Saturday, March 19, 2011

Rationality #Fail

Odds of a nuclear core meltdown are estimated by scientists to be 1 in every 10,000 years. That’s very interesting especially in light of the fact that we have had 3 at least partial core meltdowns in just the last 50 years. This is the kind of statistic that makes us shake our head at such mathematical estimates based on a purely rational approach. Of course anyone in our profession will instantly see the parallel between the utter failure of the scientific estimate regarding potential nuclear disasters and the utter failure of the estimated risk of financial meltdown in 2007. Statistically both were nearly impossible and incredibly unlikely. And both are occuring in a very regular time-line. What becomes very clear is that complex systems defy rational mathematical estimates of risk.

We were pondering these thoughts last week when our intelligent friend Alex recommended reading Richard Bookstaber’s A Demon of our Own Design. Fantastic book — here are a few quotes:

“I believe the markets can better conquer their endogenous risks if we do not include every financial instrument that can be dreamed up, and take the time to gain experience with the standard instruments we already have. Just because you can turn some cash flow into a tradable asset doesn’t mean you should; just because you can create a swap or forward contract to trade on some state variable doesn’t mean it makes sense to do so. Well, in the efficient market paradigm it does. . .But in the world of normal accidents and primal risk, limitless trading possiblities might cause more harm than good. Each innovation adds layers of increasing complexity and tight coupling. And these cannot be easily disarmed through oversight or regulation. If anything, attempts at regulating a complex system just makes matters worse….Rather than adding complexity and then trying to manage its consequences with regulation, we should rein in the sources of complexity at the outset.

Simpler financial instruments and less leverage make up a painfully obvious prescription for fixing the design of our markets. These modifications will lead to a financial marketplace that will be apparently less finely tuned and less responsive to investor needs. But, like the coarse response mechanism of the cockroach, when faced with the inevitable march of events that we cannot even contemplate, simpler financial instruments and less leverage will create a market that is more robust and survivable”

Friday, March 18, 2011

Daytraders: Hang with your own kind

We read an interesting article a while back by Kid Dynamite about the benefits of seeing opposing viewpoints. The article was well written and made sense for his trading style as a swing trader. However, all we could think about is how the exact opposite is true for daytrading. Once again, time frame changes everything.
At our stage of the game all the technical matters are automatic. We know our setups, we know exactly what to do in terms of risk management, it’s become second nature. What’s left is all psychological. The quality of our set-ups is consistent, our risk management is stable, so what’s left is all mental.
As a daytrader you have to make instant decisions within seconds and when you are putting that much money on the line in a split second decision you will rarely have 100% conviction. The money at risk for a swing trader’s typical 8% stop can easily be equivalent to 50 cents for a typical daytrade. It’s notoriously easy to get talked out of a daytrade position. Daytrading is much more instinctual than swing trading, and the less rational thought that goes into it, the more psychological it becomes.
This is one of the biggest drawbacks of a chat room that has traders who use different trading strategies: you mix in every color and in the end you’ll get an ugly brown. This is the reason that the traders we follow on stocktwits all have similar trading styles, we want the confirmation, we do not want dissent. If we’re in a trade it’s because it fulfilled the required conditions (set-up, risk/reward) and the last thing we want is to question the trade.

Thursday, March 17, 2011

Trading Strategies

We have four different strategies based on daily charts that we commonly use:
1. The first is the one most familiar to traders and that’s the “break-out”. This is a trend-following strategy. It works well in trending bull markets.
2. The second is the “break-down” and it is also a trend-following strategy. It works well in trending bear markets.
2. The third is buying support, a reversion to mean strategy. This works well in markets that are correcting but still in longer term bull trend.
3. The fourth is shorting resistance and is also a reversion to mean strategy. This works well in rallies within longer term bear trends. This strategy can however also work well in range bound markets or nervous markets.
In addition to these strategies (all based on daily charts) we have three intraday strategies that we have created over the years that work in conjuction with the daily strategies: the base and break, the Indy, and the overshoot support. The first two are used in the trend following strategy, while the third is used in reversion to mean buying support strategy.
Here is an example of a typical break-out: BHI breaks out of congestion over 72.

Here is an example of a typical break-down: JDSU will probably hit some stops through this support base of 20. This strategy hasn’t work well for a while as buyers have repeatedly bought the dip; where stocks should typically die, they instead reverse. We are not interested in breakdowns at this point.

Here is an example of the third strategy, buying support within established longer term bull trends: CLF near 80 would be supported by the ascending 100SMA and daily support and would get us involved long:

Here is an example of the fourth strategy, selling resistance within established bear trends, OR in nervous markets. QCOM short 55 would most likely be good for a daytrade short as there is strong resistance at that level. Note that we always buy the first test of support and short the first test of resistance. After that we don’t get involved. This means we would expect the first touch of 55 to work well as a resistance short, but the second test to quite possibly be a successful breakout.

Of course there are also many nuances that come from the intraday set-up (for example we don’t buy support if it is basing on it instead of a vertical panic move towards it, etc) and many smaller points one has to keep in mind when trading these strategies. However, this is the skeleton of how we have traded over the last 14 years, and will most likely trade until we retire.

Late night thoughts

$ES_F is bobbing up and down with the Nikkei as news reports have become more optimistic in the last 4-5 hours. The first big reaction of this market is going to be completely correlated with the headlines and Japanese market reaction. If they can bring the power online and gain hold of the situation, market will bounce. If they fail to do so in time and situation deteriorates we will see more selling. Pretty simple stuff. However what will come after that initial reaction will be much more complex, not headline driven, and much more difficult to game.
We’re in for some turbulent times. Stay smart, don’t chase and whatever you do, don’t panic to the downside or the upside. And if you feel like you don’t have an edge then just stay out. There are worse things that can happen than staying in cash in once in a decade type catastrophic event.

Wednesday, March 16, 2011

Market Talk

We wrote in our newsletter last night,

“Today could very well be a short-term bottom but we’d be surprised if it were “the” bottom. Why? Japan, the 3rd largest economy in the world, is effectively paralyzed and the risks of contagion to an already fragile world economy, in our opinion, are not priced into the current market prices, off just over 1% from pre-Japan crisis. Nevertheless we’re not going to overthink this and as always, trade the charts. But it is something in the back of our head making us more conservative towards anticipatory breakouts and swings.”

And indeed, today two daytrade breakouts triggered and both worked for daytrades but would have failed as swings. Until the flow of news slows down this will be a daytrader market. As our readers know we love buying panic — but when we do it’s rarely when the market is reacting to real-time geopolitical events/natural disasters (and most panic moves down aren’t — usually it’s a follow up of an event that already happened, a cascading of fear versus a real-time reaction). And on the rare occasions when we do get involved on reaction to real-time news, (we were buying the panic on the BP disaster), it’s when the event is more finite and contained. Macondo could have gotten worse but it never was on the same level as what is happening now in Japan. We don’t know how the situation will develop and what the fallout will be, but we won’t be involved until the possiblity of a full blown core meltdown is off the table or at least we see a real crash (down 2% not good enough for us to put on the risk, $ES_F 1224 would probably tempt us though as that would be flash crashy). In sum, for us it has been more profitable to buy panic when the news is already in and we’re only dealing with investor psychology than when the market is fluctuating based on real-time news.