Risk Management 101

It's been said that among traders there are those who quietly know and there are those who desperately hope. The trick is to equip yourself with the tools and mindset to enable you to join the ranks of the first group rather than the second. To that end I'm just finishing up Peter Bernstein's history of risk. Now, before you roll your eyes in utter boredom, I've got to say that this book is just as exciting as any Agatha Christie mystery or Charles Dickens classic. The cast of characters is equal to none. Along the way you'll learn about the quirks and foibles of such colorful notables as Fibonacci, Cardano, Bernoulli, Gauss, Galton, von Neumann (father of game theory), Markowitz and many, many more who were responsible for developments in mathematics that led to probability theory, betting, uncertainty principles, game theory, the insurance industry and, of course, risk management. The book covers a lot a ground but if trading is your thing and you want to develop a methodology to limit your losses, this book will certainly give you a lot of ideas to spring off from. This is not a trading book . . . there are no systems described or TS code for you to cut and paste. but you'll get a good perspective on how some of the best mathematical minds in history solved complex problems (sometimes with great success, sometimes with resounding failure). I bought a used copy through Amazon for $7.50, although it appeared new to me. A bargain at 10x the price IMHO.
Just a few things to ponder in closing:
Half the people you know are below average.
The 50-50 rule: anytime you have a 50-50 chance of making money in the market. .there is a 50-50 probability you'll lose money.
The early bird may get the worm, but the second mouse always gets the cheese.
And as my friend Steve Forbes says: "It's better to be lucky than smart".
Frankly, I tend to believe that you make much of your own luck and as such I'd prefer to be lucky and smart.

Weekly Update

Last week's update pretty much abandoned my VIX60 hope and instead forecast a VIX50-55, which turned out to be eerily correct. Projections like that and the whole butterfly scenario (updated below) are greatly facilitated by using linear regression studies like the LR30 channel, and of the many TA studies available to traders, this one remains one of my real workhorses for longer time frames. For those who haven't checked him out yet, Richard Muelhberg, uses the 3 LRs for daytrading a wide range of ETFs and futures and has an excellent, and very modestly priced, trader training service. Best of class (LR30 channel behavior) is the XLE. With the dunce cap in the left corner is the XLF, which is just plain awful looking. (Will somebody please give Barney Frank and the Senate Banking Committee a good cattle prodding to get their act together?)

Distinct divergence between daily and weekly signals on the VIX and the T2100 (advance/decline line), so next week should be interesting.

With all 4 of the ETF basket coming off extremely oversold RSI2 bottoms or double bottoms, the odds favor a surge for at least a few days, although a couple good pops could easily swing things back into the overbought range. Most of the BZB Dirty Dozen support/resistance systems are on BUY signals, but based on current momentum many also look to be quickly approaching a neutral stance.

Butterfly Update:

The XLE Jan 47 butterfly played out perfectly and based on the current LR30 channel, I'm inclined to do it again. More than likely I'll wait till next Wednesday to see out the long weekend effects the markets before jumping in. With the plethora of bad news streaming out, the odds don't favor a trend change at this time (IMHO), but stranger things have happened and if the Gaza situation gets resolved (unlikely), or if some of the majors give guidance higher (unlikely), then I'll look to close some of my neutral positions such as the XLP butterfly which is still right on the money, as is the XLU butterfly.

RSI 2 Breakout system

With all the buzz about the RSI2 lately (too many links to post), I thought I'd explore the trading opportunities when the RSI2 breaks out of an oversold or overbought range, as defined by a moving average. One of the problems with the RSI2 is that oversold or overbought conditions, as measured by the RSI2 can continue for some time, thereby frustrating traders who jump the gun with their entries. In previously profiled systems like the Grand Slam series (see BZB Dirty Dozen systems on the right panel of the blog) we used the "cross above" and "cross below" signals to trigger the trades. . .with respectable results. This system is a bit different in that it uses a moving average of the RSI2 indicator as a baseline and then looks for crosses above and below that MA line to trigger the trades. While not wildly successful, the results are certainly encouraging of further work in this direction and when added to the larger Kit of Parts systems, including the KOP10 and KOP16, to provide a nice confirmation.

TS 2000i is shown below.

Blogger, of course, won't let me post the open code because of the symbols so, as usual, the open code is posted as a comment for those who wish to cut and paste into their own platform.

The Earnings Game

With earnings season ramping up I thought it would be timely to profile several free earnings reporting sites that might help scalpers shave off a few bucks.

First up. . . Zack's The site highlights earnings surprises, up and down, along with a full menu of earnings summaries and a reporting calendar. Big surprises in the direction of the open can produce some quick returns. They also have a service called Surprise Trader for swing traders with a money back guarantee that's worth a look.

Next is RTT News This site profiles positive and negative pre-announcements along with an earnings calendar and a full report of latest earnings. This is interesting opportunity to trade the rumor and those that bought HMSY and MDAS at yesterday's open and then closed the trades at the first 3 bar parabolics reversal put some quick change in their pockets. If scalping appeals to your trading mind and risk comfort level, this is a fertile site for some quick gains.

Finally, hands down, the best non-technical blog of all time (IMHO) Between the Hedges To even begin a half way fair analysis of this site would require more time than I have. Bottom line, just link over there and delve in. Live upgrades, downgrades, market snapshots, momo stocks, charts, news, performance stats, links to magazines and newspapers around the world (how about the Times of India or the Brazil Post?), video news and more, much more. If you started reading the new material in this blog at 6 in the morning, there's virtually no way you could finish it all by 6 at night, so you've got to be a bit selective about your focus here. A real treasure trove.

This is a late post addition, but deserves a close read. Bepsoke, a site I have mentioned many times before, produced a series earnings season posts on Jan 13th. Scroll down on the Besoke link to catch 'em all.

XLF A Year Later

Back on Feb27, 2008 I profiled the XLF financial sector Spyder. This was the makeup back then:

Below is the current makeup of the XLF. As you can see, there's been a bit of re-alignment in the portfolio with JPM and WFC carrying more of the load. This adjustment makes a lot of sense when you review a recent study by Bespoke which examined the 5-year CDS (credit default swap) prices of various financial companies. Wish I could just post the chart for comparison purposes, but that would be rude to Bespoke, a great site for enquiring market minds. The bottom line is that, based on Bespoke's study of US firms, MS, GS, AXP, UBS and C are at the highest risk of defaut and JPM, WFC and BAC are the lowest.

Now, if you watched Larry Williams' presentation on the I-Trade link I provided last week you know that Larry might consider this a marginal buy candidate based on the level of the open interest. This argument is supported somewhat by the recent short interest chart, although keep in mind the last date charted here is 12-15-2008, so we're a little behind the curve.

With the RSI2 clearly at oversold levels, selling the Feb 10 puts will put $.64 in your pocket, leaving you with the ETF at $9.36 if things get really nasty. Just something to consider. A buy/write on the Feb 11s will yield $.98.

More on the Put Write

Last week I mentioned the Put/Write strategy in lieu of a Buy/Write approach. While I can't claim that the post stimulated a lot of interest, several other bloggers have run with ball, including Bill Luby, who has some excellent links on the topic. One of Bill's commentators notes that there actually is a Put/Write ETF . . . ETJ, which suffered a major drawdown in October, but which now is solidly out performing much of the market.
I also noted with some amusement that the February issue of Active Trader Magazine (sorry, you've got to pay for this one) has a feature article by Steve Papale on the merits of selling puts/versus covered calls.

Weekly Update

Bob Dylan said "You don't need a weather man to tell which way the wind blows" and the 4 ETF basket study of the 3LRs suggests we've got more of the same to go. Although the RSI2 (the indicator Larry Connors calls the "holy grail") is fast approaching oversold levels, the MACD and the stochastics argue for a continued slide. So much for a "Kiss the channel goodbye", the Qs and IWM have retreated back to the LR30 mean and XLF, showing the greatest weakness of the 4, looks headed for the lower support channel band at 11.00.

The VIX rose almost 10% for the week to close at 42.82 and both the daily and weekly LR30 studies support a continued rise. Although my target of 60 looks a little unlikely, a 50-55 level certainly seems doable if things get agoing to the downside. Earnings season kicks off next week and, like a good game of liars poker, expect in inordinate amount of head fakes and countervailing trading, which should translate into a hike in the volatility.

T2100 (advance decline line) is following suit with the 4 ETF basket and adds credence to the argument for the downside.

Inside Days

Here's a little study based on an article in the latest Currency Trader magazine. This is another free e-format magazine, and while I seldom trade the currencies, the systems that they profile are often very applicable to the equities markets and HEY!, it's free. The article in question (p.20, January 2009) was produced by the CT staff and looked a couple ways to enhance the performance of a simple inside day system. Basically they added a range filter and a trend filter to temper the drawdowns. I, of course, am never content to just accept these things so I

tested my own variation of the system using a moving average condition to filter the trades in addition to the range filter. If you compare their code with mine you'll also see that I have reversed the threshold signals, keeping with my tendency to "do the opposite" per my earlier Castanza studies. Average holding times are about a week and over the test period the system generated about 1 trade/month. Clearly the short side has wildly outperformed the long side, as reflected in the equity chart and the downtrend that has characterized the markets for the last 14 months. As I have mentioned before, my use of the system would be to confirm other Kit of Part system signals for short term cycle tops and cycle bottoms. This, in turn, guides the daily bias of my daytrading. . . either selling the rallies or buying the dips. . .depending on the direction of short term momentum.

Finally, I hope you checked into the Future I-Trade site I mentioned yesterday. The presentation by 20 year trading veteran Al Brooks is really an eye-opener for daytraders as Al uses no indicators (other than a 20 EMA) to guide his trades. Clearly a unique approach and packed with nuggets of trading wisdom.

TS2000i code for inside day system posted below:

As usual, blogger is not letting post the open code beacuse of the > symbols. The open code is posted as comment #1 for you cut and pasters.

Some educational links

While we're waiting for the market to find a short term bottom, run over and register for the free Futures magazine I-Trade shows and then login, go to the Presentation Center, and listen to several extended presentations including a 70 minute gem from Larry Williams, founder of the Commitment of Traders reports, wherein Larry lets a few cats out of the bag that he typically charges a few grand to share. Al Brooks also talks about price action setups and Dan Passarelli examines various option strategies relevant to today's volatility. A few other presentations are also available, including FX, depending on your interests. Well worth your time IMHO.
On the recommendation of the Clueless One I've been dinking around the Pristine site for a bit just checking out their offerings, including live options, futures and stocks trading rooms. You can sign up for a free 2 week trial and they do have some nice products to offer, although clearly at a price. They're a local group to me and I've visited their offices a few times to check em' out. Very credible and systematic (not systems traders). Greg Capra's (founder of Pristine) Tools and Tactics for the Master DayTrader is a classic and still very applicable to making money in today's markets. Their daytrading style is a bit too frantic too suit my temperament, but the stock and option plays of the day and week warrant a close look.

Selling Puts or Buy/Write?

Not exactly a new theme, but a fine article by Peter Stolcers in the new Futures & Options Trader magazine sheds new light on these opportunities. The magazine is downloadable and subscriptions are free. The articles profile strategies that are not just for futures and/or options traders and the systems profiled are generally a few notches down in sophistication from the Stocks and Commodities type. Well worth the price!

With 10 days till Jan expiration, here are 4 sample naked put selling scenarios. Now these are just look-see things, not recommendations, but it gives you a sense of the scale of opportunity in these various equities. Worst case is the market really tanks and you're forced to buy the underlying at a significant discount to today's price, which means you better have some free capital available, or be prepared to cover the position at a loss pre-expire.

I favor the GE and XLE situations.

Finally, Dr. Brett is sharing some of his pivot trading tactics although he uses a proprietary pivot calculation tempered by a volatility factor to determine R2-S2 pivot levels. You can find a great (IMHO) pivot calculator on the ride side of this blog under DATA & CHARTING. The calculator has 3 different calculation settings, so if you want to narrow the range of the standard (classic) pivot calculations, use the Camarilla model.

Grand Slam Update

Just a little update on the Grand Slam 2 system (see BZB Dirty Dozen Systems in blog panel on right for TS code details). I'm still using the default settings with no updated optimization. . . and the results are still pretty impressive. With the system currently on a SELL, I closed my few very short term XLP and XLB longs and covered my longer term GE position with the Feb 16 calls to lock in a few bucks. Since everybody and his brother have already expressed the strong conviction that a pullback is imminent, I figure. .HEY!, why fight the crowd? The rally seems to be losing momentum, with a lot of dojis popping up on the charts today. And, with the RSI2 now at stratospheric levels, the odds strongly favor some level of retracement. Whether the rapidly approaching earnings season will provide the catalyst for such a retreat remains to be seen.

I'd like to see the VIX make a another run-up to the 60s so I can sell off some longer term premium, but that's just a wait-and-see scenario.

XLE continues to outperform the rest of the basket, ostensibly driven by the Gaza conflict.

Finally, I would be remiss if I didn't mention that Bill Luby has posted 2 great NY Times articles (IMHO) that deserve to be read by anyone who wants an deeper insight into the origins and depths of the current meltdown.

Weekly Update

The bullish prognosis for the markets forecast last week played out pretty much as expected. The big question now is . . .will it continue? Virtually all the indices are now in overbought territory as measured by the RSI2, although savvy traders know that in itself should not warrant a bearish view. Volume was, well, pathetic for the previous week, again as expected and that is a significant warning flag when gauging the strength of last week's rally.
I mentioned the concept of "kissing the channel good-bye" in previous posts and all 4 of the ETF basket are poised to do just that with regard to the LR30 upper channel line. However, with fundamentals continuing to crumble as unemployment and foreclosures continue to rise and with the Pres-Elect claiming that the "worst is yet to come", I think suspicion is justified before initiating any new long positions for more than a day. . . or if for a longer period, then tactically hedging those positions for protection back to the recent mean.

Above is the VIX in daily and weekly bars and below that the Telechart T2100, which is the advance/decline line, again in daily and weekly bars. I'm not going to even try to project what the VIX might do next, but I suspect this coming week's post-holiday trading with resumed "normal" volume may provide a strong indication of the next significant trend move.

Dividend Power

Here's a little update of my previous LEAP studies, but I've added the contribution of annual dividend payouts for the LEAPS. Dividends are obviously distributed throughout the year, but I was only interested in seeing how the payout affected the total LEAP ROI. In most cases, it increases return by about 5%. . . not an insignificant number. The Qs are the exception of this study, as they pay virtually nothing.
The VIX is crossing below the 40s level today, and if this tendency continues the expectation is for premium to decline and thus for total returns to diminish.

Power of the Fool

Back in the good ole days, about 10 years ago, making money off popular momentum was easy as pie. One of my favorite plays was simply watching Wall Street Week with Lou Rukeyser on Friday nights. The show was PBS's longest running and most successful offering. Lou always had a group of fund managers on the show whom he called the Elves and each week they would recommend a few stocks that they felt would outperform the market. The standing joke was that Lou never met a stock he didn't like and, like Mr. Micawber in Dickens' David Copperfield, he was always waiting for things to turn up.

The easy money here was simply buying the basket of stocks that were recommended Friday night on Monday morning's open and holding 2 days, closing the positions at Tuesday's close. This little no-brainer system which only required you to watch TV Friday nights was a consistent winner with over 80% profitable returns for several years.

As the electronic marketplace became more sophisticated and available, and other folks recognized this easy money trade, the rush to get in on Monday's open made the trade a bit more problematic.

Just a little history there. . . .

Skip forward to present day and a follow up to the Wall Street Week format. Enter the Motley Fool, a widely syndicated company that seeks to "educate, amuse and enrich". . . kind of like Lou in a clown's suit. The Fool is bit more participatory though and has a thing they call the CAPS service wherein members rate stocks. Current top rated stock with 5 stars is KFT with 93% of CAPS members expecting it to outperform the market. Even in a recession, people gotta eat.

With KFT currentlty at 26.45 the ATM is actually a $1 OTM as we are trying to capture that gain in the play also.

Take a LEAP

Here are a few more LEAP examples, using some of the SPDR Xxx components.
Keep in mind that Jan 09 data reflects options that will expire in 18 days, so the ROI is really based on a little more than half a month.
I've added the beta values for each of the ETFs to see if that makes a significant difference.
I've also profiled XLF twice. With XLF at 11.53, or mid strike, I've included the slightly ITM (11) an the slightly OTM (12) to check for possible performance edges.
XLF clearly provides a ROI performance edge, both short term and long term, reflecting the level of uncertainty surrounding this sector. Next is line is the XLE, lagging in return considerably, but still reflecting the petro-engine that will drive world economies for the foreseeable future.
As with my kit-of-parts basket of systems (KOP) approach to trading select ETFs, one way to minimize risk with these Buy/Write leap positions is to identify a basket of stocks and/or ETFs and spread your exposure.

LEAP or no LEAP?

Clueless has been mentioning his LEAP positions lately so, being a pitiful copycat, I thought I'd look at what some LEAP opportunities might look like to generate a little premium decay for the coming year.
This is obviously a small sample . . .GE, XLE and the Qs and only examines the ATM situation as of Friday's closing prices. We can go a lot further with this study if sufficient interest.
Top to bottom are the Jan, Mar, Jun and Jan10 option strings for GE, XLE and the Qs. I've highlighted the ATM option strikes on each matrix.

Below is a little spreadsheet showing the relative payout for each of the ATM positions over time. %ROI is the total premium received based on a current Buy/Write position.

Monthly Y is the % premium received divided by the number of months the position is held.

With relatively high quality CDs currently paying about 2-2.5%/ year, this approach certainly looks like something to consider. The overall annual average return of 20% for this little basket also provides a nice cushion in the event of further declines and involves basically no monitoring, although working this thing a bit with a timing model can double or triple your returns. The ROI potential is clearly maximized by using the shorter term options, a fact known to anyone who actually trades options, but cyclical price movement can significantly effect the ability to produce a continuing level of premium decay if, for example, the market were to drop another 20% in the next few months. This risk management trade off has be to closely considered. . .pay me now. . .or maybe pay me later.

A obvious simple strategy here is to spread the position over a number of strikes to both hedge the position if the markets fall and to allow for some good gains if the markets rise.

Of course, you could just sell puts . . . this is the other side of the coin and will be examined in a future post.

Weekly Update: Looking Bullish

Above is the daily bars 3 LRs study for my little ETF basket, while below is the weekly bars 3 LRs study. It's occasionally useful to scale back your view of the the charts to get a bigger perspective on how far we've come.
On the daily bars the oversold RSI2 and stochastics are encouraging on all four charts and the 22,10 envelope channel is bullish to neutral across the board.
Two concerns are the downslope MACD and the recent holiday plunge in volume.
Of the basket, XLE and XLE appear to have the best upward momentum potential.

A little different story on the weekly bars, where the MACD is solidly bullish. Once again there's always a technical trade-off, and in this case its the anemic 22,10 envelope channel and the almost overbought level of the RSI2 in the Qs, IWM and XLF.
If the market does make a positive move the lower legs of the LR30 channels will provide the first major resistance levels to be broken. With another low volume week on tap, there's a high probabilty that we'll see some continuing gyrations before momentum finds a solid direction.

More GE

I mentioned the volatility skews typical of thinly traded days . . . like today. although these skews present some great scalping opportunities, the other side of the coin is that there tends to be considerably more technical "noise", false starts and head fakes for us daytrader types than in otherwise "normal" days where volume is not 2 or 3 SDs away from the 10 or 20 day moving average.
Apparently not a lot of folks showed up today since, as of 13:00 total volume in the Qs is 9M and GE is showing 14M.
So much for the small talk.
GE still managed to produce a nice little payday with only an hour's exposure and the setup closely followed the pattern I have detailed many times in the past.
This will be the last of the GE/NYAD divergent trade posts . . . read the GE/NYAD archives to bulk up on the trade rules, which you will probably refine to fit your own trading style. For my part I intend to program this setup into TS and run it in auto-trade for a while to see how it pans out. So far, every time GE and NYAD have diverged for over 8 minutes, this setup has produced a net profit. When I first started these setup posts the net yield was approximately $ .01/minute of trade exposure. In more recent trades, we've seen that return diminish considerably. That may be the product of overall market volatility, which, as measured by the VIX, has retreated from the mid 60s to the current mid 40s. I've mentioned before that a least one large prop shop and several commercial trading firms focus on these arbitrage type GE trades using vast sums of capital and that the only reason this trade works for an average retail trader now is precisely because of the high VIX conditions. . . so milk this thing while you still can.
Today's trade stats:
Time in trade: 10:26 - 11:00 = 34 minutes and 10:26 - 11:32 = 66 minutes
Trade gain: 16:10 - 16:02 = .08 and 16:10 - 15.92 = .18 for a total of $ .26

GE Rules

Another relatively easy GE/NYAD scrap (I'm not going to call them scalps anymore) today.
I've also shown the NYAD in a separate chart box below the main GE/NYAD chart just to show the relative dynamics of the NYAD.
GE had almost identical volume as the Qs and IWM today 65M, demonstrating it's popularity. I hope none of you guys are telling your buddies about these trades. If you do, this little mean reversion trade is going to fade away faster than Madoff's billions.
The entry SELL trigger was picture perfect at 13:00, with GE having diverged against the NYAD for the previous 50 minutes.
The parabolics got us in dead on 13:00, the 8/16 fired a confirmation at 13:14. Now, after 23 years of trading there are a few things I know. . one of which is that skewed volatility pops up in pre -holiday, thinly traded markets. This is where following the NYAD as the true pulse of the market pays off and encouraged me to double my original 13:00 position at 13:14 when the 8/16 crossed.
My optimistic goal at this point was a retreat to the PP pivot, which would have taken GE down to 16.15. But, alas, this was not to be.
At 14:00 the NYAD shows some strength, although the lower NYAD chart shows what a wimpy little surge that was.
NEVERTHELESS, being the nervous nelly that I tend to be, I close half the position at 14:10 and am considering closing the rest when the NYAD does a plunge at 14:30 and GE follows suit.
Once again I'm looking at the PP pivot as the next downside target, but GE's failure to breakthrough 16.21 on multiple attempts tells me that the path of least resistance is the close out, which I do, with some luck at 15:06 on a kiss-off bar at 16.25.
Time in trade: 13:00 - 14:10 = 70 minutes and 13:14 -15:06 = 112 minutes (way too long)
Trade gain: 16.48 - 16.33 = .15 and 16.43 - 16.24 = .19
Net gain = .34
Another subpar trade, but I'm glad I doubled up with the 8/16 cross as it made the trade worthwhile.

XLP Butterfly

Here's another example of a flat 75 day LR30 pattern that may have some potential as a butterfly play. Unfortunately, XLP shares some of the same option drawbacks as its SPDR counterpart XLU (as detailed last Friday) . . .that is, low volume, wide spreads and limited option exchange participation.
From a strictly technical standpoint, the short term chart of XLP looks almost bullish, with the envelop channel in the lower panel on an ascent and the STO and RSI poised to turn up (maybe).

Two scenarios are examined here, both with 2 strike spreads. XLP is a bit unusual in the tightness of the LR30 channel bands, which translates into an overly excessive risk/reward ratio when looking at 3 strike spacing scenarios like the XLE butterfly profiled Dec 10th.