Four Basic Rules

“I just need to have a follow thru plan and patience on my trades”

I’ve heard the statement above a million times. Here’s my answer to that question.

As you know, this is much easier said than done. However, it can be done. There are two things that will aid you in this process.

Practicing patience is the key, but it’s hard. In the end it will pay off.
The most important thing to understand is “what is the risk” you are taking on a trade? Said another way, ‘understand money management’.

It’s easy to talk about those things, but actually putting them into practice is different. It only comes from practice, practice, practice.

Base your trading on 4 rules and you can achieve the results you want.

why am I getting into this trade?
where am I getting in?
where is my profit target?
where is my stop loss?

Once you implement those 4 rules, a few things will begin to happen.

you’ll begin looking for trades to do.
- If you answer question #1, that means you have to find trades. When you begin looking for trades you’ll need to learn how indicators behave and how to combine indicators to find trades.
by answering question #2 you learn the methodology of entering trades.
by answering # 3, you learn what logical profit targets are. Said another way, you’ll start to learn entry techniques.
by answering # 4, you gain confidence, because you know the risk.

Your confidence will begin to build and something else will happen. You’ll get into the rhythm of the market because you’ll be involved in the market, all day long. You’ll soon be able to scalp trades, in between the times you are waiting for your indicators to give you signals. The scalps will become easier because you’ll begin applying the 4 questions, to a scalp trade.

Example:

why am I getting into this SCALP trade?
- Because I’m in the flow. I can see where the market stops and starts
where am I getting in?
- as soon as I see it stop or start
where is my profit target?
- Usually a tic or two in the TY Futures, depending “Average True Range”.
where is my stop loss?
- Same as my profit target. I may look at the “Average True Range” or use a “Detrend Oscillator.

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DiNapoli

Dissecting the Fed Minutes (how to)

Let’s see if we can pull out some important words from the fed minutes by “Discecting the Fed Minutes”.

* * *

December Meeting Minutes

Show Increasing Worries

Of Inflationary Pressure

By GREG IP

Staff Reporter of THE WALL STREET JOURNAL

January 5, 2005; Page A2

"cost and price pressures were likely to become a clearer intermediate-term risk…absent further interest-rate increases.

The minutes suggest that the Fed is less likely to pause in its interest-rate increases this year than markets may have expected.

"The tone of these minutes is notably more hawkish than in November.”

At their November meeting, officials explicitly said future rate changes were contingent on coming economic data. But in the minutes to December's meeting, officials do not repeat that. Rather, they fret that even at 2.25%, the federal-funds rate "remained below the level" needed to keep inflation stable and the economy at full employment.

…there is no sign the Fed is worried enough about inflation to switch to half-point rate increases.

In the statement released after its meeting, the Fed said it could raise rates at a "measured" pace, and it continued to characterize the risks of inflation going higher or lower as "roughly equal."

That characterization struck some analysts as out of step with the minutes. "They say the [inflation] risks are balanced, but the minutes suggest the risks may be modestly to the upside." He [the analyst] says that means the Fed will likely raise rates at each of its next four meetings.

Mr. Sack noted that the statement released in December was almost identical to November's, but "the tone of the minutes of the two meetings is very different."

While policy makers generally expect underlying inflation to remain near its current low level of about 1.5%, using their preferred measure, the minutes show growing debate over risks. They said that high oil prices and the lower dollar "could get embedded in higher inflation," that slowing productivity growth will make it costlier for companies to boost production, and that it's unclear whether the economy is operating much below full employment.

The Fed…expects inflation, excluding food and energy, to be "stable." In September, it thought inflation would "remain at or below its current level."

The low level of bond yields in the face of the Fed's clear intentions to raise interest rates has also puzzled some Fed officials, who wondered if the prior prolonged period of low interest rates had contributed to "excessive risk taking." Officials pointed to low corporate bond yields relative to risk-free Treasurys, more initial-public-stock offerings, an increase in mergers-and-acquisition…

Write to Greg Ip at greg.ip@wsj.com

* * *

What this tells me is the following:

Watch numbers that have to do with Inflation and Productivity. They will be more volatile than in the past few months. Especially, PPI core, and CPI core.
watch oil
watch the US Dollar
make a note that a .50 hike at any one fed meeting is NOT in the market

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Fixed Income Basics

Overview of Debt offering

Corps raise capital through debt offerings
1. Sell stock, or
2. Issue debt
  1. bonds
  2. notes
  3. bills
    1. discounted

Types of Debt

1. ABS

a. asset backed Securities

2. Government

a. quick facts

i. biggest debt issuer in the world

ii. larger and larger portion goes debt service

iii. need to sell more and more debt to service debt

iv. the more they issue the better for traders

1. creates supply

v. current deficit is aprox., 6.4 trillion

vi. lower taxes create a bigger deficit

1. taxes finance the deficit

b. Muni’s

i. Municipalities

ii. Tax-free

c. T-bills

i. discounted to yield

a. you’re paying less than par value

ii. no interest payments (no CR)

iii. make the money through the discount on the issue date

iv. receive principal at maturity

v. usually 3 mos., or 6 mos., 1yr duration

d. fixed-income securities

i. quick facts

a. called fixed-income because they literally set a fixed coupon rate payable over the life of the security

ii. notes

a. 2-10 yr duration

b. 2 year note

i. issued last week of month

ii. settles last day of month

iii. 3-year note

a. issued quarterly

iv. 5-year note

a. issued first week of month

b. settles and matures on 15^th of month

v. 10-year note

a. issued quarterly, however

i. currently (2003-2004) they are reopening the following month after issue, so

ii. they really issue new notes 4 times a year and they reopen 4 times a year

vi. Bonds

a. anything over 10 year duration is considered a bond

b. treasury stopped issuing bonds in 10/2001 and is reissuing 02/2006.

vii. TIPS

a. 5,10,20yr

b. indexed to CPI (inflation)

c. at maturity you make the CPI adjustment. Example:

d. buy 5yr TIPS with 2.5% coupon

e. CPI average = 4% over 5yr duration

f. at maturity you are awarded a 1.5% adjustment which is added to the original CR of 2.5%.

g. TIPS are complex and getting more popular in 2004

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Linear regression

Explanations

“Linear regression [LR] is a statistical tool used to predict the future from past data, and commonly used to determine when prices are overextended.”[1]

“Linear regression is used to explain and/or predict. The general form is:

Y = a + bX + u

Where Y is the variable that we are trying to predict, X is the variable that we are using to predict Y, a is the intercept, b is the slope, and u is the regression residual.

Regression takes a group of random variables, thought to be predicting Y, and tries to find a relationship between them. This relationship is typically in the form of a straight line (linear regression) that best approximates all of the X to Y.”[2]

Reread the last explanation. It looks complicated but it’s not.

Here’s another explanation from Prohet.net.

”A Linear Regression Channel 100% is created by drawing parallel lines above and below the Linear Regression line.

“Parallel and equidistant lines are drawn two standard deviations above and below a Linear Regression trendline. The distance between the channel lines and the regression line is the greatest distance that any one closing price is from the regression line. Regression Channels contain price movement, the bottom channel line provides support and the top channel line provides resistance. Prices may extend outside of the channel for a short period of time but when prices remain outside the channel for a longer period of time, a reversal in trend may be indicated.

“A Linear Regression trendline shows where equilibrium exists but Linear Regression Channels show the range prices can be expected to deviate from a trendline.”[3]

Prohet.net

And here’s one last explanation from danielstrading.com

“The Least Squares Linear Regression line indicates the dominant market trend relative to time. In simple terms, is the market trending lower or higher with respect to time? It can inform you when the market is diverging from an established trend, but only when prices fluctuate uniformly around the trendline and within a narrow range. The better the fit of the equation to the data, the more reliable the linear trend. Once the calculations are completed, FutureSource draws the trendline on the screen.

“Do not rely on this study when prices deviate widely about the trendline. The fit of the trend to the data is most likely not very reliable. If the price chart flows uniformly about the regression line, the market should have a tendency to continue in the direction of the statistically fit trendline. Any large deviation from the regression line implies a change in the dominant market trend.

“The least squares methodology can be found in most books on basic statistics. It is a rather intense calculation process.”[4]

There are different types of LR models. One type allows the user to specify a specific start and end point in time. Another model self adapting or automated moving regression lines. I’m interested in the automated LR’s. They are often called Dynamic Regression Channels.

The interpretation of how to trade the LR is important. Paritech.com explains this very well.

“The interpretation of a Linear Regression indicator is similar to a moving average. However, the Linear Regression indicator has two advantages over moving averages.

“Unlike a moving average, a Linear Regression indicator does not exhibit as much delay. Since the indicator is fitting a line to the data points rather than averaging them, the Linear Regression line is more responsive to price changes.

“The indicator is actually a forecast of the next periods (tomorrow’s) price plotted today. The Forecast Oscillator plots the percentage difference between the forecast price and the actual price. Tushar Chande suggests that when prices are persistently above or below the forecast price, prices can be expected to snap back to more realistic levels. In other words the Linear Regression indicator shows where prices should be trading on a statistical basis. Any excessive deviation from the regression line should be short-lived.”[5]

[On a side note, I wanted to point something out. The name that appeared in the paragraph above, Tushar Chande, is important. His book, Beyond Technical Analysis, is nothing short of awesome. I will be getting into his work in a later paper because I’m currently working with his indicators.]

Here’s another way to trade LR, as told by Keystone-web.com.

“There are two ways to use linear regression. The first is to trade in the direction of the linear regression line. The second is to plot the linear regression line and two parallel equidistant lines above and below it. To determine the distance, use a point which is the furthest away from the linear regression line on the price bar. The two lines act as support and resistance. Once the lines are broken for a sustained period of time, this is an indication that the trend has reversed or gained tremendous momentum.

“The space inside the channel is where equilibrium exists, where prices can be expected to deviate from the original linear regression line. As with Bollinger Bands, when prices move outside or to the extreme channel line, price tends to move back to the opposite channel line.”[6]

LR channels are probably the most common way to trade on a short-term basis. To set this up on a chart you’ll have to put in standard deviations to tell the charting software where you want to set the channels.

Standard Deviations Settings:

The web site RT Investor has a tool box that describes this part of the inputs very well.

“The following approximations offer a few rules of thumb for using the standard deviation settings:

Plus or minus one standard deviation takes in 68.3% of all expected outcomes (historical price moves)
Plus or minus two standard deviations takes in 95.4% of all expected outcomes (historical price moves)
Plus or minus three standard deviations takes in 99.7% of all expected outcomes (historical price moves)

“For example, excursions of price more than 2 standard deviations above or below the regression line represent an unlikely event (less than 5% probable). Such excursions usually represent overbought or oversold conditions.”[7]

Start experimenting with Linear Regression on your charts in different time frames and see what you come up with.

References

http://www.linnsoft.com/tour/techind/linReg.htm

http://www.investopedia.com/terms/r/regression.asp

http://www.paritech.com/paritech-site/education/technical/indicators/trend/linear1.asp

http://www.trade10.com/

http://www.prophet.net/learn/taglossary.jsp?index=L&entry=LRC

http://www.danielstrading.com/content/reso_inte_lear_pag13.php

http://www.keystone-web.com/technicals/trend.html

Footnotes

[1] http://www.linnsoft.com/tour/techind/linReg.htm

[2] http://www.investopedia.com/terms/r/regression.asp

[3] http://www.prophet.net/learn/taglossary.jsp?index=L&entry=LRC

[4] http://www.danielstrading.com/content/reso_inte_lear_pag13.php

[5] http://www.paritech.com/paritech-site/education/technical/indicators/trend/linear1.asp

[6] http://www.keystone-web.com/technicals/trend.html

[7] http://www.linnsoft.com/tour/techind/linReg.htm

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Losing Trades; Part I

I’m always looking for the formula. There’s a formula for everything. When it comes to holding on to losers and taking winners too soon, there’s also a formula.

Kahneman and Tversky (K&T) wrote a paper in 1979 that advanced much of the work done in this field from the late 1930s all the way to the early 1960s. Their theory is called the “prospect theory”. Shefrin and Statman (S&S) took that work a step further, in 1985. Their theory is called the “disposition effect”. Barber and Odean (B&O) took it further and called their theory, simply, “overconfidence”. All these theories can be grouped into a category called ‘Behavioral Finance’.

The one common denominator from these studies, including two studies I haven’t mentioned that were done in the 1930s and 40s, are startling, considering the length of time taken into consideration. All of the studies state that traders hold losers too long and get out of winners too soon. But why? Why do traders do this?

Concerning losers, K&T explain that traders don’t sell losers because of the desire to avoid the regret of a losing trade. It’s that simple; a trader has not come to terms with the loss. This means they didn’t do their homework. This means they didn’t have a plan. A trader must answer four questions before getting into a trade.

why am I getting into the trade?
where am I getting into the trade?
where is my stop?
where is my profit target?

Answering these questions allows you to act analytically and leave the emotion out of it. Emotions will convince you, in the end, to hold on to the losing trade. Emotions will convince you to find a reason to stay in the trade.

K&T write, “…a person who has not made peace with his losses is likely to accept gambles that would be unacceptable to him otherwise.”[1]

The message K&T are trying to get across may be stated as follows: As a trader, you will hold on to losers longer if you don’t have a plan in place before you enter the trade.

The mental tennis that accompanies a losing trade is familiar to all traders. The thoughts that run through a trader’s mind, during a loser are all there to avoid having to cut your losses and get out.

For example the thoughts might range from:

Why does the market always go against me?
Can’t I get into at least one winner?
If I get out then the market will end up going my way, if I don’t get out then the market will keep going against me.
Please please please come back to my price so I can scratch the trade.
I give up. As soon as I get out of this trade I’m going to change careers.
Maybe I should look at the 30 minute chart to see if it’s still bearish? Just because the 5 minute chart went against me doesn’t mean that the 30 minute chart did.
What about the daily chart? It’s still bullish!
Maybe I can find a different indicator and that will support my position? I hate the MACD anyways. I’m going to try the %R.
This trading system stinks, I’m going to kill the guy who gave it to me, it’s all his fault.

How do I know? ‘Cause I’m guilty of all of the above.

If I know what my risk is (what my stop loss is) then it takes all mental tennis (emotion) out of the equation. If I know my profit target, that also takes mental tennis out of the equation. Does that mean I can’t change my profit target when the market gets there? Perhaps moving to a trailing stop? Of course not. I can change my mind about the profit once it’s hit. But, not the stop.

If I know my max loss on a trade then I know all the consequences of that loss

It’s within my daily stop loss limit.
If I get stopped out, then I’m going to have to work hard the rest of the day to dig my way out of the hole.

Number 2, above, is arguably the biggest reason futures traders don’t take losers when they should. Think about it.

The three studies introduced at the beginning of this paper were based on investors in the stock trading world. There are two professors that moved prospect theory, the disposition effect and overconfidence theory to the futures trading world. They are, Locke and Mann.

Part II of this paper will be about their 1999 study of futures traders, Do Professional Traders Exhibit Loss Realization Aversion?

Footnotes

[1] Kahneman, D. and A. Tversky, 1979. Prospect theory: an analysis of decision under risk. Econometrica 47, pp286-287

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Losing Trades; Part II

This paper continues to look into the behavior of traders when it comes to losses. I will be citing two professors that are experts in this field.

Peter J. Locke is from the Finance Department, School of Business and Public Management, The George Washington University, Washington DC.

Steven C. Mann is from the M.J. Neeley School of Business, Texas Christian University. Fort Worth, Texas.

Locke and Mann (L&M) have written some fantastic studies on the behavior of the financial market. Their papers have centered on price and trader behavior. Today, I’ll continue part I of this paper, Losing Trades, and delve into the findings of a 1999 study by Locke and Mann titled, Do Professional Traders Exhibit Loss Realization Aversion?

L&M expand on prospect theory[1] (Kahneman and Tversky 1979)[2] and the disposition effect[3]. L&M call their theory, loss realization aversion.

Allow me to move sideways for a few sentences and explain something about White Papers. White papers are simply scientific studies written on a specific subject. A White Paper begins with an abstract (summary of the paper). The White Papers I’ve been reading about trader’s behavior, concerning losses, all state a very simple concept, in the abstract.

In essence they say traders hold losing trades longer than winning trades and the average position size for losing trades are larger than for winners. The previous sentence is almost verbatim from L&M’s paper, but this is the gist of what all the papers say.

It doesn’t matter what type of trader the papers are covering, professional or not. They all exhibit the same behavior. You are a professional trader, so you are not immune.

L&M write, “Relatively successful traders are less prone to sit on losing trades.”[4]

That statement is simple enough. Yet, it’s appears it’s extremely complicated to the professional trader.

And, the professional trader has some great stories to back up their reasons for holding on to losers. For example, “I’ve had big losses but you’re ignoring my big winners.”

That statement is arguable. Show me the data! Well…the data states something different.

L&M write, “…consider trades with absolute revenues over $100 for the Deutsche mark. While the mean loss is slightly larger than the mean gain ($227 compared to $225), the percentage of large losses (14.5%) exceeds the percentage of large gains (11.8%).”[5]

L&M state that you lose. Large losses are bigger than large gains by just under 3%. Multiply that number by your position limit and probability states you lose. There can be no argument. That’s why casinos have all of your money. They have the probability with them, all the time.

Let’s move back towards the main topic. That topic is, professional traders are generally the same as non-professionals in that they hold losers longer than winners.

L&M write, “Comparing gains to losses, the results are striking: professional traders as a group hold losses significantly longer than gains. Panel A shows that overall, losses are held substantially longer than gains for all four commodities [that they studied]. Median and average holding times for losses range from 35% to 133% longer than counterpart holding times for gains.”[6]

They go on to say, “…we were concerned that gains and losses might be treated differently depending on the size of the absolute revenue. We tested for differences in holding times by revenue magnitude using the revenue categories developed for table 3 [see table(s) at end of paper]. These results are reported in Panel B of table 4, which provides overwhelming evidence that gains are realized more quickly than losses regardless of the magnitude of the absolute gain….Clearly, the professional traders in our sample appear to exhibit the characteristics of loss realization aversion as a group - in that they hold losing trades longer than winning trades.”[7]

Lastly, they write, “Table 5 provides results of tests for differences between prior opportunities to exit trades at gains versus losses by reporting mean and median potential exit minutes for gains compared with losses. The results clearly show that traders, on average, pass up more opportunities to exit losing trades at a loss than they do winning trades at a gain. The first two columns of Table 5 report mean and median potential exit minutes for gains and losses. For all four pits, trades that eventually result in a loss are preceded by significantly more prior opportunities to realize that loss than similar gainful opportunities for their counterpart winning trades.[8]”

If I’ve gotten the point across that traders hold losers longer than winners, then my job is done. Part III will discuss what successful professional traders do to be successful.

[1] “Prospect theory modifies expected utility theory in two areas, and leads to predictions that are consistent with investor loss realization aversion. First, investor utility is assumed to be a function of gains and losses relative to a benchmark, rather than a function of absolute wealth. Second, while standard utility functions are concave on both sides of a wealth point, prospect theory assumes utility functions that are concave for gains and convex for losses (but steeper so that overall risk aversion is attained). The prediction of a disposition effect relies on these two wrinkles to expected utility theory.” -- Do Professional Traders Exhibit Loss Realization Aversion? Locke and Mann, p3.

[2] Prospect theory: an analysis of decision under risk, Kahneman, D. and A. Tversky, 1979.

[3] “…the disposition effect, based on the prospect theory of Kahneman and Tversky (1979), as an explanation for the perceived anecdotal evidence at that time of investor reluctance to realize losses. The disposition effect arises when investors focus on a reference point for their position from which gains and losses are calculated, rather than following a portfolio choice model. Agents are alleged to use a form of “frame reference” - evaluating opportunities to close existing positions as either gains or losses, measured against the reference point.” -- Do Professional Traders Exhibit Loss Realization Aversion? Locke and Mann, p3.

[4] ibid p2.

[5] ibid pp12-13.

[6] ibid p13.

[7] ibid p13-14

[8] ibid p15.

Tables and further reading suggestions follow: