Category: Trading 101

Theresa Lo offered a nice comment on price:

“I know you’re used to reading financial blogs that opine ad nauseum everyday. I have no idea how they do it, nor am I going to try. You see, I show up each morning to make money; cash facilitates life. I don’t care for conspiracy theories or consider fiat currency an Ayn Rand moral dilemma. I won’t waste time tracking the defunct M3. Who cares if the Plunge Protection Team is real or not? @*$%@#$ corporate greed. I cannot right the alleged wrongs of capitalism – that’s what the SELL button is for. Use it. I simply accept the Darwinian nature of the markets. There is a financial circle of life and it cannot be defied. There is no good or bad. There are only profits or losses. That’s why tracking and trading price is the way to go. In an imperfect world, it’s all we have.”

Barry Ritholtz adds a great comment on his blog:

“We could merely guess – and all these calls for buying big cap tech stocks in the face of declining stock prices, decreasing P/E multiples, and rapid commoditization of their products have been nothing more than blind guesses. However, we find it is much more advantageous to wait until a given stock, sector, index or market proves itself before leaping into the fray. This is an admittedly humble approach (surprised?). We acknowledge that the future is unknown, that us Humans are particularly bad at conjecturing what lies ahead, and that most people on Wall Street refuse to acknowledge this. We confess to having no idea what the hell is going to happen even next year. Will the GOP lose control of Congress? Will bird flu kill millions? Will Iraq get even worse? And what about Katharine McPhee – can she win it all on American Idol? We own up to having no clue about any of these burning issues. And neither, we must tell you, does anyone else. So rather than merely speculate, we would rather allow a given sector to develop on its own. When we got bullish on Oil in December 2003, crude had broken out over $30, and was heading higher. Similarly, our calls on US Equities post Tax cut in 2003 wasn’t until the technical picture improved. We got bullish on Japan in 2004 when it was apparent that it had started to work; Those who were merely “guessers” had 15 years to get it wrong. Our bullishness on Gold was for similar technical reasons – after a long period of under performance it was starting to work also. Regular readers are all too familiar with our expectations for how this bull market ends – an ugly and violent death – but as long as the trend remains up, we are loathe to fight the tape and get short. Indeed, we still are not short any US equities, although we have some in the money VIX options and a few Q puts – as hedges. While we may wax eloquent and muse about what may come eventually, our investments stay on the same side of the market as the overall trend – or at worst, in cash. Once we see proof positive that a stock, sector or market has shifted direction, then we can jump in.”

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Here is a take on “compounding” from a reseller of the Winton Capital trend following fund:

“There’s a good rule of thumb for estimating realistic returns from equities over time. Take the rate of inflation and add on a risk premium of 3%. With inflation currently at around 2.6%, you could expect returns from equities to be around 6% over the next few years. However, big external shocks can have a significant negative effect on equity markets and there is no guarantee that you will get back what you invest. The Matrix Ascension Plan aims to give you higher returns than equities over the next seven years and capital protection. The Matrix Ascension Plan enables you to benefit from the returns of a Fund managed by Winton Capital Management, a company that has a track record of producing high returns for investors. In October 1997, they launched the Winton Futures Fund which has provided investors with annualised returns of 21.01%. As a comparison,the annualised returns from the FTSE 100 Index over the same period have been 0.28%. To put these returns in some sort of context, if you had been the buyer of Vincent van Gogh’s ‘Irises’ in 1947, you would have paid $80,000. The next time it changed hands, in 1987, it was bought for $53.9m. This seems an extraordinary rise in value but mathematically it shows a compound average annual growth rate of 17.7% – less than the annualised returns from the Winton Futures Fund over the last six and a half years.”

I liked the van Gogh compounding example. It really points out the “magic” of compounding.

Investment banks spend millions upon millions to produce research. J.P. Morgan Securities Ltd. recently produced “Volatility, Leverage and Returns”. Read PDF. An excerpt:

“We find, though, that active managers of bond and hedge funds earn lower alpha when volatility rises unexpectedly. This is because many are structurally long risky assets that get hurt when volatility rises. Alpha returns when volatility stops rising and becomes high only when volatility starts falling again.”

Of course, much of this report is the opposite of a trend following thought process.

A recent article of mine on skill-based trading (PDF).

More.

An excerpt from Reminiscences of a Stock Operator:

“My losses have taught me that I must not begin to advance until I am sure I shall not have to retreat. But if I cannot advance I do not move at all. I do not mean by this that a man should not limit his losses when he is wrong. He should. But that should not breed indecision. All my life I have made mistakes, but in losing money I have gained experience and accumulated a lot of valuable don’ts. I have been flat broke several times, but my loss has never been a total loss. Otherwise, I wouldn’t be here now. I always knew I would have another chance and that I would not make the same mistake a second time. I believed in myself. A man must believe in himself and his judgment if he expects to make a living at this game. That is why I don’t believe in tips. If I buy stocks on Smith’s tip I must sell those same stocks on Smith’s tip. I am depending on him. Suppose Smith is away on a holiday when the selling time comes around? No, sir, nobody can make big money on what someone else tells him to do. I know from experience that nobody can give me a tip or a series of tips that will make more money for me than my own judgment. It took me five years to learn to play the game intelligently enough to make big money when I was right.”

Jesse Livermore Books:

• How to Trade in Stocks (PDF)
• Reminiscences of a Stock Operator (PDF)

Watch video about things ceasing to be “normal” in excerpt from ‘Trillion Dollar Bet’:

You can order full video from Amazon.