Wednesday, July 31, 2013

Dalton, Jones, & Dalton, Mind Over Markets, updated edition

Mind Over Markets, the book that popularized (and expanded on) Peter Steidlmayer’s Market Profile, was first published in 1990. Anyone who bought the book expecting a self-help manual would have been sorely disappointed because what they got instead was a pretty complicated alphabetic model for organizing the distribution of market data along price and time axes. Twenty-three years later James F. Dalton, Eric T. Jones, and Robert B. Dalton are back with an updated edition of their text, Mind Over Markets: Power Trading with Market Generated Information (Wiley, 2013).

The book itself is organized according to the Market Profile trader’s achievement level—novice, advanced beginner, competent, proficient, and expert—with the greatest time spent on the competent level. The expert trader gets a mere two pages.

Although the authors stress that Market Profile should not be used in a vacuum and that traders must always think and make their own decisions, they throw a couple of bones to those looking for “steadfast rules.” “[M]arket-generated information, when observed and interpreted through the Market Profile, will at times reveal unique situations that offer a high degree of certainty.” These special situations are: 3 to I days, neutral-extreme days, the value-area rule, spikes, balance-area breakouts, and gaps. “There are no guarantees, but one of the comforts of a Special Situation is the identification of a mechanical trade—a trade that almost has to be done (under the right market conditions).” (p. 239) As should be evident, the special situations are defined using Market Profile language; there’s no shortcut to identifying these trading opportunities. Moreover, “successfully using Special Situations involves a synthesis of market understanding, time, and experience.” (p. 262) There’s no shortcut to trading success in general.

In analyzing market structure, the authors are inclined to anchor intraday activity to the way the market opens. “With an understanding of market conviction, it is possible to estimate very early on where the market is trying to go, which extreme is most likely to hold (if any), and even what type of day will evolve. In other words, the market’s open often foreshadows the day’s outcome.” (p. 63) There are four basic types of opens—the open-drive, open-test-drive, open-rejection-reverse, and open-auction, all analyzed in some detail.

One of the theses of this book--familiar to many, very profitable to few, and treacherous to the unwary--is that “the best trades often fly in the face of the most recent market activity.” (p. 110) That is, when a market trades above or below an accepted reference point and fails to follow through, this often sets up a powerful reversal trade. And if the reference point of a higher time frame supports that of the lower time frame, the reversal move can be even greater.

The strength of Mind Over Markets is that it introduces the reader to a “way of organizing market activity as it unfolds.” But, caveat emptor, Market Profile “is not a system that predicts tops and bottoms or trend continuation any more than the teacher’s grade chart is an indicator of overall student intelligence.” (p. 8) Only fortune tellers have crystal balls.

Monday, July 29, 2013

Lloyd, Successful Stock Signals for Traders and Portfolio Managers

In this comprehensive recently released book, part of the Wiley Trading Series, Thomas K. Lloyd Sr. draws on 25 years of experience teaching portfolio managers how to use technical analysis. Although the book’s subtitle is Integrating Technical Analysis with Fundamentals to Improve Performance and although the book pays lip service to fundamental analysis, it focuses on the most frequently used technical indicators, chart patterns, and techniques to offer Successful Stock Signals for Traders and Portfolio Managers.

What sets this book apart from most of its competitors is its extensive analysis of case studies. Here and there Lloyd relies on posts he contributed to, but for the most part his analyses appear for the first time in this book. He looks primarily at stocks that for better or worse have captured the imagination of the trading public and that have well-known stories—stocks such as GMCR, FB, HLF, LNKD, CMG, JCP, CRM, SBUX, PCLN, AAPL, NFLX, and LULU in addition to such stalwarts as HD and WMT.

Two chapters study stocks that have blown up after negative earnings surprises or after publicly shared research by short sellers (think, e.g., of the dramatic drop in Green Mountain Coffee Roasters after David Einhorn delivered a presentation exposing its weaknesses). The question the author asks is whether there were sell signals before the fall. His answer, not unexpectedly, is “yes.” In the case of Green Mountain, “the technical sell signals triggered before Einhorn’s October 17 presentation were: price breaks below the 50-day moving average, price forms a double top, the 20-day breaks the 50-day moving average in a downtrend, the CMF goes into the red below the line, plus D1 in green and minus D1 in red do a negative crossover on directional movement, “ ADX trends up as price drops, “the Keltner channel reverses from uptrend to downtrend, price violates the mean dotted line of the Keltner channel,” and “performance relative strength reverses to a downtrend underperformer.” (pp. 127-28) One might say “wow”, but as Lloyd writes in more expansive prose, “The weight of evidence in these technical signals was overwhelming and indicated that something was happening to Green Mountain before October 17 that was not good.” (p. 128)

Another thorny question that this book addresses is when you should buy on weakness. In addition to other weapons in his arsenal, Lloyd brings out a traditional 3 box reversal point and figure chart, which he uses throughout the book in addition to candlestick charts, to study the case of LNKD.

There’s a wealth of information in Successful Stock Signals for Traders and Portfolio Managers that goes far beyond the usual technical analysis texts. Moreover, Lloyd’s analyses clearly illustrate that technical analysis is not a rote method but rather an art that requires skill and experience to use well.

Wednesday, July 24, 2013

Pignataro, Financial Modeling and Valuation

Paul Pignataro has written a book that even “dummies” can understand. In Financial Modeling and Valuation: A Practical Guide to Investment Banking and Private Equity (Wiley, 2013) he takes Walmart as a case study and walks the reader step by step through its financials as well as the Excel key strokes required to hardcode them.

The first part of the book builds a complete financial model from the company’s income statement, cash flow statement, depreciation schedule, working capital, balance sheet, and debt schedule. The second part undertakes a valuation analysis, including a discounted cash flow analysis, a comparable company (in this case Costco) analysis, and a precedent transactions analysis.

Walmart works well as a focal company, at least until the author gets to the chapter on precedent transactions. Using precedent transactions to assess the approximate value of a company is similar to using comparable recent real estate transactions to assess the approximate value of your house. If, however, your estate is so big that nothing like it has sold recently, you have a problem using this method. (An aside: in case you missed it, the most expensive U.S. estate ever to be formally listed hit the market in May—Copper Beech Farm in Greenwich, CT, with a $190 million price tag. The not so applicable precedent in Greenwich sold for $45 million in 2004.) The closest Pignataro could come was the KKR acquisition of Dollar General.

This book assumes no prior knowledge of Excel coding. Here’s a single example of the many Excel formulas and tips the author offers. Most people who use Excel have experienced that dreaded circular reference error message. Usually it’s simply operator error, but if you’re building a financial model of a company and haven’t changed your Excel settings you’re bound to encounter it. “In a fully linked model, there is one major, yet important circular reference flowing through the statements. This circular reference is related to the debt and interest. Specifically, if debt is raised in the debt schedule, cash at the end of the year will increase and therefore interest income will increase. As interest income links to the income statement, net income is increased. That net income increase flows to the top of the cash flow statement, and increases cash and, more importantly, ‘Cash flow before debt paydown’ at the bottom of the cash flow statement. This cash flow before debt paydown links to the debt schedule and increases the cash available to paydown debt, and therefore increases the cash at the end of the year, which increases the interest income, and so on.” (p. 242) The author explains how to adjust Excel settings (found under “File,” “Options,” “Formulas,” and “Calculation options”) to enable iterative calculations and how to fix the number of iterations Excel should cycle through.

Pignataro is the founder and CEO of the New York School of Finance, which means that he knows a thing or two about training investment professionals from scratch. So if you’re interested in a career in investment banking or private equity or if you’re an investor, retail or institutional, who wants to learn more about the nitty-gritty of valuation, this book fills the bill.

Wednesday, July 17, 2013

Hammer, Architects of Electronic Trading

Most of us rarely think about all the technology that’s required to keep markets humming—at least not until there’s something like the flash crash. We take it for granted that brokerage firms will process our trades in a timely fashion (ever more quickly) and that our account balances will always be accurate. Of course, a lot of talent, effort, and money go into building and maintaining this infrastructure.

Stephanie Hammer talked to key technology experts and in sixteen interview-style chapters takes the reader behind the scenes—and into the future. Architects of Electronic Trading: Technology Leaders Who Are Shaping Today’s Financial Markets (Wiley, 2013) is written with the layman in mind, which suggests that Hammer probably did a lot of skillful editing.

As I read this book I found two themes especially intriguing. First, how long a technological edge lasts. (I’m always interested in the fleeting nature of edges.) And second, what kinds of changes we can expect in the not too distant future. Let me share some of the often conflicting answers the interviewees provided.

So, how long does an IT edge last these days?

“An edge becomes stale extremely quickly if it is horsepower related. It is a question of months maybe.” (p. 19)

“Not as long as it used to. Advances in technology are leveling the playing field. …Software and ‘wetware’ also provide an edge, and the good news is that you can keep a software edge longer because it is harder to commoditize.” (p. 40)

“[A] pure, network speed advantage may last between three and six months.” (p. 55)

“It’s hard to say. Months. Maybe a year or two.” (p. 85)

“Putting an expiration date on an edge is tough because the duration of an edge varies greatly according to what it is. Coding (non-algorithmic) is almost commoditized. Hardware and networking are ascendant.” (p. 150)

Looking into the future, the interviewees pondered what the next “quantum leap” in trading technology would be. They suggested a range of possibilities, among them: quantum computing; the ability of wireless transmissions to cross the Atlantic and, soon thereafter, the Pacific Oceans; and complex event processing (CEP) platforms. Other interviewees pointed to technologies currently in use that will undoubtedly become even more sophisticated, such as FPGAs (field programmable gate arrays), GPUs (graphical processing units), and cloud computing. By the way, for those aspiring to “affordable desktop supercomputing,” dollar for dollar GPUs “offer 10 times the processing power of traditional central processing unit (CPU) technology.” (p. 33)

Naturally, interviewees addressed issues of high frequency trading and data centers. But technology is also used to help control risk, with an emphasis on the word “help”; technology is not a panacea. And then we have the “big data” that “firms can utilize for pattern recognition, to discover new linkages between datasets and by extension, potentially valuable correlations among products, markets, and even events.” A caveat here: “the reality of the current situation is that firms are having varying degrees of success in terms of the value that they are deriving from data.” (p. 146)

Architects of Electronic Trading offers a cogent account of the various components that make up this complex field. I am certainly better informed for having read it.

Monday, July 15, 2013

Bernstein, All About Day Trading

Jake Bernstein, who already has more than 44 books to his credit, is back with yet another: All About Day Trading (McGraw-Hill, 2013). It’s written for the novice who wants to try his hand at trading stocks and/or futures intraday.

Some of the advice, such as not to trade with a delayed quote feed, is directed at those whom I would unkindly call dim bulbs. But most of Bernstein’s dos and don’ts (mostly don’ts) are not only good tips for beginners but useful reminders for those traders, and not just day traders, who have amassed more experience than profits.

Bernstein advocates what he calls the STF (setup, trigger, and follow through) trading model. The setup is a testable algorithm—no subjective, “look like” patterns allowed here. The trigger can be defined in terms of a technical indicator, preferably one that’s not bounded since indicators that have upper and lower limits, such as RSI and Lane’s stochastic indicator, give too many false signals. Follow through includes both managing risk and maximizing profit. Exits, in the author’s view, are less mechanical than entries.

Bernstein offers some specific examples as they relate to the STF trading structure. For instance, trading with gaps, an open-close moving average method, a moving average channel method, and a 30-minute breakout method.

A key chapter deals with trade management. Bernstein argues that “every trade you make must have a predetermined stop loss, as well as a predetermined first profit target.” (p. 109) How does the trader set his stop loss and profit target? “The stop loss for each trade must be a function of the underlying system” and/or market volatility, “not just a function of what you can afford to risk.” (p. 110) Six tables illustrate his point. Each shows the same trading strategy with different stop loss amounts: $500, $1000, $1500, $2500, $4000, and no stop loss. “Note,” he says, “the significant improvement in performance as the size of the stop loss increases. Note also that the stop loss size eventually reaches a point of diminishing returns, at which an increase in the stop loss no longer improves performance commensurately.” (p. 111)

As for profit maximization, big money is made in the big move; “80 to 90 percent of your money is going to be made on 10 to 20 percent of your trades.” (p. 118) Trading more than one lot, preferably multiples of three, “allows you the flexibility of taking in some profits … and holding some profits for the anticipated large move.” (p. 111)

Bernstein also touches on the “higher”-frequency trading that is available to the retail trader. He describes some futures trades he himself made using one-minute charts to generate trading opportunities during established trends.

All About Day Trading is, as the title indicates, quite comprehensive. It’s a very good place for the novice trader to start.

Wednesday, July 10, 2013

Wolfinger, The Rookie’s Guide to Options, 2d ed.

Those who have read the first edition of a book always want to know what is new in the second edition. So, before I look at the book as a whole, here’s a quick answer. In addition to the usual emendations and clarifications and a not-so-usual format change, Mark Wolfinger has added a chapter on calendar spreads and another on exercising (or, preferably, not exercising) an option.

Now that I’ve satisfied those who read The Rookie’s Guide to Options: The Beginner’s Handbook of Trading Equity Options when it came out five years ago, let me move on to write something for those for whom the book is an unknown quantity.

Option trading is an ever growing business as more and more investors seek to juice their returns. Perhaps I simply move in the wrong circles, but my sense is that retail investors are no longer using options primarily to protect their portfolios or to earn a little extra monthly income with covered calls. After all, the market has been trending up pretty strongly so protection hasn’t paid off and the Buy-Write Index underperformed the S&P Total Return Index by 11% in 2012. Many investors are instead succumbing to the siren call of leverage and short time frames. Why be content with a 20% return in a year if you can make that much in a week?

I guess one could call Mark Wolfinger old fashioned. After seven chapters that deal with “option essentials,” he devotes the next seven chapters—more than a third of the book—to basic conservative strategies such as covered calls, collars, and cash-secured puts. The final part of the book goes “beyond the basics” with discussions of the Greeks, European-style index options, risk management, and exercising an option as well as four additional strategies: credit spreads, iron condors, calendar spreads, and double diagonals.

If you are the type who views an option trade as a lottery ticket, if you are inclined to buy a far out of the money weekly call that could potentially yield a three- or four-digit percentage return but that is almost certain to expire worthless, this book won’t speak to you—at least not until you realize that you’re on a financially suicidal path. The reality is that every beginning option trader should learn the kinds of strategies Wolfinger describes even if he doesn’t plan to use them very often or right away. They can be quite useful when it comes to portfolio management, plus they’re excellent learning tools. Paper trade the basic strategies and, with Wolfinger’s tips on preparing the trade, making the trade, and managing the trade, start to learn how options really work. Soon enough you’ll be ready to move on to the more advanced strategies. Eventually, with study and practice, you’ll no longer be a rookie.

Monday, July 8, 2013

Miller, Chronicles of a Million Dollar Trader

When I reviewed Jim Paul’s What I Learned Losing a Million Dollars last month, I concluded that it was much more valuable than most “What I Learned Making a Million Dollars” books. I stand by my hedged judgment. But Don Miller’s Chronicles of a Million Dollar Trader: My Road, Valleys, and Peaks to Final Trading Victory (Wiley, 2013), though not quite the exception that proves the rule, comes close.

In 2008, as the financial markets became increasingly volatile, Don Miller was in his element. He had started the year with a modest retirement fund balance of a little over $700,000. If he was ever going to reach financial security, 2008 was the ideal time to push his intra-day trading skills to the limit. His goal was to add a million dollars to his nest egg over the course of twelve months. By July 4, when he began his online journal, he was more than halfway to his goal. For whatever reason he decided to share his journey (I assume that if his gains had been insignificant in the first half of the year we would never have heard from him) Miller became a dedicated blogger, recording his daily thoughts, trades, and results.

This book is a compilation of selected blog posts, mostly from 2008, with 15-minute ES charts added to make sense of Miller’s trade reports. Once he overachieved, with a net profit exceeding $1.5 million in 2008, he became more reflective in his 2009 and 2010 posts as his account more or less plateaued in early 2009. Then came the MF Global bankruptcy in 2011 and with it angst in spades. Miller had approximately $3 million in three personal trading accounts with the clearing firm—and for a while it seemed he might have lost everything. He devotes a brief chapter to this crisis.

Readers looking for trading strategies that will produce outsize gains come rain or shine won’t find them here. Miller took advantage of favorable intraday trading opportunities that don’t happen every year. What the book does offer, however, is an account of how an individual who had honed his skills for years without remarkable results pushed himself day after day when the market was finally willing to reward all that work, how he fought his way inch by inch (think Al Pacino’s motivational speech in Any Given Sunday) toward the goal line. He intentionally adopted a “coming back from draw” mind-set. He sacrificed sleep to trade early morning, he graded himself relentlessly and often mercilessly. He found inspiration in poker and football. (By the way, his favorite “trading” book is The Tao of Poker—which I too can heartily recommend.) He used emotions to his advantage, admitting that he traded better and in a more focused state when he was angry. Journaling also contributed to his focus.

Reading Miller’s book is a bit like watching the Rocky films. You don’t learn how to box but you come away with some important life lessons. Life lessons, in this case, that just might make you a very good trader one day.

Wednesday, July 3, 2013

Emons, The End of the Risk-Free Rate

Ben Emons, a senior vice president and global portfolio manager at PIMCO, argues that we need to adjust our financial models to reflect, as the book’s title states, The End of the Risk-Free Rate: Investing When Structural Forces Change Government Debt (McGraw-Hill, 2013). Emons’ thesis, if sound, is challenging; it calls for a paradigm shift. For instance, equities are priced off the risk-free rate. But if there is no longer a risk-free rate, if (to look only at the domestic market) U.S. Treasuries now carry an element of risk, and presumably an element of risk that is dynamic, how do you calculate the risk premium that is built into a stock price? Equity pricing models need to be redrawn. And options prices would have to be recalibrated as well; the risk-free rate is, after all, an input to the Black-Scholes model. (A proofreading aside, it is not—as it appears in both the text and the index—the Black-Sholes model.)

Unfortunately, Emons’ book doesn’t serve his thesis especially well. He writes like a bond guy, actually like a Dutch bond guy. Which means that his prose is often incomprehensible. To take but a single sentence—and it’s supposed to be a full sentence (p. 62): “In connection is a ‘sudden stop’ at which foreign capital withdrawals that cannot be offset sufficiently by domestic capital.” I assume that “withdrawals” should read “withdraws,” but I can’t parse “in connection.” The book suffers mightily from the absence of a good copy editor and proofreader.

For those who are willing to soldier on, let me try to summarize the author’s argument for his claim that “the present-day risk-free rate resembles an ‘upside-down’ world.” First, the “risk-free rate can be seen as the sum of two kinds of expectations: an expectation of future inflation and future real GDP growth.” With the so-called risk-free rate now at 0, we can conclude that both expectations have been dampened considerably. “That effect gets momentum in case of ‘flight to safety’ during a crisis situation. Because this flight to safety affects the risk-free rate, it also affects risk premiums for other securities.” In 2012 the equity risk premium reached its highest level since the 1960s, nearly five percent. “Based on historical data on equity risk premiums by Ibbotson, at ultra low levels of risk-free rates, the risk premiums represent an ‘old normal.’ It creates the perception that, for example, stocks are dramatically undervalued. That may not be fully correct because historical models are using a risk-free rate based on the assumption of growth rates from better times.” And so, Emons concludes, we get to the upside-down world where the risk-free rate “is distorted on the one hand by flight to safety and central banks; on the other hand, the risk-free rate is assumed in models to be at old school value when growth was higher.” (pp. 29-30)

This book is ostensibly directed at investors who have to make decisions in this new, uncertain environment. I would narrow its audience to exclude all but relatively sophisticated bond investors, academics, and professional money managers. Retail investors in stocks who are not comfortable with the language of bonds will struggle.

Monday, July 1, 2013

de Brabandere & Ivy, Thinking in New Boxes

You can’t think without boxes, the authors claim, so don’t even try. Instead, they propose Thinking in New Boxes, which they describe as A New Paradigm for Business Creativity (Random House, 2013). This book won’t be published until September 10, so what I’m offering here is a sneak preview, compliments of NetGalley.

To make sense of the diversity, complexity, chaos, and uncertainty we constantly confront, we use mental models (such as working hypotheses, frameworks, and paradigms) or boxes within these models (such as concepts and stereotypes). But this latticework of mental models, to use Charlie Munger’s phrase, can be constraining; “we all become trapped by our boxes over time.” (p. 20) In order to look at the world from a fresh perspective and innovate, we need to think in new boxes.

The authors outline a five-step approach. First, doubt everything. Second, probe the possible. Third and fourth, diverge and converge. And finally, reevaluate relentlessly.

Of these five steps, only the third and fourth need some clarification. Divergence, as the authors understand the term, “calls upon you to create many new models, concepts, ideas, and ways of thinking. It entails a freeing up of the mind and spirit so that even what may seem like foolish or ill-advised boxes are not rejected—yet.” Convergence, by contrast, is a winnowing process “where your ideas transform from a long list into a more select group, and then eventually down to a still smaller number (or even just one idea) that can be implemented to achieve breakthrough results.” (pp. 33-34) As Linus Pauling famously wrote, “The way to get good ideas is to get lots of ideas and throw the bad ones away.” (p. 101)

In this post I want to spend a little time on the fifth, absolutely critical step—reevaluate relentlessly. As the authors write, “No idea is good forever. No matter how brilliant, how resilient, how imaginative, how timely and effective, every box you conceive will benefit from being modified, improved, and ultimately replaced.” Or, in the words of Oliver Wendell Holmes, Jr., that I particularly like: “To rest upon a formula is a slumber that, prolonged, means death.” (p. 161)

Reevaluation requires a prospective mindset. That is, “it requires you to become much better attuned to many of the various things that may change in the future over the midterm and the long haul, and be better able not only to detect the early signs of such change ahead of time, but also to act upon these signals promptly and effectively. And it requires you to realize that even when”—in fact, especially when—“everything is going well, you still need to be on the lookout.”

The authors continue: “The signs of change—and your ability to see and prepare for them—occur along a spectrum. At one end of the spectrum, you’re encountering vivid paradoxes … that are relatively easy to detect and, hopefully, respond to. At the other end of the spectrum, you’re scarcely able to see, or may be entirely blind to, the inevitability of change and the constant prospect of failure. … All along this spectrum are all manner of ‘weak signals’ that your own current biases and perceptions make it difficult to detect. … Sometimes you notice the weak signals yet say to yourself, ‘no big deal.’” (p. 168)

Throughout their book de Brabandere and Ivy focus on typical business examples. But their principles can easily be extended to one of the biggest businesses of them all, the financial markets. Financial products change, technology changes, players change, economic realities change, regimes change. The individual investor or trader who keeps doing the same thing over and over again, rationalizing his stuck-in-the-mud behavior by saying that basic principles don’t change and human nature doesn’t change, will never achieve the level of success of investors and traders who are willing to reevaluate their models relentlessly. Renaissance Technologies’ Medallion Fund is an extreme example of this willingness and has the returns to match. And please don’t bring up Warren Buffett as a counterexample; he is much more amenable to change (including investing in those “financial weapons of mass destruction,” derivatives) than he lets on.