bonds (US). Each trade deducted $75 for slippage and commissions.
System death: Quick or slow and painful? Table 1 lists the 55-21 55- 21 breakout system’s back-test results from 1986 to 2007. Like most trend-following systems, it has a low win/loss ratio of 26 percent that is offset by a large ratio of average winners to losers (2.99). The system gained an average 10 percent per year from 1986 to 2004. By that point, however, trend-following systems
ACTIVE TRADER • May 2008 • www.activetradermag.com
had grown in popularity, and their effectiveness began to wane. Figure 2 (p. 16) shows the breakout strategy’s equity and drawdown curves. In 2004 it lost 26 percent and reached a new maximum drawdown of 37 percent, exceeding its previous maximum drawdown of nearly 40 percent in 2000. Let’s assume a system dies when it reaches a new yearly maximum drawdown twice as large as any previous year. By any definition, however, the system suffered a quick death in 2004 with this 12-contract portfolio. But remember: Performance tends to be cyclical, and systems can be resurrected after profitability improves.
Warning signs There were warning signs prior to the breakout system’s swift, yet temporary, demise in 2004. Figure 3 (p. 17) plots the strategy’s annual returns, which trended downward and fell below zero in 2002 — a red flag. continued on p.
15
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Trading Strategies continued
TABLE 1: BREAKOUT SYSTEM PERFORMANCE Profitability
Trade statistics
Initial balance:
$1,500,000
No. trades:
4,165
Net profit:
$4,170,514
Number of wins:
1,087
Number of losses:
3,078
Win/loss:
26.1%
Return on investment (ROI):
278.03%
Compound annual ROI:
6.22%
Max drawdown:
58.72%
Long wins:
583
Longest drawdown (in years):
6.28
Long losses:
1,543
MAR ratio:
0.11
Short wins:
Sharpe ratio:
0.23
Short losses:
Return retracement ratio:
0.20
Avg. $ win to avg. $ loss:
Sterling ratio:
0.34
Max. consecutive wins:
6 31
504 1,535 2.99
Std. dev. of daily percentage returns:
1.42%
Max. consecutive losses:
Value at risk:
3.51%
Days winning:
2,802
Expectation:
7.78%
Days losing:
1,767
Kelly:
0.01
Avg. days in winning trade:
Sum of up % / sum of down %:
1.07
Avg. days in losing trade:
Percent new highs:
29 5
2.66%
Although the system made money overall since 1986, it suffered a maximum drawdown of 59 percent in 2005, which no one would tolerate. Source: Mechanica (www.mechanicasoftware.com)
Legend:
Kelly: Percent of trading capital that should be risked on each trade to
Net profit: Profit at end of test period, less commission. Return on investment (ROI): Net profit divided by initial capital. Compound annual ROI: Compounded annual growth rate. Max drawndown: Largest percentage decline in equity. Longest drawdown (in years): Longest period the system is between two equity highs. MAR ratio: Annual return divided by largest largest drawdown. Sharpe ratio: Average return divided divided by standard deviation of returns returns (annualized). Return retracement ratio: Compounded annual growth rate divided by an average maximum daily retracement from a prior equity peak or subsequent low. Sterling ratio: Compounded annual growth rate divided by the average maximum drawdown, less 10 percent. Std. dev. of daily percentage returns: Standard deviation of system’s percentage gain or loss on each day. Value at risk: A measure of estimated losses over a specific time period. Expectation: Winning percentage multiplied by average winner minus losing percentage multiplied by average loser.
Studying the system’s monthly performance is even more illuminating (as shown in Figure 4). In March 2003, the system lost 20 percent, dropping almost twice as much as in any previous month. This plunge preceded a string of 12 losing 15
maximize total returns with a fixed-fractional money management strategy. strategy. Sum of up % / sum of down %: The percentage return of all winning days divided by the total percentage return of all losing days. Percent new highs: Percentage of days on which a new equity high is made. No. trades: Number of trades generated by the system. Number of wins: Number of winning trades. Number of losses: Number of losing trades. Win/loss: The percentage of trades that were profitable. Long wins: Number of profitable long trades. Long losses: Number of unprofitable long trades. Short wins: Number of profitable short trades. Short losses: Number of unprofitable short trades. Avg. $ win to avg. $ loss: Average winner divided by average loser. Max. consecutive wins: The maximum number of consecutive winning trades. Max. consecutive losses: The maximum number of consecutive losing trades. Days winning: Number of days in which ROI is positive. Days losing: Number of days in which ROI is negative. Avg. days in winning trade: The average holding time for winning trades. Avg. days in losing trade: The average holding time for losing trades.
months — March 2005 to February 2005 — and could have acted as an early warning signal to avoid the system, at least le ast temporarily temp orarily.. Had you spotted this weak performance, you might have avoided drawdowns
of 37 percent in 2004 and 55 percent in 2005. Finally,, contrarians may have noticed Finally how popular trend-following had become in 2004 — Michael Covel’s book Trend Following was published amid a great deal
www.activetradermag.com • May 2008 • ACTIVE TRADER
Mechanica Software code 'Exit Code IF LONG > 0 AND DAYSINTRADE = 1 THEN MEMORY[1] = COL2[1] - 4 * COL7[1] IF LONG > 0 AND DAYSINTRADE > 1 THEN SELLSTOP = MEMORY[1] IF LONG > 0 AND COL2[1] < COL3[1] THEN SELLOPEN
55-21 breakout system
SYSTEM = 1 COL1 = HIGH[55] COL2 = LOW[21] COL3 = LOW[55] COL4 = HIGH[21] COL5 = CLOSE COL6 = ATR[1] COL7 = EMA[COL6,15] SIZING[1] = POINTVALUE * COL7
(SYSTEM = 1: long code)
'Entry Code IF CLOSE[1] > COL1[1] THEN BUYOPEN IF CLOSE[1] < COL3[1] THEN SELLOPEN 'Exit Code IF LONG > 0 THEN SELLSTOP = COL2[1] IF SHORT > 0 THEN BUYSTOP = COL4[1] 80-20 MA crossover system
SYSTEM = 1 COL1 = CLOSE COL2 = EMA[COL1,20] COL3 = EMA[COL1,80] COL6 = ATR[1] COL7 = EMA[COL6,15] SIZING[1] = POINTVALUE * COL7 'Entry Code IF COL2[1] < COL3[1] THEN SELLOPEN
(SYSTEM (SYSTE M = 2: short code) code) 'Exit Code IF SHORT > 0 AND DAYSINTRADE = 1 THEN MEMORY[1] = COL2[1] + 4 * COL7[1] IF SHORT > 0 AND DAYSINTRADE > 1 THEN BUYSTOP = MEMORY[1] IF SHORT > 0 AND COL2[1] > COL3[1] THEN BUYOPEN
SYSTEM = 2 COL1 = CLOSE COL2 = EMA[COL1,20] COL3 = EMA[COL1,80] COL6 = ATR[1] COL7 = EMA[COL6,15] SIZING[1] = POINTVALUE * COL7
Money management code (both systems)
'Entry Code IF COL2[1] > COL3[1] THEN BUYOPEN
STARTDATE = 19860101 STARTDATE STARTUPCASH = 1500000 NEWCONTRACTS = (.005 * TOTALEQUITY) / SIZING[1]
You can copy this code at www.activetradermag.com/code.htm
FIGURE 2: BREAKOUT SYSTEM — EQUITY AND DRAWDOWN CURVES
of press coverage. When any particular method becomes popular enough to be the subject of an entire book, it is probably wise to avoid that technique for a while. In late 2005, performance improved; the strategy gained 3.5 percent in both 2005 and 2006 and climbed another 12 percent in 2007. While not spectacular, these modest returns may signal the renewed effectiveness of breakout techniques. Although drawdowns were still relatively large compared to previous periods, they were decreasing, another good sign. continued on p.
In 2004 this breakout system lost 26 percent, reaching a new maximum drawdown of 37 percent. The strategy’s strategy’s decline exceeded its previous maxi- mum drawdown of nearly 40 percent in 2000. Source: Mechanica (www.mechanicasoftware.com)
17
ACTIVE TRADER • May 2008 • www.activetradermag.com
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Trading Strategies continued
FIGURE 3: ANNUAL RETURNS
market. Conversely, Conversely, the system sells short when the short-term MA crosses below the longer-term one, because price is falling. In this example, a 20-day SMA represents the short-term moving average, and an 80-day SMA represents the long-term one. Trade rules: 1. Ent Enter er long long and exit short at the next day’s open when the 20-day moving average of closing prices rises above its 80-day moving average.
The breakout system’s system’s annual performance p erformance fell below the zero line in 2002 — a red flag.
2. Exi Exitt long long and enter short at the next day’s open when the 20-day moving average of closing prices drops below its 80-day moving average.
FIGURE 4: MONTHLY RETURNS
In March 2003, the system lost 20 percent, dropping almost twice as much as in any previous month — a warning signal to avoid the system, at least temporarily.
In 2007, for example, the maximum drawdown was less than 20 percent, about half of its maximum drawdown in 2004.
Moving average crossover system Another trend-following example is a moving average (MA) crossover system 17
that tracks two simple moving averages (SMA) with different lengths. A shorterterm moving average responds faster to price changes than a longer-term MA. When a short-term moving average crosses above its longer-term equivalent, price is rising, so the system buys the
This stop-and-reverse (SAR) system is always in the market as it goes long after closing short trades and sells short after exiting long trades. Table 2 (p. 18) shows the crossover system’s performance from 1986 to 2007, using the same futures portfolio used in the simple breakout system. This system has compounded annual gains of 13.96 percent, meaning it was more than twice as profitable as the breakout system. But the MA crossover system is always in the market, so it is exposed to more risk than the breakout approach. appro ach. Figure 5 shows shows the MA crossover system’s equity and drawdown curves. For years, the strategy performed well until it had two consecutive losing years in 2003 and 2004, falling 15 and 18 percent, respectively. respectively. That drawdown grew to 60 percent in 2005. It’s clear the system began to fail in 2003, and it bottomed out in 2005. This MA crossover system died for the same reason the breakout system did:
www.activetradermag.com • May 2008 • ACTIVE TRADER
Both strategies are trend followers. Again, however, warning signs emerged before performance took a nose dive in 2003. Had you examined the crossover system’s quarterly returns, you would have found a striking anomaly (see Figure 6). Prior to 2001, the strategy posted eight quarterly losses of more than 10 percent from 1986 to 2000. But in each case, a large quarterly loss was followed by either a gain or a smaller loss in the next quarter. In Q4 2001, the MA crossover system lost 11 percent, followed by a 16.5-percent loss in the next quarter — an unprecedented drop at the time. And this volatility spike preceded even larger losses. Although the strategy recovered to reach new equity highs in early 2003, it continued on p.
FIGURE 5: CROSSOVER SYSTEM — EQUITY AND DRAWDOWN CURVES
The MA crossover strategy performed well until it had two consecutive losing years in 2003 and 2004, falling 15 and 18 percent, respectively. respectively. But it recov- ered to hit new equity highs in 2006 and gained nearly 60 percent that year. Source: Mechanica (www.mechanicasoftware.com)
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TABLE 2: DUAL MA CROSSOVER SYSTEM PERFORMANCE Profitability
Initial balance: Net profit: Return on investment (ROI):
Trade statistics
$1,500,000 $26,801,140 1,686.74%
No. trades:
922
Number of wins:
272
Number of losses:
650
Compound annual ROI:
13.96%
Win/loss:
29.50%
Max drawdown:
59.76%
Long wins:
153
Longest drawdown (in years):
3.19
Long losses:
309
MAR ratio:
0.23
Short wins:
119
Sharpe ratio:
0.50
Short losses:
341
Return retracement ratio:
0.64
Avg. $ win to avg. $ loss:
Sterling ratio:
1.09
Max. consecutive wins:
10 20
3
Std. dev. of daily percentage returns:
1.62%
Max. consecutive losses:
Value at risk:
4.22%
Days winning:
2,921
Expectation:
19.38%
Days losing:
2,648
Kelly:
0.06
Avg. days in winning trade:
Sum of up % / sum of down %:
1.11
Avg. days in losing trade:
Percent new highs:
157 30
4.49%
The crossover strategy beat the breakout approach (Table 1) with a 13.96-percent compound annual ROI. But it also had a crippling 60-percent drawdown in 2005. Source: Mechanica (www.mechanicasoftware.com)
ACTIVE TRADER • May 2008 • www.activetradermag.com
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Trading Strategies continued
lost 33 percent in Q2 2004. This equity decline could have acted as a signal to avoid the system. Figure 5’s equity curve shows the crossover system rebounded to reach new equity highs in 2006 and gained nearly 60 percent that year.
FIGURE 6: QUARTERLY RETURNS
Life after death? It pays to study a system’s equity curve, because strategies tend to die after sudden and unprecedented drops in equity. If your strategy’s strategy’s performance drops quickly and sharply, sharply, you should s hould probably stop trading it, especially if those losses are unusually large. Also, pay attention to what strategies people are trading by monitoring blogs and message boards. The more popular a system is, the greater the odds it will fail. The good news: Dead systems often show new signs of life after they become
The MA crossover system lost 11 percent in Q4 2001, followed by a 16.5-per- cent loss in the next quarter. This equity decline could have acted as a signal to stop trading the system.
unprofitable and lose popularity. popularity. Both systems discussed here started to work again recently. recently. But don’t try to time this cycle too closely. Instead, wait for a
Related reading Controlling risk in a breakout system Active Trader , March 2008. “
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Back testing trade strategies without sizing your positions correctly can produce misleading results. This study of two related break- out systems tells the tale. Filtering Bollinger Band breakouts Active Trader, December 2007. “
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Does volatility make or break your strategy? Avoiding chop- py market conditions strengthens this system. Other articles: Trend strength indicator Active Trader , August 2005.
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This system expands and modifies basic moving average concepts that a market is in an uptrend when price is above a moving average (the magnitude of the trend being dependent on the length of the moving average), and the farther price is above the average, the stronger the momen- tum. Short-term WMA crossover system Active Trader , May 2004. “
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These buy and sell signals are based on crossovers of two weighted moving averages (WMA), which react more quick- ly to price moves than a simple moving average (SMA).
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For information on the author see p.
4 .
Moving average crossover Active Trader , July 2002. “
By Christian Smart:
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system to start winning again before trading it.
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This system goes long when a short-term and long-term moving average intersect. Building a better trend indicator Active Trader , May 2001. “
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How accurately are you defining the trend for your short- term trading? Here’s an alternative to traditional moving average techniques that will let you know when the market is in buy mode or sell mode. Breakout trading technique article collections (basic and advanced): The Basic breakout trading technique collection features 12
articles that explain and illustrate basic breakout concepts, including breakout trading strategies based on chart analy- sis and simple breakout-channel calculations. The tech- niques cover time frames from intraday to multi-week. The Advanced collection includes 10 articles that explain different trading systems, strategies, and concepts based on breakout trading. Also, there are special Trading System Labs that illustrate trailing stop and walk-forward testing techniques for breakout systems. You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
www.activetradermag.com • May 2008 • ACTIVE TRADER
Advanced STRATEGIES
TIPS, treasuries, and insurance Traders and investors who buy TIPS thinking they’re getting protection protection against inflation may be disappointed by a comparison to regular treasuries.
BY HOWARD L. SIMONS
T
raders are bettors at heart, so let’s make a collective bet right now: Very few traders see themselves as being in the insurance business. This is no doubt a matter of self-perception as the insurance industry is seen as dull and bureaucratic, while many traders view Animal House as the highest achievement of American cinema. The sentiment is reciprocated as well. Insurance mogul Warren Buffett takes potshots at derivatives wherever and whenever he can, even though his businesses are nothing but a giant derivative trade. But many of the concepts of trading — options trading, especially — are explained best in insurance terms. You pay a premium to insure against an event and you either forfeit that premium or collect if the event occurs. The concept extends to futures markets, too. A hedger who sells forward in a backwardated market or who buys forward in a carry market is exchanging a known loss against the risk of an even greater loss if he remains unhedged.
TIPS and inflation insurance
Protected Securities (TIPS) involves insurance against unexpected increases in inflation. The principal on TIPS increases (after a lag) along with the all-urban consumer price index, not seasonally adjust-
ed (CPI-U). Certain economists and many investors have become enamored with TIPS for two separate and disparate reasons. Economists like to think the difference in yield between conventional
FIGURE 1: TIPS BREAKEVEN RATES IGNORE REPORTED INFLATION
Comparing TIPS breakeven rates and the year-over-year change in the CPI-U (lagged two months) reveals the TIPS market has no predictiv predictive e relationship to reported inflation.
The market for Treasury Inflation20
www.activetradermag.com • May 2008 • ACTIVE TRADER
FIGURE 2: TIPS UNDERPERFORMED AS BREAKEVEN RATES RATES FELL
treasuries and TIPS – the so-called “breakeven rate of inflation” – is rich with information on the course of inflation. Investors like to think TIPS will protect them from the ravages of inflation. Both are wrong. Let’s take a look at the relationship between TIPS breakevens and the yearover-year change in the CPI-U, lagged two months; this is the best statistical fit between the two series. Stare at Figure 1 and search for how well the TIPS market predicts reported inflation. The proper conclusion is it does not. What about protecting investors against inflation? Let’s assume, for the sake of argument, whoever is selling TIPS to you is not a complete fool. Their expectations of inflation are going to be the same as the market’s, plus or minus a margin of error. How could they be otherwise, unless we assume TIPS sellers are endowed with superhuman forecasting abilities that the rest of us are denied? This implies TIPS should be priced against future inflation in an actuarially fair manner, similar to how other insurance rates are set. If this is the case, TIPS can provide protection only against unexpected inflation — i.e., that quantity in excess of the market’s expectations at the time. This implies properly priced TIPS should return no more than treasuries over time unless TIPS sellers underpriced the risk of future inflation. Figure 2 compares the total return of a Vanguard TIPS-based mutual fund to the Merrill Lynch index of 10- to 15-year treasuries, both re-indexed to June 2000. The two series matched each other closely until the Federal Reserve abandoned its rate-hike campaign in August 2006 (green vertical line). The implication here is investors began overpaying for inflation protection at that point. continued on p.
The total return of a TIPS-based mutual fund and the Merrill Lynch index of 10- to 15-year treasuries tracked each other closely until the Federal Reserve abandoned its rate-hike campaign in August 2006, implying investors began overpaying for inflation protection at that point.
FIGURE 3: TIPS AND NOMINAL TREASURY RETURNS AS A FUNCTION OF U.S. EQUITY RETURNS
There is significant evidence treasury treasury yields fall faster than TIPS yields, with no change in inflation expectations.
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21
Advanced Strategies continued
FIGURE 4: COMPARING REAL AND NOMINAL 10-YEAR HISTORIC VOLA VOLATILITY TILITY
Treasuries and crisis insurance
Before February 2003, TIPS volatility was often less than treasury volatility. Once the Fed abandoned its inflation-fighting campaign campaign and began flooding the markets with liquidity, the volatility situation reversed and TIPS volatility moved above treasury volatility after September 2007.
FIGURE 5: THE EMBEDDED CALL OPTION IN NOMINAL TREASURIES
The distribution of large positive returns for T-notes dwarfs that of TIPS. The price jumps that tend to occur on days with bad economic news or stock market declines have no counterpart in TIPS prices.
However, what if TIPS breakevens were not solely the result of inflation expectations, but were distorted by swings in treasury yields? We are all familiar with the flight-to-quality phenomenon — the rush into T-bonds for safety whenever the stock market does a face-plant on the pavement. If investors flee into conventional treasuries and do not flee at an equal pace into TIPS (why should they?), then treasury yields would fall faster than TIPS yields and the breakeven rate would fall — with no change in inflation expectations required. There is substantial evidence this occurs (Figure 3). Mapping the daily percentage changes of TIPS and treasury yields going back to February 1997 against the daily return on the broadbased Russell 3000 index shows the regression beta for treasuries is significantly lower than it is for TIPS (-0.0912 as opposed to -0.0507). Moreover, while the variance of treasury returns relative to TIPS returns is much larger when stocks rally, it is even larger when stocks falter. The flight-to-quality observed for treasuries does not exist in TIPS even though the two securities both bear the full faith and credit of the U.S. Treasury. There are three reasons for this. First, when stocks decline, inflation expectations can diminish. Second, the “short call option” on government honesty embedded in TIPS — you are at the mercy of the government telling you what their increased obligation to pay more as the result of higher inflation is — can increase and diminish the prospective return on TIPS. Third, because TIPS are taxed on their inflationaccrued principal much in the same way zero-coupon bonds are taxed on “phantom” income, the embedded short call continued on p.
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Advanced Strategies continued
option on that element of TIPS’ payoff function can increase and diminish the prospective return on TIPS. If we view T-bonds as insurance against a financial disaster such as the 2007 credit crunch, the comparison starts to come clearly into view. The impulse to buy insurance against an immediate loss of current investments is more powerful than the impulse to buy insurance against the CPI-U over a forward 10-year averaging period, is it not?
Insurance and volatility We can compare these relative impulses We by comparing the realized volatility of TIPS and treasuries. Prior to February 2003, TIPS volatility often was less than treasury volatility (Figure 4). The two measures converged but the deviations often were for TIPS volatility to be less than treasury volatility volatility,, especially during stock market downturns. The February 2003-July 2007 period was characterized by generally declining breakevens. Once the Federal Reserve abandoned its inflation-fighting campaign in favor of flooding the markets with liquidity in response to the credit crunch, the volatility situation reversed. Demand for inflation protection surged, and TIPS volatility moved above treasury volatility after September 2007. A second way of looking at the relative insurance demands of TIPS and treasuries is to map the distribution of their returns (Figure 5). The distribution of large positive returns for T-notes is much higher than expected and dwarfs that of TIPS. These price jumps tend to occur on days with bad economic news or stock market declines; there are no corresponding surges in TIPS prices.
A tip on TIPS
Deceiver on two grounds. The first is they let down economists who thought the derived breakeven rate gave them a free lunch – a perfect and frictionless window into inflation expectations. The second is they let down investors who thought the principal accrual gave them a free lunch – protection against inflation with no concomitant reduction in return.
Will any of this change c hange TIPS’ popularity with either group? group? Not a chance. Those who sell the promise of a free lunch can stay in business for years. Maybe we should talk about Social Security and company-paid medical insurance next. For information on the author see p.
4 .
Related reading Other Howard Simons articles: “Gold: Sound and fury, signifying nothing” Active Trader , April 2008.
Gold has burst to new highs as the U.S. stock market and dollar have tanked, but don’t believe the easy explanations about the yellow metal’s role as an inflation barometer or hedge. “Had enough of the dollar and stuff?” Active Trader , March 2008.
Analysis shows the relationship relationship between the dollar and commodity prices isn’t what most people think. “Oil prices and global petroleum inventories” Active Trader , February 2008.
Is an oil shock — and even higher prices — a real possibility? “Bonds and the first rule of trading” Active Trader , January 2008.
Where do we stand after a 25-year bond bull market? Get ready to adjust your T-bond and T-note strategies. “Howard Simons: Advanced Currency Concepts, Vol. 1” A discounted collection that includes many of the articles listed here. here.
You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
So there we have it: TIPS are the Great
23
www.activetradermag.com • May 2008 • ACTIVE TRADER
TRADING System Lab
The 4-percent model FIGURE 1: SAMPLE TRADE
BY VOLKER KNAPP
Market: Stocks. System concept: The 4-percent
model is a mechanical trend-following approach developed by Ned Davis and popularized in Martin Street . Zweig’s book Winning on Wall Street. It is based on weekly percent changes in the Value Line Composite index, also known as the Value V alue Line Geometric index (VLG). The model goes long when the market makes a 4-percent up move (on the assumption this indicates an uptrend and price will continue to
The system typically has long holding periods. In this case, a long trade that opened in January 2005 was still open more than a year later. Source: Wealth-Lab Pro 5.0
rally) and gets out (or sells short) during downtrends. The system tested uses the Value Line Arithmetic index (VLA) which, like the VLG, equally weights every stock in the Value
4 percent from the previous week’s value, and does the opposite when the index drops 4 percent. This method is comparable to the Donchian four-week break-
Line Investment Survey — 1,700 stocks across a broad spec-
out rule, which goes long when price exceeds the highest high
trum of capitalizations and industries.
of the past four weeks and goes short when price drops below
The VLA is constructed by calculating the ratio of each stock’s
the lowest low of the past four weeks. The essential goal of both
closing price to its previous close — e.g., if today’s price is
models is to avoid trading insignificant market swings while
52.64 and yesterday’s price was 51.22, the ratio would be 1.03
staying on the right side of the dominant market trend.
(52.64/51.22). All the ratios are summed and then divided by the total number of stocks in the index. (For more
This system takes long trades and stays out of the market during downtrends. Figure 1 shows a typical trade.
information about the VLG and VLA go to www.valueline.com/news/vlv070406ut.html.)
Strategy rules:
The most notable aspect of this technique is its simplicity; there is nothing to calculate except the weekly close of the VLA. The system generates a buy signal when the index rises at least 24
1. When the VLA rises 4 percent percent or more from from the previous week’s close, go long at the market www.activetradermag.com • May 2008 • ACTIVE TRADER
FIGURE 2: EQUITY CURVE
on the next bar. 2. When the VLA falls falls 4 percent percent or more from the previous week’s week’s close, exit tomorrow at market. Money management: Allocate 10
percent of equity per position. Because it would be impossible to take a 10-percent position in all 17 stocks in the portfolio whenever a buy signal is generated, trades are prioritized by lowest price (i.e., positions are established in lower-priced
The system outperformed buy-and-hold for the majority of the test period.
stocks first) to capture as many opportu-
Source: Wealth-Lab Pro 5.0
nities as possible. Starting equity: $100,000. Deduct
FIGURE 3: DRAWDOWNS
$8 commission and 0.10 percent slippage per trade. Test data: The system was tested on
Active Trader Trader Standard the Active the Standard Stock Portfolio, which contains the following 17 stocks: Apple Inc. (AAPL), Boeing (BA), Citigroup (C), Caterpillar (CAT), Cisco Systems (CSCO), Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), International Business Machines (IBM), Intel (INTC), International Paper (IP), J.P. J.P. Morgan Chase (JPM), Coca Cola company (KO), Microsoft (MSFT), Starbucks (SBUX), AT&T (T), and Wal-Mart (WMT). Data source: Fidelity The biggest drawdown occurred in 2002 in the depths of the post-2000 bear market. None of the other drawdowns exceeded 30 percent (top). Aside from a nearly two-year stretch that ended in 2001, the time between new equity highs was not excessive for a trend-following system (bottom).
(www.fidelity.com). Test period: February 1998 to
January 2008.
Source: Wealth-Lab Pro 5.0 continued on p.
2 6
ACTIVE TRADER • May 2008 • www.activetradermag.com
25
Trading System Lab
continued
STRATEGY SUMMARY Test results: Despite its simplicity simplicity,, the
4-percent model is a surprisingly robust trend-following strategy. strategy. The system outperformed perfor med buy-andbuy-and-hold hold by a small margin, producing a slightly higher net profit (240.9 percent vs. 233.9 percent), with annualized gains coming nip and tuck as
Profitability Net profit: Net profit: Profit factor: Payoff ratio: Recovery factor: Exposure: Total commission:
$240,916.71 240.92% 4.44 2.74 4.83 65.97% $1,568.00
Trade statistics No. trades: Win/loss: Avg. profit/loss: Avg. holding time (bars): Avg. profit (winners): Avg. hold time (winners):
98 64.29% 15.34% 168.54 29.91% 192.89
Avg. loss (losers): Avg. hold time (losers): Max consec. win/loss:
-10.90% 124.71 10/4
well (13.1 percent vs. 12.8 percent). However, a look at the equity curve (Figure 2) reveals the prolonged depth of the buy-and-hold drawdown in the after-
Drawdown
Max. DD: Longest flat period:
-24.45% 544 bars
math of the 2000 market collapse, which took the market almost six years to overcome. The 4-percent
The system made only a handful of trades (98), but the aver-
system, though, continuously set new equity highs after 2001.
age trade returned a whopping 15.3 percent. A high payoff ratio
Although the system’s equity line is quite ja gged, its risk is
(the absolute average profit divided by the absolute average loss)
considerably lower than buy-and-hold’s, with the typical draw-
of 2.7 and a high profit factor (4.4) are results you would expect
down lasting only six months to a year. The maximum draw-
from a trend-following system, but a 64.3-percent win rate was
down (which occurred more than five years ago) was less than
quite a surprise.
25 percent (Figure 3), compared to buy-and-hold’s devastating
The system’s most significant drawback is its excessive exposure; it spent nearly 66 percent of the time in the market. The
61 percent drawdown.
PERIODIC RETURNS % profitable periods
Max consec. Max consec. profitable unprofitable
Avg. return
Sharpe ratio
Best return
Worst return
Monthly
1.14%
0.53
15.50%
-11.15%
42.50
5
4
Quarterly
3.41%
0.48
28.14%
-14.55%
46.34
5
3
13.02%
0.48
43.61%
-8.60%
54.55
2
1
Annually LEGEND
Net profit — Profit at end of test period, less commission. Profit factor
for winning trades. Avg. loss — The average loss for losing trades.
Average profit of — Gross profit divided by gross loss. Payoff ratio — Average
Avg. hold time (losers) (losers) — The average holding time for losing trades.
winning trades divided by average loss of losing trades. Recovery fac-
Max consec. win/loss — The maximum number of consecutive win-
tor — Net profit divided by maximum drawdown. Exposure — The
ning and losing trades.
area of the equity curve exposed to long or short positions, as opposed
Avg. return — The average percentage for the period. Sharpe ratio
to cash. Max. DD — Largest percentage decline in equity. Longest flat
— Average Average return divided by standard standard deviation of returns (annualized).
period — Longest period, in days, the system is between two equity
Best return — Best return for the period. Worst return — Worst
highs. No. trades — Number of trades generated by the system.
return for the period. Percentage profitable periods — The percent-
Win/loss — The percentage of trades that were profitable. Avg. profit profit
age of periods that were profitable. Max consec. profitable — The
— The average profit for all trades. Avg. hold time — The average
largest number of consecutive consecutive profitable periods. periods. Max consec. unprof-
holding period for all trades. Avg. win — The average profit for win-
itable — The largest number of consecutive unprofitable periods.
ning trades. Avg. hold time (winners) (winners) — The average holding time
26
www.activetradermag.com • May 2008 • ACTIVE TRADER
FIGURE 4: ANNUAL RETURNS
average holding time was around 170 days, equivalent to buying around Christmas and selling just before Labor Day. This sluggishness is most likely a result of the system’s rudimentary exit strategy. Equity growth came in stages, and up years alternated with down years (Figure 4). There were six winning years and four losing years and the average annual profit was 13 percent. However, the losses were noticeably
There were four losing losing years, but none were consecutive and all were were smaller than the smallest winning year. year.
smaller.
Source: Wealth-Lab Pro 5.0
simplicity,, the system’s performance Bottom line: Despite its simplicity
hard times set in, as was the case before the declines of Sept. 11,
was clearly better than the overall market’s (represented by the
2001, late 2002, and 2005. But sometimes the system’s logic
buy-and-hold approach) in terms of both return and risk. The
fails, as it did in late 1999 and last year. Despite an advancing
system’s primary drawbacks were its relatively high exposure
market in 2007, notice how the system sat on its hands through-
and occasional tendency to miss some big moves.
out 2007; not a single trade was triggered. (On the other hand,
Generally, a pullback in the index will save the system before
the system did not get caught in the January 2008 meltdown.) One possible way to make the system more responsive
FIGURE 5: PROFIT DISTRIBUTION
would be to base the signals on recent troughs or peaks in the index. For example, a buy signal could occur when the VLA rises 4 percent or more from its most recent trough.
For information on the author see p.
4 .
Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see tested, please send the trading and money-management rules to
[email protected] . Disclaimer: The Trading System Lab i s intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee
Four stocks — AAPL, CSCO, HPQ, and SBUX — accounted for the majority of the system’s profits.
future results; historical testing may not reflect a system’s behavior in real- time trading.
Source: Reports-Lab
ACTIVE TRADER • May 2008 • www.activetradermag.com
27
Active Trader INTERVIEW
Vitaliy Katsenelson: Market skeptic Are Ar e stocks stocks stuck in in neutral? neutral? This pro professi fessional onal invest investor or and author claims the market has fizzled out.
BY DAVID BUKEY
V
italiy Katsenelson is a port-
Despite his gloomy outlook,
“I was using Bloomberg and taking
folio manager, author, and
Katsenelson is an optimist who believes
teacher who isn’t shy about
investors have many opportunities to
discussing the problems he
make money even if the stock market
degree in finance, Katsenelson earned an
remains volatile.
MBA and became a Chartered Financial
sees with stocks s tocks today. today. Price-to-earnings (PE) ratios and profit margins (earnings /
As a professional value investor,
sales) are at historically high levels and
Katsenelson searches for undervalued
will likely drop in the near future, which
stocks with earnings and dividend growth
means stocks could trade in a range-
— an approach well-suited for range-
bound market for years.
bound markets as stocks bounce around,
The trouble began when the last long-
but ultimately go nowhere.
term bull market ended in 2000 as the
Katsenelson, 34, grew up in the
S&P 500 index traded at 33 times earn-
Russian city of Murmansk, above the
ings — more than twice its 100-year
Artic Circle, and emigrated to the U.S.
average of 15.2 (on a one-year trailing
with his family in 1991 after the Cold
basis). Although PE ratios have dropped
War ended. His family settled in Denver
somewhat over the last seven years,
where he attended the University of
Katsenelson thinks they will fall further
Colorado.
because stocks are still expensive by his-
In college, Katsenelson took a part-
Finance 101, and it just clicked,” he says. After graduating with a bachelor’s bachelor’s
Analyst (CFA). Katsenelson’s recent book Active Value Value
Investing: Making Money in Range-bound Markets (John Wiley and Sons, 2007) digs deep into historical fundamental data to show how high PEs drag down stocks, while low PEs often give them a boost. All of his claims come from analyzing analyzin g up to 200 years of price and earnings values. Although he has a long-term market outlook, Katsenelson’s timing couldn’t have been better. He finished Active Value Value Investing months before the housing bubble popped and the credit market seized
torical standards. And when PE ratios
time job at Investment Management
up, but its premise has been surprisingly
slide, stock returns suffer because that
Associates, building a database for the
accurate as the S&P 500 has declined 17
decline cancels out any positive effect of
firm. He then began executing trade
percent from its Oct. 11 high (as of
earnings growth.
orders and became fascinated with stocks.
March 6).
28
www.activetradermag.com
•
May 2008
• ACTIVE TRADER
FIGURE 1: A FALLING PE RATIO KILLS GROWTH
The book’s first section explains how
including TheStreet.com,
stocks’ current dilemma resembles the
MarketWatch.com, MarketW atch.com, and an d
beginnings of the three previous secular,
Minyanville.com.
or long-term, range-bound markets of the
In mid-February mid-Februar y, Katsenelson
past century, each of which lasted 13 to
spoke with us about what’s in store
18 years. The remaining chapters define
for U.S. stocks and the themes of his
the tenets of value investing, describe
book.
how to customize it for range-bound markets, and illustrate how valuation tools such as discount cash flow (DCF)
AT:: AT
Why do you think the U.S.
analysis can help you buy and sell stocks
stock market is in a range-bound
profitably.
market right now?
In the hands of a less-talented writer, these topics might seem dry or tedious,
VK:
First, I’m referring to long-term,
but Katsenelson’s enthusiasm is infec-
secular markets — more than five
tious, and his discussions are filled with
years. The long-term cycle has many
colorful anecdotes and self-depreciating
cyclical periods in it. The last one
humor.
lasted 16 years (1966-1982 ) and included five cyclical bull markets,
“
In previous
five bear markets, and one rangebound market. In my book, I distinguish between
range-bound
bear and range-bound markets, which is a huge difference. Both start at high
markets, high-PE
valuations, but during long-term bear
stocks significantly
markets, economic growth remains
Source: http://contrarianedge.com
negative. It’s a good bet the U.S economy is resilient, and the market will
underperformed
Wal-Mart’s price hasn’t changed much since 1999 because two factors are working against each other — earn- ings climbed 300 percent, but its PE ratio declined from 44 to 16.
AT:: AT
So PE ratios are too high?
recover from this cyclical decline. But if
”
low-PE stocks.
you don’t think that’s true, then it’s a bear
VK: Yes.
market.
derived from two sources — price appre-
If I had to assign probabilities to the
The return from a stock is
ciation and dividends. In the long run,
These days, Katsenelson works as a
type of market we have ahead of us, I’d
however, price appreciation can be
vice president and partner for the same
say 2 percent (bull), 20 percent (bear ), ),
explained by earnings growth and PE
money-management firm where he start-
and 78 percent (range-bound).
contraction or expansion.
ed nearly 12 years ago. He also teaches
For a secular bull market to develop,
When the stock market moves, that
classes on practical equity analysis and
you need average — not great — eco-
movement can be explained by three fac-
portfolio management at the University of
nomic growth, which is a misconception.
tors — earnings, PE changes, or a combi-
Colorado at Denver’s Graduate School of
Stocks’ PE ratios also need to expand, but
nation of the two. At the end of bull mar-
Business. In addition, Katsenelson occa-
PEs must expand from a low base.
kets, stocks’ PE ratios are very high. If
sionally writes articles for the Financial
Times, Barron’s , and several Web sites ACTIVE TRADER •
May 2008
•
www.activetradermag.com
you assume economic growth remains continued on p.
3 0
29
Active Trader Interview continued
Is that what you meant when
constant, then investors are willing to pay
AT:: AT
more for the same growth.
you wrote in in Active Active Value Investing Investing
In 1999, for example, Wal-Mart (WMT ) traded at 44 times earnings. In
that range-bound markets are brutally toxic to high-PE stocks?
faster too. You can’t really compromise on that one. Next, the balance sheet is extremely
the past eight or nine years, WMT hasn’t
important, because you want a financially
gone anywhere, while earnings have
strong company. The economy is either in
tripled at the same time. Two factors are working against each other — earnings climbed 300 percent, but the PE ratio declined from 44 to 16.
“
Looking at numbers
its PE contracted. Both forces worked
environment, accessing capital markets, financing your debt, and borrowing
without thinking
Wal-Mart didn’t didn’t go anywhere because becaus e
recession or on the brink, so in today’s
money becomes a privilege.
”
is dangerous.
against each other to create a range-
AT:: AT
bound market (see Figure 1, p. 29).
Has that really changed in the
past six months? VK:
Exactly. But if Microsoft (MSFT ) was
VK: Yes.
During an economic expansion, exp ansion,
Because earnings were rising
founded in 1966, it still would have done
companies consider access to capital mar-
and the PE ratio was dropping, price
well, because it had an incredible growth
kets as a birthright. If a company needs
didn’t go anywhere?
rate that was sustained for 30 years. It
money, they’ll get it. But during economic
wouldn’t have performed as well as it did,
contractions, banks are more stringent
though. thoug h. If you think you’ve you’ve found anoth-
about lending.
AT:: AT
VK:
Exactly. If you think Wal-Mart’s
earnings will grow at an average rate,
er company like Microsoft, then buy it.
then you need to subtract PE contraction
But realize that for every Microsoft, there
money becomes an important competitive
from what WMT earns. Therefore, its
are a lot of Ataris — companies that
advantage in itself. If a company can’t
stock returns won’t be high.
failed.
borrow money, money, its value valu e drops. And if you
In the book, I examined the 1966-82
can borrow money, money, you can probably buy
range-bound market and measured how stocks with different PEs performed. I
These days, the ability to borrow
that company for 20 cents on the dollar. AT:: AT
In your book, you mention three
divided S&P 500 stocks into five quin-
main criteria for a good stock in a
tiles, according to PE. Then I tracked per-
range-bound market — quality quality,, valua-
formance of those stocks many times —
tion, and growth. In this environ-
problems in the short-term credit mar-
1966-82, 1968-82, and so on.
ment, it’s tough to find stocks that
kets — commercial paper — in
AT:: Am AT
I correct in assuming the
meet all three t hree components perfectly. perfectly.
August 2007 were a big deal? Short-
stocks and held them for different periods
When should you compromise, and
term debt really is essential to a com-
— 16 years, 14 years, 12 years, etc.?
how can you find stocks that meet at
pany’s survival, right?
High-PE stocks significantly underper-
least two of your guidelines?
What happened if you bought high-PE
formed low-PE stocks. Even if a company
VK: Absolutely Absolutely..
The first element of a quality stock
Companies that tha t have
grew earnings at an above-average rate, its
VK:
PE ratio dropped at a much faster rate,
is a sustainable competitive advantage,
every month. But at some point, the debt
which killed the benefits from higher
which acts as an electric fence around a
matures, and they must refinance it.
growth.
company’s cash flows. And if the compa-
[Commercial paper] matures every 30
ny is growing at an above average rate, it
days. In good times, refinancing was an
also guarantees those cash flows will grow
automatic process, but not now. now.
30
debt have to make an interest payment
www.activetradermag.com
•
May 2008
• ACTIVE TRADER
When picking stocks, make sure the company has a strong balance sheet and high free cash flow, so they can borrow money in any environment. Or even bet-
“
I love to buy stocks ”
that analysts hate.
ter — select stocks of companies without
(profits/sales) were above average and will likely drop, reverting to their long-term average. Yesterday, Yesterday, I calculated which sectors have those vulnerable higher profit margins — energy, energy, materials, industrials,
debt. I love companies with no debt and a
promises. Make sure management isn’t
technology,, and financials. Therefore, if technology
lot of cash, because it’s tough to go bank-
focusing only on short-term performance
you own stocks in those sectors, try to
rupt.
and making compromises to please Wall
normalize their earnings.
Free cash flow is the cash remaining after a company has paid for its ongoing
Street. Management should have enough self-
expenses and future growth. Companies
confidence to be honest and acknowledge
can do great things with free cash flow —
when they make mistakes. If you don’t
buy back stock, pay dividends, and buy
admit mistakes, then you will probably
VK:
their competitors for pennies on the dol-
ignore problems, which will only get
Express ( AXP AXP) a couple of weeks ago,
lar, if the opportunity arises. However,
worse. Warren Buffet is honest and admits
which reported 2007 earnings per share
Microsoft spent billions of dollars invest-
when he makes mistakes, which is why
(EPS) of $3.38, adjusted for one-time
ing in companies in different industries
people respect him so much.
items. To normalize earnings, I noticed
such AT&T (T ) in the 1980s and 1990s, a stupid move.
Look at how much stock management
AT:: AT
How do you normalize earnings?
For example, I analyzed American
credit-card defaults were at an all-time
owns. If they own a great deal of stock,
low of 3.3 percent. Going forward,
Also, a company that generates a high
their interests are aligned with yours. But
defaults will increase as they revert
return on capital (ROC ) has a couple of
if they own a small portion of the compa-
toward the mean. Instead of 3.3 percent, I
advantages. First, if it has had a high ROC
ny, they could run it into the ground and
used 5 percent, and earnings dropped to
for years, and you can project into the
move on.
$2.60 instead of $3.38.
future, then it probably has a sustainable
Then, I used earnings of $2.60 to cal-
competitive advantage, which is great. And a high return on capital means earn-
culate AXP’s value. The point is to adjust AT:: AT
It seems there aren’t any short-
ings growth is cheaper, because the com-
cuts. For instance, you shouldn’t pick
pany isn’t capital intensive. Finally, it indi-
stocks based on just one or two vari-
cates the company has high free cash
ables, simply by screening for stocks
flow.. All those numbers are interrelated. flow
with low PE or price-to-book-value ratios, right?
those earnings for potentially lower profit margins.
AT:: AT
In your book, you say investing is
often an ambiguous exercise. Will you elaborate on that statement?
AT:: AT
Regarding the three dimensions
VK: Yes.
Looking at numbers without Let’s discuss discounted cash flow
of a good stock, quality seems to be
thinking is dangerous. Some stocks trade
VK:
the most important, but also the most
at low PE ratios for the right reasons. If,
analysis, which tries to estimate what a
subjective aspect, right?
for example, you scanned for low PE
company will earn in the future. Then,
stocks last year, a lot of home-building
you choose a discount interest rate to
and financial stocks would have
convert future cash flows into today’s
thing. Especially management, which is
appeared. But when home builders trade
money. By definition, that’s what a com-
probably the most subjective component,
at low PEs, they are expensive, because
pany is worth — the core of all funda-
but it makes a huge difference. Listen to
their earnings are at a cyclical high.
mental analysis.
VK: Yes.
It’s difficult to quantify quan tify every-
conference calls and be a skeptic. When management speaks, they make certain ACTIVE TRADER •
May 2008
•
I recently wrote an article for Barron’s arguing that companies’ profit margins
www.activetradermag.com
But you make a lot of assumptions. continued on p.
3 2
31
Active Trader Interview continued
Let’s say I crunched the numbers
FIGURE 2: A CONTRARIAN VIEW OF NOKIA
prescription drugs. And their
for a result of $10.70, and that
stocks declined over a two-month
stock trades at $10 today. today. The
period.
problem is most analysts would
If you examined the news, it
claim the company is $0.70
sounded horrible. And if you rely
undervalued, but I made so many
on headlines to invest, that would
assumptions to derive that num-
have forced you to sell either
ber, you can’t be that specific.
stock.
Instead, the company is fairly val-
However, you need to quantify
ued, because if I change the
the impact of bad news. Most
assumptions slightly, slightly, I’ll get a dif-
investors didn’t realize 95 percent
ferent value.
of transactions at Walgreen’s were
A lot of fundamental-analysis fund amental-analysis
paid by insurance companies.
tools act like a shotgun, not a
Therefore, WMT’s WMT’s plan didn’t
sniper rifle. When I value compa-
affect CVS or WAG much, because
nies, I look for a general value,
it only influenced customers who
and I have no delusions about a
paid for drugs directly — five per-
company’s exact worth. Many
cent. If you used common sense,
analysts try to calculate exact
you would have realized investors
numbers, but that’s nearly impos-
overreacted when they sold CVS
sible. Precise numbers can give
and Walgreen’s.
investors a false sense of security. Try to understand what’s driving the value in each company. You can calculate discounted cash
Another example is Nokia
In 2004, Nokia looked cheap to Katsenelson who thought its loss of U.S. market share was overblown. Its price tripled within three years.
(NOK ). ). In 2003 and 2004, its stock was beaten down because it
Source: eSignal
was losing market share in the
flows in about five minutes. You just need to find operating cash
U.S., which had been 15 percent Earlier, you mentioned the impor-
of their sales. By 2004, the U.S.
flows, take out capital expenditures, and
tance of being a skeptic when invest-
dropped to just 7 or 8 percent of their
determine the right forecasting period.
ing. How can that mindset help
sales.
AT:: AT
The key is to use your own assump-
investors find good stocks?
tions to determine a company’s value with AT:: AT
You don’t want to look too far
VK:
First, you need to distinguish
discounted cash flow analysis. This tool is
between a good company and a good
handy, because you can plug in lower
stock. A good company meets the quality
assumptions for growth. Even if you
and growth dimensions, while a good
assumed Nokia would grow at a slower
example, American Express has such a
stock appears when you can buy it at a
rate, it was still worth more than its stock
strong brand name, which creates a
perfect margin of safety (a certain percent-
price of $12 in 2004.
strong competitive advantage. I feel com-
age below its fair value, determined by DCF analysis). Investors often focus more on the company than its stock, which creates opportunities. Two Two years ago, CVS Caremark (CVS) and Walgreen Co. (WAG) were beaten down because Wal-Mart
And since 2004, Nokia has tripled
announced its plan to introduce generic
(see Figure 2).
out, right? VK: You
can with some companies. For
fortable looking 10 years in the future — AXP will still be in business, making makin g more money. But with companies such as Blockbuster (BBI) or NetFlix ( NFLX ), ), who knows?
32
If you asked “what would happen to NOK’s sales if it lost U.S. market share completely — from 8 percent to zero?” The answer was it had little impact on NOK’s value, because 92 percent of sales came from the rest of the world.
www.activetradermag.com
•
May 2008
• ACTIVE TRADER
Suppose you know a company is worth AT:: AT
How should value investors
$1 in the long run, and it trades at $0.70
stocks from which to choose. Although I’m not predicting the mar-
adapt their approach for range-
today. Many fund managers will dump
ket, there is a very high probability the
bound markets — by buying stocks
the stock, because they could lose their
market’s long-term slope will flatten
below their fair values to increase
jobs before the stock rose to $1. But if
because of high PEs and profit margins.
their margin of safety?
you can afford to hold the stock for a
And if I’m wrong, the opportunity cost is
couple of years, you can often make
low. If a full-blown bull market develops,
money.
my strategy should still perform as well as
VK: Yes.
They should also look for high
dividend yields and stick to high-quality
In the past, I ignored stock analysts’
stocks. They also need to be more proac-
reports, but I don’t now because I’m look-
If a range-bound market appears, my
tive sellers.
ing for those time-arbitrage opportunities.
strategy should beat other ones, and if a
These reports have a short-term focus as
bear market emerges, you still own high-
analysts try to predict what EPS numbers
quality companies that grow earnings and
may be reported next quarter. If an ana-
pay dividends. And you bought them
value with discounted cash flow
lyst doesn’t like a stock in the short run,
with a high margin of safety saf ety.. Therefore,
analysis, is that value your sell target?
that’s great, because I have a longer time
that strategy should still outperform the
horizon. I love to buy stocks that analysts
market.
AT:: AT
VK:
When you calculate a stock’s stock’s fair
That’s right. Over O ver time, a stock’s fair
— or better than — the overall market.
hate.
value changes, depending on earnings growth. For example, we bought
AT:: AT
Microsoft when it traded at $22 in June
AT:: AT
You also mention your approach
Your book mentions a couple of
Web sites where investors can find
2006, and it went up to $28. And we
isn’t about timing the market, but tim-
ideas such as Joel Greenblat’s strategy
bought more shares recently recently,, because
ing individual stocks. What’s the dif-
of ranking stocks by low PE ratios
even though price rose, earnings grew
ference?
and high return on shareholder equi- ty taken from his book The book The Little Book
more, so now Microsoft is cheaper than VK:
when we bought it.
AT:: AT
One of the themes of Active Active
is that Wall Street has Value Investing Investing is a short-term outlook. Instead of blam-
It’s very difficult to systematize the
that Beats the Markets (magicformu- Markets (magicformu-
market-timing process. When you time
lainvesting.com). That seems like a
the market, you must identify the event
quick way to find good stocks. Do
as well as its timing. Also, you must
you have any other suggestions?
know the market will react to it. Let’s assume you predicted the sub-
VK:
Stockticker.com and gurufocus.com
ing mutual fund managers, you sug-
prime mortgage crisis and its timing —
are a good source of ideas. These Web
gest it’s just human nature to want
the summer of 2007. That’s brilliant, but
sites may point you in the right direction,
instant gratification.
the market didn’t care [because the Dow
but they’re no substitute for your own
still jumped 8.5 percent from mid-August
research.
It’s a cultural issue. Over the years,
to mid-October 2007.] Timing the market
marketing departments have taken over
is so difficult because of human emotions.
stocks that Warren Buffett has bought. If
the mutual fund business — it changed
And there are so many factors that influ-
you followed Warr Warren en Buffett blindly blindly,, you
from [value] investing to tracking the
ence markets.
would have done fine, except there’s a
VK:
However, you can create a system to
hottest fund.
For instance, many investors buy
delay in that information. So, Buffett
When mutual fund f und managers buy bu y a
time stocks. First, calculate a company’s
might have sold [a stock] already, and you
stock, they need it to climb in the short-
worth and the required margin of safety safety..
think he still likes it.
term, because they have short-term incen-
If you analyze enough stocks, it’s just a
tives. This situation creates opportunities
matter of time until stocks hit your buy-
must know why you own it to maintain a
that I call time arbitrage.
ing price. And you have hundreds of
rational state of mind.
ACTIVE TRADER •
May 2008
•
www.activetradermag.com
Also, when stocks drop, you really
33
Q& A
Ari Kiev on trading stress and leadership Trading coach Ari Kiev’s two most recent books target trading stress and the challenge of building a successful hedge fund. BY MARK ETZKORN
Y
ou can’t accuse Dr. Ari Kiev of resting on his laurels. Having barely had time to enjoy the release of his 2007 book, Mastering Trading Stress: Strategies for Maximizing Performance (Wiley Trading, 2007), the psychotherapist, former Olympic advisor, and trading coach has just seen his sixth trading book, Hedge Fund Leadership: How To Inspire Peak Performance from Traders and Money Trading, 2008), hit Managers (Wiley Trading, bookstore shelves. In a recent conversation, Kiev, who was once a consultant to Steve Cohen’s SAC Capital Management, discussed the impetus for writing Mastering Trading Stress. “I’ve always dealt a little bit with stress in the various books I’ve written over the years,” he says. “I decided I had enough material about it, including particular case examples showing how people dealt with it and how it impinged upon their trading, that it would be worthwhile to put together a complete book.” Kiev, who has dealt with stress management and post-traumatic stress disorder in other areas of his work, sees direct 34
correlation with the mental challenge of the markets. “It seemed to me that people experiencing stress in the markets were experiencing some of the same symptoms as people who had post-traumatic stress disorder,” he says. “This tended to impact the way they were trading: Their decisions were less thoughtful, more impulsive, and more fearful, and they were often paralyzed. “[This comparison was] a useful paradigm to explain what traders go through, and to help them understand this and find a way to work more objectively, objectively, rather than overreacting to their own exaggerated interpretations of what was going on in the market.” AT:: In trading, doesn’t everything ulti- AT mately revolve around stress and how to deal with it? Are there other stresses aside from the stress of potentially los- ing money?
AK: There is a range of stresses. Even under ordinary circumstances there’s the fact that if you’re a really good trader you’re probably right only 55 to 60 percent of the time, so there’s the stress of
dealing with failure or striking out. Also, when you’re right, you’re only making money on a very small percentage of your trades — that is, the bulk of your profitability comes from only 3 to 5 percent of your trades — so there’s stress in not being as successful as you might like and in managing expectations. There’s stress in terms of dealing in a world of uncertainty un certainty,, because you’re making predictions, taking bets, and handicapping with insufficient information. You’ree dealing with a situation in which You’r you’re not completely in control and you have to learn to handle that. AT:: In the book you talk about person- AT ality types. One that jumped out as potentially being problematic in trading was the perfectionist personality.
AK: I think if you’re a perfectionist, [you may be well suited] to being a good analyst: You’re never satisfied with the data you have, so you keep digging to get a more complete picture and as much understanding as you possibly can. But that desire to have all the information is something you have to let go of if you’re going to be a portfolio manager,
www.activetradermag.com • May 2008 • ACTIVE TRADER
“Successful traders have
learned to master their anxieties and use the adrenaline response that occurs when in a highly intense situation to improve their focus and tenacity; they don’t let it interfere too much. They know what they need to do to produce certain results and they’re willing to do the necessary work, but they’re not hung up on what the result is.” which is a job in which you have to operate with insufficient information. You have to rely a little bit more on your intuition and ability to see patterns, trends, and how things are [evolving]. That’s a stressful thing — it’s not like being an accountant who’s adding up numbers and having the luxury of reviewing them over and over. The most successful traders and portfolio managers have learned to master their anxiety, and they utilize the adrenaline response that occurs when they’re focused and concentrating in a highly
intense and competitive situation. They use it to improve their concentration, tenacity,, and intensity; they don’t let it tenacity interfere too much. They have a goal, a target: They know what they need to do to produce certain results and they’re willing to do the necessary work, but they’re not hung up on what the result is. AT:: But you also say there’s no “best” AT personality for trading.
AK: I’ve been involved in selecting people as portfolio managers and have done all kinds of psychological evaluations to try to understand the range of personality characteristics that might make up the ideal performer. Successful traders have a range of personalities. The critical thing is they must be risk takers who are comfortable with uncertainty and have a certain degree of abstract reasoning ability. ability. They have to enjoy trying to piece together the mosaic of information needed to make a good investment, and they need some degree of caution, thoroughness, and coachability.. ty But not everyone has all these things and not everyone has the same mix of them. You can learn to manage your strengths and weaknesses, and you don’t necessarily need to have all the ingredients to begin with. Some people who are very cautious become successful portfolio managers, and you also find big risk takers who learn how to balance their risk-taking propensities with risk-management principles that are consistent with good portfolio management. AT:: Ultimately your conclusion is that AT you can’t completely completely eliminate stress, correct? You can only learn to manage it?
AK: Yo You u can’t eliminate it. You really want to learn how to ride with it, not to cover it up. You have to be able to admit you’re having difficulty difficulty,, you’re uncertain,
ACTIVE TRADER • May 2008 • www.activetradermag.com
or you’ve made mistakes; you have to be able to say, “This was the bet, and it didn’t work, let’s cut the position and move on and put our capital and effort into higher-conviction ideas where we’ve done more work and have a little bit more confidence in the outcome.” The natural inclination is to hold on to a loser and rationalize the loss — “Well, if I like it at $20, I like it even more at $15, and even more at $10.” You have to keep evaluating the quality of a trade idea and whether the reason you got into the position is still valid and justifies holding it even when it’s going against you. AT:: How do you draw the line AT between confidence and arrogance in trading?
AK: A confident person is someone who has knowledge about his strengths and weaknesses, has a replicable process that allows him to analyze and invest in a profitable way, and is able to adjust as the data changes. When he’s going through a drawdown, he’s comfortable paring down [his positions], rather than starting to think catastrophically — that things are desperate and he has to swing for the fences. He recognizes there will be fluctuations and “black-swan” events throughout the year, but he’s confident he’s he’s survived them in the past and he’ll survive them again. As a result, he doesn’t flail about when things aren’t working. He prepares, he does more work, he deploys less capital, and he waits for the markets to become more rational before going back in with larger positions. An arrogant person believes his press clippings and is not humble enough to recognize the market is bigger than he is, that it’s a sign of strength to admit when you’re wrong — to take your lumps and get ready for recovery when conditions are better. Arrogance is sort of a protective overcontinued on p.
3 6
35
Q&A continued
confidence designed to cover up feelings of vulnerability and a nd inadequacy, inadequacy, whereas confidence is a quiet understanding that you’re ultimately going to prevail if you follow your plan.
some other kind of exercise, or by staying away from alcohol and late nights during the week in order to keep themselves physically fit and mentally prepared to deal with the high stress and intensity of trading.
AT:: What are some tactics traders can AT use to defuse especially tense or stress- ful situations?
AK: First, traders need to recognize there are going to be stressful periods when they lose focus and trade from an emotional perspective rather than objectively. The best thing to do is develop a regular routine — say, on a daily basis — of meditation, relaxation, visualization, and related techniques that help you become more centered. Yoga is a good example. I worked with one guy who spent 45 minutes every morning doing yoga and, in the course of being in this relaxed meditative state, visualized various scenarios and how he would handle trades depending on what the circumstances were, what data came out, and what moves took place in the market. This allows him to review what he’s going do in advance; he has a few scenarios embedded in his thinking and he has developed the ability to get centered and relaxed in the face of stress. You don’t don’t develop the ability to do this when you’re stressed, you need to learn to do it [through regular practice] — you develop the habit, so that during the course of the day as you become tense, flustered, or frustrated, you’re able to chill out and take a few minutes to get back into that meditative state in which time slows, your heart rate and breathing slow, you’re calmer and able to see the data more clearly, and you’re less likely to overreact impulsively, impulsively, which often gets you into trouble. Preparation and experience in getting relaxed are very useful. Now, some people get to this state of mind by jogging or 36
AT:: Sounds like a “healthy body, AT healthy mind” kind of thing.
AK: Absolutely Absolutely.. AT:: Can you talk a little bit about the AT topic in your other book on leadership qualities in traders?
AK: In the course of teaching people about managing stress, I came face to face with what the best hedge-fund and portfolio managers do that differentiates them from those who aren’t so successful. Besides stress management techniques and a “trading-to-win” philosophy, philosophy, they have a goal and reverse engineer their strategy to determine what kind of positions they need to take in terms of the deployment of capital, they have good risk-management statistics so they’re able to evaluate how they’re doing based on their stats and can make adjustments (whether they’re holding losers too long, getting out of winners too soon, or making money in the short-term, intermediate term, or long-term), they identify the most successful patterns in their trading and begin to trade in a more success-oriented way. It’s a very labor-intensive process to be successful, but the more you do these things, the [easier it is] to handle trading stress because you’ve taken out some of the mystery from a game that has a lot of mystery to it. Now,, leadership comes into selecting Now se lecting people to be on your team, guiding them, sharing your vision and getting people to buy into it, and aligning incentives so people stay with you more than a couple of years. [The team] really becomes invested because they feel appreciated, and empowered, and they’re able to make
decisions and challenge points of view. These things take a certain amount of work — it doesn’t happen automatically. automatically. Good portfolio managers and traders who start hedge funds often have very little experience managing other people. It takes a certain amount of coaching, selfawareness, and willingness to interact with people in a more meaningful way than you might have considered necessary than when you were just running a portfolio. AT:: Is there an analogy to the very suc- AT cessful hitting coach in baseball who wasn’t actually a great hitter himself? Are there there people who aren’t aren’t necessarily the greatest individual traders but who have the ability to assemble the right team and teach the right skills?
AK: That’s an interesting question. The way it seems to work in most hedge funds is that the guy who sets it up has already been successful at managing a portfolio, but if you interview a variety of hedge-fund leaders, as I did for this book, you’ll find they come from diverse backgrounds: portfolio managers, analysts, bankers, asset gatherers. Some people are better at managing people, others are better at creating an organization, and others are better at defining the process. There’s no one way it has to be done. The commonality is an awareness of the need to empower people. But people do this in varying degrees. In some places the head guy is very collegial and makes partners out of people; in others it’s a more authoritarian situation. I think the one generalization would be that, just as I discovered traders trade very differently, to be successful [as a hedge fund manager] you have to figure out what process works for you, develop a methodology and strategy around your strengths, and then recognize when you need additional assets or qualities from other people, who you then
www.activetradermag.com • May 2008 • ACTIVE TRADER
Related reading Previous Ari Kiev articles and interviews:
bring into the team. Self-awareness is critical. You have to be able recognize what’s needed to win, but not be so arrogant to think you’re the only one who can do it. You have to be willing to admit when other people can do certain things better than you, and empower them to take on those functions. Now, that’s just managing a portfolio. Managing a hedge fund adds other dimensions: It’s managing more people, more money, investors, a back office — it’s managing a company, and you have to make a decision whether to trade and also manage, or get someone else to manage. Different people have different models. You have to be willing to face fac e your strengths and weaknesses, be open, and trust and empower people to get the most out of them. You have to recognize the subtleties regarding what makes for top-notch performance and what motivates people. Everybody has something to contribute. The key is to figure out what someone can contribute naturally. naturally. What is it they do instinctively and can be helped to improve upon, rather than trying to get them to change, which only leads to frustration? There are really a lot of parallels with the work I’ve done for years in psychotherapy in trying to help people get a better handle on themselves to make a difference in their own lives — to have a goal, a step-by-step plan, to be able to tap into their own inner potential so they are self actualized in a greater way than they might be otherwise be. I think all of this is what you find in what you might call “transformative” leadership, or “authentic” leadership, where the leader is functioning in terms of what works best for him while recognizing that other people aren’t necessarily going to be like him. They’re going to bring something else to the table, and that’s the beauty of it all.
“ Entering the trading zone: Q&A with Ari Kiev ” Active Trader , June 2000. Given his past career as a consultant to Olympic athletes, it’s it’s not surprising that psychiatrist and trading coach Dr. Ari Kiev draws frequent parallels between success on the athletic field and success in the market. “ Q&A: Psyching out risk with Ari Kiev ”
Active Trader , January 2003. In challenging market environments, even seasoned traders can find them- selves breaking rules and taking unnecessary risks. Dr. Ari Kiev discusses how to make the best of bad times. “ Managing losses,” by Ari Kiev
Active Trader , March 2001. How a trader manages losses is a key to trading success. “ Mind over money management ,” by Ari Kiev
Active Trader , June 2001. The risk door swings both ways: Taking too much risk or not taking enough can sabotage your trading. Learn how to improve your understanding of risk and trade according to the prevaili prevailing ng market conditions. “ Psychological roadblocks to successful risk management,” by Ari Kiev
Active Trader , April 2001. How you handle risk goes a long way in determining whether you’ll be a prof- itable trader. Overcoming stress and emotions and having a specific plan are crucial to trading success. “ The psychology of handling risk ,” ,” by Ari Kiev
Active Trader , January-February 2001. Effective trading requires requires the ability to separate emotions from actions. Learning how to analyze your reactions to your trades can help you better respond to the realities of a situation instead of responding to your interpretations. Note: These articles (except ( except “Q&A: “Q&A: Psyching out risk with Ari Kiev”) are also part of the “Trading Psychology Collection,” a discounted set of articles in a single PDF file. Ari Kiev books:
• Hedge Fund Leadership: Leadership: How To Inspire Inspire Peak Performance Performance from Traders and Money Managers (Wiley Managers (Wiley Trading, 2008). • Mastering Trading Trading Stress: Strategies for Maximizing Performance Performance (Wiley Trading, 2007). • Hedge Fund Masters: Masters: How Top Hedge Fund Traders Set Goals, Overcome Barriers, and Achieve Peak Performance Performance (Wiley (Wiley Trading, 2005). • The Psychology of Risk: Mastering Market Market Uncertainty Uncertainty by Ari Kiev and Ken Grant (John Wiley, Wiley, 2002). • Trading in the Zone: Zone: Maximizing Performance with Focus and Discipline (John Wiley, 2001). • Trading to Win: The Psychology of Mastering the the Markets (John Wiley, 1998). You can purchase and download past articles at www.activetradermag.c www.activ etradermag.com/purchase_ om/purchase_articles.htm articles.htm
ACTIVE TRADER • May 2008 • www.activetradermag.com
37
Trading setup
The Face of TRADING
Hardware: PC with dual 2.0-GHZ processors and 3.25 GB RAM; 22- inch flat-panel monitor.
Brushing up profits
Software: TradeStation. Internet connection: Cable.
BY ACTIVE TRADER STAFF
Brokerage: On-line direct access, Ameritrade, TradeStation. TradeStation. Name: Steve Reeves Age: 56 Lives and works in:
Seattle, Wash.
I
n 1980 a childhood friend gave Steve Reeves a copy of Joe Granville’s Granville Market Letter .
“I became interested in his on-balance volume (OBV) work and started following his stuff,” Reeves says. Reeves was starting his dentistry career, but he began trading stock options on the side. He charted stock prices by hand, including tools such as the advance/decline line, and found he really enjoyed the analysis. Trading has been a good accompaniment accompaniment to dentistry for him. “They are really separate brain functions,” Reeves says. “One is pretty mechanical, while the other is all thinking and much more emotional.” Through the years, Reeves has continued to pursue trading on the side, trying differentt methodologie differen methodologiess and strategies. “It has been very humblin humbling,” g,” he says. He attended workshops by trader Linda Bradford Raschke during the 1990s, which he found to be helpful. He has also tried mechanical system trading. “System trading is not really for me,” Reeves says. “Over time [a system might] test out, but I just don’t like taking big drawdowns. I think some systems are good, but you have to sit through the bad times, and it is hard for me to sit and watch a stock go down. I have a low risk tolerance for large losses — I like to sleep at night.” Ultimately, Reeves found a method within his comfort zone. He may check the markets in between patients, but he tries not to make decisions during the day. “I try to spend an hour after work going 38
through charts charts and putting orders orders in,” he says. One of the biggest drawback drawbackss is the time trading consumes each day. “It soaks up too much time,” he says. “I can spend a whole day watching, but it is better not to make decisions during the day.” Reeves remembers the early days when he created charts by hand and had to wait for the newspaper to get stock prices. “You had to wait till the next morning to find out how things were doing,” he says. But in some ways, Reeves prefers the old days. “Real-time feeds have made it hard,” he says. “It’s really emotional; it gets you because you can see all the squiggles.” “I guess I’m a little addicted to it,” he adds. “I try to go on vacation and not do anything. But it’s hard. You can even get information on your phone.” Outside of trading: Reeves has been a practicing dentist for nearly 30 years. Trading methodology: Reeves has settled on a swing trading tr ading method, incorporating elements he learned from Raschke’s trading seminars. He puts on about 10 stock trades per week, focusing on a small group he has followed for years, plus some exchange-traded funds (ETFs). He usually holds positions for about four to six days. He is a 100-percent technical trader and monitors several indicators, including Linda Raschke’s 3-10-16 oscillator, volume, Bollinger bands, and the twoday rate-of-change r ate-of-change.. His trading philosophy is to trade with the trend, buying on pullbacks. He places orders at night and tends to focus on long trades; if he wants to put on a short trade, he typically uses ETFs, such as the Ultrashort S&P 500 Proshares. Reeves
monitors daily charts to make trading decisions and notes that some pullbacks tend to last three to five days, while others last seven to 10 days. Reeves tries to buy the first pullback after a lower low, after it looks like a bottom has been made. In addition to the price pullback, he may act on a signal from the Bollinger Band — for example, when price hits the bottom band. With Raschke’ Raschke’s 3-10-16 oscillator oscillator method, Reeves says a buy trigger occurs in an uptrend when the slow line is moving up and the fast line is moving down. “I’m looking to buy if it’s a shallow pullback,” he says. Reeves will place a stop at the last swing low on the daily chart. chart . On the upside, Reeves doesn’t use set objectives, but prefers to monitor positions as they develop. “I try to t o take off half my position when I have a decent gain, after three or four up days,” he says. “I’ll take half off and move my stop up to a two-bar daily close.” Most important lesson learned: “You have to follow your own parameters and your own risk levels. Everyone is different. You have to make your own decisions.” Best thing about trading: “Being right [and the satisfaction of knowing] I followed my rules and my discipline.” When not trading: Reeves works at his dental practice and enjoys photography, hiking, skiing, and golfing. Best trading books/Web sites: Street Smarts by Linda Raschke and Larry Connors and Dow Theory Letters published by Richard Russell.
For definitions of the indicators referenced referenced in this article, see “Key concepts” on p. 62.
www.activetradermag.com • May 2008 • ACTIVE TRADER
ETF Snapshot Date: March 6 The following table summarizes the trading activity in the most actively traded exchange-traded funds. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each mark et’s liquidity, direction, direction, and levels of momentum and volatility. See the legend for explanations of the different fields. Market Positive one-year performance UltraShort Financials*** Brazil United States Oil Fund Gold Gold FTSE/Xinhua China 25 Index Energy Oil Services UltraShort Russell 2000*** Emerging Markets Malaysia Taiwan Hong Kong UltraShort S&P 500*** Materials Mexico Consumer Staples Industrial UltraShort Dow 30*** Negative one-year performance S&P Home Building Index Financial Dow Jones U.S. Real Estate Retail Ultra S&P 500** Russell 2000 Value Index Consumer Discretionary Semiconductor Japan Ultra Nasdaq 100** Russell 2000 Index Retail Russell 2000 Growth Index S&P Midcap 400 Index S&P 500 Index EAFE* Technology Health Care Nasdaq 100 Dow Jones Industrial Average Russell 1000 Growth Index Singapore UltraShort Nasdaq 100*** Utilities
Symbol
Sector
Volume
1-year RS rank
SKF EWZ USO GLD GDX F XI XLE OIH TWM EEM EWM EWT EWH SDS XLB EWW XLP XLI DXD
Leveraged inverse index Regional Energy Metals Metals Index Energy Energy Leveraged inverse index Emerging Markets Regional Regional Regional Leveraged inverse index Materials Regional Consumer Industrial Leveraged inverse index
6.55 M 16.31 M 4.08 M 10.83 M 4.83 M 7.51 M 23.44 M 7.91 M 8.82 M 23.13 M 4.57 M 11.78 M 8.14 M 25.19 M 13.94 M 4.36 M 3.27 M 6.80 M 5.64 M
81.14% 76.78% 67.41% 50.65% 44.04% 38.93% 32.72% 31.62% 30.42% 20.36% 18.61% 16.08% 12.50% 11.96% 10.75% 9.46% 5.06% 3.70% 0.17%
20.10% / 93% -0.77% / 100% 8.48% / 72% 3.80% / 36% 7.86% / 42% -4.92% / 73% 2.42% / 33% 3.00% / 13% 9.85% / 100% -3.10% / 100% -6.77% / 82% 7.04% / 41% -3.15% / 41% 5.98% / 91% 0.95% / 11% -2.97% / 67% -0.37% / 0% -1.77% / 67% 4.37% / 92%
24.43% / 84% 12.41% / 56% 21.54% / 100% 8.81% / 67% 16.80% / 94% -1.55% / 11% 12.35% / 91% 13.50% / 97% 8.88% / 34% 3.60% / 32% -7.35% / 100% 18.78% / 94% -4.04% / 28% 3.31% / 19% 6.36% / 56% 1.92% / 26% 1.42% / 26% -0.82% / 16% 2.22% / 11%
50.01% / 95% -3.74% / 26% 20.83% / 67% 23.14% / 94% 18.06% / 73% -27.93% / 85% -0.43% / 0% -2.99% / 29% 35.25% / 92% -15.47% / 83% -7.70% / 95% -1.92% / 19% -21.60% / 95% 29.68% / 97% -3.95% / 55% -10.11% / 73% -7.67% / 100% -10.35% / 83% 24.38% / 97%
.78 / 97% .44 / 60% .46 / 87% .26 / 53% .53 / 57% .22 / 52% .36 / 12% .29 / 0% .49 / 45% .40 / 78% .72 / 92% .21 / 15% .26 / 43% .44 / 43% .42 / 23% .48 / 55% .32 / 28% .30 / 30% .45 / 45%
XHB Index XLF Financial IYR Real Estate XRT Retail SSO Leveraged index IWN Index XLY Consumer SMH Technology EWJ Regional QLD Leveraged index IWM Index R TH Retail IWO Index MDY Index S PY Index EFA Index XLK Technology Tec hnology XLV Health Care QQQQ Index DIA Index IWF Index EWS Regional QID Leveraged inverse index XLU Utilities
9.19 M 122.86 M 9.93 M 5.59 M 7.79 M 3.10 M 6.47 M 11.14 M 25.97 M 11.19 M 89.10 M 9.01 M 3.45 M 4.68 M 224.58 M 13.30 M 3.86 M 3.32 M 163.03 M 15.37 M 3.86 M 4.54 M 36.31 M 6.13 M
-46.35% -32.17% -30.96% -26.54% -22.17% -21.41% -18.32% -17.83% -17.02% -17.01% -15.36% -11.96% -9.30% -8.02% -6.90% -4.79% -4.26% -3.46% -1.88% -1.78% -1.56% -0.67% -0.41% -0.29%
-6.95% / 70% -8.83% / 88% -4.24% / 79% -6.37% / 100% -5.73% / 92% -5.33% / 100% -3.43% / 100% -1.28% / 29% -1.38% / 27% -6.82% / 86% -4.68% / 100% -3.08% / 60% -4.72% / 100% -3.65% / 100% -2.77% / 91% -0.34% / 0% -2.18% / 43% -3.57% / 100% -3.10% / 85% -1.95% / 92% -2.04% / 91% -3.96% / 56% 7.33% / 92% -2.07% / 40%
-8.63% / 52% -11.20% / 80% -6.38% / 53% -4.53% / 43% -3.49% / 10% -5.14% / 43% -2.25% / 17% 1.94% / 50% -0.08% / 0% -3.84% / 20% -4.13% / 45% -2.42% / 36% -3.96% / 35% -2.25% / 38% -1.50% / 14% 1.66% / 25% -1.39% / 14% -4.01% / 56% -1.49% / 26% -1.19% / 8% -0.11% / 0% 1.28% / 29% 2.95% / 17% -4.00% / 39%
-8.94% / 10% -22.21% / 96% -16.92% / 84% -15.68% / 84% -28.99% / 98% -14.23% / 88% -12.75% / 83% -14.90% / 72% -14.46% / 99% -39.98% / 98% -15.70% / 94% -11.10% / 92% -16.88% / 99% -13.24% / 93% -13.15% / 97% -15.58% / 87% -18.14% / 93% -12.63% / 100% -19.42% / 100% -11.43% / 96% -12.99% / 96% -19.31% / 86% 49.93% / 100% -14.12% / 100%
.68 / 90% .44 / 90% .35 / 53% .43 / 80% .25 / 38% .42 / 58% .40 / 82% .18 / 40% .32 / 37% .12 / 23% .36 / 45% .59 / 80% .31 / 42% .41 / 38% .33 / 38% .23 / 20% .15 / 20% .41 / 53% .18 / 20% .35 / 42% .29 / 23% .30 / 70% .25 / 30% .39 / 60%
* Europe, Australasia, and the Far East
** Tracks twice the move of this index.
Legend Vol: 30-day average daily volume, in thou- sands (unless otherwise indicated). OI: Open interest, in thousands (unless oth- erwise indicated). 1-year RS rank: The percentage price move from the close one year ago (250 trading days) to today’s close. 10-day move: The percentage price move from the close 10 days ago to today’s close. 20-day move: The percentage price move from the close 20 days ago to today’s close.
39
10-day move/rank
20-day move/rank
60-day move/rank
Volatility ratio/rank
*** Tracks twice the inverse, or opposite, of this index.
60-day move: The percentage price move from the close 60 days ago to today’s close. The “Rank” fields for each time window (10-day moves, 20-day moves, etc.) show the percentile rank of the most recent move to a certain num- ber of the previous moves of the same size and in the same direction. For example, the “Rank” for 10-day move shows how the most recent 10-day move compares to the past twenty 10- day moves; for the 20-day move, the “Rank” field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the “Rank” field shows how the most recent 60-day move compares to the past
one-hundred-twenty 60-day moves. A reading of 100 percent means the current reading is larger than all the past readings, while a reading of 0 percent means the current reading is small- er than all previous readings. These figures pro- vide perspective for determining how relatively large or small the most recent price move is com- pared to past price moves. Volatility ratio/rank: The ratio is the short- term volatility (10-day standard deviation of prices) divided by the long-term volatility (100- day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.
www.activetradermag.com • May 2008 • ACTIVE TRADER
STOCKS & FUTURES Snapshot The following tables summarize the trading activity in the most actively traded stocks and futures contracts. The information does NOT consti- tute trade signals. It is intended only to provide a brief synopsis of each market’s liquidity, direction, and levels of momentum and volatility. Volume figures are for the most-active contract month in a particular market and may not reflect total volume for all contract months. For a more extensive futures snapshot, see Futures & Options Trader magazine (www.futuresandoptionstrader.com). Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based on pit-traded contracts, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic). Stocks snapshot snapshot as of March 6
Positive one-year performance
Symbol
Volume
1-year RS rank
10-day move/rank
20-day move/rank
60-day move/rank
Volatility ratio/rank
Apple Inc.
AAPL
47.21 M
37.47%
-0.50% / 12%
-0.88% / 0%
-37.76% / 100%
.12 / 2%
Exxon Mobil
XOM
25.57 M
18.83%
-2.77% / 89%
3.77% / 27%
-7.64% / 87%
.44 / 48%
Oracle
ORCL
45.01 M
15.63%
1.80% / 100%
-2.29% / 6%
-9.04% / 89%
.22 / 18%
EMC Corp.
EMC
42.37 M
15.40%
-2.33% / 50%
-2.46% / 15%
-22.97% / 65%
.10 / 28%
AMAT
27.60 M
9.82%
4.41% / 33%
15.16% / 97%
10.06% / 97%
.43 / 82%
INTC
77.60 M
4.03%
-2.12% / 54%
-0.25% / 0%
-28.34% / 96%
.11 / 8%
WM
38.28 M
-72.01%
-29.67% / 100%
-31.31% / 92%
-38.20% / 54%
.35 / 100%
C
98.36 M
-57.94%
-15.49% / 100%
-21.36% / 96%
-38.30% / 90%
.25 / 95%
WB
29.20 M
-50.65%
-17.81% / 100%
-20.41% / 91%
-36.52% / 100%
.52 / 100%
Applied Materials Inc. Intel Corp. Negative one-year performance Washington Mutual Citigroup Wachovia Corp. American International Group Group Inc.
AIG
26.24 M
-37.92%
-9.90% / 60%
-17.70% / 91%
-30.22% / 100%
.54 / 90%
Bank of America
BAC
47.20 M
-28.32%
-13.48% / 100%
-13.73% / 94%
-19.51% / 82%
.70 / 100%
CMCSA
24.23 M
-24.54%
0.61% / 0%
12.50% / 55%
7.82% / 78%
.12 / 18%
JP Morgan Chase
JPM
36.64 M
-23.45%
-13.23% / 100%
-14.52% / 89%
-18.90% / 100%
1.08 / 92%
Wells Fargo
WFC
36.11 M
-19.33%
-9.47% / 83%
-7.48% / 44%
-12.24% / 52%
.64 / 90%
Pfizer
PF E
40.51 M
-15.03%
-3.62% / 82%
-4.43% / 78%
-11.52% / 100%
.50 / 58%
Dell Inc.
DELL
31.35 M
-13.37%
0.83% / 27%
1.89% / 71%
-22.50% / 63%
.13 / 27%
Cisco
CSCO
77.87 M
-8.21%
3.23% / 50%
3.73% / 71%
-12.79% / 34%
.12 / 12%
GE
43.68 M
-4.25%
-2.46% / 65%
-3.92% / 55%
-11.74% / 67%
.17 / 20%
T
34.08 M
-4.19%
1.60% / 20%
-3.79% / 30%
-8.97% / 85%
.15 / 0%
YHOO
59.13 M
-1.44%
0.99% / 0%
0.46% / 0%
11.98% / 52%
.10 / 3%
Comcast Corp.
General Electric AT&T Inc. Yahoo!
Futures snapshot as of March 6
Market
Pit E-symbol symbol
Exchange
Volume
OI
10-day move/rank
20-day move/rank
60-day move/rank
Volatility ratio/rank
CME
2.20 M
2.32 M
-2.90% / 92%
-1.65% / 14%
-13.22% / 97%
.33 / 38%
E-Mini S&P 500
ES
10-yr. T-note
ZN
TY
CBOT
1.49 M
2.18 M
0.08% / 11%
0.06% / 11%
3.68% / 55%
.34 / 67%
5-yr. T-note
ZF
FV
CBOT
786.7
1.63 M
1.02% / 77%
1.03% / 44%
4.64% / 89%
.38 / 83%
30-yr. T-bond
ZB
US
CBOT
516.5
940.8
-0.76% / 20%
-0.92% / 28%
1.70% / 6%
.51 / 87%
E-Mini Nasdaq 100
NQ
CME
440.0
398.5
-3.48% / 86%
-1.94% / 20%
-19.59% / 100%
.17 / 22%
2-yr. T-note
ZT
TU
CBOT
350.2
1.07 M
0.84% / 79%
0.86% / 43%
2.83% / 95%
.30 / 82%
CL
NYMEX
280.2
309.9
7.37% / 67%
19.70% / 97%
20.04% / 74%
.50 / 85%
Crude oil E-Mini Russell 2000
ER
CME
258.5
646.2
-5.07% / 100%
-6.24% / 61%
-16.66% / 98%
.36 / 50%
Mini Dow
YM
CBOT
191.9
92.7
-2.04% / 92%
-1.35% / 14%
-11.58% / 97%
.36 / 45%
Eurocurrency
6E
CME
165.6
196.5
3.73% / 67%
6.34% / 100%
4.31% / 59%
.77 / 92%
Corn
ZC
Gold 100 oz. Soybeans
ZS
Natural gas Wheat
ZW
E-Mini S&P MidCap 400
ME
EC C
CBOT
129.1
311.4
6.22% / 72%
11.09% / 50%
39.46% / 96%
.20 / 42%
GC
NYMEX
127.4
284.5
2.94% / 29%
7.37% / 60%
20.11% / 87%
.24 / 52%
S
CBOT
85.1
130.7
2.66% / 0%
9.45% / 53%
28.89% / 78%
.24 / 50%
NG
NYMEX
69.4
122.4
9.57% / 70%
20.24% / 96%
38.54% / 95%
.32 / 57%
W
CBOT
45.1
90.2
8.22% / 50%
7.84% / 28%
23.31% / 53%
.61 / 80%
CME
27.0
107.7
-3.68% / 100%
-3.61% / 38%
-14.12% / 96%
.42 / 43%
This information is for educational purposes only. Active only. Active Trader Trader provides provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Active timeliness. Active Trader assumes Trader assumes no responsibility for the use of this information. Active information. Active Trader Trader does does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.
ACTIVE TRADER • May 2008 • www.activetradermag.com
40
INSIDE the Market
BY JEFF JEFF PON PONCZA CZAK K
In this section… Privacy amendment proposed
43
DOJ critiques futures clearing structure
44
Quick Scalps
44
Managed money
45
Coffee heating up
46
Rogue trader costs firm $141.5 M with unauthorized trades in wheat futures.
Debate over investor arbitration
47
SEC pr propo oposes ses new new ETF ETF rul rules es
48
BY CHRIS PETERS
Stock firms
48
Gold: $1,000 — then what?
49
Global news
51
Rogue trader shredded in wheat market
M
F Global Ltd. (MF), a futures and derivatives brokerage firm that accounts for a large
portion of CME trade volume, lost $141.5
than 8 percent to 1,214.50 (Figure 1). Representatives for MF global wouldn’t comment on the exact nature of Dooley’s
trades, except that he held positions in several contract months. Although the total number of contracts was excessive,
FIGURE 1: WILD WHEAT
million on Feb. 27 after liquidating more than 15,000 wheat contracts. MF Global trader Evan “Brent” Dooley had taken the positions in overnight trading before the regular trading session opened on Wednesday W ednesday,, Feb. 27. Wheat futures had been experiencing record volume and price moves prior to the debacle. Wheat had increased 76.6 percent in 2007 to $8.85 per bushel, and another 35.5 percent between Jan. 2 and Feb. 26, 2008. Prices consistently hit their daily limits for two weeks in early February,, prompting the Commodity February Futures Trading Commission (CFTC) to approve an increase in daily price limits from 30 cents to 60 cents and the doubling of speculator margin calls. The day Global nearly 6 percent of their total
Wheat futures declined in pre-market trading when Dooley was rumored to have shorted thousands of contracts, but the market shot higher in the regular session as MF Global extricated itself from the positions.
assets, May wheat (WK08) jumped more
Source: TradeStation
before Dooley’s trades would cost MF
41
www.activetradermag.com • May 2008 • ACTIVE TRADER
FIGURE 2: ROGUED
the number in each contract
revenue growth of 29 percent
may not have been large enough
year-over-year and futures and
to trigger speculative position
options volume growth of 47
limits.
percent. After the event, the
MF Global CEO Kevin Davis
CME group released a statement:
stated in a conference call the
“MF Global has met and contin-
following day that under normal
ues to meet its obligations to
conditions the retail trader limit
CME Clearing and remains in
controls used by the firm would
good standing as a clearing
have prevented such actions by
member of the exchange.” The
a single trader, but these con-
IntercontinentalExchange
trols were turned off for internal
released a similar statement.
trades because of their effect on
Despite the reassurance, MF
execution speed. Later state-
Global stock (MF) fell 40 per-
ments made by the firm attrib-
cent in the two days following
uted the mishap to “system fail-
the incident (Figure 2), and on
ure.” In an interview with the
Feb. 29 Credit Suisse, UBS, and
Lehman Brothers all downgradWall Street Journal shortly after MF Global’s stock plummeted almost 30 percent the incident, Dooley himself ed the stock. On the same day, after unraveling the trades, the largest single day said, “the computer system MF Global announced six of the loss in the stock’s history. failed on a lot of things.” company’s executive officers and Source: eSignal The evidence suggests Dooley board members purchased $3 shorted wheat, placing orders million worth of MF Global The evidence suggests from home using MF Global’s retail order stock in a move to reassure shareholders. entry system before pit trading opened in In a letter to clients on March 2, MF Dooley shorted wheat, the hope prices had peaked. The market Global reiterated client funds were unafopened nearly 10 percent lower than the previous day’s close, but quickly shot up nearly 20 percent in the next few hours. MF global became aware of the position, which greatly exceeded Dooley’s own account balance, and immediately
placing orders from home using MF Global’s retail order entry system
began liquidating the positions, incurring the $141.5 million loss. Dooley D ooley,, who
before pit trading
MF Global’s fiscal third quarter report
their systems to prevent any further unauthorized trading. Since then, they have hired two consulting firms: FTI Consulting to review their retail order Group to assess their overall risk environment.
opened in the hope
with the firm for more than two years, was immediately fired.
had made the “necessary adjustments” to
entry systems, and Promontory Financial
according to the National Futures Association’s Web site had been registered
fected by the loss and that the company
A federal investigation by the U.S. Attorney’s Office in Chicago has since
prices had peaked.
released on Feb. 1 had highlighted net ACTIVE TRADER • May 2008 • www.activetradermag.com
been launched to look into the nature of Dooley’s trades. At press time, there was continued on p.
43
42
Inside the Market continued
Rogues gallery no indication of legal action against Dooley.. MF Global has stated they Dooley are not the focus of the current fed-
Losing $141 million isn’t something anyone in any old job can do — it takes a trader. Nonetheless, a hit of this size is rather unremarkable in the pantheon of rogue trader incidents in the modern era. Here’s how Evan Dooley stacks up against some of the other loose cannons of the past two decades.
eral investigation. According to a CFTC press release on Dec. 26, 2007, the CFTC settled previous actions against MF Global for violations arising out of “their mishandling of hedge fund accounts.” The settlement required MF Global and one of their associates to pay more than $77 million in fines and restitution. Among other things, the document stated MF Global “failed to have sufficient internal controls, policies, and procedures concerning external communications with third parties and changes to Internet access of account information. MFG also failed to institute sufficient internal controls, policies, and procedures to detect and deter possible wrongdoing.” Dooley could not be reached for further comment.
Year
Trader
Loss
Market
Institution
2008 2008 2004 2002 1996 1995 1995 1992
Evan Dooley Jerome Kerviel Luke Duffy John Rusnak Yasuo Hamanaka Nick Leeson Toshihide Iguchi Anthony Catalfo, Donald Zimmerman
$141 mil. $7 bil. AU$360 mil. £350 mil $2.6 bil. $1.6 bil. £557 mil. $6 mil
Wheat futures Stock index futures FX options FX options Copper Nikkei futures U.S. T-bonds T-bond futures/ options
MF Global Société Générale National Australia Bank Allied Irish Banks Sumitomo Corporation Barings Bank Resona Holdings Lee B. Stern, Goldenberg Hehmeyer
The list contains only individuals who were taking unauthorized or illegal positions — hence the absence of multi-billion-dollar blowups resulting from institutionally sanctioned trading, such as Amaranth (2006), the venerable Long-Term Capital Management (1994), and Metallgesellschaft (1994). The 1992 entries, Anthony Catalfo and Donald Zimmerman, made the list because of the audacity of their ploy and the fact that it brought down one of the unfortu- nate clearing firms (Lee B. Stern) through which they were doing business. With virtu- ally no money they essentially bluffed their way onto seats at the Chicago Board of Trade and (almost) executed their one-day-and-go-away plan of triggering a panic in the T-bond market by shorting massive quantities of bond futures and simultaneously buying boatloads of bond puts on an employment report day. The market actually went their way for a while before the ploy was discovered and their positions were liquidated.
SEC proposes customer privacy safeguards
W
ith identity theft such a high-profile problem in the online economy — and the trading industry being such a high-profile part of that economy — the Securities and Exchange Commission (SEC) has pro- posed changes to existing industry practices designed to protect investor information. In March the SEC voted unanimously to propose amendmentss to Regulation S-P, amendment S-P, which outlines privacy priv acy obligations for SEC-regulated businesses. In the SEC’s statement Erik Sirri, Director of the SEC’s Division of Trading & Markets, said, “Today’s proposal should help guard against growing problems problems such as identity theft and intrusions into online brokerage accounts. It also includes a pragmatic exception that
43
would continue to protect information while providing an orderly mechanism for departing representatives to take limited customer information to their new firms. This should help give firms flexibility while facilitating the trans- fer of accounts, promoting investor choice, and providing firms with legal certainty.” According to the press release, the proposed amend- ments would provide more specific requirements for safe- guarding information and responding to information secu- rity breaches, and would update Regulation S-P’s safe- guarding and disposal provisions. The comment period for the proposal will end 60 days from the date of publication of the proposed rule in the Federal Register.
www.activetradermag.com • May 2008 • ACTIVE TRADER
DOJ takes stand on clearing BY JIM KHAROUF
A
Department of Justice (DOJ) comment letter roiled exchange stocks and raised industry fervor in February when it advocated radical changes to the clearing structure for U.S. futures exchanges. The DOJ called for an end to “exchange control of financial futures clearing” and an examination of a single clearing house for the futures industry, similar to those found in U.S. securities for stocks and options trades. The 22-page letter, written in response to the Department of Treasury’s request for comment on the regulatory structure of U.S. financial markets, pointedly states that the current clearing house structures run by futures exchanges impede competition and recommended that the U.S. Treasury review the clearing system in place today. The letter, written by the same DOJ staffers who approved the CME Group’s acquisition of Chicago Board of Trade (CBOT) last July, said “the department believes that the control exercised by futures exchanges over clearing services … has made it difficult for exchanges to enter and compete in the trading of financial futures contracts.” DOJ also called for fungible futures contracts and a clearing structure that more closely resembles those that service the U.S. stock markets, served by the Depository Trust Corporation, and the U.S. options markets, served by Options Clearing Corporation. DOJ urged the “Treasury to propose a thorough review of futures clearing and its alternatives, including a careful examination into whether a regime more similar to that in the equities or options markets is feasible and would lead to significant consumer benefits.” DOJ’s comment letter also says “if regulatory policies that encourage and facilitate exchange competition were adopted, futures clearinghouses would likely clear
for multiple exchanges and treat identical contracts as fungible. Futures exchanges would, in turn, compete in terms of price, quality of execution systems and the speed and completeness of information available to market participants.”
CME spirals CME Group’s stock plummeted on the news, falling $103.55 or 17.5 percent Feb. 6 to $485.25, a day after the stock slipped 3.2 percent when the comment 45
continued on p.
Quick Scalps Meet the Nasdaq OMX Group The Nasdaq Stock Market completed its combination with OMX AB (a former Nordic financial exchange operator), creating the Nasdaq OMX Group, “the world’s largest exchange company” according to the Feb. 27 announcement. As part of the t he transaction, Nasdaq OMX Group also became a 33 1/3-percent shareholder in DIFX, Dubai’s Dubai’s international financial Exchange (Borse Dubai is a 19.9-percent shareholder of Nasdaq OMX Group). OMX Nordic Exchange, while no longer a legal entity, represents the common offering from Nasdaq OMX exchanges in Helsinki, Copenhagen, Stockholm, Iceland, Tallinn, Riga, and Vilnius.
ICE, OCC cross margin Russell contracts IntercontinentalExchange (ICE) announced in March it received regulatory IntercontinentalExchange approval from the Commodity Futures Trading Commission (CFTC) for cross- margining Russell Index futures and options contracts. The ICE’s most actively traded Russell-based instrument is its Russell 2000 futures contract. The approval will allow the ICE’s clearing arm to cross-margin positions with the Options Clearing Corporation (OCC), which is the clearing organization for U.S. exchange-traded equity and equity index options. Cross-margining Cross-mar gining reduces the margin requirements for qualifying traders, who would otherwise have to pay the full margin rates for related instruments trad- ed on the different exchanges. Risk-reducing positions — e.g., a long position in one Russell contract complemented by a short Russell position in a contract on the other exchange — would receive a reduced margin rate. Specifics of the cross-margining program can be found at https://www.theice.com/clearing_cr https://www .theice.com/clearing_cross_margin.jhtml. oss_margin.jhtml.
Osaka and ISE want to launch “revitalizing” Japanese options platform The Osaka Securities Exchange (OSE) and International Securities Exchange (ISE) have signed a Memorandum of Agreement (MOA) that outlines their plans to build a cooperative relationship as “the first step toward the formation of a joint venture and the launch of a new, jointly owned options trading platform.” The venture is designed for the Japanese options market. In the joint press release, OSE President and CEO Michio Yoneda says, “[T]his initiative will help to revitalize the Japanese equity options market and to establish it as a useful investment tool for investors.”
ACTIVE TRADER • May 2008 • www.activetradermag.com
44
Inside the Market continued letter became public. And New York Mercantile Exchange (NYMEX) shares fell 17.6 percent or $18.78 Feb. 6 to $87.88, while IntercontinentalExchange’s (ICE) shares slipped 7 percent or $8.75 to $115.90. CME and NYMEX had announced they were in merger and acquisition talks. Both stocks slowly recovered but still were below the pre-DOJ letter prices. CME and other exchanges stand to lose a major source of revenue if a single futures industry clearinghouse is created as the DOJ suggests. Last year, CME reported $1.76 billion in clearing and transaction fees, up from $1.34 billion in 2006. Total CME 2007 revenue was $2.12 billion, vs. $1.6 billion for 2006. It
is not clear how much of that revenue comes specifically from clearing fees because CME has always bundled the transaction and clearing fees into one price. CME CEO Craig Donohue did his best to allay concerns that the U.S. government was aiming to take away the CME clearinghouse. He told analysts in a special conference call that the issue raised by the DOJ has been debated and discussed for many years within the industry in various forms. “This is simply a comment letter,” Donohue says. “This is not something that’s never been talked about. The tugof-war between exchanges and intermediaries with respect to controlling the clearinghouse has a lot more to do with busi-
Managed futures performance: Barclay Trading Group’s January 2008 rankings January 2008 return Top 10 traders ranked by January managing more than $10 million as of 1/31/08. Trading advisor 1. Friedberg Comm. Mgmt. (Divers.) 2. Emil van Essen (Spread Trading) 3. Kelly Angle Inc. (Genesis) 4. Hawksbill Capital Mgmt. (Gl. Divers.) 5. Mulvaney Capital Mgmt. (Gl. Markets) 6. DUNN Capital Mgmt. (WMA) 7. Claughton Capital 8. Keck Capital Management 9. Fort Orange Capital Mgmt (Gl. Strat.) 10. Rochester Capital (Managed Futures)
January Janu ary return (%)
2007 YTD return (%)
$ Under mgmt.
62.90 31.00 30.48 23.63 21.65 19.94 19.87 17.91 16.98 15.85
62.90 31.00 30.48 23.63 21.65 19.94 19.87 17.91 16.98 15.85
16.9M 19.0M 23.0M 42.5M 98.0M 57.7M 30.5M 22.6M 16.4M 30.0M
Top 10 traders ranked by January 2008 return managing less than $10 million as of 1/31/08. 1. Somers Brothers Capital (Divers.) 2. Abundance Fund, LLC 3. Edge Inv Mgmt (Gl Diversified) 4. Barbashop LLC 5. Linn, Hare, Huckabay (Apex) 6. Visioneering R. & D. Co. (V-100 E) 7. Red Rock Capital (Diversified) 8. Montague Financial (Pascal) 9. DUNN Capital Mgmt. (Combined) 10. Dreiss Research Corp.
24.60 23.61 21.25 18.00 17.58 17.09 16.46 15.67 14.69 14.57
24.60 23.61 21.25 18.00 17.57 17.09 16.46 15.67 14.69 14.57
3.1M 1.1M 2.4M 2.0M 2.0M 1.1M 3.4M 1.8M 9.4M 1.4M
Based on estimates of the composite of all accounts or the fully funded subset method. Does not reflect the performance of any single account. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. Source: Barclay Hedge (www (www.barclayh .barclayhedge.com) edge.com)
45
ness interests than it does with the public benefit.” Donohue also fended off questions about the DOJ’s apparent contradictory stance — first approving its acquisition of CBOT, which effectively granted the combined exchange about 90 percent of the U.S. futures execution and clearing business — and then stating that such a structure is anti-competitive. The DOJ’s comments focused on financial futures contracts, not those of commodities such as energy futures, which are highly competitive between the NYMEX and ICE.
Go slow Market participants voiced reservations about the DOJ’s proposed solution and none believed change is likely anytime soon. The Treasury, led by Sec. Henry Paulson who spearheaded the call for comments on achieving more competitive U.S. financial markets, will be undergoing a transition in the coming months with a new president starting next January Ja nuary.. Sharon Brown-Hruska, vice president in the securities and finance practice at NERA Economic Consulting, is a wary of such a major structural change. “You want to be fair to the clearing firms and the exchanges,” Brown-Hruska says. “The government should be cautious when engaging in micro-structure management or trying to dictate what the perfect structure of the industry is or should be.” Others questioned why the DOJ was coming in with its comment letter now, about two months after the deadline for comment letters for the Treasury. CFTC commissioner Bart Chilton said in a statement he found several aspects of the DOJ letter troubling. For one, Chilton said the focus is clearly outside the parameters of what the Treasury had requested — which was comment on regulatory oversight of U.S. financial markets. Many of the prior comments dealt with merging the CFTC and the Securities Exchange Commission. “The business model the DOJ staff is now condemning received, only a few short months ago, the legal blessing of the DOJ following its extensive, compre-
www.activetradermag.com • May 2008 • ACTIVE TRADER
hensive, and exhaustive review of the CME/CBOT merger,” Chilton says. Another industry executive says the futures industry does not need a single clearing entity, but rather a change in the way clearing houses interact with one another. Many FCMs and customers are frustrated by exchanges which fail to offer margin offsets on competing products at
other exchanges, which ultimately forces market users to post margin at two exchanges. “I’m not in favor of spinning off clearing into one entity and I don’t think that adds value,” the executive says. “But regulators should mandate cooperation among clearing houses.” The Futures Industry Association (FIA)
issued a statement supporting the DOJ’s recommendation for a review of exchange-controlled clearing. In 2003, the FIA also pushed for other clearing changes such as directed clearing, or clearing choice. But such debates have raised the dialog and then quietly been shelved. This time, it may be different.
Java jolt: Something’s brewing in coffee BY ACTIVE TRADER STAFF
Y
FIGURE 1: ICE COFFEE
our morning cup of joe may get more expensive over the next several months to a year.
Nearby ICE Futures US coffee futures surged to multiple-year highs in February and analysts say there could be more to go on the upside. After the May 1997 top at 280.00, coffee declined into 2001 before creeping higher, forming the large base evident on the monthly coffee chart (Figure 1). Most analysts agree the coffee market has etched a major long-term bottom on the charts, and the recent price action portends even higher prices to come. “We have a big base going back to the late 1990s,” says Paul Hare, executive vice president at the Linn Group. “[The market has] established a bottom, there is no question about it.” This year’s rally through the 140.00-apound level (topping the May 2005 high of 139.50) was a significant upside breakout. “When you come out of a formation like this over the past 20 years you’ve had big moves out of your base,” Hare says. Fundamentally, the case for higher coffee is there. Producer stocks have been falling recently. Judy Ganes Chase, president of JGanes Consulting, has forecast a 138-million-bag figure for world production in 2008-2009 vs. a consumption estimate of 133 million bags. “Through 2009-2010 we will see limited supply,” supply,” she says. “Consumption is getting close to production,” agrees Hernando de la Roche,
Coffee futures have been percolating higher since the 2001 bottom. Despite the early March correction, industry watchers expect coffee to push higher. Source: TradeStation
managing director at Hencorp Futures in Miami. Citing historically low inventory levels and rising consumption levels (1 to 2 percent per year), de la Roche says the balance between supply and demand will be tighter every year. “This is the first time both Arabica and Robusta (the two primary coffee grades ) have rallied together not as a direct result of frost or drought in Brazil,” Ganes says. Brazil is the world’s world’s largest coffee producer and exporter. In recent months, coffee futures have been driven higher in part by “pervasive fund buying” as trend and momentum players jump on commodity market ral-
ACTIVE TRADER • May 2008 • www.activetradermag.com
lies. Nonetheless, Ganes adds, even “when you take that out of the equation and go back to the underlying fundamentals they are pretty solid.” May coffee futures corrected in early March (Figure 2), but overall analysts weren’t fazed by the retreat. Analysts are pointing to the 200.00 mark as a clear upside target for the market. Beyond that, Hare says the 2.1200 zone is a key Fibonacci retracement target (61.8 percent of the May 1997-December 2001 sell-off) as a possible objective into the summer months. Given the way coffee has trended on a historical basis, he even sees the potential for a spike to 250.00 or 260.00. 46
Inside the Market continued
Groups exchange barbs regarding investor arbitration
A
recent survey conducted by professors at Pace University and the University of Cincinnati College of Law was not very friendly to the arbitration process used by Wall Street to resolve disputes with investors. More than 3,000 investors, lawyers, and security employees who had been involved in arbitration between January 2002 and December 2006 were surveyed, and only 28 percent thought the process was fair. Furthermore, only a quarter of investors surveyed thought the process was fair. The survey was commissioned by the Securities Industry Conference on Arbitration (SICA), and the results did not please the folks at the Securities Industry and Financial Markets Association (SIFMA). SIFMA published a response entitled “The Thinking Person’s Guide to Interpreting the Latest Survey on Subjective Perceptions of Fairness of Securities Arbitration” in which it questioned the process used in conducting the survey and downplayed the results. “The survey focuses solely on subjective perceptions by arbitration participants and does not address objective standards of substantive or procedural fairness,” the response says. “The survey, for example, attempts to analyze fairness, in part, by participants’ views about the alleged time and cost inefficiency of arbitration, and about the alleged bias of arbitrators. Yet, individuals’ perceptions about these particular factors can be proven to be inaccurate because these factors have already been measured objectively and empirically.” For starters, SIFMA points out the survey consisted of 40 multiple-choice questions and was sent to about 30,000 people. However, only 10 percent of that group responded and, of that total, almost 60 percent settled before the 47
Thirty-five percent of customers would not choose arbitration in the future because they believe it is unfair; 44 percent did not think arbitration was conducted “without bias.” hearing concluded. However, a lawyer for SICA called SIFMA’s response “out of touch,” and Jill Gross, co-author of the study, says SIFMA was “denigrating the observations and views of an entire class of arbitration participants.” According to the survey, survey, almost 35 percent of customers would not opt for arbitration in the future because they believe the process is unfair, and 44 percent did not think arbitration was conducted “without bias.” Unfortunately,, arbitration is the only Unfortunately route aggrieved investors have if they believe they have been wronged. Before opening an account, brokerages require investors to sign an agreement that they will seek arbitration and not opt to go to court if there is a dispute. Of those in the survey who had been lawyers, plaintiffs, or defendants in a court case over the past five years, 63 percent say arbitration was “very unfair” compared to court. A lawyer for SIFMA claimed the investors who responded to the survey but did not go through the entire process, opting instead for an early settlement, are
unqualified to comment on the process. However, a SICA spokesman says a participant doesn’t need to see the arbitration to the end to determine if there is bias involved. More than 55 percent of arbitration cases were settled in 2007, up from 36 percent in 2003. However, while 42 percent of investors won their cases in 2006, that number dropped to 37 percent in 2007. Still, SIFMA believes an increase in settlements shows investors are happy with the process, saying nobody would agree to settle unless they believed the settlement was fair and adding that many on the brokerage side also believe the process is unfair, balancing out the results. “The Thinking Person’s Guide…” states, “Customers, on the one hand, felt they were not fully compensated for their losses. Securities firms, on the other hand, felt that customer awards were overly generous. The fact that both sides were somewhat dissatisfied with the outcome does not reflect that the process is biased. Rather, it is a good indication that the system is taking a balanced approach and producing results that are within an acceptable range of fairness.” However, state regulators have sided with investors, claiming the survey points out the need for removing industry members from arbitration panels. Bryan Lantagne, chairman of the arbitration working group sponsored by the North American Securities Administrators Association (NASAA), says “We’re trying to see whether the investors believe [the arbitration system is] fair. Now we have a report that shows that they don’t, and everyone’s trying desperately to put a spin on this. These numbers really speak volumes to what the investors believe. That’s crucial to the forum. If they feel they’re forced to go into a forum that’s biased, it perverts the program.”
www.activetradermag.com • May 2008 • ACTIVE TRADER
SEC wants to streamline the ETF pipeline
E
xchange-traded funds (ETFs) have been the golden child of the equities industry for several years, and the SEC has proposed new rules to make it easier for ETFs to operate. In early March the SEC proposed two new rules under the Investment Company Act to permit exchange-traded excha nge-traded funds (ETFs) to operate without obtaining
“individual exemptive orders” from the Commission — a process that adds time and costs to bringing new ETFs to market. “The proposed rules would increase investor choice by eliminating a barrier to entry for new participants in this fastgrowing market, while preserving investor protections,” said Andrew J. Donohue, Director of the SEC’s Division of
Investment Management, in the SEC’s press release. “Permitting most ETFs to come directly to market without the cost and delay of obtaining an exemptive order would also allow staff to focus on more novel and difficult requests.” The comment period for the proposal will end 60 days from the date of publication of the proposed rule in the Federal Register.
STOCK PRICES OF TRADING-RELATED FIRMS Company
Symbol
Exchange
Closing price 3/6
1-month change
% change high
52week low
52week vol.*
Avg. daily ($)
Market cap
Brokerages Track Data Terra Nova Financial Group TD Ameritrade Charles Schwab OptionsXpress TradeStation AB Watley Watley Siebert Financial E*Trade AlphaT Alpha Trade Man Financial Global
TRAC TNFG AMTD SCHW OXPS TRAD ABWG SIEB ETFC APTD MF
NASD OTC BB NASD NASD NASD NASD Pink Sheets Sheets NASD NASD OTC BB NYSE
1.74 1.41 17.2 18.96 21.9 9.37 0.07 3.03 3.77 0.195 18.39
0.07 0.02 -0.41 -1.22 -2.5 -1.1 -0.01 -0.53 -0.83 -0.045 -9.9
4.19% 1.44% -2.33% -6.05% -10.25% -10.51% -12.50% -14.89% -18.04% -18.75% -34.99%
3.86 2.5 21.31 25.72 34.95 14.87 0.45 5.76 25.79 0.33 32.2
1.45 1.1 13.82 17.41 20.78 9.28 0.009 3 2.08 0.1035 14
8,062 23,892 5.59 M 12.5 M 1.23 M 537,739 82,605 3,056 39.9 M 82,491 1.95 M
$14.6 M $38.2 M $10.2 B $21.9 B $1.38 B $414 M $2.04 M $67.3 M $1.74 B $9.05 M $2.21 B
Exchanges/Trading firms IntercontinentalExchange New York Mercantile Exchange Nyfix CME Group Nasdaq Stock Market Interactive Brokers NYSE Euronext Penson Worldwide
ICE NMX NYFX CME NDAQ IBKR NYX PNSN
NYSE NYSE Pink Sheets NYSE NASD NASD NYSE NASD
132.44 99.38 4.1 505.45 38.79 29.71 61.6 9.35
16.54 11.5 0.25 20.2 -1.37 -2.89 -7.43 -2.32
14.27% 13.09% 6.49% 4.16% -3.41% -8.87% -10.76% -19.88%
194.92 148 7.5 714.48 50.47 35.93 101 34.91
114.62 86.61 3.6 475.17 26.57 21.00 62.05 9.245
2.22 M 2.21 M 54,860 1.00 M 2.54 M 981,843 4.20 M 270,056
$9.29 B $9.23 B $150 M $26.9 B $4.44 B $1.19 B $16.3 B $237 M
Market makers/Specialists Knight Capital Group LaBranche
NITE LAB
NASD NYSE
15.92 4.34
-0.66 -1.07
-3.98% -19.78%
18.49 9.3
11.5 4.03
2.30 M 675,448
$1.55 B $267 M
Miscellaneous Value Line Interactive Data Corporation eSpeed MarketAxess
VALU IDC ESPD MKTX
NASD NYSE NASD NASD
40.25 27.77 11.38 8.83
0.34 -0.76 -0.62 -0.65
0.85% -2.66% -5.17% -6.86%
56 33.68 12.97 19.87
31.1 22.92 7.02 9
4,661 268,142 235,523 224,839
$402 M $2.62 B $356 M $272 M
*over last three months
ACTIVE TRADER • May 2008 • www.activetradermag.com
48
Inside the Market continued
Gold express may lose steam above $1,000 BY ACTIVE TRADER STAFF
FIGURE 1: PARABOLIC RALLY
Y
ou don’t have to look far these days to find a commodity market scoring new all-time highs. However, in the days leading up to spring, one particularly “sexy” market — gold — finally climbed above the psychologically significant and historic $1,000-an-ounce mark. Gold has been moving higher since 2001, although the lion’s share of the current rally has occurred since April 2003 and the months since June 2007 have been especially explosive (Figure 1). However, starting in 2001, the U.S. Federal Reserve embarked upon a historical monetary policy easing cycle that ultimately took the fed funds rate down to 1 percent. The U.S. dollar entered a major bear market around that time and commodity markets boomed across the board. Gold bugs woke up after more than a decade of hibernation. For several years, the rally in the gold market was a quiet upward march, with the price of the yellow metal climbing to $456.50 in December 2004. By mid-2006 gold had vaulted to around $725, followed by nearly a year of consolidation. In August 2007 the Fed launched a new easing cycle after a year of holding rates steady. “Gold was trading sideways after the May 2006 peak until the Fed started cutting rates,” says Dan Vaught, futures analyst at Wachovia Securities. The dollar continued to fall, which continued to bolster commodity prices. “Gold and all internationally traded commodities that are priced in dollars see a negative correlation between the dollar and the price of the commodity,” he says. But what’s happening now goes beyond 49
This monthly chart of continuous gold futures highlights the huge gains the market has made in recent months. Source: TradeStation
anything that can logically be squeezed out of the fundamentals.
Self-fulfilling prophecy? A bevy of factors f actors have fed the new gold mania, which has intensified in recent months. Flight-to-safety concerns regarding the U.S. sub-prime debacle supported gold in late 2007 and beyond, and concerns that global inflation would pick up amid the strong world-wide demand for commodities also underpinned the yellow metal. Historically Historically,, gold has been seen as both an inflation hedge and a flight-tosafety vehicle. Plenty of purely speculative money has been chasing the gold market. “The continued capital influx has tended to exaggerate this move,” Vaught says. With the U.S. stock market pushing
lower and real estate markets collapsing across the U.S., investment money has flowed into the commodity arena. “Commodities have been the success story,” story ,” he says. “There are tremendous amounts of capital being thrown at this market as traders and funds look for assets that are performing well.”
It’s not just gold Gold may be the marquee market, but virtually all metals have been rallying across the board, with double-digit gains in both the precious and industrial sectors. Terence Gabriel, senior technical strategist at Ideaglobal in New York, points out that gold futures gained 45 percent from the end of February 2007 to the end of
www.activetradermag.com • May 2008 • ACTIVE TRADER
FIGURE 2: FLIRTING WITH $1,000
February 2008. During that same period, silver rallied 40 percent, copper soared 41 percent, and platinum skyrocketed 74 percent. Gabriel noted that platinum and palladium have both “gone ballistic” in part due to recent South African mine shutdowns. The market catalysts for industrial and precious metals are not necessarily the same, though. According to Gabriel, industrial metals have the benefit of strong emerging market demand for the actual use of the materials, while precious metals benefit from dollar weakness and instability, which may be leading into forward-inflation expectations.
The energy connection With crude oil topping $100, the passthrough costs of higher energy prices have the potential to ripple through virtually every aspect of the global economy. “The big inflation concern really goes back to energy,” Vaught says. “Gold traditionally has been closely associated with the energy sector. As long as crude oil prices remain strong, gold will remain strong. Ultimately, Ultimately, when and if crude turns downward, I think gold bulls would be hard pressed to sustain this rally.”
Bubbles and fair value Leonard Kaplan, president of Prospector Asset Management and long-time gold watcher, says the financial world over the last eight years has been all bubbles, citing the Nasdaq top in 1999, the real estate bubble, and now commodities. “Is any of it real?” he asks. “Of course not. [The recent upward spiral in gold prices] is total mania. There are 10,000 hedge funds with hundreds of billions of dollars throwing money at gold. Will it end very badly? Yes. But will it end a week from now, a month from now, or three years from now? No one knows. “Gold is worth about half of where it is right now. If you can produce gold at $350/400 ounce, why is it worth $950?
After consolidating between roughly $960 and $995, on March 13 gold finally cleared the $1,000 psychological hurdle. Source: TradeStation
This is only about money chasing money.” When asked if he thought gold was overvalued, Vaught says unlike most other commodities, “Gold value is such a nebulous concept.”
The $1,000 barrier Just as this story s tory went to press, gold pierced the $1,000 mark, another notch on its historical-significance belt (Figure 2). Most market watchers agree the level has acted as a “magnet,” as round numbers so often do. What happens next, though, is very much open to debate. “The parabolic structure of the rally would tend to suggest that we are close to the end of the move,” Gabriel says. “It is a dangerous market once it gets over $1,000.” He is forecasting a near-term thrust above $1,000 — perhaps a top at $1,025 or even $1,100. From there, however, he believes the market is vulnerable to a hefty correction, possibly to the $750 to $800 level.
ACTIVE TRADER • May 2008 • www.activetradermag.com
“Looking at reward/risk at over $1,000, the next move favors a correction,” Gabriel says. “It is a crowded trade to chase gold at $1,000.” However, Gabriel expects a late-spring, early-summer sell-off to present another buying opportunity in the continuing long-term uptrend in gold. Expectations remain high the U.S. Federal Reserve will continue its easing stance in an effort to stave off recession into mid-year (the next scheduled interest-rate meeting is on March 18). Lower interest rates weigh on the U.S. dollar, which in turn could continue to support gold and other commodity prices. Again, the big question is, how far f ar and for how long? There are huge risks to overheated markets. “As long as the Fed continues to be the slut of Wall Street, I think metals go higher,” Kaplan says. “It is very difficult to know what can prick a bubble.” His advice for those interested in trading gold: “Go to Las Vegas. The odds are better.” 50
Inside the Market continued
Global News EUROPE The European Central Bank (ECB)
held overnight interest rates steady at 4 percent at its March 6 meeting. France’s Q4 GDP increased 0.7 per-
cent, a 4.2-percent gain from a year ago. Decreases in household and gov- ernment expenditure, industrial produc- tion, and exports contributed to the slowest quarterly economic growth in more than a year. Germany’s unemployment rate fell
in December for the sixth consecutive month to 7.8 percent — 1.2 percent less than a year ago. Unemployment has fallen steadily in Germany since January 2006 when it hit 10.4 percent. Germany’s GDP grew 0.3 percent in Q4, due in part to an increase in exports. This brings the growth since Q4 2006 to 3.7 percent. UK unemployment fell 0.2 percent
Interest-rate monitor The Bank of Canada lowered its overnight target rate 0.50 percent to 3.5 percent. The Bank of England lowered its bank rate 0.25 percent to 5.25 percent in February and held steady in March.
The Reserve Bank of Australia raised its overnight lending rate 0.25 percent to 7.25 percent.
The Bank of Japan (BOJ) raised its overnight rate 0.25 percent to 0.50 percent. Reserve Bank of New Zealand held rates steady at 8.25 percent. European Central Bank (ECB) held rates steady at 4.0 percent. Bank of Japan (BOJ) held rates steady at 0.5 percent.
The Swedish Riksbank raised its repo rate 0.25 percent in February to
4.25 percent, the eleventh increase in two years. The National Bank of Romania raised its monetary policy rate 1.0
percent in February to 9.0 percent, a 2.0-percent increase since June of last year.. year
ASIA & AUSTRALIA
in biomedical manufacturing rather than the impact of the slowing U.S. economy,” economy ,” according to a government press release. GDP has increased 10.8 percent over the past year. Singapore’s Q4 unemployment fell to 1.6 percent, down from 1.7 percent in Q3 and down 1.0 percent from the same period last year. Growth in the construction sector doubled in 2007 compared to the previous year, con- tributing to the decade-low unemploy- ment estimate. The Central Bank of Philippines lowered its overnight borrowing rate 0.25 percent to 5.0 percent in
to 5.2 percent in the October- December period, down 0.3 percent Japan’s Q4 GDP grew 0.3 percent from the same period last year. This compared to the previous quarter, a January, marking four consecutive January, coincides with a 74.7-percent employ- 1.2-percent increase from year ago. months of 0.25-percent decreases. ment rate, the highest level since com- Japan’s unemployment rate was parable employment recording began 3.8 percent in December, the same as in 1971. In February, the Bank of in November. November. This level is 0.2 percent AMERICAS England lowered its overnight lend- less than the rate reported in ing rate 0.25 percent to 5.25 percent, December 2007. the same rate as a year ago. It held Canada’s unemployment rate fell rates steady at its subsequent meeting The Reserve Bank of Australia 0.2 percent in January to 5.8 percent, on March 6. raised its cash rate 0.25 percent to equal to the 33-year low recorded in 7.0 percent in February. This rate has October 2007. Employment has contin- Czech Republic incumbent increased steadily since early 2005 ued to climb in many sectors, bringing President Vaclav Klaus was reelect- when it was 5.25 percent. The the employment rate up to a record ed for a five-year term, defeating Australian unemployment rate fell high of 63.8 percent. The Bank of University of Michigan economics pro- 0.2 percent to 4.1 percent in January, Canada lowered its overnight fund- fessor Jan Svejnar in a heated race 0.6 percent less than a year ago. Over ing rate 0.25 percent to 4.00 percent, requiring three separate rounds of vot- the past decade, the unemployment the lowest rate since April 2006. ing. The Czech National Bank rate has fallen 3.8 percent. raised its two-week repo rate 0.25 percent to 3.75 in February. This rate Hong Kong’s November-January has increased steadily from 1.75 per- unemployment rate held steady at AFRICA cent in April 2005. 3.4 percent from the previous three- month period. This is the lowest figure The National Bank of Poland in 10 years. Employment surged to over South Africa’s Q4 GDP rose 5.3 per- raised its 28-day intervention rate 3.55 million, another record high. cent from the previous quarter and 4.6 from 5.0 percent to 5.25 percent in percent from a year ago. Expansion in January.. This marks the fifth increase in January Singapore’s GDP rose 2.42 percent in the manufacturing and construction the last 10 months after hitting a Q4 — a slowdown from the previous industries played a significant part in recent 4.0-percent low in 2006. quarter due mostly to a “sharp decline this growth. 51
www.activetradermag.com • May 2008 • ACTIVE TRADER
Global MARKETPLACE FOREX (VS. U.S. DOLLAR)
Currency
Current price vs. U.S. dollar
1-month ga g ain/loss
3-month gain/loss
6-month gain/loss
52-week high
52-week low
Previous rank
1
Swiss franc
0.96312
5.43%
7.84%
16.49%
0.9699
0.8005
2
2
Swedish krona
0.16266
4.89%
4.58%
11.81%
0.1635
0.14
8
3
Brazilian real
0.59898
4.87%
7.67%
17.08%
0.6001
0.453
14
4
Taiwanese dollar
0.03244
3.71%
4.81%
7.20%
0.03255
0.02983
6
5
Japanese yen
0.009655
3.25%
6.47%
11.79%
0.00970
0 .00805 0.
1
6
Euro
1.52127
3.14%
3.33%
11.74% 11
1.5302
1.3072 1.
7
7
Australian dollar
0.92718
2.51%
6.49%
12.58%
0.9497
0.7672
5
8
Russian ruble
0.04167
2.43%
1.86%
6.96%
0.04178
0 .03799 0.
10
9
Singapore dollar
0.71971
1.90%
4.09%
9.86%
0.7204
0.6468
3
10
Chinese yuan
0.14087
1.08%
3.99%
6.23%
0.1406
0.1285
4
11
New Zealand dollar
0.79807
1.00%
4.48%
15.17%
0.8213
0.6642
12
12
British pound
1.98464
0.74%
-2.99%
-1.46%
2.1161
1.918
13
13
Canadian dollar
1.00772
0.61%
2.21%
5.96%
1.1038
0.8455
15
14
Hong Kong dollar
0.12843
0.17%
0.09%
0.09%
0.129
0.1277
11
15
Thai baht
0.03192
-1.66%
-3.59%
2.24%
0.03396
0.02782 0.
16
16
Indian rupee
0.02481
-1.86%
-2.05%
1.51%
0.02549
0.02237 0.
9
17
South African rand
0.12747
-4.49%
-13.36%
-7.82%
0.1555
0.1242
17
Rank* Country
As of March 6 *based on one-month gain/loss ACCOUNT BALANCE Rank 1 2 3 4 5 6 7 8 9 10 11 12
52
Country Sin ing gapore Swit Sw itze zerl rlan and d China Hong Kong Neth Ne ther erla land ndss Taiwan Sweden Russia Germany Japan Canada Brazil
2007 41.395 65.534 379. 37 9.16 162 2 22.796 55.891 25.402 25.903 72.543 175 75.3 .37 71 195 95.9 .90 04 25.603 10.253
Ratio* 27 15.8 11.7 11.7 11.2 7.4 6.8 6 5.9 5.4 4.5 1.8 0.8
2006 36.288 58.708 249. 24 9.86 866 6 20.586 8.6 24.661 27.707 95.322 147. 14 7.1 134 170. 17 0.4 437 20.792 13.276
2008+ 42.208 64.106 453.14 453. 146 6 20.456 6.7 28.365 25.584 49.181 174 17 4.1 .137 37 195 19 5.1 .145 45 17.909 4.299
Rank 13 14 15 16 17 18 19 20
Co C ountry Mexico France India UK Aust strrali liaa U.S. Sou outth Af Afri rica ca Spain
2007 -6.368 -39.363 -23.131 -96. -9 6.6 687 50.816 -784 -7 84.3 .341 41 -18. -1 8.49 495 5 -138.916
Ratio* -0.7 -1..6 -1 -2.1 -3.5 -3 .5 -5.7 -5.7 -5. 7 -6.7 -6 .7 -9.8
2006 -2.425 -27 -2 7.7 .71 12 -9.503 -77 -7 7.2 .236 36 -41.49 -811 -8 11.4 .483 83 -16 -1 6.6 .608 08 -106.399
+ 2008 -10.588 -48 -4 8.885 -32.301 -105.1 -105 .14 44 -52.988 -788 -7 88.2 .293 93 -19. -1 9.2 237 -154.849
Totals in billions of U.S. dollars *Account balance in percent of GDP +Estimate Source: International Monetary Fund, World Economic Outlook Database, October 2007
www.activetradermag.com
•
May 2008
• ACTIVE TRADER
NON-U.S. DOLLAR FOREX CROSS RATES Rank
Currency pair
Symbol
March 6
1-month gain/loss
3-month ga g ain/loss
6-month gain/loss
52-week high
52-week low Previous
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Franc / Canada $ Franc / Pound Real / Canada $ Real / Pound Real / Aussie $ Franc / Euro Franc / Yen Aussie $ / Canada $ Aussie $ / Pound Real / Euro Real / Yen Euro / Yen Canada $ / Pound Aussie $ / Euro Aussie $ / Yen Pound / Euro Pound / Yen Canada $ / Euro Canada $ / Yen Aussie $ / Franc
CHF/CAD CHF/GBP BRL/CAD BRL/GBP BRL/AUD CHF/EUR CHF/JPY AUD/CAD AUD/GBP BRL/EUR BRL/JPY EUR/JPY CAD/GBP AUD/EUR AUD/JPY GBP/EUR GBP/JPY CAD/EUR CAD/JPY AUD/CHF
0.95606 0.48535 0.59459 0.30186 0.64617 0.6331 99.76636 0.92038 0.46725 0.39376 62.04962 157.582 0.50784 0.60955 96.04732 1.30461 205.585 0.66246 104.392 0.96295
4.79% 4.66% 4.23% 4.10% 2.30% 2.22% 2.10% 1.89% 1.76% 1.67% 1.56% -0.11% -0.13% -0.61% -0.72% -2.33% -2.44% -2.45% -2.56% -2.76%
5.50% 11.16% 5.33% 10.99% 1.10% 4.37% 1.29% 4.18% 9.77% 4.20% 1.13% -2.95% 5.36% 3.06% 0.02% -6.11% -8.88% -1.08% -4.00% -1.25%
9.93% 18.22% 10.49% 18.82% 4.00% 4.25% 4.21% 71.03% 14.25% 4.78% 4.74% -0.04% 7.53% 0.76% 0.75% -11.82% -11.85% -5.17% -5.20% -3.35%
0.9751 0.4889 0.5946 0.3019 0.6544 0.6369 101.852 0.9493 0.4753 0.3995 66.2821 168.96 0.5219 0.646 107.831 1.4968 251.095 0.7476 124.527 1.0755
0.8044 0.4005 0.5213 0.2431 0.5883 0.5942 92.152 0.8439 0.3975 0.3569 54.3068 149.227 0.4373 0.5727 85.975 1.3001 203.462 0.639 98.32 0.9452
1 2 5 8 11 4 13 3 6 10 19 17 12 7 16 9 18 15 20 14
GLOBAL STOCK INDICES Rank
Country
Index
March 6
1-month gain/loss
3-month g ai ain/loss
6-m -mo onth ga g ain/loss
52-we wee ek high
52-we wee ek low Previous
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
South Africa Brazil Canada Mexico Japan Singapore Hong Kong U.S. UK Italy Australia France Germany Switzerland India
FTSE/JSE All Share Bovespa S&P/TSX composite IPC Nikkei 225 Straits Times Hang Seng S&P 500 FTSE 100 MIBTel All ordinaries CAC 40 Xetra Dax Swiss Market BSE 30
31,079.15 62,975.00 13,360.44 28,717.04 13,215.42 2,917.92 23,342.73 1,304.34 5,766.40 25,148.00 5,531.90 4,678.05 6,591.31 7,269.90 16,542.08
11.47% 6.79% 3.83% 2.82% 0.89% -0.48% -0.54% -1.67% -1.86% -2.55% -2.57% -2.87% -3.74% -3.91% -8.81%
7.73% -4.28% -3.53% -8.13% -16.75% -17.86% -21.03% -13.47% -11.09% -16.01% -16.94% -17.55% -16.99% -16.84% -16.44%
2.27% 15.40% -3.15% -6.81% -18.71% -15.81% -2.94% -11.78% -8.66% -18.43% -11.71% -16.11% -13.52% -17.67% 5.93%
31,728.18 66,529.00 14,646.80 32,851.10 18,297.00 3,906.16 31,958.40 1,576.09 6,754.10 34,369.00 6,873.20 6,168.15 8,151.57 9,548.10 21,206.80
24,005.35 42,051.00 12,011.68 25,282.30 1 2,572.70 12 2,859.08 18,738.50 1,270.05 5,338.70 24,545.00 5,253.50 4,505.14 6,384.40 6,950.90 12,316.10
9 3 2 1 13 12 11 4 5 10 7 14 15 6 8
GLOBAL SHORT-TERM SHORT-TERM INTEREST RA RATES TES Country U.S. Japan Eurozone UK Canada Switzerland Australia New Zealand Brazil Korea Taiwan India South Africa
Interest rate Fed Funds Rate Overnight call rate Refi rate Repo rate Overnight funding rate 3-month Swiss Libor Cash rate Cash rate Selic rate Overnight call rate Discount rate Reverse repo rate Repurchase rate
Rate 3 0.5 4 5.25 3.5 2.75 7.25 8.25 11.25 5 3.375 6 11
Last change 0.5 (Jan. 08) 0.25 (Feb. 07) 0.25 (June 07) 0.25 (Feb. 08) 0.5 (March 08) 0.25 (Sept. 07) 0.25 (March 08) 0.25 (July 07) 0.5 (Sept. 07) 0.25 (Aug. 07) 0.125 (Dec. 07) 0.5 (Dec. 07) 0.5 (Dec. 07)
Sept. 07 4.75 0.5 4 5.75 4.5 2.75 6.5 8.25 11.25 5 3.25 6 10
March 07 5.25 0.5 3.75 5.25 4.25 2.25 6.25 7.5 12.75 4.5 2.875 6 9
GLOBAL BOND RA RATES TES Rank 1 2 3 4 5
Country Japan Germany Australia UK U.S.
Rate Government Bond BUND 10-year bonds Short sterling 10-year T-note
March 6
138.97 117.24 93.73 94.28 116.245
1-month 0.82% 0.28% -0.19% -0.28% -0.73%
3-month 2.04% 1.77% -0.28% 0.86% 2.76%
6-month 2.41% 3.07% -0.38% 0.78% 6.49%
Hiigh H 139.45 118.08 94.355 94.92 119.03
Low 130.96 109.92 93.46 93.6 103.21
Previous 3 2 4 5 1
All data as of March 6 ACTIVE TRADER •
May 2008
•
www.activetradermag.com
53
THE Economy FIGURE 1: QUARTERL QUARTERLY Y GDP PERFORMANCE
U.S. economic briefing FED MINUTES REVEAL CONCERN ABOUT ECONOMY AND INFLATION Date and time: Feb. 20 at 2:15 p.m. ET Summary: The Federal Open Market Committee (FOMC) acknowledged economic conditions had “decelerated sharply in recent months,” according to minutes from its meeting on Jan. 29 and 30. The Fed cited several sources of the economic troubles: sluggish home sales, slowed consumer spending, reduced industrial production, weakened labor market, and rising inflation. The following tables compare the S&P 500’s daily and weekly reactions to economic releases as well as historical behavior since 1997 (or earlier). The S&P 500 climbed at least 0.69 percent on CPI and PPI report days in late February,, while it fell 0.84 percent following a February dismal jobs report on March 7.
Rate changes
Historical moves since 1994 0.31% -0.06%
Report day Five days later Unchanged rates
Historical moves since 1994 0.21% 0.38%
Report day Five days later
Fourth-quarter GDP growth remained at 0.6 percent, according to a preliminary preliminar y (second) estimate. In 2007, average quarterly GDP growth was 2.5 percent, its lowest performance since 2002. Source: Bureau of Economic Analysis Seasonally adjusted
*advanced **preliminary
FIGURE 2: PAYROLLS VS. UNEMPLOYMENT RATE
February payrolls fell by 63,000 in February February,, the largest decline since March 2003. In addition, the unemployment rate’s three-month average hit a two-year high. Source: Bureau of Labor Statistics
Seasonally adjusted
FIGURE 3: OVERALL VS. CORE INFLATION
FOURTH-QUARTER GDP REMAINS WEAK Report: Gross domestic product for Q4 2007 (preliminary estimate) Date and time: Feb. 28 at 8:30 a.m. Actual: 0.6 percent Previous: 0.6 percent Consensus: 0.8 percent
G DP Report day Five days later 54
S&P 500 reaction -0.89% -3.36%
Historical moves since 1994 0.00% 0.43%
The PPI’s annual gain jumped to a new high in January, while the CPI and core readings rose slightly. Source: Bureau of Labor Statistics
Not seasonally adjusted
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•
May 2008
• ACTIVE TRADER
FIGURE 4: ISM MANUFACTURING INDEX
PPI LEADS INFLATIONARY PRESSURES Report: Consumer Price Index (CPI) 20 at 8:30 8:30 a.m. a.m. Date and time: Feb. 20 Actual: 0.4 percent (core 0.3 percent) Previous: 0.4 percent (core 0.2 percent) Consensus: 0.3 percent (core 0.2 percent)
CPI Report day Five days later
S&P 500 reaction 0.83% 2.41%
Historical moves since 1980 0.06% 0.15% In February, the ISM manufacturing index dropped 2.4 points to 48.3, its lowest value since April 2003.
Report: Producer Price Index (PPI) Date and time: Feb. 26 at 8:30 a.m. Actual: 1.0 percent (core 0.4 percent) Previous: -0.3 percent (core 0.2 percent) Consensus: 0.4 percent (core 0.2 percent)
PPI Report day Five days later
S&P 500 reaction 0.69% -2.95%
Historical moves since 1994 0.11% 0.41%
MANUFACTURING INDEX FALLS TO FIVE-YEAR LOW Report: ISM manufacturing index Date and time: March 3 at 10 a.m. Actual: 48.3 Previous: 50.7 Consensus: 47.5 ISM manufacturing Report day Five days later
S&P 500 reaction 0.05% -2.81%
Historical moves since 19 1997 0.28% 0.53%
Source: Institute of Supply Management
Seasonally adjusted
FIGURE 5: S&P PERFORMANCE
The S&P 500 fell 3.27 percent in February amid recession worries, following a 6.12- percent loss in January.. The January market dropped another 2.8 percent in the first week of March. Source: eSignal
FIGURE 6: S&P 500 REACTION TO NEWS
DROP IN PAYROLLS POINTS TO RECESSION Report: Employment 8:30 a.m. a.m. Date and time: March 7 at 8:30 Non-farm payrolls Actual: -63 K Previous: -22 K Consensus: 25 K Unemployment rate Actual: 4.8 percent Previous: 4.9 percent Consensus: 5.0 percent S&P 500 Historical moves Employment reaction since 1994 -0.84% 0.12% Report day ACTIVE TRADER •
May 2008
•
The S&P 500 gained or lost roughl roughly y 0.8 percent on report days in February and early March. However, the market managed to bounce off intraday lows and close up 0.1 percent when the ISM manufacturing index hit the Street on March 3.
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55
Trading BASICS
The maxiworld of mini futures Afterr only a decade, Afte decade, mini mini future futuress contracts contracts are are some some of the the most activel actively y traded traded futures futures in the world. Get the facts on the growing list of U.S.-traded mini futures. BY STEVE GRAUBART
T
he launch of the E-Mini S&P 500 futures contract in 1997 offered an alternative vehicle to trade the S&P 500 stock index. Over time, its smaller size attracted large numbers of traders who could not afford the margin (upwards of $20,000 per contract) and risk profile of the fullsized, pit-traded S&P 500 futures contract. Although in retrospect its advantages might seem obvious — a smaller contract that offers more precise trade sizing and the ease of instantaneous electronic trading — the success of the EMini S&P was hardly assured. And to the surprise of many longtime floor traders, by 2003 the E-Mini S&P futures had passed the once-dominant pit-traded contract in volume. It hasn’t looked back since. Since then, futures exchanges have launched many other mini-sized trading products. Along with many new stock index products have come offerings in grains, energy, currencies, and metals. Table 1 lists the product specifications for actively traded mini futures contracts traded at the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX),
Related reading “The futures advantage” Active Trader, October 2002. Part I of our two-part guide showing the unique characteris- tics of futures. The Article explains basic principles, highlights key trading concepts and helps minimize the risks of trading in this arena. “Market mechanics” Active Trader, November 2002. Article highlights the unique properties properties of futures futures and the mechanics of futures contracts that will allow you to focus on strategy instead of things like rollover and price limits. “Futures contracts and rollover” Futures & Options Trader, April Trader, April 2007. From a strategic perspective, there’s really no difference between stock and futures. Generally, the same approach used to exploit trading opportunities in stocks can be applied to futures, and vice versa. However, futures do have characteristics that make trading them slightly different from trading stocks. Note: Some of these articles are also part of the “Futures Basics Collection,” a discounted article set packaged in a single PDF file. You can purchase and download past articles at www.activetradermag.com www.activ etradermag.com/purchase_ar /purchase_articles.htm ticles.htm 56
and the U.S. branch of the Intercontinental Exchange (ICE). Many of these contracts, including several mini stock-index contracts, are among the most actively traded U.S. futures (see “Stocks and Futures Snapshot,” p. 40).
Trading in bytes One common characteristic of all the mini contracts is that they are traded electronically electronically,, regardless of exchange. Before electronic trading assumed the primary position in the U.S. futures market, exchanges’ electronic trading systems (such as the CME’s Globex) were outlets to try out new contracts with relatively low overhead. Today, Today, however, electronic volume outstrips pit volume, and new contracts are almost always launched electronically even if they also have pit trading. Electronic trading hours are usually different from pit trading hours. For example, the E-Mini S&P trades virtually 24 hours a day (except for Sundays): 5 p.m. to 3:15 p.m. (CT) the next day, with a 15-minute break until 3:30, followed by trading until 4:30 p.m. and a 30-minute break until 5 p.m. By contrast, the pit-traded S&P contract trades 8:30 a.m. to 3:15 p.m. This means the price data for the two contracts is actually different — e.g., the intraday highs and lows are likely to be different for the E-Mini and standard S&P contracts. This, of course, will impact your analysis. Mini contract sizes vary from 20 percent (stock indices) to 50 percent (crude oil and some metals) of full contract size, with margin proportionally smaller. For example, one full point (1.00) of the E-Mini S&P 500 contract represents $50, compared to $250 for the full-sized S&P 500 futures contract, and the E-Mini’s $4,500 per contract margin is one-fifth the full contract’s $22,000 margin.
Trends in minis Interest in mini futures contracts doesn’t appear to be waning. Three-quarters of the contracts in Table 1 increased their average daily volume from January 2007 to January 2008, although the most popular markets continue to be the stock indices.
They’re not that mini Finally, despite their smaller contract sizes, trading mini futures on minimum margin is still risky: The leverage you are employing when trading mini contracts is still very high compared to stock trading, for example. Make sure you fully understand the instrument you want to trade before putting money at risk. www.activetradermag.com • May 2008 • ACTIVE TRADER
TABLE 1: U.S.-TRADED MINI FUTURES CONTRACTS
Contract Symbol Exchange
Stock indices: E-Mini S&P 500 E-Mini NASDAQ 100 E-Mini Russell 2000 E-Mini MSCI EAFE E-Mini MSCI Emerging Markets E-Mini S&P MidCap 400 E-Mini S&P SmallCap 600 Mini-sized Dow NYBOT Russell 1000 Index Mini NYBOT Russell 2000 Index Mini Currencies: E-Mini Euro FX E-Mini Japanese yen Eurodollar 5-Year E-Mini Bundle Energy: miNY Light Sweet crude oil miNY natural gas miNY gasoline RBOB miNY heating oil Metals: Mini-sized gold Mini-sized silver miNY gold miNY silver miNY copper Grains: Mini-sized corn Mini-sized soybean Mini-sized wheat *As of Feb. 25, 2008
ES
CME
NQ
CME
ER2
CME
EFE
CME
EMI
CME
EMD
CME
SMC
CME
YM
CME
RF
ICE
TF
ICE
E7
CME
J7
Contract size
$50* index $20* index $100* index $50* i ndex in $50* i ndex in $100* index $100* index $5* index $100* index $100* i ndex in
% of full contract
Sample price
20%
1,355.75
20%
1,781.00
20%
694.90 2,043.60 1,159.20
20%
801.30
20%
368.50
20%
12,395 739.00 694.90
50%
1.4805
CME
62,500 Euros 6,250,000 yen
50%
9,294
E5B
CME
$100,000
10%
96.0838
QM
NYMEX
QG
NYMEX
QU
NYMEX
QH
NYMEX
YG
CME
YI
CME
QO
NYMEX
QI
NYMEX
QC
NYMEX
YC
CME
YK
CME
YW
CME
500 barrels 50% 2,500 million m m Bt u 25% 21,000 gallons 50% 21,000 gallons 50% 33.2 troy oz. 1,000 troy oz 50 troy oz. 2,500 troy oz. 12,500 l bs. lb 1,000 bushels 1,000 bushels 1,000 bushels
98.230 8.891 2.5220 2.7381
33%
937.5
20%
18.077
50%
944.50
50%
18.035
50%
3.7980
20%
$5.22.2
20%
$14.20
20%
$10.49.4
ACTIVE TRADER • May 2008 • www.activetradermag.com
Tick size/ value
0.25/ $12.50 0.25/ $5.00 0.10/ $10.00 0.10/ $5.00 0.10/ $5.00 0.10/ $10.00 0 .10/ 0. $10.00 1/ $5.00 .05/ $5.00 .10/ $ 10.00 $1 0..0001/ 0 $6.25 0.000001/ $6.25 0.0025/ $12.50 2.5¢/ $12.50 .005/ $12.50 1¢/ 1¢ $21.00 1¢/ 1¢ $21.00 10¢/ $3.32 $.001/ $1.00 $0.25/ $12.50 $0.0125/ $31.25 $0.0020/ $0 $25.00 1/8¢/ $1.25 1/8¢/ $1.25 1/¢/ $1.25
Average daily volume January January Ja 2008 2007
Change
Initial m a r g i n*
2,63 2, 631, 1,27 279 9
1,03 1, 030, 0,10 104 4
155% 15 5%
$4,500
552,590
339,124
63%
$3,250
318,766
167,592
90%
$5,250
89 2
132
576%
$6,250
324
N/A
N/A
$4,688
34,654
18,792
84%
$4,000
397
N/A
N/A
$2,250
224,229
107,702
108%
$3,125
610
N/A
N/A
$2,600
324
N/A
N/A
$3,000
1,597
1,696
-6%
$1,418
11 2
25
348%
$1,350
4
11
-64%
$1,485
17,496
39,743
-56%
$3,544
4,577
12,061
-62%
$1,688
5
1
400%
$4,050
6
293
-98%
$3,375
9,218
5,959
55%
$1,121
2,507
1,558
61%
$812
58
38
53%
$2,363
35
14
150%
$3,038
30
20
50%
$3,882
67 5
768
-12%
$270
2,309
2,158
7%
$594
34 3
220
56%
$810
LLaaunch date
Sept. 1997 June 1999 Oct. 2001 March 2006 Oct. 2007 Jan. 2002 July 2007 April 2002 May 2007 Aug. 2007 Oct. 1999 Oct. 1999 Oct. 2006 June 2002 June 2002 Jan. 2006 Jan. 2006 Oct. 2001 Oct. 2001 Dec. 2006 Dec. 2006 Dec. 2006 April 2003 April 2003 April 2003
57
TRADING Resources
NEW PRODUCTS
& SERVICES
ATC Analytics, LLC has released NexTrend version 7.0. The all-
inclusive software, available starting at $9.95 per month, provides traders of every level with information and tools needed to make informed decisions. NexTrend is a full-featured, downloadable multi-tasking program. The software, username, and password can be used anywhere in in the world. NexT NexTrend rend offers online stock quotes, scanning, real-time news, alarms, and history for domestic and international securities. More information about ATC Analytics and its products can be found at www.nextrend.com. The Commodity Futures Trading Commission (CFTC) has approved trading in additional Eurex products for the U.S. market effective immediately. The approval comprises the futures on the Dow Jones STOXX Large 200 Index and Dow Jones STOXX Small 200 Index as well as six Dow Jones STOXX 600 sector indices. These newly available futures enable U.S. customers to trade specific segments and sectors of the European stock universe represented by the DJ STOXX 600 Index. Eurex launched futures on the two DJ STOXX size indices on July 23. These futures on the DJ STOXX Large 200 Index and DJ STOXX Small 200 Index supplement the futures available on the DJ STOXX Mid 200 Index, which was approved by the CFTC in 2007. The DJ STOXX 600 sector index futures cover the insurance, media, utilities, travel and leisure, personal and household goods, industrial goods, and services sectors and complement the banking sector futures, which are already available to U.S. customers. More information is available at http://deutsche-boerse.com. FXCM’s No Dealing Desk trading platform recently added an
additional bank as a price provider, bringing the total to seven global banks that compete to provide pricing for FXCM’s Trading Station. Over the last three months, typical spreads have already tightened. For a complete list of currency pairs and their new tighter spreads, go to www www.fxcm.com. .fxcm.com. eSignal has upgraded its LiveCharts product. LiveCharts offers
users Web 2.0 functionality via eSignal’s social networking site and also links with Quote.com. Running entirely on eSignal’s data network, LiveCharts is powered by PlusFeed data, a low latency, consolidated data feed service from Interactive Data Real-Time Services. LiveCharts is a java-based application that integrates streaming charts, portfolios, and real-time news on any Web browser. browser. This upgrade includes a new, new, customizable modular interface, major international stock exchanges, and the popular currency spot market, in addition to data for major U.S. stocks, options, and futures markets. This LiveCharts upgrade 58
also doubles the number of technical studies and line tools available. In addition, many new add-ons are available, including Option Chains, Market Depth, Premium News as well as QuoTrek, a mobile product that brings real-time quotes, charts, and news to BlackBerries, smartphones, and other handheld devices. Full product information is available at www.LiveCharts.com. DiscoverOptions provides options education and resources to
help traders find opportunities in all market conditions, including bearish markets. The DiscoverOptions Education Center (www.DiscoverOptions.com) (www .DiscoverOptions.com) provides articles, lessons, Web casts, and other content for all levels of options traders. DiscoverOptions provides a clearer understanding of how using options can help minimize risk, generate additional income, and allow traders to profit under virtually any market condition. The DiscoverOptions Personal Mentoring Program’s curriculum is taught by options professionals who work with students one-onone, showing them how to identify profitable trades in variable markets using proven back-tested strategies. Rosenthal Collins Group (RCG) has introduced a package of advanced Java-based interactive charts from Barchart.com on its
RCG Onyx 2 trading platform. The new service represents the most advanced Java-based charting technology that Barchart has offered to date. The charting, available on the Internet both through the RCG Onyx 2 trading platform and RCG Onyx Web, the online account management tool, includes real-time and historical price and volume information for the major futures exchanges in North America. It provides multiple interactive charting types, including bar charts, candlestick charts, and dozens of technical studies. Users can view charts for multiple commodities at a time and can customize them by designating time periods analyzed and trading styles. RCG and Barchart are offering “continuation” charts for futures contracts, enabling users to capture the “roll” when contracts expire and to select charts based on daily, weekly, or monthly activity. More information can be found at www.rcgdirect.com. www.rcgdirect.com. Saxo Bank (www.saxobank.com) now offers FX options to pri-
vate investors in the U.S. after its success in Europe and Asia. Saxo Bank was the first forex options trading provider to offer options trading for 31 major forex crosses directly on live streaming prices without dealer intervention to private investors. Options can be quoted with one-day to one-year expiries, as well as zero to 100 deltas.
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•
May 2008
• ACTIVE TRADER
BOOKSHELF Mastering Trading Stress: Strategies for Maximizing Performance
Technical Analysis Tools: Creating a Profitable Trading System
By Ari Kiev Wiley,, 2008 Wiley Hardcover,, 224 pages Hardcover $49.95
By Mark Tinghino Bloomberg Press, 2008 Hardcover,, 295 pages Hardcover $39.95
Trading can be emotionally and psychologically taxing. As markets grow increasingly complex and volatile, so do the stresses involved in trading them. In this book, psychiatrist Ari Kiev discusses where this stress comes from, how it affects traders, and how to reduce it. Real-life traders provide examples of how they manage stress, enhance performance, and a nd improve profitability profitability..
Instead of relying on a single indicator, most traders use many technical analysis instruments. In this book, Mark Tinghino discusses several technical approaches and explains how to create a profitable system. He covers the relationship between fundamental and technical analysis, how to time buying and selling, and how to use spreads to manage risk.
Winning with Options: The Smart Way to Manage Portfolio Risk and Maximize Profit
The ART of Trading: Combining the Science of Technical Technical Analysis with the Art of Reality-Based Trading
By Michael C. Thomsett AMACOM, 2008 Paperback, 248 pages $19.95
By Bennett A. McDowell Wiley,, 2008 Wiley Hardcover w/ DVD, 320 pages $70.00
Geared toward the average trader, this book describes options as a smart and practical way to protect and enhance a portfolio. The book introduces readers to many aspects of option trading and offers strategies to help manage risk and turn a profit through basic concepts and real-life examples.
This multimedia package discusses the Applied Reality Trading (ART) and includes ART trading software. It explains how to ignore others’ opinions and suggestions and develop a system that aligns with your personality. Whether enhancing a fundamental approach or creating a purely technical one, this book attempts to provide all the tools traders need.
Beating the Market, 3 Months at a Time: A Proven Investing Plan Everyone Can Use
By Gerald Appel & Marvin Appel FT Press, 2008 Hardcover,, 218 pages Hardcover $24.99 Rather than handing your hard-earned cash over to a professional investment manager, this book claims that by spending only one hour every three months you can take matters into your own hands, using the authors’ recommendations and simple investment techniques. These father-and-son investment advisors offer advice on portfolio construction, increasing investment safety, improving rates, and identifying strong market sectors. They demonstrate how to quickly evaluate, adjust, and optimize performance. ACTIVE TRADER •
May 2008
•
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The Rookie’s Guide to Options: The Beginner’s Handbook of Trading Equity Options
By Mark D. Wolfinger W&A, 2008 Hardcover,, 232 pages Hardcover $34.95 In his book, Mark D. Wolfinger explains how options work and how you can employ them to earn profits and manage risk. Aimed at the novice investor, it offers step-by-step instructions on option systems from basic techniques to more complicated strategies such as iron condors and double diagonals. He explains when different strategies should be used depending on the situation and objectives. 59
May 2008
TRADING Calendar
LEGEND
1
CPI: Consumer price index
• March personal income
ECI: Employment cost index
• March construction spending
First delivery day (FDD): The first day on which delivery of a commodity in fulfillment of a futures contract can take place.
• April ISM business report
2
• April unemployment • March factory orders
First notice day (FND): Also known as first intent day, this is the first day on which a clearinghouse can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillment of a futures contract. The clearinghouse also informs the seller.
3
FOMC: Federal Open Market Committee
5
GDP: Gross domestic product
6
4 • April ISM non-business report
ISM: Institute for Supply Management Last trading day (LTD): The final day trading can take place in a futures or options contract. PPI: Producer price index
7
• Q2 productivity and costs (prelim) • March consumer credit credit
8
• March wholesale inventories
9
• March trade balance
PMI: Purchasing managers index Quadruple witching Friday: A day where equity options, equity futures, index options, and index futures all expire.
10 11
CBOT: Chicago Board of Trade CME: Chicago Mercantile Exchange
12
• April federal budget
NYMEX: New York Mercantile Exchange
13
• March business inventories inventories • April retail sales
S
M
T
W
T
F
S
28
28
29
30
1
2
3
4
5
6
7
8
9
10 10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
14
• April CPI
15
• April production and capacity utilization • May Philadelphia Philadelphia Fed survey • LTD: June crude oil options (NYMEX) LTD: June
16
• May University of Michigan consumer sentiment index (prelim) • April housing starts • LTD: All May equity and index options LTD: All
60
www.activetradermag.com • May 2008 • ACTIVE TRADER
Economic release
17 18 19
• April leading indicators
20
• Apr April il PPI • April Chicago Chicago Fed national activity activity index • LTD: LTD: June June crude oil futures (NYMEX)
21 22 23
Release time (ET)
GDP
8:30 a.m.
CPI
8:30 a.m.
ECI
8:30 a.m.
PPI
8:30 a.m.
Productivity and costs
8:30 a.m.
Employment
8:30 a.m.
Personal income
8:30 a.m.
Business inventories
8:30 a.m.
Durable goods
8:30 a.m.
Retail sales
8:30 a.m.
Trade balance
8:30 a.m.
Housing starts
8:30 a.m.
Production
• April existing home sales • LTD: LTD: June June T-bond T-bond futures (CBOT)
24
& ca c apacity utilization
9:15 a.m.
Leading indicators
10 a.m.
Consumer confidence
10 a.m.
Univ. of Michigan
25 26
• Markets closed — Memorial Day
27
• May consumer confidence • Apri Aprill new home sales sales • LTD: June gold options (NYMEX) LTD: June
consumer sentiment
10 a.m.
Wholesale inventories
10 a.m.
Philadelphia Fed survey
10 a.m.
Existing home sales
10 a.m.
Construction spending
10 a.m.
Chicago PMI re report
10 a.m.
ISM report on business
10 a.m.
ISM non-manufacturing report
28
• April durable goods
on business
10 a.m.
• LTD: May gold futures (NYMEX)
New home sales
10 a.m.
Chicago Fed
29 30
• Q1 GDP (prelim) • May University of Michigan consumer sentiment index (final) • April personal income
national activity index
10 a.m.
Factory orders
10 a.m.
Federal budget
2 p.m.
Consumer credit
3 p.m.
• May Chicago PMI Note: For expiration dates of commodity futures and options, as well as first notice and first delivery dates, see the calendar in Futures & Options Trader magazine Trader magazine (www.futuresandoptionstrader.com).
ACTIVE TRADER • May 2008 • www.activetradermag.com
The information on this page is subject to change. Active change. Active Trader Trader is is not responsible for the accuracy of calendar dates beyond press time.
61
Key CONCEPTS
3-10 oscillator: The difference between a three-day simple mov-
The indicator is similar in concept to the moving average enve-
ing average and a 10-day simple moving average, plus a second
lope, with an important difference: While moving average
line which is a 16-period simple moving average of the 3-10
envelopes plot lines a fixed percentage above and below the average
line. In “T “Trader rader toolbox” ( Active Trader Trader , March 2004) trader
(typically three percent above and below a 21-day simple moving
Linda Raschke said, “On a chart, I usually just alter the settings
average), Bollinger Bands use standard deviation to determine how
for the MACD, changing the moving average type from expo-
far above and below the moving average the lines are placed. As a
nential to simple and the moving average lengths to 3, 10 and
result, while the upper and lower lines of a moving average enve-
16.”
lope move in tandem, Bollinger Bands expand during periods of rising market volatility and contract during periods of decreasing
Advance-Decline line: A breadth indicator that measures aspects of
market volatility volatility..
supply and demand not always reflected directly in price. The
Bollinger Bands were created by John Bollinger, CFA, CMT,
indicator is a day-to-day running total of the number of stocks
the president and founder of Bollinger Capital Management (see
that have closed higher on the day (advancing) minus the num-
Active Trader Trader , April 2003, p. 60). By default, the upper and
ber of stocks that have closed lower on the day (declining). A
lower Bollinger Bands are placed two standard deviations above
version using the week-to-week figures can also be used as a
and below a 20-period simple moving average.
longer-term indicator. The most commonly referenced A-D line is the one calculated
Upper band = 20-period simple moving average + 2
on New York Stock Exchange (NYSE) stocks, but the indicator
standard deviations
can be calculated on any index or exchange.
Middle line = 20-period simple moving average of
Calculat alculation ion
closing prices
A-D line = [AS(today) – DS(today)] + AD(prev)
Lower band = 20-period simple moving average - 2 standard deviations
where AS(today) = the number of advancing stocks (those that
Bollinger Bands highlight when price has become high or low
closed higher than the previous day’s day’s close)
on a relative basis, which is signaled through the touch (or
DS(today) = the number of declining stocks (those that
minor penetration) of the upper or lower line.
closed lower than the previous day’s close) AD(prev) = previous day’s A-D line value
However, Bollinger stresses that price touching the lower or upper band does not constitute an automatic buy or sell signal. For example, a close (or multiple closes) above the upper band
That is, add the difference between the number of advancing
or below the lower band reflects stronger upside or downside
stocks and declining stocks today to yesterday’s A-D number,
momentum that is more likely to be a breakout (or trend) sig-
which is the running total of all previous days. A nominal value
nal, rather than a reversal signal. Accordingly, Bollinger suggests
is often used to begin the A-D calculation.
using the bands in conjunction with other trading tools that can supply context and signal confirmation.
Bollinger Bands: Bollinger Bands are a type of trading “envelope”
consisting of lines plotted above and below a moving average,
Donchian breakout (channel breakout, breakout system,
which are designed to capture a market’s typical price fluctua-
n-bar breakout): Named after the man who popularized the
tions. 62
continued on p.
www.activetradermag.com
•
May 2008
63
• ACTIVE TRADER
Key concepts
continued
approach, Richard Donchian, this approach refers to buying a
days ago) or (Ptoday – Pn days ago)/Pn days ago. Except for
price move above an n-bar (n-day, n-week, or n-minute, etc.)
scaling, the resulting momentum and ROC indicators are the
high and selling on a move below a n-bar low. Donchian’s origi-
same; momentum simply expresses price change as the differ-
nal “system” was called the “four-week rule” and consisted of
ence between two prices, while ROC expresses price change as a
buying and selling moves above and below the four-week high
percentage or ratio.
and low, respectively. Pure breakout systems are often designed in stop-and-reverse
Although it is often Moving average convergence-divergence (MACD): Although
(SAR) fashion: when a buy signal occurs, any existing short
grouped with oscillators, the MACD is more of an intermediate-
position is liquidated and a new long position is simultaneously
term trend indicator (although it can reflect overbought and
established; when a sell signal occurs, the long position is liqui-
oversold conditions).
dated and a new short position is established. Thus, the system is always in the market. One basic variation is whether a trade is triggered by a simple
The default MACD line (which can also be plotted as a histogram, as is the case in the accompanying article) is created by subtracting a 26-period exponential moving average (EMA) of
penetration of the n-bar high or low or by a close above an n-
closing prices from a 12-period EMA of closing prices; a nine-
bar high or below an n-bar low.
period EMA is then applied to the MACD line to create a “signal line.”
u sed to describe Momentum (or “price momentum”): A generic term used
MACD = EMA(C,12)-EMA(C,26)
the rate at which price changes as well the name of a specific
Signal line = EMA(MACD,9)
calculation. Rate of change (ROC) is simply an alternate version of this basic indicator. The implications and interpretations of
On balance volume (OBV): A running sum of daily market volume
these two studies are identical.
weighted by whether the market closes up or down for the day. day.
Momentum/ROC are similar to oscillators, such as the relative strength index (RSI) and stochastics, in that they are generally intended to highlight shorter-term price momentum extremes (overbought or oversold points). The most common calculation for momentum is simply today’s price (typically the closing price) minus the price n days
Joe Granville introduced the indicator in his book New Strategy
of Daily Stock Market Timing for Maximum Profits . To get the current OBV reading, today’s volume is added to or subtracted from the previous OBV reading based on whether the market closes up, down or unchanged on the day. The formulas are:
ago: If today closed higher than yesterday: (Ptoday – Pn days ago).
The most basic ROC formula is today’s price divided by the price n days ago:
(Ptoday/Pn days ago).
yesterday’s OBV + today’s today’s volume
If today closed lower than yesterday: yesterday’s OBV - today’s today’s volume
If today closed unchanged from yesterday: yesterday’s OBV
Alternate calculations for rate of change are 100*(Ptoday /Pn 63
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Xview www.xview.com www.activetradermag.com • May 2008 • ACTIVE TRADER
TRADE Diary
Reversing a pattern in gold pays dividends.
TRADE Date: Monday, Feb. 25. Entry: Long April 2008 mini gold futures (YGJ08) at $933.90. Reason(s) for trade/setup: Having topped $900, robust gold trading has morphed into something approaching public “gold fever” as more ordinary investors read about the market’s supposed inevitable rise to $1,000 — and beyond. Hype aside, what scant historical parallels exist support the notion that gold is in a selffulfilling prophecy mode that will propel it to the major round-number price of $1,000. (After that, it’s anyone’s guess.) “Futures Insight: Gold” ( Active Trader Trader , April 2008, p. 40) showed that gold has favorable odds of rising for the first two months after seven-month, 33-percent rallies, the most recent of which had concluded in January. The median closing gain in the first month was 5.75 percent; 7.96 percent for the second month. Extending this pattern would roughly forecast a $981 February close (the actual close turned out to be $975) and a $1,001.87 March close. After paying the price for over-eager entries in the volatile gold market (see the Trade Diary on p. 88 of the April issue of ), this trade represented an attempt to get back on Active Trader Trader ), the correct side of the market — i.e., waiting for price to pull back and buying at a relative low price rather than going long on a short-term upside breakout and hoping the move would continue.
Source for all charts: TradeStation
Wee got in on the third day of a correction after the Feb. 21 W high (just below $960). Although the $933.90 entry price was a little more than five points above the Feb. 25 low, it represented a nearly $25 (2.6-percent) correction from the Feb. 21 high. (Note: The trade was actually entered in the electronic market before the open of the Feb. 26 day session.)
Initial stop: $922.90, which is $5.70 below the low of the entry day. Although from that perspective the stop is rather tight, it is nonetheless $17 (1.8 percent) below the entry price. Initial target: $984. The target was based on the prior upswing, from Feb. 13 to Feb. 21, which resulted in a low-tohigh gain of nearly 60 points. Adding that amount to the entry day low created a target around $988.00.
Trade Summary Date 2/25/08
Stock YGJ08
Entry 933.90
Initial stop 922.90
Initial target 984.00
IRR 4.55
Exit 974.10
Date 2/29/08
P/L 40.20 (4.3%)
LOP 44.50
LO L OL -5.30
Length 4 days
Legend — IRR: initial reward/risk ratio (initial target amount/initial stop amount). LOP: largest open profit (maximum available profit during lifetime of trade). LOL: largest open loss (maximum potential loss during life of trade).
65
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•
May 2007
• ACTIVE TRADER
RESULT Exit: 974.10 Profit/loss: +40.20 (4.3 percent). Trade executed according to plan? No. Outcome: Other than the early exit, the trade was executed according to plan. The entry timing was definitely better on this trade than for our other recent gold trades; the market closed nearly $14 above the entry price on Feb. 26 and pretty much marched straight upward for the next three days. Wee did get out too early, W early, though. On Feb. 29 the market lost some momentum intraday after topping above $978. After three days of higher highs, lows, and closes and a nearly $50 gain from the Feb. 26 low to the Feb. 29 high, it seemed time to take money off the table and wait for a pullback before considering re-entering for another run at $1,000 — rather than risking another one of this market’ m arket’s dramatic corrections. (We don’t trust this market!)
Of course, the next day gold jumped as high as $993 and hit $995 two days later. However, it subsequently retreated twice to around $960 (the first time, the day after it first reached $993). It can be a challenge taking profits in a market making alltime highs because there are no existing reference points. Conservatively extrapolating from the market’s recent up moves (other up swings had, in fact, been larger than the one we used to estimate a target) is as viable an approach as any. However, this trade is another example of the benefits of taking partial profits. We could have exited part of our position early and potentially enjoyed $20 more of profit on the remainder of the position. Final note: As planned, we re-established a long position around $5.00 below this trade’s exit price. For more coverage of the gold rally, see “Gold express may lose steam above $1,000” on p. 49.
Note: Initial targets for trades are typically based on things such as the historical performance of a price pattern or trading system signal. signal. However, individual individual trades are a function function of immediate immediate market behavior; initial price targets are flexible and are most often used as points at which a portion of the trade is liqui- dated to reduce the position’s open risk. As a result, the initial (pre-trade) reward-risk ratios are conjec- tural by nature.
ACTIVE TRADER •
May 2008
•
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66
TRADE Diary
Trade plan not followed to the letter, but close enough. TRADE Date: W Wednesday ednesday,, Feb. 27, 2008. Entry: Short March 2008 mini Dow futures (YMH08) at 12,721. Reason(s) for trade/setup: With price approaching the implied chart resistance of the Feb. 1 high and the market still in a downtrend, we will look to go short on an intraday up move. The market jumped higher a little after 9:30 a.m. CT, and we went short after it failed to quickly surpass the new 12,752 intraday high.
Source: TradeStation
Initial stop: 12,774, which is 24 points above the session’s high. Initial target: 12,619, which is 5 points above the session’s low — we expect the market to at least test the day’s range. Take profits on partial position and lower stop.
RESULT Exit: 12,657. Profit/loss: +64 (0.5 percent). Trade executed according to plan? No. Outcome: The market moved sideways to slightly higher for more than two hours after the entry. (It might be interesting to test the odds of a move in either direction out of a consolidation
that has lasted more than n bars, after an up or down move of x percent.) The market eventually resolved itself to the downside and we got out at what amounted to the third down thrust, lowering a stop order along the way. way. We exited the position early, early, and in its entirety, because we decided the initial target was too aggressive: The market had fallen relatively far relatively fast (almost 100 points in less than an hour), and was also approaching possible support around 12,640. Wee actually expected to re-enter on the short side after a W bounce, but the market kept rallying strongly enough to dissuade us. Note: Initial targets for trades are typically based on things such as the historical performance of a price pattern or trading system signal. However, individual trades are a function function of immediate market behavior; initial price tar gets are flexible and are most often used as points at which a portion of the trade is liquidated to reduce the position’s open risk. As a result, the initial (pre-trade) reward-risk ratios are conjectural by nature.
Trade Summary Date 2/27/08
Stock YMH08
Entry 12,721
Initial stop 12,774
Initial target 12,619
IRR 1.9
Exit 12,657
Date 2/27/08
P/L 64 (0.5%)
LOP +76
LOL -41
Length 3 hours
Legend — IRR: initial reward/risk ratio (initial target amount/initial stop amount). LOP: largest open profit (maximum available profit during lifetime of trade). LOL: largest open loss (maximum potential loss during life of trade).
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May 2008
• ACTIVE TRADER