Wallstrip: A Peter Lynch Agenda?

Our daily read of the always-entertaining Wallstrip.com (now added to our recommended sites) today took us to consideration of International Gaming Technologies.  After enjoying Lindsay Campbell’s undercover work in Atlantic City (you should, too), we started talking about how the site might help us in choosing investments.

We realized that the stories had a "Peter Lynch" quality, setting the table with companies that had products people used and knew.

We see the stories not as an answer, but as an agenda.  The companies covered are all about where the action is, and what is attracting customers.

As always, an investors must do their own homework, but many will find the companies reviewed to be an interesting place to start.

And they will have a lot of fun doing it!

no positions — yet …

Pinch-hitting for Lenny

Lenny Dykstra was scrappy and successful as a major-league baseball player.  I often had Dykstra on my fantasy baseball teams, since I was always willing to "pay up" for him in the draft.  Since his retirement from baseball, he has been putting together an investment fund for athletes.  This is important since their big earnings years end early but their needs continue.  Dykstra has gotten some nice media exposure and also writes a column for theStreet.com’s premium site, RealMoney.

Reading his column today, I shouted out, "Hey, Ryan!  Lenny Dykstra recommends buying the July doubles (calls with a 55 strike, expiring in July) in Amgen."

Ryan is our (very astute) trader and also a sports expert.  He asked, "Do you mean THE Lenny Dykstra?  Is this good news, or should we be selling?"  Ryan was joking, because we also hold a deep call in Amgen, one of our favorite positions.

Dykstra, according to this story, learned to identify key buying points by studying with Richard Suttmeier, chief market strategist for Joseph Stevens & Co., and also a RealMoney contributor.  Suttmeier uses technical analysis to determine key trading points and has a model that projects fair value for various stocks and sectors.  Dykstra uses this information for buys.  He chooses to sell quickly when the stock makes a small gain.  It is a very active trading style.

It is not our mission to tell Lenny Dykstra how to trade his positions, particularly since he says it has worked well for him.  For our readers, however, we would like to recommend an alternative approach.

What Seems Wrong

These options have a very high delta, making them stock equivalents.  Playing for a one-point move in the option, as Dykstra does, increases trading costs and caps the gain.  Dykstra does not offer any advice on what happens when the position moves against him.  This must happen with some frequency.  Is there a trading stop?  The strategy described runs counter to traditional trading advice about letting winners run and limiting losses.

What Works for Us

What we do is to use deep calls as a stock substitute in positions where we have a long-term fundamental view.  We use technical analysis to aid in entering the position and adjusting it.  We start with a call that has low premium over parity (15% or so) and about 85 deltas.  If the stock sells off, we have protection because the option gains more premium as it declines toward the strike.  The deltas become smaller and the premium over parity increases.  There is also an absolute limit to losses in case of some disaster.  If the stock declines and our fundamental reasons for owning it remain intact, we roll to a lower strike, perhaps in a longer month, and add dollars.

If the stock price increases, we roll the position up, taking money off the table.  This allows us to continue to profit from a big run while managing risk.

Summary

It all starts with identifying good stocks.  No system will work without a sound stock-selection basis.  We choose the same stocks in our fund that we buy in our successful program for individual investors.  We have proven that the deep-call approach has higher gains than a buy-and-hold strategy, while taking less risk.

A crucial concept is taking the right position size.  We do not buy more exposure in options than we would take if buying the underlying stock.  Those who use deep calls to take outsize positions are adding too much risk and getting too little diversification.

There are many ways to trade successfully.  Time horizon and attention to risk are both critical. Traders and fund managers who have some longer-term positions might wish to consider our approach.

Meanwhile, we wish Lenny Dykstra the best of luck in his efforts.  We hope that he can help many of our favorite athletes.

Margin Debt and Sentiment

Margin debt tracked by the New York Stock Exchange has hit a new record high.  Traditionally, this is viewed as a sentiment indicator reflecting extreme bullishness.  The interpretation is bearish and contrarian.  It is a risky thing for stocks if anyone interested in buying has already done so — and borrowed money to do it!  That is the interpretation placed on the data by the Wall Street Journal.  Here is the lead from their report:

A rising stock market continued to inspire investors to go into debt to
buy stocks last month, sending margin-debt figures past their previous
record, which was set several years ago in the waning days of the
tech-stock boom.

At the Big Picture, Barry Ritholtz starts with the traditional interpretation, writing that "As of today, more people have borrowed money from their their brokers to buy stocks than ever before."  Barry goes on to explore some factors that prevent a direct comparison with the old record, set in 2000.  His readers also make a number of good comments.

A fundamental question is whether margin is also used for short selling.  Bill Rempel (aka No Doo-Dahs!) raised the question in a thoughtful analysis of Bloomberg’s report on the story.  The  Bloomberg author did not himself know the answer.  In a second story, Bill lays out several factors to consider before using margin debt as a sentiment indicator.  He raises excellent questions for anyone interested in making careful comparisons.

When we entered the hedge fund business, all of the prime brokers wanted to know how much short selling we would do and whether we would use margin.  The money generated from the short sales is profitable for the brokers since the interest they earn is greater than that paid to the hedge fund.

Perhaps readers will help enlighten us on the factors making up the margin debt measure.  Meanwhile, regular readers of "A Dash" know that we regard market valuation as the best long-term sentiment indicator.

The Most Expensive Investment Research of 2006

I had an interesting call this weekend from my most astute investor.  Since he wants to be anonymous, let’s call him "Bob".  Here is our conversation, with a few pointers and charts included — items that he requested I send him by email.  [Readers will benefit from taking the time to follow the links to past posts.]

Bob:  I enjoyed reading your research reviews last year, and I have a question.  What was the most expensive Wall Street research for 2006?

Jeff:  Do you mean the report that had the highest price tag?

Bob:  (chuckling) No!  I mean the one that cost people the most money.

Jeff:  Ahh.  Good question and the answer is easy.  The research on what happens when the Fed is trying to achieve what people call a "soft landing."

Bob:  That would not have been my guess.  I was thinking the election cycle or something.  What was so bad about the Fed and the soft landing.

Jeff:  It was a perfect storm for harming the individual investor and average trader.  First, the original work was a poor research design, but subtle enough that it took some skill to see the problem.  Second, it came from a big name firm so it got a major play in the media – basically accepted as gospel on CNBC.  Third, the concept was elusive, and subject to misinterpretation.  Finally, the leading blog sites gave it a big play.  The result was that anyone listening missed a big rally.

B:  You sound like a professor.  But I asked the question, so what was wrong with the research.

J:  Lack of data is the main problem.  There have not been enough Fed tightening cycles to draw sound conclusions.  You have to reach too far into the past, and then you still do not have enough cases.  The researchers used all of the data they had without regard for relevance.

A technique used in Research Design 101 is to look at a time series of results.  The reported research results assumed that the Fed is no better now than it was in the Hoover Administration.  This is typical of Wall Street.  Fund managers all figure that they are smarter and better.  In any other field of study we expect that there has been great progress – nuclear power, space exploration, biotech, DNA matching, weapons development, better airplanes and cars – you name it.  Despite this, the Street thinks that decades of Nobel Prize winning research in economics and the development of computer modeling make no difference.  Criticizing the Fed is a game, like second-guessing football coaches.

Take a look at some real data on recessions.  A good question is what proportion of the time the economy has been growing versus in recession.  This chart shows that by decade.
Recessions_by_decade It is readily apparent that the economy is now more resilient.  But the chart does not tell the whole story.

Fed tightening cycles have also had less impact on stocks.  Recessions — whether or not they result from tightening cycles — have had little impact on the overall earnings prospects of the market, as measured by earnings expectations for the S&P 500.
Sp_500_earnings_timeline_1
Recessions, when they occur, are briefer and with a smaller impact.  This is the best way to look at the data — as a continuous process of economic performance.  It reflects many factors, not just the Fed.

Even if one looks at the data from the perspective of a discrete series of Fed moves — the wrong method in my view — the stock market effect is quite different from that suggested in the original research.

After_the_fed_3If one  looks at "recent" data — say from the last thirty years or so — the  result is much different  from the conclusion drawn from the  "dead ball"  era used in the original research.  If you are trying to forecast, would you think that thirty years was far enough back to go?  In running your business, would you look at the recent trend or go back to the 20’s or the 50’s?

B:  I remember hearing and reading about this repeatedly.  Everyone said a soft landing was nearly impossible.

J:  That’s right.  We pointed out these problems in mid-August, but the media was running with the story.  CNBC quoted the study repeatedly.  Major writers featured it.  The big-time bearish blogs called it a myth.  They utilized pejorative symbolism which frightened the individual investors.  I warned about this out on "A Dash" and also in individual conversations.

B:  So those who listened to the mainstream media and the blogs lost out?

J:  Big time.  Those who did not understand this Fed cycle  have missed a big rally.  Even if there finally is a correction or recession, stocks may not dip back to the August levels.  Look at the chart.
[click to enlarge]Sp_500_6_months
Investors have missed 15% in the S&P 500 and 20% in the Nasdaq while waiting for a Fed-induced correction.  (Meanwhile, Vince’s intermediate-term models gave us a buy signal on August 8th.)

Even if we eventually have a correction or a recession, the pullback may not take us down to the August levels.

B: What do you mean about "understanding this Fed cycle."  You are not suggesting that this time is different are you?  We all know that is a mistake.

J:  When the tightening starts from a level that is far below "neutral" and proceeds very gradually to a point that is slightly above neutral, it is different.  It is not like a tightening cycle where inflation was already out of control, and the Fed needed to choke the economy.  I repeat that there are not enough cases for a quantitative analysis of tightening.

B:  Personally, I have followed your advice and remained invested.  Some of my friends have not.  What would you tell them?

J:  I am not surprised that many have missed out.  The misinformation on this subject reached many — perhaps millions of investors, while "A Dash" has a loyal readership best measured in hundreds.  That is actually a good thing for those who are just now getting involved. Most still do not understand, and we will see some fund managers chasing for performance.

Despite the rally, I feel that most of the opportunity remains.  Stocks have only begun to catch up with the record run of earnings growth.  I have tried to illustrate that in my valuation stories on "A Dash".

B:  I have been reading that earnings are going down, reverting to the mean.

J:  That just means that we are returning to normal growth instead of exceptional growth.  Don’t confuse a lower rate of growth with an actual earnings decline.  Take another look at the chart of forward earnings.

Meanwhile, I’ll try to cover the subject of misleading articles on earnings.  The list of topics grows….It is more difficult when writing fresh analysis.

And our conversation reverted to the normal subjects — sports, bridge, poker, kids, and good restaurants.  It is nice to have some astute investors who ask good questions.

Build your own trading system? Hmm…

Not so long ago, designing a trading system was viewed as a highly technical problem that required talented developers, special background, and great skill.  An individual investor would no sooner build a trading system than he would a refrigerator.

Advertisements for brokerage firms signal that this has all changed.  Several of the leading discount brokers now bombard television watchers with the same message:  You CAN do this at home.  One firm explains how easy it is to develop and back test strategies with their online software.  Another uses rotoscoped images to capture the indignation of some investors who are all smarter than their brokers.  A third shows investors making smart moves while taking a minute away from running the restaurant or the construction site.

At "A Dash" we have tried to show the challenges in developing systems and interpreting data.  Making powerful software simple to use and data more readily available just makes it easier for non-experts to lose a lot of money.

One graphic example is better than many admonitions from us.  Check out the story of a rookie prop trader and his foreign exchange system, as reported by Tyro.  Tyro’s friend was intelligent and methodical.  He did a lot more work than most and took what he believed to be a cautious approach.  After a month of awakening at 5 AM to test his system through paper trading, he was ready for the real show, going carefully with 2% positions.  You can guess the result.

He did many things right, but it is so easy to go wrong.  Go to Tyro’s site and read the entire well-told tale.  Thanks also to Trader Mike for highlighting  story.

Aspiring system traders should read (at least) Fooled by Randomness and the Portfolio Management Forumulas, the first book in the Ralph Vince "trilogy" (both featured on our recommended list at the right).  These books will explain many of the traps as well as some good methods for testing a system.

If you do not find these books to be real page-turners, (we did), then system trading is probably not for you.

Enhancing Trader Performance by Brett N. Steenbarger

At "A Dash" we have been reading Dr. Brett Steenbarger’s recent book, Enhancing Trader Performance, now featured on our recommended list.  (Some time spent in air travel is always good for serious reading.)  Our audience will find this book quite helpful.  In general, we feature work as we specifically cite it in our own analysis.  There are so many applications in this book, that we will be pointing to it repeatedly.

For now, let us consider a very general review, showing who will find the book helpful and why.

Greatest Strengths

The greatest strength of this work is the authoritative combination of theory and practice.  Dr. Brett draws upon a body of theoretical literature showing a logical progression from building competence, moving from competence to expertise, and using that expertise to become successful.  It is the whole package presented by a great writer who understands the theory.

Unlike many works where the strictly academic approach renders them inaccessible to most readers, this book is fun.  Each theoretical step is salted with examples from those who have achieved great success by implementing the principles.  The reader learns about how noted athletic performers like Dan Gable, Wayne Gretzky, Muhammad Ali, and Lance Armstrong employed the specific methods described.  This does not mean, of course, that these athletes had all read the relevant literature.  Instead, they learned or developed key methods on their own.  Nonetheless, their success demonstrates the power of the theories.

For traders, another great strength of the book is the application of theory to practice.  Because of his personal work in observing and helping traders with their problems and methods, Brett’s writing really comes to life.   Anyone has done some trading will recognize the characters in themselves or someone they know.  Any trader has experienced many of the same foibles as the featured characters, who are all real traders. The reality of the examples gives the lessons
and advice the ring of authenticity.

Wider Applications

While the book is aimed at a trading audience, it is quite useful for anyone engaged in competitive activity where performance is measured.  This is not just about trading.  Those competing in athletics or games of the mind will find the work most helpful.  Our own experience involves competing and coaching people in competitive activities like bridge, backgammon, chess, sports handicapping, poker, and debate.  Nearly every chapter has lessons for those striving for success in these fields.

An Important Lesson

There are also important lessons for the individual investor.  So much of today’s marketing makes it seem easy for anyone to beat the market.  Enhancing Trader Performance shows that learning the key lessons to become successful is hard work.  It requires a level of commitment that many would not have.  It is better to know this before starting, than to learn the hard way.

Summary

Briefly put, this is a must-read for traders and for system developers.  It is also recommended for those engaged in any competitive activity.  Finally, it is useful for individual investors.  Taking the time to understand the problems faced by top traders is the first step.  Those unwilling to make the time commitment to read and learn are unlikely  to achieve long-run success.  Read this book first!

The Black Swan Challenge

Trader Mike is one of my daily reads.  If you are serious about trading or investing, he should also be on your list.  He is always a source of great ideas, information, and links.  Today he has done a beautiful job of describing the key elements of the Amaranth blowup.  To get a complete understanding you should follow the links in his post.  (He has the tagging implemented nicely, and I am just trying to learn it.  It is one thing to have information and another to convey it.  In my classes, I had notecards and legal pads.  I wrote things on a blackboard and challenged students — no PowerPoint, which had not been invented yet!!  The old guy is trying to learn the new tagging tricks.)

On to today’s challenge:

Suppose that you had a trading strategy that would normally just break even, or perhaps even lose a little each month.  That does not sound very good, does it?  Now let’s further suppose that the strategy scored big on any "black swan" event.  In short, it could be genuine portfolio insurance.

How should you present this to the world?  Is anyone interested?  How many managers have something like this as part of their portfolio?

(For those following the job applicant series, there is a scheduled applicant with a method like this, but circumstances and Mike’s great post have prompted me to advance the "challenge").

The Risk Challenge

Can you specify the risk in your positions?

  • What is the worst thing that could happen?  How much would you lose?
  • How should you measure risk?  Is it a question of daily volatility?  What about absolute risk?
  • You may have positions that seem uncorrelated to the market.  The positions may even seem negatively correlated (think airlines and energy stocks) so that they offset each other.  Could anything happen to change the relationship?
  • Do you have a plan of action if something negative happens?  Do you "fade the move" getting bigger, or do you stop out your positions taking a loss?  Without an advance plan, it may be difficult to think clearly in a crisis situation.
  • Does backtesting accurately reveal risk?

These are certainly not all of the questions, but they are important ones.  Traders and investment managers who do not have good answers may find themselves facing a day of reckoning.

A Trading Idea?

The always-entertaining Daily Options Report provided some commentary on a trading rule.  Take a look at the analysis by James Altucher (and the suggestion in the comments by Muckdog) and then we’ll add a thought.

Link: STOP TRADING!.

So NOW you tell me. Jim Altucher adds more info to the "buy the 1st trading day of the month" rule.

Continue reading…