As the impending doom of the CFA Level 1 test date approaches my review of the material has prompted me to talk about Efficient Market Hypothesis. In the texts they outline 3 scenarios, weak form EMH, Semi-strong form and Strong form EMH. It is humorous how the text essentially says if EMH holds then no single person can really earn above average returns on a risk adjusted basis. At the end it basically says there is conflicting information.
The odd thing to me is how it barely touches on market psychology and behavioral finance when I think that is the more relevant factor that drives markets. The amusing thing to me is when they compare fundamental analysis to technical analysis and how they seem to be mutually exclusive. I always take fundamental analysis to be the more "conservative" discipline however when it is examined more closely how conservative is it? In addition how much different is it to technical analysis? The reason I say that is because no matter what you are doing, either fundamental or technical analysis, it involves two things: speculation and confirmation.
In fundamental analysis, which is supposedly more conservative you are speculating about future earnings and future cash flows of a company and hoping past performance is repeatable. Then you wait for confirmation at earnings time, whether it has an upside suprise or a disappointment, then everyone scrambles to readjust their outlooks and price targets. Earnings is apparently the number one reason for stock appreciation. Analysts themselves are generally fairly poor at determining future earnings. Hell, I got much closer than most on my Apple estimates and I had yet to learn anything about future cash flow discounting, WACC, etc... I think also some studies have shown that analyst ratings are a 50/50 shot at best, which makes me wonder what they are doing. Some of that could be political or business reasons, which obviously shouldn't factor in.
I guess the point I am trying to make is that how can a market be efficient when it is supposedly being efficient based off of speculation and incorrect information in the first place. Yes, once news comes out it is fairly quickly adjusted to, but it is adjusted to again based on speculation and the psychology of investors and traders that push stocks up or down.
Technical analysis is not without its drawbacks either however I think now more than ever it has been shown to be more useful than fundamental analysis. Someone may have sworn that GE was a steal at 18.50(which has acted as long term support so that lends support to the argument). However, the bottom line is everything is driven by supply and demand, if that level no longer holds because demand is not there then clearly people don't think it's cheap or want to buy it. Forced selling and uncertainty about earnings threw any type of speculation on future earnings and "fundamentals" out the window. In that scenario all you can do is watch price and volume movement and wait for things to stop going down. Obviously once things do stop and there seems to be price stability either people now find that stock attractive to buy or new news came out to make them buy it. Either way it doesn't matter, what does matter is that you now see the demand there.
The above example also lends credence to behavioral finance or how market psychology effects things. An efficient market would never have bubbles and subsequent bursting of those bubbles. However the fact is that there are bubbles and they overshoot on the upside just like they do on the downside. Take oil for example, it got to nearly 150, now its down at 50, it's actual fundamental supply and demand is likely around 75, but again you have speculators trying to gauge how bad the recession will be and large hedge funds that were far too leveraged and overweight oil and had to get out. The Oracle of Omaha Warren Buffet thought GS was a screaming buy at 120, he must really have liked it at 55 too. The market is driven by fear and greed and you constantly see things get mispriced because the market is either too fearful or too greedy.
The last thing I want to ponder is the matter of self fulfilling prophecies. Whether it is a GS analyst saying oil will go to 150, or a price pattern, some things just seem like they just get the market to buy into it so it happens regardless if it "should". I was told a statistic(that I need to verify) that head and shoulder patterns complete close to 90% of the time. So even if I am going only off technicals I remain curious as to why the pattern forms and why if it does form should it automatically increase as high as its pattern past the neckline? I have to guess that some of it is just because people think it should do that, it does. Same thing with fibonacci retracements, IMO they have absolutely no basis for working because you can chose a high and low wherever you want and they may or may not line up with support and resistance, but if everyone uses them, they work. My opinion is that most traders use rules and price targets and possibly the lines themselves when trading so they appear to work.
Self fulfilling prophecies are again a market behavior and could be exploited for above average returns if they work. I have to assume they are for the most part self fulfilling because I don't think that as a stock confirms a price pattern like a head and shoulders all the analysts following the company immediately agree(or just before it happens agree) that the stock is under valued by the amount the stock "Should" increase according to the pattern.
Anyways, those are my thoughts. EMH is mostly fiction in my opinion, I wish I had a true way to profit from these opinions but sadly I am sure they are nothing new. What the CFA books did show is that to consistently earn above average risk adjusted returns you just have to trade off of inside information, no big deal LOL.
Wednesday, November 26, 2008
Friday, November 14, 2008
Note To Self: Stay Hedged
This market climate has been extremely frustrating especially when attempting to go long. Any attempt at being long recently has ended up with an exit and a loss. I was long yesterday, too much so and didn't exactly like when we were testing the lows again. The bear trap was even more concerning when we dropped below 830 on the S&p. To my credit, I did not panic out at the lows, I had the mental fortitude to hold as I noticed there was not any extensive panic selling after stop losses got triggered. It could have also been stupidity to continue holding because I would have had to exit with greater losses. But we had a very large reversal and ended way up on the day. I took that opportunity to remove a lot of my long bias and bought some calls on the ultra short russell 2000 at the end of the day because it was at support and most stocks had rallied back to resistance levels and I assumed we could have profit taking.
This proved to be a good thing because today we gave back quite a bit of the previous rally and during the whole down turn I was making money on my calls. I am still frustrated because I took my hedge off, which worked out great until the last 30 mins of the day. I can't be too upset being down 2% when the market was down 4%, however had I just held my hedge I would have ended up 3% instead of down 2. Obviously hindsight is 20/20 and even if I thought we would give back some of the come back at the end of the day I would not have predicted giving it almost all back. My guess is margin clerks and hedge fund redemptions along with most people locking in some profit before the G20 all added to the accelerated decline into the close.
My thoughts are that until we finally see some improvement in the job market and consumer data I will not be without offsetting trades. I chose the russell today because I assumed if we continued rallying today the russell would not participate as much and if we sold off the russell would sell off more, which was correct. I think the name of the game going into the new year will be to sell the rallies and always have pair trades on. Right now I have to have the mind set of just surviving and not trying to make money because a lot of people are not surviving or making money, even the professionals.
Looking ahead I think once Obama names all his players and gets into office the market will like that certainty even if his policies will be unknown. I think there could be more pain to come after looking at action in goldman sachs and citigroup over the past week. I am surprised goldman has not said anything to address the decline. So far it's looking like shorting berkshire hathaway could be a good play with GS and GE both way down haha, jk.
Historically, the upcoming week is typically bullish for stocks going into thanksgiving. I am hoping so and plan on having my bullish bias into the end of the week then lightening it up and picking up some good looking bearish setups. The action right now is just unpredictable and it is very trying.
I plan on doing somewhat of a case study of previous price action. I want to see if there is any pattern in terms of time length or percent move over the indicies, for example if during a bear market do we have 5 down days for every 2 up days, or in a bull market 3 up days for every 1 down day, etc. This could be a useful way in trying to enhance gains and pick times to add or subtract from positions. Since GE said it's dividend is safe for 09 maybe I'll just let it all sit in that until after my CFA test and sell options against it. :-)
This proved to be a good thing because today we gave back quite a bit of the previous rally and during the whole down turn I was making money on my calls. I am still frustrated because I took my hedge off, which worked out great until the last 30 mins of the day. I can't be too upset being down 2% when the market was down 4%, however had I just held my hedge I would have ended up 3% instead of down 2. Obviously hindsight is 20/20 and even if I thought we would give back some of the come back at the end of the day I would not have predicted giving it almost all back. My guess is margin clerks and hedge fund redemptions along with most people locking in some profit before the G20 all added to the accelerated decline into the close.
My thoughts are that until we finally see some improvement in the job market and consumer data I will not be without offsetting trades. I chose the russell today because I assumed if we continued rallying today the russell would not participate as much and if we sold off the russell would sell off more, which was correct. I think the name of the game going into the new year will be to sell the rallies and always have pair trades on. Right now I have to have the mind set of just surviving and not trying to make money because a lot of people are not surviving or making money, even the professionals.
Looking ahead I think once Obama names all his players and gets into office the market will like that certainty even if his policies will be unknown. I think there could be more pain to come after looking at action in goldman sachs and citigroup over the past week. I am surprised goldman has not said anything to address the decline. So far it's looking like shorting berkshire hathaway could be a good play with GS and GE both way down haha, jk.
Historically, the upcoming week is typically bullish for stocks going into thanksgiving. I am hoping so and plan on having my bullish bias into the end of the week then lightening it up and picking up some good looking bearish setups. The action right now is just unpredictable and it is very trying.
I plan on doing somewhat of a case study of previous price action. I want to see if there is any pattern in terms of time length or percent move over the indicies, for example if during a bear market do we have 5 down days for every 2 up days, or in a bull market 3 up days for every 1 down day, etc. This could be a useful way in trying to enhance gains and pick times to add or subtract from positions. Since GE said it's dividend is safe for 09 maybe I'll just let it all sit in that until after my CFA test and sell options against it. :-)
Wednesday, November 5, 2008
Time to Evaluate
The real test of any theory is how it holds up under scrutiny of analysis through the scientific method. In that spirit, starting from Nov 1 I will be keeping a close track record of my trades and performance to evaluate the validity of risk management and to prove to myself it is the best method in the long run. I will do this also to keep track of monthly returns. My goal is to have positive monthly returns each month.
Why start now? Partly because I believe a majority of the volatility is behind us so it will be easier to set stops and not get completely whipped around with wild swings. In the spirit of my CFA studies and good science I want to find out what my expectancy is, and how well I can do following my strict rule set. I also want to see if there is a difference in daytrading expectancy vs. intermediate term expectancy. In the long run there should be no difference however maybe my psychology is set up better to day trade, or maybe it is better to trend or swing trade or maybe not trade at all.
Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)
Let's say I only take trades with a 1:3 risk/reward ratio. If my risk is R and I plan to lose 1R to every 3R gain and I expect to be correct or take trades that help me be correct 30% of the time.
(.30*3R)-(.70*R)=.9-.7=.2
This appears to be a good trading plan because it has a positive expectancy, which means over the long term I should make money. Limiting my loss to R will likely require that I set hard stops so it is never violated. So far I have been good at using my own discipline to cut a loss during a day trade. So far on 6 futures day trades I have made $95 dollars, with 2 of those being successful. This basically supports my trading plan because I was risking less money and making less. However, it is frustrating because my first trade of the day today was a success, then the second one was not because I cut the loss. Had I held a little longer it would have been successful in hitting my profit target(same with other times). However, the amount of loss I hold through did not warrant the return. Not to mention later in the day we sold off significantly, and if that had unfolded right after I bought a future and didn't cut my loss I would have had a very large loss.
The other side of the challenge is setting a target and being patient enough to let it reach it. I bought puts on the DIA yesterday at the close because I felt the rally favored a sell the news type scenario once the president was elected. This proved to be correct, however I took my gain too early in the day and had I held till the close my gain would have been 3x larger. I did attempt to be smart, I locked in most of my current profit then let the remaining contracts go, the downtrend it was following broke so I took the remaining profit assuming a reversal. The reversal was short lived and eventually we had a large sell off into the close.
Speaking to the large picture I think we had some good profit taking due to there really being no actual resolution and no one knows what Obama will do and who he will appoint yet. Cisco reported and met expectations but had a bad outlook which will weigh on tech tomorrow(futures are down 2%), which is unfortunate because I am long Dec calls on the Q's and I suspect I'll have to sell. A further sell off though should set up some nice buying opportunities in some good names I have been wanting to get into such as VMW, AAPL, CHK.
The Jobs report could be another negative catalyst however if we are truly bull confirmed people should start dip buying on these pull backs. We should see support around the 9,000 level.
So, the name of the game now is evaluation. Is this a worthwhile cause? I will compare my results to the averages and see if my rules and timing ability is a pointless affair as most money managers claim.
Why start now? Partly because I believe a majority of the volatility is behind us so it will be easier to set stops and not get completely whipped around with wild swings. In the spirit of my CFA studies and good science I want to find out what my expectancy is, and how well I can do following my strict rule set. I also want to see if there is a difference in daytrading expectancy vs. intermediate term expectancy. In the long run there should be no difference however maybe my psychology is set up better to day trade, or maybe it is better to trend or swing trade or maybe not trade at all.
Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)
Let's say I only take trades with a 1:3 risk/reward ratio. If my risk is R and I plan to lose 1R to every 3R gain and I expect to be correct or take trades that help me be correct 30% of the time.
(.30*3R)-(.70*R)=.9-.7=.2
This appears to be a good trading plan because it has a positive expectancy, which means over the long term I should make money. Limiting my loss to R will likely require that I set hard stops so it is never violated. So far I have been good at using my own discipline to cut a loss during a day trade. So far on 6 futures day trades I have made $95 dollars, with 2 of those being successful. This basically supports my trading plan because I was risking less money and making less. However, it is frustrating because my first trade of the day today was a success, then the second one was not because I cut the loss. Had I held a little longer it would have been successful in hitting my profit target(same with other times). However, the amount of loss I hold through did not warrant the return. Not to mention later in the day we sold off significantly, and if that had unfolded right after I bought a future and didn't cut my loss I would have had a very large loss.
The other side of the challenge is setting a target and being patient enough to let it reach it. I bought puts on the DIA yesterday at the close because I felt the rally favored a sell the news type scenario once the president was elected. This proved to be correct, however I took my gain too early in the day and had I held till the close my gain would have been 3x larger. I did attempt to be smart, I locked in most of my current profit then let the remaining contracts go, the downtrend it was following broke so I took the remaining profit assuming a reversal. The reversal was short lived and eventually we had a large sell off into the close.
Speaking to the large picture I think we had some good profit taking due to there really being no actual resolution and no one knows what Obama will do and who he will appoint yet. Cisco reported and met expectations but had a bad outlook which will weigh on tech tomorrow(futures are down 2%), which is unfortunate because I am long Dec calls on the Q's and I suspect I'll have to sell. A further sell off though should set up some nice buying opportunities in some good names I have been wanting to get into such as VMW, AAPL, CHK.
The Jobs report could be another negative catalyst however if we are truly bull confirmed people should start dip buying on these pull backs. We should see support around the 9,000 level.
So, the name of the game now is evaluation. Is this a worthwhile cause? I will compare my results to the averages and see if my rules and timing ability is a pointless affair as most money managers claim.
Saturday, November 1, 2008
We Made It!
It couldn't have been more fitting that one of the scariest and worst months in stock market history ended the trading week on Halloween. Volatility has been ridiculous lately, so I have taken to using smaller and very few position sizes remaining essentially delta neutral until the market calms down, not to mention most of my time is spent studying for the CFA at the moment. I think volatility should calm down after the election so hopefully we can start some steady trends and options will be more appealing to buyers.
As of right now we seem to have put in a short term bottom at 8,000. Depending on what happens in the coming months and into next year that may not be the ultimate bottom but it seems more and more likely as we go higher from here. The NYSE bullish percent went on to a buy signal on the point and figure charts, which makes it a "bull confirmed" status, meaning bull market. This is supposedly the lowest a confirmation has ever happened at 20%, it could be a false signal but as of now until it is broken buying the dips is much more appealing and trends should hopefully last longer than a day or two.
If hedge fund and mutual fund liquidations are essentially done there will likely be a steady stream of money coming back into the market over the next few months if we don't get any unexpected surprises like a country defaulting.
I recently got approved for Forex and Futures on my new thinkorswim account which should offer some good opportunities to diversify. If europe is/will be in a recession it seems logical that they will continue to cut rates, and since the our rates can only go down another percent I think this will pressure the euro making it good to be long the dollar and buying on dips. A strong dollar will pressure crude and commodities however those have come down so hard from forced selling I think I'll wait for them to regain a correlation.
We broke above 9,250 and finished above it today pointing to higher stock prices going forward. Today was kind of funny because it was much less volatile during the day(ie normal) and seemed boring after we have had such swings all month. In the final 30 mins there was quite the battle though, in 2 mins I think the futures sold off 150 points, traded in a range then finished up back close to their highs within the last 5 mins. I took the opportunity to trade some futures today, it was slightly frustrating but highlighted the necessity of rules and risk management. 3 times in a row I took trades, with the trend and had to get back out with a loss. Then my 4th trade was profitable and made up for all my losses. I ended up making 5 dollars total in the futures haha but it shows that you can take multiple small losses and still make money. My other lesson was to take positions a little bit closer to trend lines. I would get back out when the lines were violated, but would generally see them come back and would have gone in my favor. Oh well, rules have to be followed as we can see and you can't mess around even trading single contracts due to the leverage they allow. Each trade risked about 1%.
Overall I am cautiously optimistic at least in the short term given what has been seemingly priced in. Consumer spending dropped by 3% which was huge and obviously is the main driver of GDP(which was -.03). I think a lot of the announced layoffs will hit next month which could be an issue obviously and is never a good thing in general(take it from the unemployed haha).
It looks like Obama is going to win the election, which I prefer but hope he has a good plan for creating jobs. Stimulus packages like Bush gave by giving out checks are worthless and do nothing but artificially create spending for a month. I hope that is not the same way Obama goes because it would be equally as worthless and add even more to our debt. If jobs get created then people can spend month after month(and hopefully this time save some too) imagine that!
Well, back to studying...
As of right now we seem to have put in a short term bottom at 8,000. Depending on what happens in the coming months and into next year that may not be the ultimate bottom but it seems more and more likely as we go higher from here. The NYSE bullish percent went on to a buy signal on the point and figure charts, which makes it a "bull confirmed" status, meaning bull market. This is supposedly the lowest a confirmation has ever happened at 20%, it could be a false signal but as of now until it is broken buying the dips is much more appealing and trends should hopefully last longer than a day or two.
If hedge fund and mutual fund liquidations are essentially done there will likely be a steady stream of money coming back into the market over the next few months if we don't get any unexpected surprises like a country defaulting.
I recently got approved for Forex and Futures on my new thinkorswim account which should offer some good opportunities to diversify. If europe is/will be in a recession it seems logical that they will continue to cut rates, and since the our rates can only go down another percent I think this will pressure the euro making it good to be long the dollar and buying on dips. A strong dollar will pressure crude and commodities however those have come down so hard from forced selling I think I'll wait for them to regain a correlation.
We broke above 9,250 and finished above it today pointing to higher stock prices going forward. Today was kind of funny because it was much less volatile during the day(ie normal) and seemed boring after we have had such swings all month. In the final 30 mins there was quite the battle though, in 2 mins I think the futures sold off 150 points, traded in a range then finished up back close to their highs within the last 5 mins. I took the opportunity to trade some futures today, it was slightly frustrating but highlighted the necessity of rules and risk management. 3 times in a row I took trades, with the trend and had to get back out with a loss. Then my 4th trade was profitable and made up for all my losses. I ended up making 5 dollars total in the futures haha but it shows that you can take multiple small losses and still make money. My other lesson was to take positions a little bit closer to trend lines. I would get back out when the lines were violated, but would generally see them come back and would have gone in my favor. Oh well, rules have to be followed as we can see and you can't mess around even trading single contracts due to the leverage they allow. Each trade risked about 1%.
Overall I am cautiously optimistic at least in the short term given what has been seemingly priced in. Consumer spending dropped by 3% which was huge and obviously is the main driver of GDP(which was -.03). I think a lot of the announced layoffs will hit next month which could be an issue obviously and is never a good thing in general(take it from the unemployed haha).
It looks like Obama is going to win the election, which I prefer but hope he has a good plan for creating jobs. Stimulus packages like Bush gave by giving out checks are worthless and do nothing but artificially create spending for a month. I hope that is not the same way Obama goes because it would be equally as worthless and add even more to our debt. If jobs get created then people can spend month after month(and hopefully this time save some too) imagine that!
Well, back to studying...
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