Security Markets Wisdom (Part 4)

Finally, to wrap it all up, I am putting together the thoughts by 2 market leaders, Dennis Gartman and James Montier. 

Again, no matter how many times it has been stressed out that market forces will bring all greed and fear into the equilibrium state as no one can keep on making money all the times. One can think of every state of the market is an equilibrium state for the past and a start of new disequilibrium for future movements. Let me explain it further - Equilibrium from past means that supply and demand would have brought the equilibrium to the price dimension where people would have taken their profits or losses out. Hence, some people would have moved out of the markets due to portfolio ruin and some would have made good profits with their bets. Now to replace the losers, new participants come in and join the market. With new participants, a new combination of greed and fear comes into the play. With new hunger for risk and reward again a disequilibrium will be created causing people to be away from risk adjusted forces. Again, greed and fear will come back in and the same process will keep on going in cycles. 

I am extremely sorry as this final post is going to be a little lengthy so I ask for your patience to scroll until the bottom so that you can fully appreciate the wisdom put forth by these pundits for people such as us. 

Dennis Gartman's Wisdom on Trading Securities

1. Never, under any circumstance add to a losing position.... ever! Nothing more need be said; to do otherwise will eventually and absolutely lead to ruin!

2. Trade like a mercenary guerrilla. We must fight on the winning side and be willing to change sides readily when one side has gained the upper hand.

3. Capital comes in two varieties: Mental and that which is in your pocket or account. Of the two types of capital, the mental is the more important and expensive of the two. Holding to losing positions costs measurable sums of actual capital, but it costs immeasurable sums of mental capital.

4. The objective is not to buy low and sell high, but to buy high and to sell higher. We can never know what price is "low." Nor can we know what price is "high." Always remember that sugar once fell from $1.25/lb to 2 cent/lb and seemed "cheap" many times along the way.

5. In bull markets we can only be long or neutral, and in bear markets we can only be short or neutral. That may seem self-evident; it is not, and it is a lesson learned too late by far too many.

6. "Markets can remain illogical longer than you or I can remain solvent," according to our good friend, Dr. A. Gary Shilling. Don't try to find logic in market movements all the times. 

7. Sell markets that show the greatest weakness, and buy those that show the greatest strength. Metaphorically, when bearish, throw your rocks into the wettest paper sack, for they break most readily. In bull markets, we need to ride upon the strongest winds... they shall carry us higher than shall lesser ones.

8. Try to trade the first day of a gap, for gaps usually indicate violent new action. We have come to respect "gaps" in our nearly thirty years of watching markets; when they happen (especially in stocks) they are usually very important.

9. Trading runs in cycles: some good; most bad. Trade large and aggressively when trading well; trade small and modestly when trading poorly. In "good times," even errors are profitable; in "bad times" even the most well researched trades go awry. This is the nature of trading; accept it.

10. To trade successfully, think like a fundamentalist; trade like a technician. It is imperative that we understand the fundamentals driving a trade, but also that we understand the market's technicals. When we do, then, and only then, can we or should we, trade.

11. Respect "outside reversals" after extended bull or bear runs. Reversal days on the charts signal the final exhaustion of the bullish or bearish forces that drove the market previously. Respect them, and respect even more "weekly" and "monthly," reversals.

12. Keep your technical systems simple. Complicated systems breed confusion; simplicity breeds elegance.

13. Respect and embrace the very normal 50-62% retracements that take prices back to major trends. If a trade is missed, wait patiently for the market to retrace. Far more often than not, retracements happen... just as we are about to give up hope that they shall not.

14. An understanding of mass psychology is often more important than an understanding of economics. Markets are driven by human beings making human errors and also making super-human insights.

15. Establish initial positions on strength in bull markets and on weakness in bear markets. The first "addition" should also be added on strength as the market shows the trend to be working. Henceforth, subsequent additions are to be added on retracements.

16. Bear markets are more violent than are bull markets and so also are their retracements.

17. Be patient with winning trades; be enormously impatient with losing trades. Remember it is quite possible to make large sums trading/investing if we are "right" only 30% of the time, as long as our losses are small and our profits are large.

18. The market is the sum total of the wisdom ... and the ignorance...of all of those who deal in it; and we dare not argue with the market's wisdom. If we learn nothing more than this we've learned much indeed.

19. Do more of that which is working and less of that which is not: If a market is strong, buy more; if a market is weak, sell more. New highs are to be bought; new lows sold.

20. The hard trade is the right trade: If it is easy to sell, don't; and if it is easy to buy, don't. Do the trade that is hard to do and that which the crowd finds objectionable. Peter Steidelmeyer taught us this twenty five years ago and it holds truer now than then.

21. There is never one cockroach! This is the "winning" new rule submitted by our friend, Tom Powell.

22. All rules are meant to be broken: The trick is knowing when... and how infrequently this rule may be invoked!

Finally, few last ones by James Montier

James Montier's 7 Immutable Laws Of Investing

1. Always insist on a margin of safety

2. "This time is different" is actually never different

3. Be patient and wait for the fat pitch

4. Be contrarian

5. Risk is the permanent loss of capital, never a number

6. "Be leery of leverage". Leverage has been the single most cause of most of the failures of almost all types of trades be it institutional or retailer.

7. Never invest in something you don't understand

I truly hope that this series was a good read to all my dear readers. I am happy to hear your comments, feedback or anything you would like to share. 

-Nitin

Security Markets Wisdom (Part 3)

I hope you have truly enjoyed reading the first 2 parts of the Market Wisdom series. Here, in the part 3, I will talk about Gerlad Loeb and in the final post of the series, Part 4, couple of more guru's sharing to wrap it up.

Gerald Loeb's Wisdom:

1. The most important single factor in shaping security markets is public psychology.
2. To make money in the stock market you either have to be ahead of the crowd or very sure they are going in the same direction for some time to come.
3. Accepting losses is the most important single investment device to insure safety of capital.
4. The difference between the investor who year in and year out procures for himself a final net profit, and the one who is usually in the red, is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures.
5. One useful fact to remember is that the most important indications are made in the early stages of a broad market move. Nine out of ten times, the leaders of an advance are the stocks that make new highs ahead of the averages.
6. There is a saying, "A picture is worth a thousand words." One might paraphrase this by saying a profit is worth more than endless alibis or explanations. . . prices and trends are really the best and simplest "indicators" you can find.
7. Profits can be made safely only when the opportunity is available and not just because they happen to be desired or needed.
8. Willingness and ability to hold funds "non-invested" while awaiting real opportunities is a key to success in the battle for investment survival.
9. In addition to many other contributing factors of inflation or deflation, a very great factor is the psychological. The fact that people think prices are going to advance or decline very much contributes to their movement, and the very momentum of the trend itself tends to perpetuate itself.
10. Most people, especially investors, try to get a certain percentage return, and actually secure a minus yield when properly calculated over the years. Speculators risk less and have a better chance of getting something, in my opinion.
11. I feel all relevant factors, important and otherwise, are registered in the market's behaviour, and, in addition, the action of the market itself can be expected under most circumstances to stimulate buying or selling in a manner consistent enough to allow reasonably accurate forecasting of news in advance of its actual occurrence.
12. You don't need analysts in a bull market, and you don't want them in a bear market

-Nitin

Security Markets Wisdom (Part 2)

I hope you all liked Part 1 of Market Wisdom by Jesse. In Part 2, I will share the facts by another pundit, Bernard Baruch. You would notice, though these people are different, yet they are trying to teach us all the same thing. Discipline and Do not speculate. 

Wisdom by Bernard Baruch-

1. Don't speculate unless you can make it a full-time job.

2. Beware of barbers, beauticians, waiters, taxi drivers — of anyone — bringing gifts of "inside" information or "tips."

3. Before you buy a security, find out everything you can about the company, its management and competitors, its earnings and possibilities for growth.

4. Don't try to buy at the bottom and sell at the top. This can't be done — except by liars. [This is an important fact that bottoms and tops just can't be traded. No one knows about it when they occur. People only know it after the fact and then they would claim how they spotted it. Those who claim to have it spotted very well, must show a history of it to have the skills acknowledged. Else, it was just a pure luck and one shouldn't trade on luck]

5. Learn how to take your losses quickly and cleanly. Don't expect to be right all the time. If you have made a mistake, cut your losses as quickly as possible.

6. Don't buy too many different securities. Better have only a few investments which can be watched.

7. Make a periodic reappraisal of all your investments to see whether changing developments have altered their prospects.

8. Study your tax position to know when you can sell to greatest advantage.

9. Always keep a good part of your capital in a cash reserve. Never invest all your funds.

10. Don't try to be a jack of all investments. Stick to the field you know best.

Hope you enjoy it.

Nitin

Security Markets Wisdom (Part 1)

Market Wisdom - In this series I will talk about most of the trading rules that have been shared by market pandits from the past and yet they are been violated in today's world by traders in the hopes of seeing a different outcome.

Trading Securities in markets are primarily driven by two psychological biases - Greed and Fear. Greed lets people take risks that they haven't thought through deep enough and they only appreciate it after seeing it. These excessing greed can lead to either huge drawdowns or entire portfolio ruin.

There have been many market pundits who have shared their wisdom from their own experiences. In this series of "Market Wisdom", I will share what they told us and yet people lack discipline and violate these rules over and over leading to negative returns in Portfolio.

In Post 1 of the series, I will post the infamous "Jesse Livermore's" trading rules that were written back in 1940. All of these rules are taken either from reading books on JL, or through various readings at reliable financial resources websites.

Market Wisdom by Jesse Livermore: 

1. Nothing new ever occurs in the business of speculating or investing in securities and commodities.
2. Money cannot consistently be made trading every day or every week during the year.
3. I become a buyer as soon as a stock makes a new high on its movement after having had a normal reaction.
4. Never buy a stock because it has had a big decline from its previous high.
5. Never sell a stock because it seems high-priced.
6. Markets are never wrong – opinions often are.
7. If you cannot make money out of the leading active issues, you are not going to make money out of the stock market as a whole.
8. The real money made in speculating has been in commitments showing in profit right from the start.
9. As long as a stock is acting right, and the market is right, do not be in a hurry to take profits.
10. One should never permit speculative ventures to run into investments.
11. The money lost by speculation alone is small compared with the gigantic sums lost by so-called investors who have let their investments ride.
12. Never average losses.
13. Wishful thinking must be banished.
14. Big movements take time to develop.
15. Do not become completely bearish or bullish on the whole market because one stock in some particular group has plainly reversed its course from the general trend.
16. It is much easier to watch a few than many. [Don't trade too many different securities]
17. Only a handful of people ever make money on tips. Beware of inside information. If there was easy money lying around, no one would be forcing it into your pocket.
18. The human side of every person is the greatest enemy of the average investor or speculator.
19. It is not good to be too curious about all the reasons behind price movements.
20. The leaders of today may not be the leaders of two years from now. 
21. Don't trust your own opinion and back your judgment until the action of the market itself confirms your opinion.

This is the end of Part 1. Stay tuned for Part 2

-Nitin

Probability Basics and Expected Value

Probability is defined as a chance that a random number will have a particular outcome. For example, there is a 50-50 chance (hence 50% probability) that a fair coin will have a heads land up. If you gather all the possible outcomes of a random variable, such as the outcomes of the dice when it is rolled up, it generates a distribution which is the key in Probability space as it gives an insight of all possible values of the Random Variable.

What is a Random Variable: 
Random variable is just a name that can be anything where an analysis needs to be performed. Common examples are, outcome of a toss coin, outcome of a Dice roll, Daily returns of the financial instrument and so on. Once you know the outcomes of the Random variable, you can assign the probabilities attached to it to generate Probability Distribution. It is this probability distribution that helps to forecast future outcomes with certain confidence.

There are 4 main topics that one must consider while working with Probability.
1. CDF - Cumulative Distribution Function - CDF, F(.), of a random variable, X, is defined as:
                F(x) := P(X <= x)
                (Probability of X is less than or equal to x)

2. PMF - Probability Mass Function. p(.) is a Probability Mass function for the random variable, X,
                P(X in A) = Summation (p(x)) for all x in A

3. Expected Value: Expected value of a random variable, X, is given by the sigma of probability weights of the random variable.
                E(X) := Summation (Random value * Probability of Random Value)

4. Variance: Variance of a Random variable, X, is defined as
                Var(X) := E[(X - E[X]^2)]
                             = E[X^2] - E[X]^2
Variance is also known as Mean of the Squares - Square of the Mean.

Real World Application: 
What is the expected value of a fair dice roll?
As we know a fair dice will have 6 faces, numbered from 1 through 6 with each face with equal probability of 0.1667 or 16% chance of each number showing up.

Expected value then becomes:
0.1667 *(1) + 0.1667 *(2) + 0.1667 *(3) + 0.1667 *(4) + 0.1667 *(5) + 0.1667 *(6) = 3.5

Therefore one can say that the average value of a dice outcome is 3.5 or there is a 50-50 chance of beating the average value in which case 50% of the times, a dice can have a value higher than Expected value (4,5,6) or 50% chance that it can have lower than expected values of 3.5 (1,2,3).

Simple stuff - isn't it?

Nitin

High Frequency Trading Overview

High Frequency Trading Overview: 

In this post, I would like to talk about a little bit about High Frequency Trading, some of the key players around it and so on.

So what is HFT and how is it different than Traditional Trading? 
High Frequency Trading refers to fast allocation/re-allocation or turnover of trading capital. In Traditional trading, a trader will look at some of the components of the trading strategy such as Charts with indicators (moving averages, RSI etc...) before committing capital to the trade. On the other hand, in HFT, computers make the decisions to fire the trade based on some econometric model that is fully tested out (back-tested) by the trader. In HFT, trade execution speed is the key as the trades might be executed in a fraction of seconds/milliseconds/nanoseconds and traditional traders can't operate at such a low latency.

* In HFT, Low latency refers to the speed of executing an order. A low latency can be a trading strategy in its own right when the high speed of execution can be used an arbitrage strategy where there are price difference found on the same security on multiple exchanges for the same security.

There are 4 key characteristics of HFT:
1. Tick by Tick Data Processing
2. High Capital Turnover (HCT)
3. Intraday Entry and Exit
4. Algorithmic Trading

Some of the key players in HFT are: DE Shaw, Renaissance Technologies, and Towa Research Capital

3 Major components of HFT system are:
1. Highly Quantitative, Econometric models that forecast short term price moves based on contemporary market conditions
2. Advanced Computer systems built to quickly execute the complex econometric model
3. Capital applied and monitored with in Risk Management and Cost Management framework

In practice, an HFT firm will use 2 years of tick level data to backtest a strategy before committing live capital on it. Since setting up an HFT strategy requires pretty sophisticated level of understanding in Finance and Economics, most of the staffing at such firms are Ph.D in Quantitative Research (Finance/Economics/Physics)

Finally, an HFT operation is more likely to survive & proper if it had leverage and high Sharpe Ratios. Leverage helps to cover the operational costs and Sharpe Ratio helps in reducingthe risk of catastrophic losses and fund ruin.

Please feel free to comment should you have further questions related HFT.

-Nitin