NBG Note

If you did buy NBG following yesterday’s crazy rant, you should definitely cash out at this elevated spike—no definitive word here on a bailout and this doesn’t look like a bottoming pattern to me yet. (never investment advice:o) )

Editorial: Greece (and the rest of the free world) is Falling

The fears about Greece and their potentially imminent insolvency are well-documented so I won’t attempt to rehash the facts. Part of the story is about the classic battle between the “working man” and the government over pension issues, as well as the tremendous cost of high unemployment. It is also a story about the insidious rise of socialism (big government) that often follows fiscal irresponsibility. The fall of Greece is a sad saga of a country that went overboard with debt financing and in many ways is emblematic of what is happening in the United States and all over the world.

Capitalism always takes the rap when things go south in the economy. Unfortunately the real issue is that most of the poor decisions that lead to economic problems are the result of the flawed and socially-permitted incentive structures within the government that influence policy and regulation. You see, in the good times, the government caters to big business to ensure healthy campaign financing. Meanwhile the two conspire to quietly and mercilessly screw the middle and lower class –who tend not to notice since their paychecks keep coming in and credit is freely available. In this case the government told the bankers: “Hey, I got an idea! Everybody wants to own a home, so lets make them happy by making it easy for them to buy so they won’t notice that we are taking their money!” The bankers said: “Hey great idea, we can lure them in for cheap and raise our rates later to get our money back!” In bad times (such as now), the government is on the ropes, and policy is quickly shifted to appeal to the “working man” and the middle class to secure enough votes to get re-elected. In the wake of high unemployment and unacceptable conditions, the public relations braintrust at the White House work feverishly to stir up blame revolving around the evils of capitalism, and greedy bankers. “We the government will protect you and save the day with new regulations to keep these criminals in check!”—no need to mention that the “eye in the sky” in this great casino we call the US economy was watching them burglarize the common man with no intervention the whole time.

So what about Greece? Here again it almost sounds like what happened at GM a short while ago. Blue-collar retired workers holding a whole country hostage. It always bothers me that those with theoretically the lowest human capital value and level of education are permitted to form politically powerful unions. They abuse these rights to procure unfairly high wages, and also to ensure that their worlds exist in some protected bubble–devoid of the standard laws of economics where everything is always absolutely guaranteed– such as pensions and benefits. In contrast the rest of the world and the educated youth these days who face guaranteed unemployment (the highest rate for educated youth in 50 years) are expected to live in an uncertain world–in this case they are beholden to the rights and future excess tax burden of someone who drove a tractor in Greece for 30 years and now demands a 28,000 Euro pension. These same people who have the power to make a difference–in the face of the possible bankruptcy of their own country–claim that these issues are “not their problem” and wish to get paid regardless of the consequences. These are the very same people in America who in the pinnacle of hypocrisy, are the first to complain that executive compensation at banks following the credit crisis as being immoral and outrageous (which it is-no dispute there). Suffice to say we live in a dangerous world populated by idiots, that are now being baited by even dumber politicians. Watch out for the pitchforks!

On the practical versus rhetorical side, traders can get a sense of the rapid acceleration of fear by watching ticker NBG which is the “National Bank of Greece.” This low-priced dog fell a hefty 13.2% yesterday, and it looks to be threatening to match previous lows during the credit crisis. Personally i think using a multi-day back-ended scaling strategy here after another big down day (perhaps 15-20%) could lead to a quick but highly speculative 50%+ gain. In this case a back-end scale would start by building up to a full position starting with 5%, then 10%, 20% 30%, and finally 35% of the desired bet size (ie if you wanted to risk $10,000, you would start with $500, $1000 etc). The general idea is that prices will probably fall after purchase, but if you scale in without risking too much up front you will come close to the short-term bottom. Even if NBG goes bankrupt eventually it won’t happen overnight—thus a short-covering spike is a good bet that even Bear Stearns experienced. Hedging this position with SKF is also useful, as it will protect you from a protracted fall, and SKF will not likely fall 50% when the rebound day for NBG finally occurs. The good old days of fear and volatility are back, and if you are quick and contrarian you can profit from it. Thankfully the stock market is our last bastion of capitalism—use while you still can!

Livermore Active Issues Index for Friday, Feb 5th

A reader pointed out that last week’s performance was overstated and he was in fact correct, I computed things manually at the time  (Corey was away) and I missed a switch.  We ran the numbers using the computer this week and corrected everything. The last couple weeks has not been kind to the Livermore and to the general market-wiping out the small outperformance and putting the index in a small drawdown. However, as a long term rotational strategy, it will not outperform the index all the time and it is certainly more prone to drawdowns than short-term strategies. The hedged Livermore investor would be down a mere 2% from inception, and this is the model index that was presented as the best performing version on a risk-adjusted and absolute return basis. If you used trailing stops through this period, you would probably be about even. Following these types of long term strategies successfully is like flossing your teeth—it should be treated as an essential yet mundane activity that you must do regularly for it to work. Have fun with your short-term or discretionary trading for a small portion of your portfolio (unless you are a pro), but let these passive strategies do the heavy lifting over time. The Livermore allows you to hold the true leaders or soon to be leaders in the market.  If you can’t make money out of the market leaders, than you can’t make money in the market.

S&P500 and VIX Consensus at Extremes

While catching up on my nightly reading I noticed the following post by Frank of Trading the Odds: http://www.tradingtheodds.com/2010/02/vix-surges-20-as-fear-returns/  In this post, Frank presents his standard approach to measuring the edge of a given setup. He does a very good job of crunching the numbers for all to see on a daily basis. In this case, the VIX surging over 20% in one day was the setup described. In general the analysis is very thorough, and the new additions to the setup evaluation framework that Frank recently built in are definitely a good improvement. That said, long-time readers know that I prefer not to use fixed percentage trading rules etc since they are not normalized within the context of a particular environment. 

 Another concern, was whether looking at the VIX vs the S&P500 directly was redundant. Generally speaking, I have found little value in using the VIX as an overbought/oversold indicator to trade the S&P500  in lieu of using the S&P500 directly (however the divergences between the two are very valuable).  In this case, my central question was whether there was information that could be derived from a consensus between the S&P500 and VIX at extremes. Could looking at both together produce superior information concerning a short-term bottom than either in isolation? To run this test I used the last 5000 bars of data on both the S&P500 index and the VIX  from Yahoo Finance. I took the one day returns for the VIX and normalized them using a 50-day percentile ranking, I did the same for the S&P500–only I subtracted the final number from 1 to account for the negative correlation between the two. Thus the worst days in the S&P500 were 90th percentile and higher using this method. Similarly, the biggest up days for the VIX were also represented by high percentile values. Lets look at the numbers:

	Next Day		max tail loss
	Return	W%	(worst next day ret)
Both>99th	0.88%	86.36%	-1.48%
Both>95th	0.50%	65.93%	-2.70%
Both>90th	0.27%	60.00%	-5.74%
VIX>99th	0.25%	69.00%	-6.87%
VIX>95th	0.20%	58.66%	-6.87%
VIX>90th	0.12%	56.19%	-6.87%
S&P500>99th	0.62%	68.06%	-3.29%
S&P500>95th	0.17%	58.89%	-6.71%
S&P500>90th	0.13%	56.73%	-6.80%

As you can clearly see, consensus indeed helps to confirm temporary market bottoms (at least for a 1-day hold). Combining both screens produced higher next day returns, higher winning percentages and lower risk of an adverse loss. However, while not shown, this “consensus” method does not help add any value outside of the extremes. Apparently, bottoms require BOTH a major spike in the fear gauge and a major loss for the S&P500 which in hindsight makes sense.

Introduction to D-VaR Position Sizing (Part 1)

Position-sizing is the least exciting topic in trading. We all find ourselves too busy looking for the ultimate trading strategies or indicators to bother with spending time thinking about how much to bet. Contrary to what you might think, figuring out how much you should bet is not just a matter of determining your expected edge. Unlike casino games with defined odds, markets are uncertain and adjusting for the unexpected tail loss is just as important as adjusting for the  expected size of your edge.

 This concept is not new to hedge funds, and to those that trade for a living; They often think about risk first because their continued existence depends on staying in the game. For this sophisticated bunch, position-sizing, diversification, and hedging are the cornerstones of their risk management approach. Many of them are well aware that initial stop losses (in contrast to trailing stops which are very useful) are highly overrated as a means of managing risk–and if used improperly will increase your chances of going broke. This is because if they are placed too tight they will protect you from tail risk but expose you to more noise. If they are place too far the reverse is true– especially with unexpected gaps.  The tradeoff is simple:  death by one severe blow, or death by a thousand cuts. Finding the optimal balance is very difficult. Initial stops are not sufficient to manage risk by themselves and function much better when they are integrated with other risk management tools. In contrast, position sizing is very useful since you a) don’t face timing risk and b) can only lose what is invested–if you bet 5% of your portfolio no surprise gaps will lead you to losing more than you have bet. 

To the best of my knowledge, I do not believe that this particular position-sizing method has been published somewhere before. However I do know that it is based on the well-known concept of “Value-at-Risk.”  From Investopedia this is defined as follows http://www.investopedia.com/terms/v/var.asp:

What Does Value at Risk – VaR Mean?
A technique used to estimate the probability of portfolio losses based on the statistical analysis of historical price trends and volatilities.

 

Investopedia explains Value at Risk – VaR
VaR is commonly used by banks, security firms and companies that are involved in trading energy and other commodities. VaR is able to measure risk while it happens and is an important consideration when firms make trading or hedging decisions.  

Generally speaking VaR looks at tail risk ,which in the industry is defined by the magnitude of expected losses at the 95th percentile (or 5% percentile of the daily P/L distribution of any strategy). Knowing the maximum losses that  might occur in extreme circumstances helps risk management professionals prepare for the worst. If you know what % risk your portfolio may incur you can theoretically budget your portfolio or individual stock position sizing to allow for a given maximum. Conventional practice is to use a normal distribution for this this task– all that needs to be known is the mean and standard deviation and this estimate can easily be derived. Unfortunately for the slide-rule boys, financial markets are really not normally distributed and tend to exhibit “fat tails.” What this means is that the maximum risk (or upside) is actually both more probable and larger than what would be expected in a utopian trading universe.  This means that typical volatility-based position sizing inherently rests on a shaky foundation. (more on this later) Why not simply look at the empirical distribution of daily returns? After all, our own empirical observation tells us that normal distributions are flawed, so why not manage risk based on experience?

In this method we will use an incredibly simple approach:

1) take the daily returns for a given stock, index or strategy

2) compute the 5th percentile of returns (max tail loss)

3) select a budgeted risk level as a maximum daily loss such as 1% (conservative) or 1.5% (aggressive)

4) your position size is the budgeted risk level divided by the absolute value of the max tail loss

5) this position may not exceed 200%

Our goals are the following:

1) Reduce the size of the worst maximum loss - especially relative to a passive buy and hold strategy

2) Improve the sharpe ratio or risk-adjusted return- also relative to a passive buy and hold strategy

The following test was done on the Dow Jones Industrial Average using Yahoo Finance data going back slightly more than 20000 bars back to 1928:

VAR Position- Sizing DJIA 1928-Present
	Gross			worst daily
	Sharpe	CAGR	SD	loss
Buy and Hold	0.24	4.5%	18.4%	-22.6%
D-VAR 1% risk	0.45	5.2%	11.5%	-7.6%
D-VAR 1.5% risk	0.41	6.9%	16.7%	-11.4%

As you can see, both goals are achieved– D-VaR shows much lower tail risk and a higher sharpe ratio. As a side bonus, it actually produces a higher CAGR than buy and hold. From the crash of 1929,the crash of 1987, the Asian crisis in 1998, to October 2008, D-Var survived them all with limited tail risk without any use of timing related tools. This makes it a definite candidate as a new position sizing method that works in real-life. In subsequent posts I will give some more examples how this can be used in basic trading strategies that are both long and short.

Beware of The Carry Trade

One good explanation for the sustained downturn we recently had these past few days is the “bull flag” breakout in the US dollar. During most of 2009 when the market was rallying, the US dollar did not break its 20-day upper bollinger band once until November, and did not make several closes above it until January. The dollar also failed to make a 50-day high the entire rally, including November,  and began threatening this milestone level in late December. Recently it made a decisive breakout. Why does this matter? Because with “free” interest rates, investors were borrowing for next to nothing in US dollars and speculating all over the world in commodities and stocks–including the US stock market. The money has to be returned at some point, and when the dollar is rising people get margin calls. This would account for the failure of the market to snap back as fast as it normally does, as speculators sell their gold, commodities and stocks into weakness to balance their books to avoid getting run over. As we saw in 2008, the dollar tends to rise in periods of weakness, and this becomes a self-perpetuating problem for other asset classes when a trend begins to strengthen. The yield curve is currently very steep, and to correct these imbalances it will need to flatten somewhat and short-term rates will have to give. Again rising rates are also bad for the market. Investors also have to be aware of the great ponzi scheme going on between China and the US, and the possibility of a surprise revaluation of the yuan. Bottom line is, this year has the potential for strange market shocks–and you should adjust your position sizing accordingly: don’t get out on margin, and try to hedge your weak links.

Livermore Active Issues Index for Friday, Jan 29th

System Testing Metrics, GIGO, and Million Dollar Questions

Readers are strongly encouraged to read the following links–I don’t want anyone to miss these very eloquent and thought provoking discussions on the topic:

What are “degrees of freedom” ? This is a very important and highly overlooked topic, and Brenda Jubin– a true market scholar– of Reading the Markets does the best job of explaining this concept that I have seen in print: http://readingthemarkets.blogspot.com/2010/01/degrees-of-freedom-kiss.html

Jez Liberty of Automated Trading Systems who is posting some very good work lately also  highlights a very subtle concept: 1) the fact that there is no magic metric for measuring performance 2) traders are better off tailoring these metrics to their own personality and preference just like they would a trading system. http://www.automated-trading-system.com/bliss-function-quantify-trading-system-objective/

Last but not least, TopTick who is a frequent poster on my forums at DV Indicators in the community section is a quant par excellence and I must say is in very good company (thanks to all the great posts out there!) and I plan to link in many posts in the future. Here TopTick produces a great breakdown of a lot of the ideas to consider for system testing and performance metrics: http://www.dvindicators.com/community/forum/?vasthtmlaction=viewtopic&t=42.0

Here is my humble take on the topic:

1) Everyone wants to know the secret to finding the perfect metric that will allow you to extrapolate the future reliably from the past.

2) Everyone wants to know how to figure out exactly when a sytem has broken down so that they can exit reliably with minimal drawdown.

These are million dollar questions and those who realistically expect concrete answers in the form of one simple equation are living in a utopian trading universe. System performance metrics ultimately boil down to measuring the equity curve and/or the profitability and variablity of the individual trades. After finding a great result in backtesting the sad truth is that you cannot neccessarily extrapolate. Neither a simple nor complex analysis using the most advanced statistics will help you separate the bogus systems from the true winners. Equity curves are simply output, they depend on what factors/systems go into them. Hence GIGO- garbage in, garbage out. If you want to combine 50 variables and test long-parameter moving average sets over short periods–guess what? degrees of freedom strike thee down! your system is bogus and I don’t care if it has a Sharpe Ratio of 4 and a 2% drawdown.  Understanding the inputs and the possible methodological flaws in trading system design are more important than the output— if you just want to find great numbers genetic algorithms and optimizers will give you what you are looking for in seconds.

Every equity curve contains a story behind the numbers, and asking good questions is the real key to finding the truth. If I looked at Madoff’s equity curve any metric I would have used would assure me of continued performance. Behind the curtain of this pretty performance was a fiction that no statistics could reveal. The only person who seemed to catch on was a fellow hedge fund manager who used ahem  ”common sense”  to point out that no strategy that was being described for Madoff’s fund or any other for that matter could possibly produce returns that consistent.

 The same applies outside the realm of pure fraud– a 100 or 200 day system test during 2008 of any mean-reversion indicator would have looked flawless and similarly invulnerable. Guess what, the real story behind the curve was that the indicators preyed ruthlessly on  tremendous uncertainty and a credit crisis that drove mass margin calls- this created unprecedented volatility and unusually chaotic correlations that are predictably cyclic—ie they won’t last forever! When uncertainty and credit was restored, profitability was restored to more normal levels. Was the system breaking down? Or was it just experiencing supernormal profitability? If we knew what drove profitability–ie volatility which was a consequence of credit issues– we could use either as a superior means of figuring out when to cash in our chips than observing the system output.

Try to think of yourself more as an experimenter or a scientist: What am I trying to measure here? Which independent variables are responsible for moderating the profitability of my system? (volatility etc)  Am I potentially measuring a spurious correlation? ie perhaps I am taking an indirect measure of something and should search for a clearer proxy (credit spreads?). Keep drilling down and connecting the dots and even if your initial efforts are not rewarded, eventually you will be better and more consistently profitable as a result.  I could go on forever, but if I can implore all of the people who “only care that something works and not why it works” to take a step back and try to understand their systems in logical terms for a change they would get much closer to getting the answers they truly seek. The best physicists–far more gifted in math that you or I— are great abstract thinkers who first seek to understand our universe with sound theory and how it fits together. In an increasingly uncertain world, it is not likely that reality will ever have the consistency and symmetry of a good theory–but the ideas help inspire better systems that are more likely to survive in the future.

Staying Objective

The last few days have certainly been scary for those who were heavily long. Knowing how to handle these kind of situations is what separates the men from the boys. As the market started turning south in the very early stages Jeff Pietsch of Market Rewind highlighted the importance of hedging http://marketrewind.blogspot.com/2010/01/portfolio-x-ray-keeping-dubble-out-of.html. The ETF Rewind exposure tool mentioned in the article is something that all the best hedge funds like  Renaissance Technologies use on a daily basis to reduce risk and stay consistent.  Another great example comes from  Charles Kirk http://www.thekirkreport.com/ who is another veteran market pro. I really like how he handled things and it struck me as being very sensible. Charles had trailing stops on all of his positions which is something he always emphasizes as a key risk management tool to preserve profits and protect you from big losses.  He happened to get stopped out during this pullback–finding himself sitting on a lot of cash. He took a day off to reflect and think about what to do next and came out with a special report the next day after spending a long time collecting his thoughts. This disciplined, common-sense approach is a timeless quality of all the successful market speculators of the past like Nicholas Darvas and William O’Neil.

I am personally always hedged and rarely take much of a net long or short position and was lucky/fortunate enough to have a couple winning days during this period. As a consequence perhaps I can offer some simple and objective advice:

1) If you find yourself in a tough spot–don’t beat yourself up or lament about what you wished you did etc. A soldier in the middle of a war would have no time or use for recriminations and neither should you.

2) Develop a game plan for what you will do NOW and try to pretend whatever P/L you have or currently had are irrelevant. Make the best decision for the present. The market is oversold in the short-term, if you were a short-term swing trader you would be long here and waiting to sell on a bounce. If you are holding a concentrated portfolio of risky stocks, swap that out for a position in a major index like the QQQQ to avoid catastrophic losses and wait to sell on that bounce.

3) Wait and watch following that bounce to see what happens. If the market firms up take an index position to play the upside. If the market and your favorite stocks threaten to break new highs you can now set some buy targets. THIS TIME make sure to set initial and trailing stops.

Additional Thoughts

1) Even thought the 20, and 50 day moving averages have been breached, we are still technically in a bull market– the S&P500 is above its 200ma and the trend is still higher(200ma is still rising).

2) Bull markets often correct to points at or below their 200mas, it is just a matter of time until this happens, and this correction could be the start of a move that reaches this point.

3) One of the most reliable signals that a new bear market has started is the Golden Cross a 50sma/200 sma crossover. This is your official signal that the game is over and the bear has truly returned.

Tips For the Future:

1) When a bull move has lasted a long time since correcting below the 50sma, or near the 200sma AND the VIX is very low compared to all readings over the past year the market is vulnerable for correction.  This is a time to purchase cheap puts or out of the money calls on the VIX to protect your long positions IN ADDITION to having trailing stops.

2) Another trigger that should encourage you to start hedging is when the RSI14 is near/at/or goes above 70 which happened on January 11th and gave you plenty of time. Previous corrections this year have followed the market reaching these levels. My recommendation is to use ETF Rewind’s exposure tool tool to sell short the appropriate ETFs to balance your risk so you are only exposed to alpha–the outperformance of your favorite stocks versus the market, instead of being exposed to the monster that is the market beta when things go south.

Livermore Active Issues Index for Friday, Jan 22th