BUY HIGH, SELL HIGHER: RELA RELATIVE TIVE STRENGTH SYSTEM SYS TEM p. 48 March 2011 • Volume 12, No. 3
®
• TRADING STRATEGIES FOR THE FINANCIAL MARKETS •
International ETF trading system p. 24
Intraday stock-index futures setup p. 18
Tale of a hedge fund p. 58
Prepping for tax season p. 62
$4.95
Capturing “alpha” with momentum and contrarian strategies p. 30
Oil back in the spotlight p. 16
Printed in the U.S.A.
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CONTENTS M 2011 • Vum 12, N. 3 TradiNg STraTegieS for The fiNaNcial MarkeTS
®
18
Trading Strategi Strategies es Time filtering scalp trades anyzn u-by-u u-by-u pmn n nty stup ts ptm tn tms. By atv T St
24
Trading international stock-index ETFs with relative strength rttn nt t stnst xn-t uns psntn p sntn nt unts’ st mts sws t ptnt t bst tuns n u vtty . By Jy kpp
BYLINE
30
Active alpha investing for the market’s “new normal” in mt nvnmnt wt ptnty tt t ,, smp eTf st ttn pp sws t bty t utpm. By Prof. Davide Accomazzo and Rosario Rivadeneyra
38
Execution and management of iron condors Tmn t mpnnt sps ts u-ptn pstn n p v ts wbs n mxmz ts ptnt. By gy Wn
In Every Issue 8
Contributors
10 Opening Trades Trends and events mvn t mts.
68 Stocks Snapshot Volume, volatility, and mmntum sttsts sts.
69 ETF Snapshot
71 Key Concepts
Volume, volatili volatility, ty, and momentum statistics for ETFs.
70 Futures Snapshot Volume, volatili volatility, ty, and momentum statistics for futures.
71 New Products & Services
72 Trade rader’ r’s Book Bookshel shelf f 73 Upcoming Events 73 Advertising Index 74 Trader’ rader’s s Marketplac Marketplace e 76 Trading Calendar
4
www.tvtm.m www.tvt m.m • M 2011 • ACTIVE TRADER
Contents
Contact Active Trader: Editorial inquiries: editorial@ac
[email protected] tivetradermag.com om
Advanced Concepts
42
Base metals and Chinese monetary policy Are sliding prices for base metals a currency trade in disguise?
Comments, suggestions:
[email protected] For advertising or subscription information, visit: www.activetradermag.com
By Howard L. Simons
Trading System Lab
48
The Business of Trading
Buy high, sell higher A relative strength stock system beats the
62
Handling IRS notices and exams
market by a wide margin in testing.
If you nd yourself confronted with an IRS notice,
By Robert Sucher Jr Jr..
learn how to proceed to avoid tax trouble. By Robert A. Green, CPA
Trading Basics
54
The Economy
Order up: 2011 Don’t get your OCOs, SCOs, and MOCs
66
U.S. economic briefing
mixed up. This primer on order types
Updates on economic numbers and
will make sense of the alphabet soup.
the market’s reaction to them.
By Active Trader Staff
Trade Diary The Face of Trading
57
Nurturing patience
80
Going long after a bearish week in the crude oil market.
Learning to wait for the trades that matter matter.. By Active Trader Staff
Active Trader Intervie Interview w
58
A new hedge-fund world In part 2 of our interview with Lars Kroijer, the former hedge fund manager discusses the future of hedge funds and the alternative to “alternative” investments for individual traders looking for an edge. By Active Trader Staff
6
www.activetradermag.com www.activetrade rmag.com • March 2011 • ACTIVE TRADER
CONTRIBUTORS ®
Howard Simons is president of Rosewood Trading Inc. and a strategist for Bianco Research. He writes and speaks frequently on a wide range of economic and financial market issues.
For all subscriber services: Active Trader Magazine
P.O. Box 17015 N. Hollywood, CA 91615 • (800) 341-9384 • www.activetradermag.com Editor-in-chief: Mark Etzkorn
[email protected] Managing editor: Molly Goad
[email protected] BYLINE Associate editor: Rakesh Sharma
[email protected] Contributing editor: Howard L. Simons Contributing writers: Marc Chandler, Keith Schap, Robert A. Green, Chris Peters Editorial assistant and webmaster: Kesha Green President: Phil Dorman
[email protected] Publisher, ad sales: Bob Dorman
[email protected] Classified ad sales: Mark Seger
[email protected]
Volume 12, Issue 3 Active Trader is published monthly by TechInfo, Inc., PO Box 487, Lake Zurich, IL 60047-0487. Copyright © 2011 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. Annual subscription rate is $59.40. The information in Active Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine
the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.
8
Geoffry Wong is a private trader using the technical analysis tools and strategies he has developed over many years. Previously, he was a propriety options and derivative trader for Goldman Sachs, where he was involved in all aspects of trading in options on futures, equities, and derivative products. Wong also assisted in research for the firm and used in-house technical and fundamental analysis to select various option strategies. At Goldman Sachs, he developed option-pricing models to find anomalies in mispriced options, and developed trading practices to profit from those anomalies. He can be contacted at
[email protected] or (917) 951-0364. Davide Accomazzo has been trading professionally since 1996. From 1996-1997 he was a Euro-convertible bond/international equities sales trader with Jefferies Group, where he covered many international funds. In 1998 he left to trade his own capital, and in 1999 he started Kensington Offshore Limited, a speculative hedge fund that outperformed the S&P 500 during the 1999-2002 boom and bust economic cycles. In 2001 he launched Kensington Capital Management LLC, a commodity trading advisor that focused on trading options on futures and currency futures. In 2004 Accomazzo was recruited by UBS Wealth Management USA to manage the portfolios of high net worth investors. In 2005, Accomazzo co-founded Cervino Capital Management LLC as managing director, head of trading and is the sole principal trader for the company’s managed futures programs. Rosario Rivadeneyra is co-founder and managing partner at Quant Investments, an investment advisory firm based in Monterrey, Mexico. She holds a Master’s in finance from EGADE, a leading business school in Mexico, and studied at the Graziadio School of Business and Management of Pepperdine University. She is a contemporary dancer and performing arts supporter. Jay Kaeppel is the author of Seasonal Stock Market Trends (Wiley, 2009) which was selected as one of the “Top 10 Trading Books for 2009” in the Hirsch Organization’s 2010 Stock Trader’s Almanac. A former commodity trading advisor, Kaeppel is an independent trader and trading strategist with Optionetics. He writes a syndicated weekly column called “Kaeppel’s Corner” for Optionetics.com. His previous books include The Four Biggest Mistakes in Option Trading (Trader’s Library 1998), The Four Biggest Mistakes in Futures Trading (Trader’s Library 2000), and The Option Traders Guide to Probability, Volatility and Timing (Wiley 2002). Robert A. Green, CPA, is CEO of Green & Company (GreenTraderTax. com), a CPA firm focused on traders and investment-management businesses. Green is also founder and CEO of the GreenTraderTax Traders Association. He is the author of The Tax Guide for Traders (McGraw-Hill, 2004) and Green’s 2010 Trader Tax Guide. GreenTrader provides tax preparation, accounting, consulting, entity, and retirement-plan formation services; IRS/state tax exam representation; and trade-accounting software. For more information or to participate in free conference calls, visit www.greencompany.com. Robert Sucher holds a M.S.E.E. in signal processing from C.S.U. Northridge (1992). After working 12 years in the military aircraft industry, he moved to the Canary Islands (Spain) where he began actively trading stocks and futures in 1999. In 2002, he started an ongoing journey with WealthLab.com, assisting customers with trading tools.
www.activetradermag.com • March 2011 • ACTIVE TRADER
TRADING OpeningStrategies TRADES
U.S. stocks follow through into new year 2009-2010 in the top 10 percent of two-year gains since 1960.
A
classic “holiday” rally closed 2010 near the year’s high, capping one of the strongest two-year runs for stocks in the past 50 years. Although it was a double-digit year for equities overall, small-cap and technology stocks led the broad market by a wide margin: The S&P 500 (SPX) gained 12.79 percent in 2010, but the marketleading Russell 2000 (RUT) doubled that return, rallying 25.41 percent. The Nasdaq 100 (NDX) wasn’t too far behind with a 19.24-percent gain. But despite the S&P’s more modest 2010 gain, its 39.23-percent return for 20092010 was the ninth largest two-year rally since 1960. And that gain pales in comparison to the index’s 84-percent gain from the March 2009 financial-panic low to the end of 2010. The bullishness carried into the first full week of trading in 2011: All U.S. indices were in the black through Jan. 7, with the Nasdaq 100 (+2.65 percent) leading the pack by a relatively wide margin, while the Russell 2000 eked out a marginal gain (+0.51 percent). The rally dampened market volatility in December nearly to its lowest levels of the year. The CBOE volatility index (VIX) fell below 15.50, the lowest it has been since April 2010, which was the last time the market sold off sharply. The declining volume trend evident since the fourth quarter of 2009 remained intact through the end of 2010, with the first week of January 2011 producing a not-uncommon spike in trading activity. ◆
S&P 500 LARGEST TWO-YEAR GAINS, 1960-2010 Years
Open
High
Low
Close
One-year
Two-year
1997-98
1163.62
1244.92
1136.88
1229.23
26.67%
65.95%
1995-96
757.02
761.75
716.69
2 0.26%
61.29%
1996-97
955.4
986.25
924.92
970.43
31.01%
57.56%
1975-76
102.49
107.46
102.12
107.46
19.15%
56.81%
1998-99
1388.91
1473.1
1387.38
1469.25
19.53%
51.40%
1985-86
249.05
254.86
241.27
242.16
14.62%
44.80%
1988-89
350.62
354.1
339.62
353.39
27.25%
43.03%
1979-80
137.21
140.66
125.32
135.75
25.76%
41.24%
2009-10
1186.6
1262.58
1186.6
1257.64
12.78%
39.23%
2003-04
1173.83
1217.33
1173.76
1211.92
8.99%
37.75%
12/31/09
12/31/10
Russell 2000
625
784
Nasdaq 100
1,860
S&P 500
10
740.74
U.S. INDICES, FIRST WEEK OF 2011
U.S. INDICES ON THE YEAR, 2010
Dow
+/-
12/31/10
1/7/11
+/-
25.41%
Nasdaq 100
2,218
2,277
2.65%
2,218
19.24%
S&P 500
1,258
1,272
1.10%
1,115
1,258
12.79%
Dow
11,578
11,675
0.84%
10,428
11,578
11.02%
Russell 2000
784
788
0.51%
www.activetradermag.com • March 2011 • ACTIVE
TRADER
Opening Trades
Industry adjusts to Dodd-Frank A more transparent, stable marketplace? Higher fees and fewer choices? Brokerage rms and analysts discuss the implications of Dodd-Frank for individual traders and investors. BY RAKESH SHARMA
T
he financial crisis of 2008 ravaged markets and rattled the financial system to its core. The Dow Jones Industrial Average (DJIA) fell 33.84 percent that year, its worst showing since 1932, early in the Great Depression, and trillions of dollars of shareholder wealth evaporated. The crisis also exposed long-ignored loopholes in financial regulations that enabled Wall Street to run amok, resulting in widespread outcry for regulatory reform. Congress passed the Dodd-Frank Act into law in June 2010 in an attempt to address U.S. regulatory shortcomings, especially the lack of accountability in over-the-counter (OTC) derivatives
FIGURE 1: NEW REGULATIONS, NEW WATCHDOGS CONSUMER FINANCIAL PROTECTION BUREAU Independent head and budget Autonomous rule-writing •
trading, such as the now-infamous credit default swap transactions that helped destroy Lehman Brothers and other investment banks. Although specific applications are still being drafted, the new rules — from proposed restrictions on proprietary trading to increased margin requirements and suitability standards — are likely to impact institutional firms and banks more than individual investors. However, there is some concern the changes will result in higher operating costs that firms will ultimately pass on to end customers — that is, average investors and traders. Overall, there is still a big gap between what the law mandates and how regulatory agencies and financial firms will satisfy the new requirements. “You don’t have the playbook as yet,” says Ken Grant, risk professional and president of Risk Resources LLC. “I would say 20 to 25 percent of the law’s impact is known while 70 to 75 percent of its impact is unknown.”
•
Creates
Regulates
National consumer
complaint hot line; Ofce of Financial
Banks and credit unions with assets over $10 billion
Contributes
To the regulation- making process
Literacy
FINANCIAL STABILITY OVERSIGHT COUNCIL Chaired by the Treasury secretary Consists of 10 federal financial regulators, an independent member, and five nonvoting members •
•
Identifies
Recommends
Regulates
Emerging risks in
Rules for capital,
Nonbank nancial
the nancial system
leverage, liquidity, and risk management
companies
Dodd-Frank mandated new government agencies intended to protect and educate public investors.
12
Educating the individual investor In addition to Wall Street chicanery with OTC derivatives, a widely held view is that widespread financial illiteracy also contributed to the financial crisis. In response, Dodd-Frank approved the creation of two new agencies (the Financial Stability Oversight Council and the Consumer Financial Protection Bureau) to protect retail investors, along with an Office of Financial Literacy to educate investors (see Figure 1). It has also mandated increased communication between brokerages and their customers. For example, brokers are now required to disclose short-sale activities once a month to customers, including information relating to compensation or financial incentives for each sale. In addition, brokers must provide customers with the option to not have their securities used in short sales. “The biggest area of impact for individual investors is that they will now have access to a constant stream of continued communication from companies,” says Charles Rotblut, vice president of the American Association of Individual Investors (AAII) in Chicago. “It is important for [investors] to know that they are active business owners if they invest in a company’s stock and active lenders if they invest in bonds.” However, Rotblut sounds a note of caution regarding the practical effect of the new information that will be available to investors. “As we have seen in the case of dieting, reinforcing a message or increased communication does not always work,” he www.activetradermag.com • March 2011 • ACTIVE
TRADER
says. “Similarly, increased communication might not always result in an educated investor.”
Proprietary trading Section 619 of Dodd-Frank has special implications for investment firms. The section, also known as the Volcker rule, named after former Fed Chairman Paul Volcker, deals with proprietary trading (in-house trading with firm, rather than customer, funds). Proprietary trading desks have become huge sources of profits for large banks and trading firms, an increasing number of which have turned to high-frequency trading strategies that now drive as much as three-quarters of the volume in the U.S. stock market. According to its advocates, the upside of proprietary trading is that it adds liquidity to the market. The downside, according to detractors, is that it increases leverage and risk at these firms, thus endangering the financial system as a whole. According to the Roosevelt Institute, a New York-based policy research institute, Wall Street firms suffered an estimated $230 billion in proprietary trading losses by April 2008. The Volcker rule prohibits banks from engaging in proprietary trading. But, the new law provides regulators with a 15-month observation period before deciding how to enforce it. In the meantime, banks are reportedly exploring ways to reorganize their proprietary trading groups, including spinning them off into “hedge funds,” to skirt the law. James Heinzman, managing director of securities solutions at Actimize, a New York-based risk and compliance solutions firm, and former managing director of Bear Sterns, says there are two schools of thought on this issue. According to the first school, the ban on proprietary trading will lead to greater transparency and a more level playing field. The second school believes the ban could lead to loss of liquidity. “There will be a reduction in the pools of liquidity available to investors, especially in the case of retail investors,” says Heinzman. Less liquidity will mean greater price volatility and spreads. “In the extreme, retail investors could end up paying higher prices and be forced to accept more risk as well,” he says. Rotblut, however, thinks limits to proprietary trading are unlikely to affect individual investors. “Hedge funds or large investment firms have more exposure to stocks with large market volumes, such as CISCO,” he says. “A reduction in proprietary trading should not impact their liquidity.” Grant says the ban will be positive for individual investors. “It takes away access to information and, consequently, the proximity advantage that institutional firms enjoy,” he says. ACTIVE TRADER
• March 2011 • www.activetradermag.com
Brokers must give customers the option to withhold their securities from short-sale lending. Broker obligations: A question of standards Dodd-Frank also calls for uniform “fiduciary standards” for brokers and investment advisors, which represent the obligation to act in a client’s best interests. Although it has not defined the standards, the law empowers the SEC to do so. Brokers are currently governed by the so-called “suitability obligation” to advise their clients. This obligation contrasts with the “fiduciary duty” that governs investment advisors, because the former incorporates factors such as client age, net worth, and time horizon into investment advice. Imposition of a more rigorous standard could impact a large cross section of traders and investors, according to some industry participants. “We have an awful lot of clients who know what they want to do in terms of trade,” Christopher Nagy, managing director at TD Ameritrade, says. “Depending on how fiduciary duty is defined, it might affect client actions.” For example, in the case of a completely self-directed investor, he says “the firm would have to check his or her liquidity and other information, which might result in delays and other problems for the investor.” According to Heinzman, introduction of a uniform standard might also affect asset classes available to investors; certain products may be deemed too risky or complex for certain market participants. “Whole classes of less sophisticated and less affluent investors may no longer have access to the products and services offered by large global investment banks,” he says. “The result will be less investment opportunities available to retail investors.” The key to making the new standards work, Heinzman says, is to “harmonize the rules between investment advisors and brokers.”
Increase in brokerage costs? The new law could end up having a significant impact on brokerage costs, for two reasons. The first cause is the “Meeks amendment,” which approves an increase in the quote fees stock exchanges charge to brokers. According to Nagy, this could have continued on p. 14
13
Opening Trades
a major impact on TD Ameritrade’s fee structure. “It has the effect of increasing fee structures significantly and impacts my ability to charge commissions,” he says. Second, the new regulations could result in higher IT costs for financial firms. David Thetford, securities compliance analyst at compliance and technology solutions firm Wolters Kluwer Financial Services, says the fiduciary duty will place an added burden on brokerages and dealers. “Implementation of the fiduciary standard will result in extra labor and more conversations about regulation,” he says. “This will likely result in higher costs for the firms.” Whether those costs are then passed onto traders remains to be seen.
The bottom line Although much about DoddFrank remains uncertain, what is clear is the law heralds a new era of increased market regulation. “We let the genie out of the bottle,” says Terence Dolan, chief executive officer at Benjamin & Jerold, a New York-based boutique financial services firm. “The question before us now is how to get it back into the bottle.” For retail investors, industry regulation is the most important part of the act. “The key for individual investors is that the SEC has the ability to enforce regulations and continues to adapt as the financial industry evolves,” AAII’s Rotblut says. According to Ameritrade’s Nagy, a balanced approach to regulation is important. “Too much regulation is a bad thing, and too little regulation is also a bad thing,” he says. “The pieces of regulation that don’t work need to be repealed.” For example, he says, strict compliance with certain sections of the Sarbanes-Oxley law (which requires all publicly traded companies to submit an annual
14
report of the effectiveness of their internal accounting controls to the SEC) had the unintended consequence of creating a high barrier to entry for some firms. There may be other unforeseen downsides to increased regulation. “The risk of companies moving businesses offshore to lessrestrictive regimes is a very real risk,” Heinzman says. It might take years to ensure clarity and impact of the new law, according to Risk Resources’ Grant. That said, he is pretty confident Wall Street will come out of it OK — despite complaints of being overburdened with regulation. “Ultimately, Wall Street will benefit because they have the resources to turn whatever happens to their relative advantage,” he says. ◆
BARCLAY TRADING GROUP’S MANAGED FUTURES PERFORMANCE AS OF NOV. 30 Top 10 traders managing more than $10 million Trading advisor
November return
2010 YTD return
$ under mgmt. (millions)
1.
Benecentia (Essentia)
21.74%
11.11%
2.
Global Invest. Mgmt (High Frequency)
20.70%
105.50%
16.4
3.
Tactical Invest. Mgmt. (Inst'l)
9.44%
53.09%
60.0
4.
24FX Management Ltd
7.89%
60.64%
49.5
5.
Astmax (AMCI)
6.53%
4.21%
10.1
6.
eStats Funds Mgmt (Delev)
5.16%
7.74%
12.0
7.
Aquila Capital Concepts (Pharos)
4.93%
-17.02%
19.5
8.
Interkraft Energy Fund
4.89%
-1.22%
14.5
9.
Aquila Capital Concepts (Pharos Evol.)
4.72%
-12.54%
12.1
10.
AIS Futures Management (3X-6X)
4.45%
24.91%
104.2
80.5
Top 10 Traders managing less than $10 million and at least $1 million 1.
Level III Management
2.
eStats Funds Mgmt (Composite)
3.
Genuine Trading (USA Index)
4.
Brock Cap'l Mgmt (Heartland Ag)
5.
10.50%
89.45%
1.9
10.40%
14.64%
6.0
10.36%
88.13%
6.5
10.20%
-14.58%
2.6
Sagacity (HedgeFX100)
9.78%
3.85%
1.0
6.
CenturionFx Ltd (6X)
7.26%
66.06%
3.5
7.
Stein Invest. Mgmt (Trading Edge)
6.78%
27.63%
2.1
8.
GTA Group (FX Trading)
6.54%
21.80%
1.9
9.
Mist Financial Group (Delta)
5.63%
7.74%
2.5
5.51%
7.42%
9.7
10.
Vermillion Asset Mgmt (Indigo)
Based on estimates of the composite of all accounts or the fully funded subset method. Does not reect the performance of any single account. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. Source: Barclay Hedge (www.barclayhedge.com)
www.activetradermag.com • March 2011 • ACTIVE
TRADER
Opening Trades
Oil flirts with triple digits in new year Although three years ago the idea of $100 crude bordered on the apocalyptic, few market watchers seem to expect another oil gusher, even as prices again edge toward the century mark. BY ACTIVE TRADER STAFF
I
n early January crude oil (CL) pushed to its highest level since 2008 — the highest, in fact, since the market was in the process of collapsing from its stratospheric July 2008 high above $147 per barrel on its way to a February 2009 low below $34 (Figure 1). As of Jan. 3, crude oil had nearly tripled in price from that nadir, reaching $92.58 after staging a choppy 30-percent rally off its August 2010 swing low (Figure 2). Long the most actively traded and widely watched commodity market, crude mostly disappeared from the headlines after its implosion, only gradually recapturing ink from the mainstream press as it sustained prices above $75 in early 2010, and especially after it tested its late-May low and clawed its way back above $90 — the final round-number threshold in the path of the psychologically loaded $100 level. However, the oil market has arguably entered a new paradigm since 2008, and the recent rally has thus far failed to engender the same level of hype that accompanied the market’s first run to $100.
Underlying market dynamics
On the fundamental side, analysts point to several reasons for the recent bump in prices. Dominant among them is positive news about the global economy, according to Chris Lafakis, economist at Moody’s Analytics. While economic growth has been slow, especially in the U.S., it has remained positive for many months, and there has been an absence of bad news to reverse the trend. “Recent positive macroeconomic data has increased investor expectations that the global economy will recover strength in 2011,” he says. As economies recover, of course, oil demand increases. “Due to an increase in demand from China and other emerging economies, and the prospects of a U.S. economic recovery, we are returning to a constrained supply environment,” says Allen Good, equity analyst at Morningstar. “That means demand may outstrip supply.” However, few analysts seem to view the market as overheated the way it was two to three years ago, and supply concerns are generally muted. The current situation is “fundaFIGURE 1: 50-PERCENT CRUDE REBOUND mentally different from what happened in 2008,” according to Lafakis says, who says tremendous demand from China, which was buying oil and oil products in preparation for the Beijing Olympics, was the main reason for the 2008 surge. “The strong demand caught investors off guard, and they panicked, sending oil futures higher,” he says. The market is less likely to be squeezed today. For example, Lafakis says OPEC currently has excess capacity of 4 million barrels per day that can be brought online if oil prices increase to $100. Some analysts think oil will hurdle $100 in the coming months, but few see the potential for a extended At the beginning of January, crude oil topped $90 for the rst time in more than run beyond that threshold. In an intwo years and recovered more than half of its massive 2008-2009 sell-off. (Prices vestment note released in December shown are weekly estimates and do not reect daily price extremes.) 2010, Goldman Sachs economists Source: U.S. Energy Information Association (http://tonto.eia.doe.gov) described a “structural bull market”
16
www.activetradermag.com • March 2011 • ACTIVE
TRADER
that would lift oil prices back to $100 per barrel. Although he says oil could hit $100 this year, Lafakis does not believe it is a sustainable level. “A price of $100 would trigger an increase in oil production,” he notes. Another question is whether the increase in oil prices could derail the still-fragile economic recovery. Lafakis doesn’t think so. “A $1 per barrel increase results in a $1 billion increase in consumers’ annual energy costs,” he says. He says it would take an approximately $20 increase to appreciably slow GDP growth.
Oil stocks Rising crude prices have, of course, buoyed the prices of oilrelated stocks. “Stocks of oil companies are probably pricing in slightly higher right now,” Good says. However, the rise in prices may not result in a bonanza across the board. “Oil producers, whether they are [sovereigns] such as OPEC FIGURE 2: THE RECENT RALLY countries or companies such as Exxon or Shell, stand to benefit the most from increased oil prices,” says Lafakis. Refineries, on the other hand, are less likely to profit from higherpriced crude. “Refiners face long-term headwinds,” Good says. “In the short term, their margins may have peaked. Now, profits depend on further acceleration in growth and demand.”
The lack of momentum in the current uptrend also plays against the participation of trend-following commodity trading advisors and hedge funds that played a big part in the 2007-2008 crude bubble (and the hedge-fund universe has been particularly decimated since then). While the initial rebound off the 2009 low was robust, price gains have been more haphazard since mid-2009. Every significant push past a $10 threshold — into the $60s, $70s, then the $80s, has been relatively short-lived and was typically followed by stagnation, and then a $5 to $10 retracement that nipped momentum in the bud just as it seemed the market might mount an extended rally. Nonetheless, there is little way to predict what might happen if the market does manage to stay above $100 for an extended period. Markets, like the people who comprise them, have relatively short memories. ◆
Price action Although crude oil’s behavior over the past 18 months bears little resemblance to its 2007-2008 run, the market has regained more than half the ground it lost in the subsequent sell-off. (However, the 50-percent rebound represents a technical hurdle in and of itself, as Fibonacci enthusiasts will likely sell into this anticipated resistance level.) ACTIVE TRADER
As of Jan. 3, March crude oil futures had topped $92, having rallied approximately 30-percent from late August 2010. Source: TradeStation
• March 2011 • www.activetradermag.com
17
TRADING TRADING Strategies Strategies
Time filtering scalp trades Analyzing hour-by-hour performance of an intraday setup highlights optimal trading times.
BY ACTIVE TRADER STAFF
T
here are several old saws about the best and worst times to put on positions during the trading day: avoid the open and close (because they’re too volatile), avoid the middle of the day (because it’s not volatile enough), and so on. The intraday volatility of the stock market does follow, on average, a very predictable intraday profile: The beginning and the end of the day are, in fact, the most active periods, as traders react to early news and establish positions at the open (or get out of bad positions held overnight) and then unwind many trades before the closing bell. The middle of the day — lunchtime in New York and Chicago, as often noted — features much less movement and volume because the early news has been absorbed and most positions have been established; the market often consolidates, or jerks back and forth, until activity picks up again in the last hour or two of the trading session. For intraday traders, the implications are fairly obvious: If you’re looking for directional moves and follow-through, avoid the “dead-zone” in the middle of the day and focus on those periods when the market is most likely to move. (Conversely, traders looking to take contrary positions may choose to sell resistance and buy support during midday ranges.) Let’s look at a basic intraday buy setup, applied on the fiveminute time frame, and see what we can learn from analyzing its behavior during different periods of the day.
The pattern: Three up and three down We will start with the simplest of patterns: three five-minute bars with successively higher lows followed by three bars with
18
successively lower lows. This pattern can be expressed by two simple rules: 1. The lows of the five-minute bars three, four, and five bars ago are above the lows of their respective preceding bars. 2. The lows of the current bar and the two preceding bars are below the lows of their respective preceding bars. As formulas, these rules are: 1. Low[5] > Low[6] and 2. Low[4] > Low[5] and 3. Low[3] > Low[4] and 4. Low[2] < Low[3] and 5. Low[1] < Low[2] and 6. Low[0] < Low[1] (Note: A version of the pattern that requires the most recent five-minute bar’s low [Low[0]] to be a certain amount below the previous low will be discussed at the end of the article.) Basically, these rules simply identify situations in which there has been upward pressure for at least three five-minute bars (notice that it can be more than three), followed by three bars of downward price action (lower lows). This representative pattern was unoptimized and was selected only because of its simplicity and relative frequency. It was originally analyzed in five-minute data in the S&P 500 ETF (SPY), continued on p. 20
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Trading Strategies
but here it will be tested on five-minute bars in the E-Mini Dow futures (YM) from Feb. 1, 2010 through July 16, 2010 — a total of 9,412 price bars, or the equivalent of more than 37 years of daily price bars. Only regular-session data was used, 8:30 a.m. to 3:15 p.m. CT. Figure 1 shows a few examples of the pattern.
Raw pattern performance The pattern formed 135 times in the 118 days in the analysis period — just a little more than once a day, on average. This is far too infrequently for a genuine scalping pattern, but it nonetheless provides enough samples to do a relatively thorough analysis. Table 1 shows the E-Mini Dow’s performance in the first 12 (five-minute) bars following the pattern, using an entry one point (tick) below the low of the second-to-last bar of the pattern (i.e., entering as soon as the final bar makes a lower low). Gains and FIGURE 1: TRADE SIGNALS
losses were calculated based on exiting at the closes of the following 12 bars. Figure 2 graphs the average and median post-pattern performance along with the market’s average and median one- to 12-bar returns for the entire analysis period. While the pattern’s returns are extremely modest, they do outperform the even more static performance of the market overall. (The analysis period as a whole was flat, dominated by an early uptrend, then a volatile sell-off highlighted by the May 2010 flash crash. The E-Mini Dow had 68 up days, 48 down days, and gained a total of 41 points between Feb. 1 and July 16, 2010.) Figure 3 (p. 22) looks beyond the closing gains to compare the pattern’s median largest up moves (LUMs) to the largest down moves (LDMs). The LUM is the biggest gain from the pattern entry to the highs of each of the following 12 bars, while the LDM is the biggest loss from entry to the lows of each subsequent bar (the chart shows the absolute value of the LDMs to make comparison easier). It’s apparent the pattern was followed by notably more up movement than down movement in the first few bars (along with the highest winning percentages, as shown in Table 1), but this edge quickly eroded until, by bar 12, the LUM/LDM ratio had fallen to 1.00. There was a somewhat stable zone in the middle: Upside movement held a small but steady edge from bar 5 to bar 9, and the median LUM ranged from 17 to 21 points during this window. Now let’s see how the pattern behaved at different times of the day.
Time of day: Frequency and winning percentage Figure 4 (p. 22) shows the distribution of pattern occurrences throughout the trading day. There’s the expected activity early in the session, but after a brief lull, another uptick occurs from around 10:10 to 10:50 CT. The period from 11 a.m. to a little after 1 p.m. is relatively quiet, except for an anomalous high reading at the 12:35 bar. A small surge in activity from 1:15 to 1:30 is followed by a
The pattern, which triggered approximately once a day, consists of three higher lows followed by three lower lows on the ve-minute t ime frame. TABLE 1: POST-PATTERN PERFORMANCE Bar
1
Avg
2.3
Med
3
2
2
1
-59
-61
-71
-65
47
49
58
72
308
177
331
196
62.96%
54.81%
54.81%
51.85%
Min
Max Sum Win%
33
2
1.34
3
2.63
4
1.58
5
6
0.23
0.77
1
1
2
2
-66
-66
-60
-63
65
64
79
28
93
152
272
54.07%
53.33%
53.33%
53.33%
7
1.29
8
2.33
9
10
11
12
2.45
1.07
1.50
5
3
5
5
-81
-88
-85
-90
97
98
92
92
284
124
171
302
54.81%
53.33%
51.85%
53.33%
2.67
The pattern’s gains were modest, with the biggest relative (per bar) edge occurring in the rst few bars — especially bar 1, which was the only bar t o have a winning percentage higher than 60 percent.
20
www.activetradermag.com • March 2011 • ACTIVE
TRADER
FIGURE 2: PATTERN PERFORMANCE
brief respite before a final high-activity period from 2:15 to the day’s end. With the exception of the relatively high frequency mid-morning period (10:10-10:50) period, the profile essentially adheres to the common pattern of activity clustering toward the beginning and end of the trading day, with a lull in the middle. Now look at Figure 5 (p. 23), which shows the winning percentages associated with patterns occurring at different times of the day. One of the most interesting things about the results is that, rather than indicating certain time periods are uniformly better than others, it shows particular time periods are associated with a tendency toward success or failure either in the first bars after the pattern or in the later bars. For example, patterns that occurred continued on p. 22
ACTIVE TRADER
The pattern had modest, somewhat haphazard performance (blue lines), although it was more bullish than the market’s overall performance (reddish lines)
• March 2011 • www.activetradermag.com
21
Trading Strategies
in the 1:05 to 2 p.m. period (red) tended to have lower winning percentages in bars 1 to 4, but from bar 5 forward, the odds of a gain were 60 percent or higher, and in three cases above 70 percent. Patterns that were triggered in the 8:45 to 9 a.m. period (medium blue) had winning percentages near 65 percent for bars 1 and 2, but that probability dropped off sharply at bar 4 and never again climbed above 50 percent. Conversely, the patterns in the 12:05 to 1 p.m. category had low winning percentages FIGURE 3: UP MOVEMENT VS. DOWN MOVEMENT
(almost all below 50 percent) through bar 6, but these jumped notably (55-60 percent) from bar 7 forward. Overall, the most consistent time periods were the 10:05 to 11 a.m. (light purple) and 2:05 to 3:15 (dark blue) periods. With a few exceptions (e.g., bar 1 for the 2:05-3:15 patterns), trades that were triggered during these periods had win rates at or above 60 percent, with the 2:05-3:15 patterns particularly strong from bar 8 to bar 12. The consistently worst period was, in fact, 11:05 a.m. to 12 p.m. (light blue), which had a winning percent below 50 percent for nine of the 12 bars. If nothing else, it appears that avoiding trades during this period would be beneficial to overall performance.
Keeping time on your side
There was, on average, more up movement than down movement following the pattern, but that edge was most prominent at bars 1 and 2. FIGURE 4: TRADE DISTRIBUTION
Aside from a bump in the number of trade signals between 10 and 11 a.m. CT, the pattern was most active toward the beginning and end of the trading session.
22
Although intraday volatility patterns are fairly stable, it is worthwhile to research how a specific pattern or strategy performs at different times of the day. The results shown here, while still preliminary, indicate that not only are some times more advantageous than others, but different times of the day may require using different holding periods or trade horizons. In this case, the same entry signal was more profitable with a short holding period (one to four bars) early in the trading session, but late in the trading session a longer holding period (6 to 12 bars) was associated with a higher winning percentage. They also point to the potential for good results — and a relatively high trade-signal frequency — in a period (roughly 10-11 a.m. CT) that is typically thought of as a uneventful time of the day. One final bit of analysis: We analyzed a modified version of the pattern on more recent data (Aug. 1, 2010, to Jan. 10, 2011, again in the E-Mini Dow futures) to see how the results compared to the initial test. This iteration of the pattern added the requirement that the low of the final bar be at least 10 points below the low of the previous bar — a criterion designed to capture more-significant price drops that were thought likely to be followed by quick bounces. The results suggested the modification might be successful in this regard, although trade frequency was quite low. There were only 35 signals, but the median gain at bar 4 was 5 points — much higher than the 1-point median gain of the original
www.activetradermag.com • March 2011 • ACTIVE
TRADER
FIGURE 5: WIN PERCENTAGE BY TIME PERIOD
pattern. However, performance dropped off sharply after bar 4, suggesting these were relatively brief trade opportunities. Nonetheless, incorporating a price-movement parameter into this type of setup could be a first step in creating a more robust signal. Analysis showed the median low-to-low decline for the final two bars of the setup was 5 points and the average was 7.3. A more moderate decline requirement (e.g., 2-4 points) for these bars might improve returns without eliminating too many signals. ◆
ACTIVE TRADER
The pattern had a low probability of success in the 11:05-noon period, but favorable odds in other periods depended on the trade’s time horizon.
• March 2011 • www.activetradermag.com
23
TRADING TRADING Strategies Strategies
Trading international stock-index ETFs with relative strength Rotating into the strongest exchange-traded funds representing different countries’ stock markets shows the potential to boost returns and reduce volatility.
BY JAY KAEPPEL
T
he concept of investing in the strongest areas of the mar-
which track the performance of different international stock in-
ket has been a winning strategy for many stock inves-
dices. In 1996 the iShares family of ETFs launched several ETFs
tors over the years. Like any strategy, a relative-strength
to track the major stock market averages of a number of various
approach — i.e., buying the stocks that are currently
countries around the globe. This universe has expanded over the
outperforming others — is by no means perfect, and can, in fact,
years to include dozens of international stock-index ETFs. Not
result in above-average volatility. Nonetheless, the potential for
surprisingly, there is a high degree of correlation among them. If
outsized returns can outweigh this risk.
there is a global stock bull market, most country ETFs will rise in
Traditionally, relative-strength investing consists of buying a
value, while most will decline in the face of a global bear market.
portfolio of top-performing stocks, and research has shown this
Nevertheless, for trading purposes, we can treat each of these
approach can greatly outperform a buy-and-hold approach over
instruments as distinct sectors.
time. The increased volatility of the approach stems from the realto an adverse event, such as a surprisingly unfavorable earnings
Applying a relative-strength strategy to international ETFs
report, that can knock it out of the sky.
The list of international stock-index ETFs shown in Table 1
ity that any individual stock — even a high-flyer — is susceptible
In time, the relative-strength method has been improved by
(p. 26) is by no means exhaustive — it does not, for example,
focusing on sectors and industry groups. Although an individual
include such important players as China and India. However,
stock can be knocked down by a one-off event, sector trends are
those in the list all have data going back to 1996, which gives us
less likely to turn on a dime and typically take a longer time to
the ability to back-test a strategy over a meaningful time period.
play out. Momentum in a top-performing sector will often taper
Figure 1 (p. 27) shows four international ETFs (representing
off — resulting in another sector assuming the top spot — before
Brazil, UK, Japan, and Malaysia, top to bottom) that have expe-
it enters a prolonged decline.
rienced varied results over the years (although all participated in
This fundamental concept can be exported around the globe through trading single country exchange-traded funds (ETFs), 24
the 2008 market collapse). continued on p. 26
www.activetradermag.com • March 2011 • ACTIVE
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Trading Strategies
There are many ways to measure the
on a sound concept — is often the most
would be held in cash.
performance of one market relative to an-
useful. The technique used here measures
other, some of them very complex. How-
the one-year percentage return for each of
have produced a gain over the previous
ever, the simplest approach — if based
the ETFs at the end of each month. The
12 months; it does not buy the “smallest
five ETFs with the best one-year returns
losers.” If no ETF has a positive 12-month
are held during the next month. Initially,
return, then no position is held during the
each of the five ETFs purchased receive 20
following month, and the entire portfolio
percent of the total portfolio equity. Sub-
is held in cash.
TABLE 1: iSHARES COUNTRY ETFS TRADING SINCE 1996
The strategy purchases only ETFs that
iShares Fund
Ticker
Australia
EWA
the top five, it is sold and the proceeds are
Canada
EWC
used to purchase the fund that took its
Sweden
EWD
place. If more than one fund drops out of
Germany
EWG
Hong Kong
EWH
Italy
EWI
their place. If fewer than five funds show
2. If five or more of these funds have
Japan
EWJ
a gain, then anywhere from 20 percent to
positive 12-month returns, during
Belgium
EWK
100 percent of the portfolio can be held
the next month hold the five with the
Switzerland
EWL
in cash. For example, if only two of the
highest returns. When starting out,
Malaysia
EWM
funds show a gain over the previous 12
allocate 20 percent of capital to each
Netherlands
EWN
months, then those two funds would be
ETF.
Austria
EWO
held while the remainder of the portfolio
Spain
EWP
TABLE 2: PERFORMANCE COMPARISON
France
EWQ
Singapore
EWS
Taiwan
EWT
sequently, each time an ETF drops from The relative-strength strategy rules are: 1. After the close of trading each month,
the top five at the end of a given month,
measure the one-year change for each
the proceeds from the funds sold are al-
of the 21 ETFs in Table 1.
located equally to the new funds that take
No. trades % profitable trades
System
Buy-and-hold
145
1
59.3%
United Kingdom
EWU
Avg. annual return
12.9%
9.0%
Mexico
EWW
Net gain
344.3%
118.6%
South Korea
EWY
StD of annual returns
18.9%
25.6%
Brazil
EWZ
Average winner
+17.3%
U.S. Total Market
IYY
Average loser
-7.5%
These international stock-index ETFs all have price histories dating back to 1996 and represent equity markets in North America, Europe, Asia, Latin America, and Oceania.
26
Median winner
+8.2%
Median loser
-5.1%
Largest winner
+260.1%
Largest loser
-31.4%
The relative-strength strategy outperformed buy-and-hold, and did so with reduced volatility.
www.activetradermag.com • March 2011 • ACTIVE
TRADER
FIGURE 1: INTERNATIONAL STOCK-INDEX ETFS
3. If a fund drops out of the top five at the end of a given month, sell this fund and use the proceeds to buy the fund that replaced it in the top five. 4. If two or more funds drop out of the top five and are replaced by new funds, the proceeds from the sold funds should be split as close to evenly as possible between the new funds being purchased. (This helps rebalance the portfolio holdings over time.) 5. If a fund drops out of the top five at the end of a given month and is not replaced by another fund with a positive 12-month return (in other words, if there are fewer than five funds with positive 12-month returns), then sell that fund and hold the proceeds in cash. 6. If no funds have positive 12-month returns at the end of a given month, sell any existing fund positions and keep the portfolio in cash. 7. If the entire portfolio goes to cash, each new fund position should be allocated 20 percent of the total account equity until five fund positions are held. These rules were tested on the 21-ETF portfolio from March 31, 1997 through Dec. 28, 2010 using an initial account equity of $10,000.
Measuring the results Table 2 compares this strategy’s results to buying and holding equal initial investments in all 21 ETFs from Table 1. During 13 years and nine months of testing, the strategy averaged an annual gain of 12.9 percent vs. 9 percent for buy-and-hold. The strategy’s ending net profit was 344.3 percent, which was nearly three times the buy-and-hold profit of 118.60 percent. Figure 2 continued on p. 28
ACTIVE TRADER
• March 2011 • www.activetradermag.com
These four international ETFs (representing Brazil, UK, Japan, and Malaysia) have experienced varied results over the years. The relative-strength strategy rotates into t he strongest ETFs (from a pool of 21) each month.
27
Trading Strategies
FIGURE 2: TRADE-BY-TRADE RESULTS
shows the strategy’s trade-by-trade percentage returns, while Figure 3 compares the strategy’s equity curve to buy-and-hold based on a $10,000 initial investment. The system made money in 10 years and lost money in four. It also outperformed the benchmark “all funds” index, which represents buying and holding all 21 funds, in 10 The strategy posted a winning percentage of nearly 60 percent. The largest single winner (+260 percent) occurred in EWO held from October 2002 to December 2005), while the largest loser (-31 percent) occurred in EWH (November 2007 to September 2008).
of the 14 years. Also, the system’s volatility (as measured by standard deviation of annual returns) was less than 75 percent that of buyand-hold (18.9 percent vs. 25.6 percent).
Diversification and momentum
FIGURE 3: EQUITY CURVES
Using simple relativestrength analysis with international stockindex ETFs allows investors to diversify stock holdings across the globe and achieve an above-average rate of return by focusing on those markets that are outperforming the rest. ◆ The strategy’s equity curve mirrored buy-and-hold’s trajectory, but outperformed it by a wide margin.
28
For information on the author, see p. 8.
www.activetradermag.com • March 2011 • ACTIVE
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TRADING TRADING Strategies Strategies
Active alpha investing for the market’s “new normal” In a market environment with potentially little to offer, a simple ETF sector rotation approach shows the ability to outperform.
BY PROF. DAVIDE ACCOMAZZO AND ROSARIO RIVADENEYRA
I
n trading there are two main approaches: momentum, when a trader bets price will continue in the direction of the previous period; or mean-reversion, when a trader bets prices are in a short-term overbought or oversold situation and are therefore expected to revert to a longer-term mean or fair value. Of course, identifying a trend in a momentum-based strategy or a contrarian overbought-oversold condition also requires determination of a time horizon. A two-week directional move may be considered a trend by one type of trader, while another may require a two-month move to qualify as a trend. Given these general investment parameters, I started researching different momentum-based ideas, testing different time periods to see if trading advantages could be found across the board by implementing simple momentum or contrarian rules to different asset classes. Further, the convergence of two factors — the realization that for a few years the passive beta approach of buy-and-hold would have been a loser, and the explosion of exchange-traded funds (ETFs) — created the conditions for this type of research.
It’s unlikely economic conditions will favor a passive investment approach in the foreseeable future. 30
The first analysis of this idea was conducted in 2008 immediately before the financial crisis as an exercise for students at the Graziadio School of Business and Management at Pepperdine University. In this article, the study is updated with two additional rotation studies using forex and commodity ETFs.
Go to p. 71 for more information about: • Sharpe ratio • Variance and standard deviation
Beyond buy-and-hold: Goodbye beta, hello alpha For years Wall Street has relentlessly promoted the buy-andhold investment approach. Over time this strategy morphed into a quasi-Holy Grail of investing for two major reasons: first, its winning streak over a fairly long time period, thanks to one of the most powerful equity market bull runs ever recorded (1982 to 2000); second, its simplicity and cost efficiency in terms of execution. The buy-and-hold strategy also fits rather well with the operational needs of the Street. It creates a constant and stable inflow of money into equities, and it frees stockbrokers and financial advisors from the heavy work of actually managing portfolios and allows them to concentrate on asset gathering. The buy-and-hold mantra also helps mutual funds by securing stable flows of capital www.activetradermag.com • March 2011 • ACTIVE TRADER
FIGURE 1: UNEVEN PERFORMANCE
Since the bursting of the tech bubble in March 2000, equity market performance has been inconsistent, and passive investment strategies have little to show for the past decade.
into investment products while minimizing liquidity issues. The success of buy-and-hold also helped validate passive investing and indexing (i.e., beta replication), an investment approach that forgoes market timing, active asset allocation, and stock picking in favor of replicating benchmark performance at low execution and management costs. All investment strategies, including buy-and-hold and indexing, experience market cycles with favorable macro and structural conditions. Inevitably, however, these cycles are followed by unfavorable periods. For example, since the bursting of the tech bubble in March 2000, equity market performance has been inconsistent and stocks have underperformed most other asset classes. As a result, a strictly passive strategy has very little performance to show over the past decade. The S&P 500 index originally peaked on March 24, 2000 with a closing price of 1527.46. It then proceeded to lose about 50 percent over the next two years before rallying to a new closing high on October 11, 2007 at 1554.41. This peak was followed by another crash — a 55-percent decline over the next year and half (Figure 1). In early 2011, the S&P had rallied back above 1250, still
ACTIVE TRADER • March 2011 • www.activetradermag.com
approximately 20 percent below its 2007 peak. And although on a rolling basis holding U.S. stocks passively for at least 10 years has rarely produced significantly negative performance in real terms (there are only three general periods of underperformance since 1880), 2000-2009 has left passive investors with large losses. To make things even more depressing for the indexing crowd, it is unlikely economic conditions will favor the passive approach in the foreseeable future. The long-term implications of the credit-deleveraging process, along with the inflationary pressures that have been steadily building up because of aggressive global monetary and fiscal policy, suggest uneven performance for equities for quite some time. For the next few years a “new normal” is likely to emerge in both the real economy and the financial markets, as they will probably reflect Main Street’s uneven performance with low-beta returns. Not so shockingly to the astute investor, active risk management and active asset allocation seem to be back in fashion. “Alpha investing,” the technique of actively seeking alternative and possibly uncorrelated sources of return beyond the passive continued on p. 33
31
Trading Strategies
TABLE 1: ETF UNIVERSE
TABLE 1: ETF UNIVERSE Available since May 2003
Available since Dec. 2007
Basic Materials
Yes
Yes
IYT
Yes
Utilities
Construction & Real Estate ITB IYR
Available since Dec. 2007
Transport
MXI IYM
Available since May 2003
Yes
IDU Yes
Yes
Yes
Yes
JXI
Yes
International IEV
Consumer Goods
Yes
Yes
Yes
KXI
Yes
FXI
Yes
RXI
Yes
AIA
Yes
Energy
EEM
Yes
Yes
Yes
Yes
IEO
Yes
EWZ
IEZ
Yes
Fixed Income
Yes
EMB
Yes
MBB
Yes
IXC
Yes
Financials Yes
TLT
Yes
TIP
IAK
Yes
Commodities
IAT
Yes
GSG
Yes
Yes
IAU
Yes
IAI IYF
IXG
Yes
Yes
Health Care Yes
IHI
Yes
IHE
Yes Yes
Yes
Industrials ITA IYJ
Yes Yes
EXI
Yes Yes
Yes
Yes
Technology IGN
Yes
Yes
IGV
Yes
Yes
IXN
Yes
Yes
SOXX
Yes
Yes
Telecom IYZ
Yes
Yes
IXP
Yes
Yes
32
Available Dec. 2007
DBA
Yes
GLD
Yes
GSG
Yes
RJI
Yes
SLV
Yes
UNG
Yes
USO
Yes
Currencies
Natural Resources IGE
Yes Yes
Commodities
IHF
IBB
Yes
FXE
Yes
FXC
Yes
FXY
Yes
FXM
Yes
FXB
Yes
FXS
Yes
The ETFs used in the study covered a wide range of stock sectors, xed income markets, commodities, and currencies.
www.activetradermag.com • March 2011 • ACTIVE TRADER
TABLE 2: ORIGINAL STUDIES
Period
3 months
12 months
STUDY 2
STUDY 3
Period: May 2003 to April 2008
Period: June 2006 to May 2008
Period: October 2006 to May 2008
Sample: 18 ETFs
Sample: 30 ETFs
Sample: 36 ETFs
Portfolio: 4 ETFs
Portfolio: 7 ETFs
Portfolio: 9 ETFs
Weight per ETF: 25%
Weight per ETF: 14.29%
Weight per ETF: 11.11%
Sectors: 4
Sectors: 7
Sectors: 5-9
Momentum Annualized return
1 month
STUDY 1
8.50%
Value
SPY
Momentum
Value
SPY
Momentum
Value
SPY
17.54%
3.94%
7.02%
17.17%
3.91%
3.13%
12.24% 9.33%
Period avg. return
0.71%
1.02%
0.78%
1.46%
0.33%
0.59%
1.43%
Period max. loss
-8.97%
-7.54%
-6.05%
-6.54%
-5.07%
-6.05%
-5.03%
-6.13%
-6.05%
Daily max. loss
-3.79%
-2.80%
-2.60%
-3.04%
-2.07%
-2.60%
-3.20%
-2.44%
-2.60%
Annualized return
20.59%
12.29%
9.21%
16.29%
7.49%
6.47%
15.56%
-5.87%
-3.19%
Period avg. return
5.15%
3.07%
2.30%
4.07%
1.87%
1.62%
3.89%
Period max. loss
-12.35%
-11.53%
-10.71%
-5.85%
-7.69%
-9.51%
-3.93%
-10.84%
-9.29%
Daily max. loss
-3.09%
-2.64%
-2.74%
-3.09%
-2.69%
-2.74%
-4.38%
-1.89%
-2.68%
Annualized return
13.03%
17.62%
7.81%
7.21%
-7.74%
-6.68%
Period avg. return
13.03%
17.62%
7.81%
7.21%
-7.74%
-6.68%
-4.65%
-
-4.95%
-
-7.74%
-6.68%
-3.83%
-
-2.96%
-
-3.27%
-2.96%
Period max. loss
Daily max. loss
0.33% 0.26%
-1.47% -0.80%
The original analysis included ETF data through 2008.
performance produced by beta exposure, is going to be the central and pivotal element of every successful portfolio.
Investment philosophy The original study looked at a simple and cost-effective way to actively manage a primarily equity-based portfolio. This article adds studies of commodity and forex ETFs as well. We focused on ETFs as low-cost allocation vehicles to help build a diversified portfolio that could be actively managed using simple rules, and applied the aforementioned major investment styles — momentum and contrarian. Although there are myriad ways to define these two approaches, the philosophy behind them can be ACTIVE TRADER • March 2011 • www.activetradermag.com
deconstructed as follows: 1. Momentum will overweight the portfolio toward those sectors/asset classes that are showing price outperformance. 2. Contrarian will overweight the portfolio toward those sectors/asset classes that are suffering price underperformance The exact rules and composition of the portfolio are described in the following section (“Trading method”). The idea was to create a model that would allow for an active sector, commodity, or forex rotation in the search for market continued on p. 34
33
Trading Strategies
anomalies. Consistent with the premise that economic and equity performance will be significantly uneven in the future, we looked for an active strategy that would capitalize on such sector discrepancies. Wee also decided not to run correlation studies, but to build W and rebalance portfolios strictly on sectors selected by the general rules. The philosophy supporting this decision was to concentrate on a strategy dedicated to significantly outperforming the benchmarks, and then analyze the risk of the portfolio by looking at how the largest losses compared to the index and by calculating the strategies’ standard deviation and Sharpe ratio.
Momentum strategies seem to work better with quicker rebalancing rebalancing,, while contrarian approaches need longer time frames to arbitrage mispricings. Trading method For the sector ETF studies (Studies 1 and 2) we first looked at the available sectors for trading via iShares and chose 42 ETFs representing the following 15 sectors: Basic Materials, Construction & Real Estate, Consumer Consu mer Goods, Energy, Energy, Financials, Health Hea lth Care, Industrials, Natural Resources, Technology, Technology, Telecommunications, Transportation, Utilities, Fixed Income, International, Fixed Fix ed Income, and Commodities. One drawback inherent in this approach is the relatively short historical period available for analysis. We believed we had to back-test at least five years of performance for the results to have a solid foundation. Because a large number of ETFs were introduced in 2006, only 19 of the 42 selected ETFs had data going back at least five years (see Table 1 on p. 32 for the complete universe of ETFs). Therefore, we decided to expand the research into two studies to compare how results would vary when more ETFs were included in the sample. The commodity and forex studies were especially impacted by limited liquidity and short history (three years), as well as a limited number of ETFs from which to choose. Despite these constraints, this was not a significant problem, as the available ETFs were diversified, liquid, and had enough price history to validate the analysis. (Over time,
34
interested researchers can conduct additional studies as more data accumulates for these ETFs.) Each study had different test periods, but all were recalibrated using the same rules: rebalancing every month, rebalancing every three months, and rebalancing every 12 months. At the end of each period (monthly (monthly,, quarterly, quarterly, or annually) an nually) we would rank the percentage performance of the available ETFs for that period. Then, for the momentum portfolio, we would buy the ETFs in the top 25 percent of the ranking for the following period. For the contrarian portfolio, we would buy the ETFs in the bottom 25 percent of the ranking in the next period. Wee equally weighted the positions of the ETFs forming the W portfolio, and only included one filter: no more than 25 percent was to be invested in each of the 15 sectors. Our benchmark was SPY, the ETF that tracks the S&P 500. Study 1 spanned May 2003 to November 2010; 19 ETFs were available for trading and the portfolio consisted of a total of four ETFs. Study 2 spanned December 2007 to November 2010; 42 ETFs were available and the portfolio contained 10 ETFs. The commodity and currency portfolios (Studies 3 and 4) were rebalanced monthly and quarterly, and they consisted of only one ETF. For the momentum portfolio, the best-performing be st-performing ETF in the current period was allocated 100 percent of capital the following period. For the contrarian portfolio, the worst-performing ETF in the current period would be the only ETF held in the following period. The commodity study included seven ETFs, while the currency study included eight ETFs. The benchmark for the currency study was PowerShares DB US Dollar Bullish Fund (UUP), which tracks the performance of being long U.S. dollar futures against six other currencies. The S&P GSCI Enhanced Commodity Trust (GSC) was used as the benchmark for the commodity portfolio. The strategies were tested on adjusted monthly closing prices (from Yahoo Finance), except for SOXX (data provided by Fidelity). Adjusted daily closing prices were used to determine the maximum daily loss within the worst period. The results do not incorporate commissions or slippage.
Test results The results in Tables 2 (p. 33), 3, and 4 (p. 37) suggest a cost-effective and simple active alpha strategy is achievable. Momentum strategies have outperformed in most time frames and different continued on p. 36
www.activetradermag.com www.activetrade rmag.com • March 2011 • ACTIVE TRADER
TABLE 3: UPDATED RESULTS
Period (months)
1
Peri Pe riod od:: May May 20 2003 03-N -Nov ov.. 20 2010
Per erio iod: d: Dec ec.. 200 20077-No Nov v. 20 2010
Sample: 19 ETFs
Sample: 42 ETFs
Portfolio: 4 ETFs
Portfolio: 10 ETFs
Weight per ETF: 25%
Weight per ETF: 10%
Sectors: 4
Sectors: Min. 4, Max. 10
Value
SPY
Momentum
Value
SPY
Annualized avg. return
11.52%
0.14%
5.65%
3.30%
-4.75%
-2.83%
Period avg. returns
0.96%
0.01%
0.47%
0.28%
-0.40%
-0.24%
Average gain
3.78%
3.56%
2.94%
4.99%
5.04%
4.76%
Average loss
-4.69%
-4.85%
-3.92%
-5.33%
-6.8 -6 .85 5%
-5.87%
Period max. return
18.06%
12.15%
9.94%
14.31%
11.02%
Period max. loss
-14.67%
-28.14%
-16.52%
-15.24%
-25.05%
-16.51%
Winning periods
66.67%
57.78%
63.33%
54.29%
54.29%
51.43%
33.33%
42.22%
35.56%
45.71%
45.71%
45.71%
Annualized std. dev. dev.
18.12%
20.23%
15.04%
21.51%
26.74%
22.00%
Sharpe Ratio
0.63
0.00
0.37
0.15
-0.18
-0.14
Annualized avg. return
12.95%
12.14%
7.29%
-1.02%
1.42%
-0.65%
Period avg. returns
3.24%
3.04%
1.82%
-0.25%
0.36%
-0.16%
Average gain
10.76%
8.73%
6.44%
10.02%
9.56%
10.79%
-8.05%
-10.26%
-7.41%
-15.67%
-13.45%
-11.11%
Period max. return
24.62%
19.61%
16.29%
21.35%
20.70%
16.29%
Period max. loss
-32.38%
-30.22%
-21.57%
-27.70%
-31.71%
-21.57%
Winning periods
60.00%
70.00%
66.67%
60.00%
60.00% 50.00%
Losing periods
40.00%
30.0 30 .00% 0%
33.3 33 .33% 3%
40.00% 40
40.00% 50.00%
Annualized std. dev. dev.
24.11%
21.72%
17.16%
30.60%
Sharpe Ratio
0.53
0.55
0.42
-0.04
0.04
Annualized avg. return
7.42%
10.16%
4.69%
10.33%
33.18%
16.88%
Period avg. returns
7.42%
10.16%
4.69%
10.33%
33.18%
16.88%
Average gain
17.54%
21.32%
11.61% 11
10.33%
33.18%
16.88%
-53.33%
-17.75%
-36.80%
N/A
N/A
31.79%
75.66%
26.35%
12.15%
-53.33%
-34.46%
-36.80%
N/A
N/A
Winning periods
85.71%
71.43%
85.71%
100.00%
100.00%
100.00%
Losing periods
14.29%
28.57%
14.29%
0.00% 0.
0.00%
0.00%
Annualized std. dev. dev.
27.96%
32.98%
19.77%
2.58%
37.92%
13.40%
Sharpe Ratio
0.26
0.30
0.23
3.94
0.87
1.25
Average loss
Average loss
12
ETFs
Momentum
Losing periods
3
ETFs
Period max. return Period max. loss
9.93%
30.30% 25.77%
-0.03
N /A
59.99% 26.35% N /A
The updated analysis included performance results into 2010.
ACTIVE TRADER • March 2011 • www.activetradermag www.activetradermag.com .com
35
Trading Strategies
Related Reading Nicholas Barberis, Andrei Schleifer. Schleifer. “Style Investing.” Harvard Institute of Economic Research Discussion Paper 1908, December 2000. Bob Litterman. “Active Alpha Investing.” Goldman Sachs Asset Management, Open Letter to Investors, 2008. R. Schiller. Schiller. “From Efcient Markets Theory to Behavioral Finance.” Journal of Economic Perspectives , 17 (Winter) 2003. E. Dimson, P. P. Marsh, M. Staunton. Staunt on. “The Worldwide Equity Premium: A Smaller Puzzle.” London Business School, EFA 2006 Zurich Meetings, April 7, 2006. H. Markowitz. “Portfolio Selection.” Journal of Finance Finance 7, No. 1, March 1952. H. Hong, J. Stein. “A Unied Theory of Underreaction, Momentum Trading, Trading, and Overreaction in Asset Markets.” The Journal of Finance, Vol. LIV, No. 6, December 1999. K. Geert Rouwenhorst. “International Momentum Strategies.” Yale School of Management, February 1997.
asset classes. Momentum outperformed benchmarks across the board, with a notable exception in the three-year study using annual rebalancing, where the value strategy performed much better (probably because of the 2008 market dislocations). However, value also did better in the longer seven-year study using annual rebalancing, indicating momentum strategies seem to work better with more frequent rebalancing while contrarian approaches need longer time frames to capitalize on mispricings. Particularly noteworthy is momentum’s outperformance in the commodity sector using one-month rebalancing, where it posted an annualized average rate of return of more than 23 percent, vs. -7.25 percent for the commodity benchmark. In forex, a threemonth rebalancing strategy performed well, both relative to the benchmark and in absolute terms, with an annualized rate of return above 10 percent. One caveat is the larger standard deviations of momentum strategies. However on a risk-adjusted basis the returns remain attractive because their Sharpe ratios are generally higher than 36
the benchmarks and in some cases higher than those of the value strategies.
Cheap and simple alpha As mentioned, the motivation behind this analysis was to test a simple and cost-effective way to produce an active alpha strategy that could replace or at least complement more traditional betadriven portfolios. The ultimate portfolio optimization comes from the ability to identify sources of return produced by active and skilled investment management. The consistent ability to create enhanced performances by superior market timing and security selection — or more simply, alpha — is today more than ever a central tenet of an optimal portfolio. Over the past decade, indiscriminate exposure to a generalized beta has produced negative returns, and future conditions do not seem to indicate a change in this situation. As a result, the need to actively incorporate alpha-seeking strategies in traditional portfolios is a priority priority.. There is a considerable amount of research to validate the both the momentum and contrarian strategies as solid starting points. Momentum strategies seem to generally work across boundaries for several reasons: under-reaction to the dissemination of news (a practical discovery in clear contrast with the efficient market hypothesis), difficulty for large investment funds to deploy their capital quickly, quickly, and, ultimately ultimately,, the simplicity of execution in momentum strategies that may lead to easy replication and selffulfilling results. Interestingly, Interestingly, studies show momentum m omentum strategies seem to be more successful in shorter-term periods, while value strategies seem to outperform over longer time horizons (see “International Momentum Strategies” by K. Geert Rouwenhorst, Yale School of Management, February 1997). This study seems to validate these conclusions: While momentum outperformed the benchmark and contrarian strategies in most scenarios, it underperformed in the simulation using annual rebalancing, which the longest time frame tested with the least frequent rebalancing. This switching of outperformance between time horizons could be exploited in a core-satellite type of portfolio, in which the core part of the portfolio is dedicated to long-term value beta exposure and the satellite is comprised of alpha-seeking momentum investing. A simple ETF momentum strategy using quarterly or monthly sector, commodity, commodity, or FX F X rotation offers a cost-effective way to capture the critical alpha component every portfolio will need to offset negative conditions for traditional beta investing. ◆ For information on the authors, see p. 8.
www.activetradermag.com www.activetrade rmag.com • March 2011 • ACTIVE TRADER
TABLE 4: UPDATED RESULTS: COMMODITIES AND CURRENCIES
Period (months)
Period: March 2007-Nov. 2010
Sample: 7 ETFs
Sample: 8 ETFs
Portfolio: 1 ETF
Portfolio: 1 ETF
Weight per ETF: 100%
Weight per ETF: 100%
Commodities: 1
Currencies: 1 GSC
Momentum
23.35%
-29.50%
-7.25%
3.21%
1.95%
-2.46%
-0.60%
0.27%
Average gain
8.91%
7.01%
5.71%
2.78%
Average loss
-7.86%
-9.56%
-7.29%
-3.72%
Period max. return
16.94%
15.08%
17.21%
9.27%
Period max. loss
-23.73%
-24.28%
-27.54%
Winning periods
57.14%
42.86%
Losing periods
40.00%
57.14%
34.07%
Annualized std. dev. Sharpe Ratio
0.68
Annualized avg. return Period avg. returns
UUP
-0.98% -0.65% -0.08%
-0.05%
3.09% 2.25% -2.49%
-2.36%
9.03% 8.43%
-8.35%
-15.42%
51.43%
61.36%
43.18% 50.00%
48.57%
38.64%
56.82% 50.00%
35.97% 30.80%
14.22%
14.43%
-0.82
-3.21%
Value
-0.24
-25.95% -8.83%
0.22
10.11%
-0.08
-7.01%
10.90%
-0.07
9.09% -1.88%
-0.80%
-6.49%
-2.21%
2.53%
2.27%
Average gain
7.95%
18.15%
16.34%
8.96%
6.12% 3.38%
Average loss
-13.94%
-17.05%
-14.57%
-7.76%
-2.21%
-4.95%
Period max. return
29.84%
39.70%
29.72%
17.27%
16.03%
8.67%
Period max. loss
-27.85%
-31.45%
-43.97%
-17.24%
-8.92%
-8.86%
Winning periods
60.00%
30.00%
40.00%
61.54%
53.85%
53.85%
Losing periods
40.00%
70.00%
60.00%
38.46%
46.15%
46.15%
31.18%
20.91%
42.97%
19.94%
6.18%
5.13%
-0.11
-1.25
-0.21
0.50
1.45
-0.40
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
Average gain
N/A
N/A
N/A
N/A
N/A
N/A
Average loss
N/A
N/A
N/A
N/A
N/A
N/A
Period max. return
N/A
N/A
N/A
N/A
N/A
N/A
Period max. loss
N/A
N/A
N/A
N/A
N/A
N/A
Winning periods
N/A
N/A
N/A
N/A
N/A
N/A
Losing periods
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
N/A
Annualized std. dev. Sharpe Ratio Annualized avg. return Period avg. returns
12
Period: Dec. 2007-Nov. 2010
Value
Period avg. returns
3
Currencies
Momentum Annualized avg. return
1
Commodities
Annualized std. dev. Sharpe Ratio
-0.47%
The updated analysis added commodity and currency ETFs.
ACTIVE TRADER • March 2011 • www.activetradermag.com
37
TRADING TRADING Strategies Strategies
Execution and management of iron condors Timing the component spreads of this four-option position can help avoid its drawbacks and maximize its potential.
BY GEOFFRY WONG
A
lthough option traders are often attracted to strategies that offer limited risk and a relatively high probability of success, these approaches are often more difficult to apply than they appear on paper.
The iron condor is a four-option strategy with limited risk that is designed to profit when the underlying market remains in a relatively low-volatility condition during the life of the trade. It is a “credit spread” — that is, the trader collects premium upon establishing an iron condor, and this net credit is the position’s maximum profit. The components of an iron condor are: 1. Short one out-of-the-money (OTM) put; 2. Long one OTM put with a lower strike price; 3. Short one OTM call; 4. Long one OTM call with a higher strike price. The trade’s maximum profit occurs when the underlying’s price is between the strike prices of the short put and short call. Notice options 1 and 2 comprise a bull put spread, while options 3 and 4 represent a bear call spread (see “Option terms” for definitions of these positions). The long call and long put options essentially protect the position against large up or down moves in the underlying instrument. Although the iron condor seems to represent a fairly straightforward concept — collect premium and keep it as long as the 38
underlying market does not break the short strikes in either direction and implied volatility remains low — it is easier to profit from these positions in theory than in practice. The reason goes back to thinking of the iron condor as the combination of a bear call spread and a bull put spread. In short, traders typically collect too little premium on either the bear call spread or the bull put spread portion of the position when entering all legs of the trade simultaneously (and they give away the bid-ask spread, too). This is a result of the differences between call and put options that are equidistant from the underlying price in a given situation. Let’s look at the mechanics of properly executing an iron condor.
Before the trade There are a few basic steps for entering any options trade. The first is identifying an appropriate underlying stock or commodity. This is more challenging than it might first seem. Basically, you should be intimately familiar with the underlying market you are interested in trading. It is not in your best interest to apply a strategy unless you have a complete understanding of the underlying stock or futures contract’s historical highs and lows, annual and quarterly reporting dates, average daily true range (volatility), and volume, as well as the open interest (the number of open positions) in the specific option contracts you might trade. All these factors play an important role in price movement. www.activetradermag.com • March 2011 • ACTIVE TRADER
Option terms Premium: The price of an option. Bear call spread: A credit spread that consists of a short call and a higher-strike, further out-of-the-money (OTM) long call in the same expiration month.
Selecting an underlying instrument with the appropriate characteristics is an important step in capturing the most premium (credit) possible. Stocks such as Apple (AAPL) will have more premium value simply because their interday volatility is greater than that of many other stocks. For example, if you sold a bear call spread on AAPL a few strikes OTM (i.e., selling an OTM call and buying a higher-strike OTM call with the same expiration date), you would expect to receive more money than if you sold a call spread on, say, Microsoft, which has much lower volatility. Larger underlying price moves translate into higher option premiums. Another factor that effects the premium value is market perception, or “bias.” Using Apple stock again, the market prices the OTM calls higher, which results in higher premiums and call-spread values. For example, the market bias a few months ago was that it was willing to pay more for OTM calls than OTM puts. As a result, calls were more expensive than puts that were equidistant from the current stock price. At times, option deltas may explain this anomaly or relationship.
Bull put spread: A credit spread that consists of a short put and a lower-strike, further OTM long put with the same expiration date. The spread’s largest potential gain is the premium collected, and its maximum loss is limited to the point difference between the strikes minus that premium. Delta: The ratio of the movement in an option’s price (premium) for every one-point move in the underlying instrument. An option with a delta of 0.5 (50 percent) would move a half-point for every one-point move in the underlying stock; an option with a delta of 1.00 (100 percent) would move one point for every one- point move in the underlying stock. Strike (“exercise”) price: The price at which an underlying instrument is exchanged upon exercise of an option. Time value (“time premium”): The amount of an option’s value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as “time decay.”
The significance of delta One of the overlooked aspects of delta is that it is synonymous to the probability of exercise — that is, the odds the underlying will be at a given (strike) price at options expiration. As a result, you need to be careful when simultaneously selling call spreads and put spreads with the same delta but different premiums. Equal probability of exercise should yield equal premium, all else being equal. If the calls in our example are trading at a premium to the puts but their deltas are the same, there is a value disconnect. If you decide to sell a call spread that is $10 OTM with a delta of 25 percent (.25) and receive a $2 credit, you would expect to receive the same $2 credit when selling a $10 OTM put spread with a 25-percent delta. However, this is often not the case. For example, in the month of January, AAPL was trading around $340. The $360 call expiring in one month was trading for $5 with a .20 delta — in other words, reflecting a 20-percent chance AAPL would be trading at $360 in one month. By comparison, the $340 put was continued on p. 40
ACTIVE TRADER • March 2011 • www.activetradermag.com
FIGURE 1: IRON CONDOR PROFILE
The iron condor has limited risk and limited prot potential, and can be broken down into bear call spread and bull put spread components.
39
Trading Strategies
True range True range (TR) is a measure of price movement or volatility that accounts for the gaps that occur between price bars. This provides a more accurate reection of the size of a price move over a given period than the standard range calculation, which is simply the high of a price bar minus the low of a price bar. The true range calculation was developed by Welles Wilder and discussed in his book New Concepts in Technical Trading Systems (Trend Research, 1978). True range can be calculated on any time frame or price bar — ve-minute, hourly, daily, weekly, etc. Using daily price bars as an example, true range is the greatest (absolute) distance of the following: 1. Today’s high and today’s low. 2. Today’s high and yesterday’s close. 3. Today’s low and yesterday’s close. Average true range (ATR) is simply a moving average of the true range over a certain time period. For example, the 20-day ATR would be the average of the true range calculations over the past 20 days.
trading for $3.50 with a .20 delta, which implies a 20-percent probability AAPL would be trading at $340 at expiration. Why should you sell the OTM put for less than the OTM call if the odds are equal AAPL will be trading at either $340 or $360 at expiration? One of these premiums is too cheap. This may be a good reason to try and leg into the iron condor and receive a higher premium for either the bear call spread, the bull put spread or both. However, because of its risks (described later), this approach is suggested for more seasoned traders.
Execution: Legging into an iron condor Entering the call-spread and put-spread components of the iron condor separately makes it possible to collect equal premiums for them. The call spreads and put spreads are sold based on favorable conditions in the underlying. For example, if the stock or commodity is approaching major resistance, you can attempt to sell the call spread first. You would be selling into strength with the understanding the market is approaching long-term resistance. Here, you are deferring to the chart. If this analysis of the underlying is correct, the stock will hold resistance and will retreat or sell off at some point. When the downside correction occurs, you can then sell the put-spread component because the market will pay more premium when the stock is dropping in 40
value. You are taking on some additional risk by selling one leg at a time, and entering the spread in this fashion requires patience. If you sold your call spreads first, you must understand you are now short the underlying instrument and have risk exposure if it rallies. For example say you sold a $29 Microsoft call and bought a $30 call. The $29 call has a delta of .25 and the $30 call has a delta of .10. This is a bear call spread, so the net difference between the two strikes is 15 percent, which in the case of selling one spread would make your short 15 shares (15 percent of 100 shares). The opposite is true if you sold the put spreads first: You would be long a certain percentage of shares.
Iron condor management As with all trading, profiting from an iron condor is a matter understanding your risk and knowing how to manage it. With condors the risk is well-defined: the difference between the strike prices and the credit received for selling the spread. For example, let’s say AAPL is trading at $340 and you sell a $360 call and buy a $380 call (a $360-$380 bear call spread) for a $2 credit. If AAPL settles at $340 at expiration, the trade profit is $2. If AAPL is trading at $365 at expiration, you would lose $5 on the $360 short call but would keep the original $2 credit, so the total loss would be $3. Determining the optimum time to sell an iron condor is a bit tricky. A good rule of thumb is to determine a consistent percentage to exit any trade — for example, a 15-percent decline in the value of the spread’s collected premium. Many traders are inclined to let their iron condors ride until expiration to collect the maximum profit. Although this works out sometimes, in the long run it usually leads to traders letting positions move against them and producing losses. Traders should clearly define their risk level for these trades and be disciplined about exiting when that loss is reached. Finally, the time value factor is very important. The goal is to optimize the decay curve — that is, catch it at its peak. Time decay is not linear; most option models show the maximum erosion occurs in the final two weeks before expiration. Accordingly, these types of strategies are most advantageous when entered with three weeks remaining until expiration. ◆ For information on the author, see p. 8. Geoffry Wong will be a speaker at the Traders Expo in New York on Feb. 22 (www.tradersexpo.com).
www.activetradermag.com • March 2011 • ACTIVE TRADER
ADVANCED TRADING Strategies Concepts
Base metals and Chinese monetary policy Are sliding prices for base metals a currency trade in disguise?
BY HOWARD L. SIMONS
T
he various creators of the euro may have had certain goals in mind for the common currency, but there is no reason to believe its spread to various funding currencies as part of global carry trades and the use of these spreads as risk barometers were on that list. Yet twelve years into the common currency experiment, this is where we find ourselves (see “A cross rate to bear,” Currency Trader , May 2009). As China has pegged its currency to the low-yielding dollar, plus or minus a little revaluation here and there, the excess carry return from the Chinese yuan into the euro can be used as a risk barometer the same way the yen carry has been (see “The Robin Hood carry,” Currency Trader, July 2010). This carry trade is composed in turn of two parts, the net interest
One of the great surprises of 2009 given China’s key role in arresting the global recession is interbank credit conditions in China began to tighten in late May 2009. 42
rate gain to be made from borrowing three-month yuan and lending into three-month euros and the change in the spot rate. Any increase in short-term Chinese interest rates relative to European rates has the dual effect of tightening domestic credit conditions in China and lowering the interest rate spread. This had been readily observable in the time zones outside of the green rectangle in Figure 1 when we mapped the carry of the yuan (CNY) into the euro against the shape of the Chinese money-market yield curve as measured by the forward rate ratio between six and nine months (FRR 6,9) plotted inversely. This is the rate at which we can lock in borrowing for three months starting six months from now divided by the nine-month rate itself; the more this FRR 6,9 exceeds 1.00, the steeper the yield curve is. The carry trade index should lead the FRR 6,9 by three months given the movement of future interest changes “rolling down the curve” into the present. This trade had been disrupted during the Eurozone’s sovereign credit crisis from December 2009 – May 2010, the time period noted in the green rectangle. One of the great surprises of 2009 given China’s key role www.activetradermag.com • March 2011 • ACTIVE
TRADER
FIGURE 1: CNY MONEY MARKET YIELD CURVE AND CARRY INTO EUR
in arresting the global recession is interbank credit conditions in China began to tighten in late May 2009 (see “Viewing the yuan from the grassy knoll,” Currency Trader , February 2011); they just did not bother telling anyone. Did this interest rate action and the carry trade into the euro have any impact on global growth prospects in general and on base metals prices in particular?
The carry trade index’s lead was disrupted during the Eurozone’s sovereign credit crisis ( December 2009 – May 2010, green rectangle).
FIGURE 2: THREE-MONTH AHEAD TIN PRICE CHANGES AS FUNCTION OF CHINESE M ONETARY VARIABLES
Money and metals Figures 2-7 depict the three-month ahead percentage price change for an LME three-month forward as a function of the Chinese FRR 6,9 led by three months and of the yuan carry into the euro. Positive price changes are depicted in colored bubbles; negative price changes in white. The continued on p. 44
ACTIVE TRADER
• March 2011 • www.activetradermag.com
43
Advanced Concepts
FIGURE 3: THREE-MONTH-AHEAD ALUMINUM PRICE CHANGES AS FUNCTION OF CHINESE MONETARY VARIABLES
FIGURE 4: THREE-MONTH-AHEAD LEAD PRICE CHANGES AS FUNCTION OF CHINESE MONETARY VARIABLES
44
diameter of the bubble corresponds to the absolute magnitude of the price change. The current data points are indicated with a bombsight; the last datum involved in calculating a threemonth-ahead return is highlighted separately, and an arrow from there to the present is overlaid on the chart. As it turns out, the high degree of correlation between the six metals involved, copper, aluminum, lead, zinc, tin and nickel, allows us to make some consistent observations. As an aside, while this is good for analytic purposes, it makes no sense economically. With the exception of lead and zinc, which often are extracted from the same ores, these metals are produced in very different areas and under different mining cycles. Moreover, the substitution between them is slight to say the least; while copper and
www.activetradermag.com • March 2011 • ACTIVE
TRADER
FIGURE 5: THREE-MONTH-AHEAD ZINC PRICE CHANGES AS FUNCTION OF CHINESE MONETARY VARIABLES
aluminum both are used in electrical wiring, we would not suggest substituting copper for aluminum in aircraft manufacture, and the world probably is not ready for beer cans made out of lead. The high correlation of these metals’ prices is due to the influence of hedge funds and other investors who insist on trading them together as a group. The net result of tightening trends for Chinese monetary policy is the bombsight had been pushed toward the southern edge of the charts; the rebounding carry into the euro has pushed the bombsight eastward over the past three months’ of data. None of the six metals examined have a positive price expectation from either this zone or trend in the bombsight. As Chinese demand has been setting the global price for more important metals such as
FIGURE 6: THREE-MONTH-AHEAD NICKEL PRICE CHANGES AS FUNCTION OF CHINESE MONETARY VARIABLES
continued on p. 46
ACTIVE TRADER
• March 2011 • www.activetradermag.com
45
Advanced Concepts
FIGURE 7: THREE-MONTH-AHEAD COPPER PRICE CHANGES AS FUNCTION OF CHINESE M ONETARY VARIABLES
FIGURE 8: MINING STOCKS ARE A CURRENCY TRADE IN DISGUISE
As Chinese demand has set the global price for more important metals such as copper, aluminum, and nickel for several years now, anyone long those metals or long mining-rm equities should run for cover when China decides to t ighten. The trade logic also works in reverse.
copper, aluminum and nickel for several years now, anyone who is long those metals as commodities or who is long the equities of mining firms should run for cover each time China decides to tighten. The trade works in reverse, of course. This should indicate global mining stocks’ relative performance is nothing other than a currency trade in disguise, and had been the case until the weak revaluation began in June 2010 (Figure 8). This development, which promised greater Chinese purchasing power along with various mining industry mergers, pushed the relative valuation of the HSBC Global Mining Index for Diversified Miners against the MSCI World index higher in a quantum fashion. Once this shock has been absorbed, watch for both the base metals and for mining equities’ valuations to resume being a strong function of Chinese monetary policy. ◆ For information on the author, see p. 8.
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www.activetradermag.com • March 2011 • ACTIVE
TRADER
TRADING TRADINGSystem Strategies Lab
Buy high, sell higher A relative-strength stock system beats the market by a wide margin in testing.
BY ROBERT SUCHER JR. System concept This system is inspired by techniques Stan Weinstein described in his book Secrets for Profiting in Bull and Bear Markets (1988, McGraw-Hill), and includes several of Weinstein’s setups, triggers, and filters. Early in the book Weinstein writes that the “blueprint” to successful trading is less about buying low and selling high than it is about buying high and selling higher. Let’s investigate how that would have worked out for the past decade. Setup conditions. Part of the trading approach is to avoid buying or holding a downtrending stock. Weinstein used multiple forms of chart analysis, including trendlines, but he recommended stocks trading below their 30-week simple moving average (SMA) should never be purchased. Therefore, the first rule ensures the stock’s 30-week SMA is above the previous week’s SMA value and that the stock is trading above it. Also, to ensure the broader market is on the trade’s side, the 30-week SMA of the S&P 500 cannot have declined more than three consecutive weeks at the time of a trade. The next part of a trade setup incorporates the relative strength (RS) of the sector as well as the stocks within that sector. All else being equal, it makes sense to buy the strongest stocks in the strongest sectors. To realize this rule, the strategy identifies 10 sector exchange-traded funds (ETFs); all stocks in the test portfolio are segregated according to the sectors represented by 48
these ETFs. The 10 sectors are ranked according to their RS, and candidate stocks are selected from the top-three sectors. Relative strength is calculated relative to a benchmark, such as the S&P 500 index. Weinstein’s RS formula (stock or ETF price divided by the benchmark) is used here, but applied somewhat differently. Instead of using the trend on an RS chart, the oneweek RS rate of change (ROC) is used to rank sectors and stocks: the strongest sector ETFs and stocks are those whose RS values are increasing the fastest. Trade triggers. Recalling the “buy high” theme, Weinstein advises to identify stocks that have consolidated in a range and do not have nearby overhead resistance. A breakout above the top of the range triggers the entry. The system simplifies the approach by establishing all-time highs and the most recent “20-percent peak” (a top followed by a 20-percent or larger decline) as overhead breakout points. Once a stock breaks above its overhead resistance, any major obstacle (sellers) impeding a stock’s advance is practically nullified. Weinstein argues that when a stock pushes into new-high territory, no one is holding it at a loss, and new short sellers represent more eventual buying demand. Position sizing/money management. Weinstein further recommends entering a trade with half the normal position size, but if the breakout volume is at least twice the most recent month’s www.activetradermag.com • March 2011 • ACTIVE TRADER
FIGURE 1: SAMPLE TRADE
Go to p. 71 for more information about: • Rate of change (ROC)
daily average (the average daily volume over a rolling month, approximately 21 days of trading), the position size is doubled Just as the “Proting with Stock Splits” system (Trading System Lab, December 2010) on a dip toward the breakout celebrated TIE, our “Buy High” system picked it up as well. price. In this system, the posiSource for all gures: Fidelity Wealth-Lab Pro/Developer 6.0 tion is instead doubled following the first daily lower low FIGURE 2: EQUITY CURVE if the price-adjusted volume (volume*close) is more than double its monthly average. Also, instead of using a typical 10 percent (of account equity) position-sizing rule, the system will use 5 percent, which can result in owning up to 20 different stocks. Exit. Weinstein advocates using sell-stop orders for exits instead of percentage targets. To simplify the test, the system uses the stock’s 30-week SMA as a primary trailing stop. However, each higher 5-percent low (a non-optimized, arbitrary value) is integrated into the trailing stop. In other words, if the stock pulls back and the daily low advances at least another 5 percent, that pullback low becomes the new The system did a good job of protecting gains, taking the system to all cash (or very close stop price, provided it is above to it) during several rough periods, most notably the 2002 and 2008 bear markets. continued on p. 50
ACTIVE TRADER • March 2011 • www.activetradermag.com
49
Trading System Lab
FIGURE 3: MONTE CARLO DISTRIBUTION OF NET PROFIT
The baseline test results were approximately 15 percent better than the average Monte Carlo simulation.
the SMA. A close below the trailing stop value triggers a sell at the market on the next day’s open. System rules
Setup and filter conditions: 1. Relative strength: Candidate stocks must be in the top-three sectors as determined by RS ranking. 2. Overall market: The 30-week SMA of the S&P 500 has not moved down more than three consecutive weeks. 3. The 30-week SMA of the stock is higher than the previous week’s SMA value and the closing price is above the SMA. Enter long if: 1. The stock closes above a prior 20-percent peak, or 2. The stock closes above the previous all-time high. (In this case, the stock must be in a top sector, but the other setup conditions do not apply.) 3. In the event of a multiple candidates competing for capital on the same day, choose the one(s) with the high RS rate-ofchange. 50
Exit rules: Sell at the market when the stock closes below any of the following: 1. An initial 10-percent stop below the close of the breakout day; 2. The 30-week SMA; 3. The most recent 5-percent trough low. Figure 1 (p. 49) shows how a trade develops. The light green background indicates that TIE’s sector (Materials) qualified a s one of the top-three sectors, and the system went long when price climbed to a new all-time high in May 2005. (Note: This was an all-time high within the test data range, beginning June 1, 1999, not an all-time high for the stock’s entire history.) The trade occurred on average volume, so only the 5-percent position was maintained, even as the sector lost its top-ranking status. The trade progressed well above the 30-week SMA (blue stair-step line) and was eventually exited by a close below a 5-percent trough low (which actually turned out to be a “shake out,” as the stock quickly reversed to the upside). Nonetheless, the system www.activetradermag.com • March 2011 • ACTIVE TRADER
Related reading
re-entered a week later following the second split shown on Figure 1’s chart, and that trade turned into a 40-percent winner. Money management/position sizing: Allocate 5 percent of account equity per position on the initial breakout signal. If the price-adjusted volume is more than twice the most recent month’s average, add another 5 percent on the open after the first daily lower low. Initial equity: $100,000. Deduct $8 per trade ($16 per round trip) in commissions.
Profiting with stock splits Active Trader ,
December 2010 Trading splits can offer a longer-term edge for stock traders. Secrets for Profiting in Bull and Bear Market s
McGraw-Hill, 1988
July 2010 (when the system also made a new equity high, Figure 2, p. 49), not in 2008 or 2009. More than 71 percent (1,565) of all trade candidates were rejected during the test because of insufficient purchasing power. (As an aside, one could capture a large number of those trades by using margin. Using 50-percent margin, annualized return
Test data: The system was tested on the constituents of the S&P 500 index as of Dec. 10, 2010), as well as the following sector ETFs: IXP, XLB, XLE, XLF, XLI, XLK, XLP, XLU, XLV, and XLY. Dividend data and non-dividend-adjusted price data provided by Fidelity. FIGURE 4: PROBABILITY OF ACHIEVING PROFIT LEVEL
continued on p. 52
Test period: June 1, 1999 to Dec. 10, 2010, which includes a 30week “seed period” during which no trading takes place.
Test results From the date of the first trade on April 18, 2000, the system performed exceptionally well in the U.S. market’s “lost decade,” returning 11.8 percent annually after costs. Although yield did not influence the entry logic, $23,361, or more than 10 percent of the net profit, is attributable to dividends received, which more than offset the $9,556 in commission costs. The maximum drawdown was moderate at -20.2 percent — and interestingly enough, it occurred in
The Monte Carlo simulation also shows the odds are good of achieving the level of protability found in the baseline test.
ACTIVE TRADER • March 2011 • www.activetradermag.com
51
Trading System Lab
increased to more than 15 percent, although the drawdown also increased, to -36 percent.) In back-tests such as this, it is helpful to use a Monte Carlo simulation to get a better perspective on “typical” performance. After performing a “trade scramble” of all 2,175 trades in the back-test, Figure 3 (p. 50) shows the baseline test’s 230-percent net profit is just above the average and median values of 500 scrambled simulations. The distribution of returns in Figure 4 (p. 51) also indicates the probabilities of achieving a profit comparable to the one in the baseline test are excellent. Figure 5’s profit-by-instrument chart shows a few symbols accounted for outsized profits, but to a lesser extent than we’ve seen in most other Lab tests. Because the system was back-tested using the relatively recent composition of S&P 500 index, the results contain a degree of survivorship bias. However, notice the dark-green cash regions in the system’s equity curve, especially during 2002 and 2008
(Figure 2). This shows how the system largely reverted to cash during the most grueling bear-market periods of the past decade. (Note that no interest was earned on free cash in the test.) Furthermore, following Weinstein’s method of avoiding stocks below their 30-week SMA should prevent positions from blowing up.
Suggestions While this system’s design often leads to successful re-entries after a stop-out (as occurred in Figure 1), it’s possible the meat of a move is already in the past. Consequently, limiting entries to stocks that break out to new all-time-high territory following a lengthy consolidation could keep portfolio cash more readily available for other stocks showing that pattern. Also, no effort was made to short stocks with weak relative strength in downtrends — a worthy topic of research. Buying low and selling high is more difficult than it sounds.
STRATEGY SUMMARY Buy-higher system
Buy and hold (SPY)
Net prot
$229,557
$682
No. trades
Net prot
229.6%
0.7%
Win/loss
Prot factor
2.02
0.00
Payoff ratio
2.75
0.00
Recovery factor
4.08
0.00
Exposure
72.2%
98.2%
Max. DD
-20.2%
$8
588 days
-52%
$9,556
1,570 days
Profitability
Longest at period Commissions
Buy-higher system
Buy and hold (SPY)
610
1
42.1%
0%
Avg. prot/loss
4.1%
-13.9%
Avg. hold time
64 days
2,678 days
19.6%
0%
112 days
0 days
-7.1%
-13.8%
Avg. hold time (losers)
29 days
2,678 days
Max consec. win/loss
10 / 13
0/1
Trade statistics
Avg. win Avg. hold time (winners) Avg. loss
Strategy Summary notes: Portfolio-level results include a 30-week “seed” period in which no trading occurs (to allow
for the initial calculation of the 30-week SMA). This has the effect of calculating slightly lower exposure and annualized returns than those actually generated by the system. Also, because of the 30-week seed period, the buy-and-hold results were calculated from the date of the rst trade, April 18, 2000. Finally, although buying and holding SPY resulted in a small net prot of $682, the trade is sh own as a loss because the $15,243 in collected dividends were responsible for that gain. Dividends, which add to the equity curve and portfolio measures, are not considered when calculating trade performance statistics. LEGEND: Net prot — prot at end of test period, less commission. Prot factor — gross prot divided by gross loss. Payoff ratio —
average prot of winning trades divided by average loss of losing trades. Recovery factor — net prot divided by max. drawdown. Exposure — the area of the equity curve exposed to long or short positions, as opposed to cash. Max. DD (percent) — largest percentage decline in equity. Longest at period — longest period the system is between two equity highs.
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www.activetradermag.com • March 2011 • ACTIVE TRADER
FIGURE 5: CONTRIBUTION CHART
Sure, it’s easy to buy stocks that appear to be at a low level, but these often continue to get even cheaper — as traders in 2008 and 2009 can attest. Weinstein’s approach of buying high and selling higher appears to have merit more than two decades later. ◆ For information on the author, see p. 8. Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see tested, please send the trading and money-management rules to
[email protected]. Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guar - antee future results; historical testing may not reect a system’s behavior in real-time trading.
While a few stocks contributed to outsized returns, this characteristic is much less evident than in the majority of Trading System Lab systems. Also interesting is that 144 stocks produced only negative results and 217 others were not traded at all.
PERIODIC RETURNS Avg. return
Sharpe ratio
Best return
Worst return
Percentage profitable periods
Max consec. profitable
Max consec. unprofitable
Monthly
1.0%
0.74
13.9%
-16.6%
51.1%
8
9
Quarterly
2.9%
0.72
24.1%
-15.1%
59.6%
10
3
Annually
11.5%
0.75
43.4%
-8.7%
58.3%
5
3
LEGEND: Avg. return — the average percentage for the period. Sharpe ratio — average return divided by standard deviation of returns (annualized). Best return — best return for the period. Worst return — worst return for the period. Percentage protable periods — the percentage of periods that were protable. Max. consec. protable — the largest number of consecutive protable periods. Max. consec. unprotable — the largest number of consecutive unprotable periods.
ACTIVE TRADER • March 2011 • www.activetradermag.com
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TRADING TRADINGStrategies Basics
Order up: 2011 Don’t get your OCOs, SCOs, and MOCs mixed up. This primer on order types will make sense of the alphabet soup.
BY ACTIVE TRADER STAFF
A
lthough trading technology continues to grow apace — especially at the professional level — one thing hasn’t changed: knowing what order type to use and when to use it is an important part of successful trading. Since we last updated our primer on order types (“Order up,” Active Trader , November 2007), the biggest change for retail traders has been the increased availability of advanced “conditional orders” that allow you to combine two or more trade instructions into a single order, which can be triggered by a wide range of market circumstances. When considering the different types of orders at their disposal, keep a few important points in mind. First, every brokerage is different, and while most of them offer the same basic menu of order-entry options, they will offer different advan ced-order types, and/or use slightly different names for them or apply them somewhat differently. Contact your brokerage directly to see what orders they offer and to make sure you understand how they function. Second, keep in mind that complex order types can provide flexibility in getting in and out of the market, but they often cost more — again, confirm fees with your broker. Finally, just because you have 10 order-entry options at your disposal doesn’t mean you necessarily need to use them. Know what works when, and why. You can know the difference between an AON and an FOK order, but if you don’t understand the potential benefits and risk of each type, and the appropriate situations in which to use them, it won’t do you much good. 54
While not exhaustive, the following list is representative of the most commonly used orders, along with some advanced order types. Your brokerage may offer order types not on this list, disallow some that are on it, or use different names or acronyms. Some brokerages also have order types that are available for one asset type (e.g., futures) but not another (e.g., stocks).
Market order The market order is the most basic order type. It is generally the default order type for brokerages (i.e., if you don’t specify an order type, it’s a market order). A market order is designed to be executed immediately at the best possible price. Traders who use market orders are less concerned with price than they are with the certainty of the order being filled. If a stock is not particularly active, it’s possible a market buy order will be executed at the best “offer” or “ask” price (see “Bid and offer basics”). However, in a high-volume, highly active stock, where prices are frequently changing, the price you expect and the price you get may be vastly different. Getting a worse price than expected may not be that big a deal for long-term investors — someone who buys $10,000 worth of stock with the intention of holding it for several years is often not very concerned with paying a few cents more than the quoted price. However, if you’re a short-term trader, two cents here or a nickel there can seriously impact your ability to make a profit on the trade. www.activetradermag.com • March 2011 • ACTIVE
TRADER
Market orders are generally the cheapest, because they are the easiest for the brokerage to execute.
Limit orders Limit orders allow you to set the specific price at which you will buy or sell. If you place a limit order to buy at $25, you won’t pay more than $25, and it’s possible (but not likely) you’ll pay less than $25. Likewise, if you place a limit order to sell at $30, you won’t get filled any lower than $30, and there’s a slim chance you’ll get filled higher. The downside to limit orders is that there is no guarantee an order will be filled. If a stock is trading at 25.03, it may or may not trade down to 25. If it doesn’t, the aforementioned limit order will go unexecuted. Historically, limit orders have been more expensive than market orders, although in an effort to obtain business, it’s common for brokerages to offer enticements that include identical commissions for market and limit orders.
Stop orders A stop order is an order that becomes “live” when a certain price level is reached. There are three kinds of stop orders: stop-loss, stop-limit, and stop. A stop-loss order is designed to cap losses on an open trade. Stop-losses are placed below (for long trades) or above (for short trades) the current market price, and will get traders out of positions before a loss exceeds a certain amount or an open profit loses any more ground. For example, a trader who enters a long trade at 25 may place a stop-loss at 24.50, hoping to cap his losses at 50 cents. However, there is one drawback to a stop-loss: When the stop price is hit, the order becomes a market order, so there is no guarantee the position will be exited at 24.50. In a fast-moving market, the price could blow through 24.50, and the order might get filled at a much lower price. One way to avoid this is to use a stop-limit order. A stop-limit order functions in the same way as a stop-loss, except when the stop price is hit, the order becomes a limit order. This guarantees the exit price will be no worse than 24.50. But there is a downside to stop-limit orders, as well: There is no guarantee the order will be filled, partially or at all. If price hits 24.50 and continues to fall rapidly, the trader may still have an open (and losing) position. Stop-limit orders can consist of two prices — a trigger (or “activation”) price and the stop-out price. For example, a stop-limit order might be, “Sell 100 shares at 24.50 stop, 24.40 limit.” The first price is the “activation price” (i.e., the price the market must trade at to make the order live) and the second price is the actual limit price that represents the worst price at which you will accept a fill. In this situation, as soon as the market trades at 24.50, an order is triggered to sell 100 shares no lower than 24.40. Again, there is always the risk you won’t get filled at all. While the majority of stop orders are stop-losses or stop-limits, a plain “stop” order can be used to enter a trade. For example, if a stock is trading at 24.85, a trader could enter a stop order to buy ACTIVE TRADER
• March 2011 • www.activetradermag.com
at 25. When (and if) the stock hits 25, the stop order becomes a market order to buy. Similarly, stop-limit orders can also be used to enter trades.
Trailing stop A trailing stop lets traders move their stop up (for a long position) or down (for a short position) in set increments as the market moves in their favor. Trailing stops are designed to help traders protect open profits. While trailing stops were not available at many brokerages a few years ago, they have since become relatively commonplace.
Day order Day orders are only good through the end of the current trading session, after which they are automatically cancelled. Most trade orders are, by default, day orders.
Good-till-cancelled (GTC) A GTC order remains open until cancelled by the trader or the broker. A trader who enters a limit order can designate that order “GTC.” That will keep the order open so it can be filled at a later date (if the market ever moves to the limit price). Most brokers will set a limit on how long GTC orders can remain open (typically between 30 and 60 days for stock trades and until expiration for futures and options trades), so it’s important to check your brokerage’s policies before placing a GTC order. Also, brokerages sometimes assess an additional fee for GTC orders.
Fill-or-kill (FOK) A fill-or-kill is an order that must be executed immediately or cancelled.
All-or-none (AON) AON orders must be filled completely or not at all. If you’ve placed a limit order for 500 shares, and only 250 are available at that price, the order will be ignored until (and if) 500 shares become available.
Market-if-touched (MIT) An MIT is a market order that is automatically activated when a designated price level is hit. This guarantees an execution will be made, although a trader using an MIT order takes the risk that all or some of the order might get filled at a price worse than the designated price level. Because of its specific limitation, this order type might be best used in highly liquid but relatively low volatility instruments that increase the odds of getting a favorable fill. A trader in a profitable long trade might use an MIT order if analysis indicates the market might reach a certain price level but there is uncertainty whether the market will sustain that level for very long. In that case, the MIT order could be used to improve the chances (compared to a limit order) of getting out of the market, even at the expense of getting a worse price. continued on p. 56
55
Trading Basics
Market-on-close (MOC) An MOC is a market order that is executed as close to the end of the trading day as possible. Some strategies are based on closing price and need to enter or exit a trade at or near that price. While placing a market order at the end of the day serves the same purpose, an MOC order can be placed at any time, eliminating the need for a trader to remember to place a last-minute order.
Market-on-open (MOO) A market-on-open is the same as an MOC order, but executed as close to the open as possible.
Limit-on-close (LOC) A limit order entered as close to the market close as possible.
Limit-on-open (LOO) A limit order entered as close to the market open as possible.
Stop-close-only (SCO) A stop order that is activated only if the stop price is triggered during the close of the trading session. If the stop price occurs before the market close, the order is ignored.
Order cancels order or one cancels the other (OCO) An OCO order cancels one order if another is filled. For example, if you were long and had both a stop-loss order below the market and a limit order to sell at a profit above the market, the two orders could be placed OCO — that is, when one order is executed, the other is automatically cancelled. An increasing number of brokers are allowing more advanced OCO orders. For example, you could place a limit order to sell at a profit, a stop-loss to exit with a loss, “OCO MOC” (order cancels order, market on close). This means the trade will be exited on the close if neither of the other two conditions are met and the orders are automatically cancelled.
One cancels all (OCA) The OCA order is similar to the OCO type, except the OCA allows for placing more than two orders. For example, if you wanted to buy any one of three stocks (but not more than one) you could enter three buy-limit orders. The system will execute the order for the first company to reach the limits set by the trader. The buy action will result in cancellation of the other orders.
One triggers another (OTA) An OTA order is consists of two orders — a primary order, and a secondary order that goes live when the first order is filled. For example, you could enter an order to automatically buy Market B if when your limit order to buy Market A is filled. Or, a fill of the primary order could trigger the entry of a stop-loss or 56
profit-taking order (or both) for that trade. (An order that simultaneously enters a stop-loss order and a profit-taking order for an open positions is sometimes referred to as a “bracket order.”)
Conditional or contingency orders Depending on your relationship with your brokerage (i.e., how much money you have in your account), there is virtually no limit to the conditional trades you can design. For example, you could place a conditional order to buy a certain stock if it makes a 10-day high on volume greater than 10 percent of its average daily volume. Or, if the three major indices are all trading within 1 percent of their five-day lows, sell a certain amount of a particular stock. Most online brokers only offer conditional orders to their most preferred customers; direct-access brokers are more likely to allow them to the customer base as a whole. However, an increasing number of brokerages are offering conditional orders based on a variety of market criteria (including indicator readings), while other brokerages offer automated trading of advanced trading strategies and c onditional rules.
Discretionary orders These orders give your broker permission (“discretion”) to execute an order as he sees best. For traders who trade only electronically, this type of trading is not available. It is primarily part of the remaining pit-traded futures markets and large institutional trading. Unless you have a very close relationship with your broker, these orders are not recommended.
Do your homework Remember, every brokerage is different. Check with your broker before placing any type of advanced or “exotic” order. Generally, the more complex an order is to a brokerage, the more the brokerage will charge you to execute it. Also, there may be restrictions on the firm’s liability for certain types of orders. Many online brokerages have separate trading programs — one for traditional buy-and-hold customers and one for more active customers. Almost certainly, the latter will offer more order options. Brokerages have created many more specialized order types over the past few years — often with proprietary names — that may reflect one or more of the order types shown here, and which may use an acronym that represents a very different order somewhere else. The downside of all the new choices is, unfortunately, a lack of standardization and the risk of confusion. Finally, if you’re already feeling a little overwhelmed, keep in mind that it’s entirely possible to be a successful trader or investor with just market, limit, and stop orders. However, knowing what else is available — and when to use it — is never a bad thing. An order type is a tool, and like any tool, you must know the right one for the job to get the desired result. ◆
www.activetradermag.com • March 2011 • ACTIVE
TRADER
The Face of TRADING Trading setup
Nurturing patience
Hardware: PC with 2.3 GHZ pro- cess, 3.25 GB RAM, two 24-inch monitors, one 17-inch Software: Sterling Trader Pro Internet: High-speed cable
BY ACTIVE TRADER STAFF
Brokerage: OptionsXpress
Name: Ayad Amary Age: 35 Lives and works in: Allentown, Pa.
A
fter graduating from college in 1997, Ayad Amary took a job at John Hancock selling mutual funds and life insurance. He did well, but was always interested in learning more about the stock market. So did some of his customers, apparently. “I was going out hustling insurance policies to business owners, and all they wanted to talk about were dot-com stocks,” he remembers. On the side, Amary studied for and eventually earned his Series-7 license. In 2000 he resigned and went to work for a small regional brokerage firm and started building a customer book. He also started trading stocks for himself, then branched into options. “I tried to carve out a niche with covered-call writing and income-generation strategies,” he says. “I had [a good customer] book, generating a lot of commissions because I had active customers.” However, the firm’s goals shifted toward new business development. “I wanted to sit at my desk and stare at my monitor and trade,” Amary says. But he soldiered on until 2005, focusing on new client generation and building a respectable $15-million customer book. In 2005, he sold his client list to another broker and left the business to enter corporate pharmaceutical sales. Again, Amary achieved the highest sales status in the entire company, but he felt something was lacking. “I did well, was making good money, had a company car and benefits working only 25 hours per week,” he says. “It made me lazy and complacent. I didn’t enjoy it but thought, ‘how can I walk away when I
am making good money?’” In 2009, despite being in the top 5 percent of the sales force in the entire company, Amary was laid off. He received a nice severance package, and he knew it was time to do what he wanted. “I’m going to do it now, or I’m going to be stuck in this corporate rut for the rest of my life,” he says. With his severance money and income from his rental properties he owned, he began trading full time. Born in Syria, Amary moved to the U.S. when he was very young. “I grew up around a lot of people, including my father, uncles, and cousins, who were gambling or playing poker at the house.” He found that when he began trading, the mentality was similar. In the beginning, Amary admits he was “looking for the action.” But he also learned “you can’t bail yourself out at three in the afternoon if you are down $500. You have to take your losses sometimes.” He read book after book early in his new trading career, but he didn’t see consistent profitability for more than a year. However, over time he developed a trading plan and found “the patience you develop as a trader really does become a habit in the rest of your life.” Trading approach: Trading stocks only, Amary puts on five to 15 trades per day lasting two minutes to six hours. He primarily trades from the open until noon because he finds fewer opportunities in the afternoon. He focuses “purely on price action,” not indicators. Amary first identifies stocks that have gapped up or down at the open, which become his universe of stocks for the
ACTIVE TRADER • March 2011 • www.activetradermag.com
day. While he trades several strategies, he estimates 50 percent of his trades are gap plays in which he trades the stock at the open in the direction of the gap, preferably if the gap is in the opposite direction of the daily trends. For example, in an uptrending stock that gaps down on the open, he would sell short half his full position size, entering on the first one-minute bar that closes lower. Amary will expand to his full position size when the trade “matures” on the 5-minute chart — i.e., on the first 5-minute bar that closes lower. He places a stop-loss above the high of the day, with a target at previous support or at a pivot level from the daily chart. Became profitable when: Amary was a member of a chat room when he started trading, and he would offer up his ideas to the room, many of which turned out to be winning trades. But Amary would also trade other ideas he didn’t put out to the chat room. “I thought, why don’t I take only the trades I put out in the room? I was taking other high-risk positions that I shouldn’t have been trading.” He started to see consistent profits when he stuck to trading his best ideas. Best thing about trading: “My time is my own. I don’t have to answer to a boss or corporation.” When not trading: Spends time with family and friends, works out, and plays cards with his buddies. Best books/websites: Trade Your Way to Financial Freedom by Van Tharp; Tradingwings.com. ◆ 57
ACTIVE TRADER Interview
A new hedge-fund world In part 2 of our interview with Lars Kroijer, the former hedge-fund manager discusses the future of hedge funds, and the alternative to “alternative” investments for individual traders looking for a portfolio edge.
BY ACTIVE TRADER STAFF
“I
t’s not like I’m sitting in front of three computer screens at 7 a.m. anymore.” That’s one of the ways Lars Kroijer describes life today. While he hasn’t retired to a tropical island, he
Having experienced the hedge-fund boom years — launching a fund at age 30, building
is far removed from the day-to-day hedge-fund grind he expe-
it up to $100 million in
rienced as head of Holte Capital from 2002 to late 2007, and
less than a year, expand-
which he wrote about in his book Money Mavericks: Confessions of
ing it to $300 million,
a Hedge Fund Manager . After closing his fund, spending some time traveling, and writing the book, Kroijer and his family moved back to the UK a little more than a year ago. He now sits on the boards of three hedge funds (run by “good friends”), which he says he enjoys.
and closing up shop
“I wish I’d had someone [to consult with] who had been
before the 2008 market debacle — he has a unique vantage point from which to comment on the hedge-fund indus-
through it already, just to talk through things,” he says. “Even to
try’s past and future, and
address the minutiae of running a hedge fund: What fraction of
its strengths and weaknesses.
the portfolio does a trader have liberty to trade with? How much
It was the blunt assessment of some of these weaknesses,
should you pay for a compliance consultant? What should you
especially the issue of high fees, that rankled some of Kroijer’s
pay per square foot of office space? There’s all sorts of things like
hedge-fund compatriots, who took him to task as someone who
that.”
turned on his industry — but only after making a healthy profit in it himself.
“There’s no doubt I was burnt out — I’d be the rst to say that.” 58
But Kroijer says he is simply pointing out what for him became mathematically obvious: the difficulty for the end investor in a fund of funds to outperform the market when two layers of www.activetradermag.com • March 2011 • ACTIVE TRADER
Related reading managers are extracting fees (the industry standard is a 2-percent management fee and a 20-percent incentive fee). An individual hedge fund can certainly provide an outperforming investment,
“Lars Kroijer: Behind the hedge-fund curtain” Active Trader , February 2011 Part 1 of our interview with Lars Kroijer.
but the deck is stacked against the investor when multiple funds are involved, even if they are all profitable. Kroijer is actually quick to defend hedge funds — more accu-
Money Mavericks: Confessions of a Hedge Fund Manager (2010, Financial Times Prentice Hall)
rately, the potential value of any individual hedge fund. But aside from the fee issue, part of the problem, he notes, is the perception that hedge funds are a monochromatic asset class — for
“There are many people who, for whatever reason, want to or
example, “U.S. biotech stocks” — when they actually represent
have to invest in hedge funds, but they don’t know what the next
diverse, distinct products. Then there is the PR problem hedge
step is, so they go to the funds of funds,” he says.
funds have faced (more so in Europe than in the U.S.) in the aftermath of the 2008 financial crisis. “The media sometimes makes it sound like this $2 trillion ‘dark
Kroijer notes that’s what pension funds did, after decades of avoiding hedge funds. He describes the situation of a hypothetical pension-fund manager: “He’s sitting there thinking, ‘Oh, we
menace,’ where everyone gets together in a back alley and decides
can’t be the only pension fund in town without a hedge-fund
what to do,” Kroijer says. “It’s not at all like that. It’s 10,000 indi-
allocation, but I still don’t know whether gold is better than silver
vidual firms that are doing completely [different] things, and they
or what fixed-income arbitrage is.’ But there’s this very nice per-
often don’t know the first thing about what the others are doing.”
son at a big fund of funds with lots of snazzy presentations showing they can create uncorrelated positive returns. That sounds good. So he buys that — it’s cheap at 1 percent per year.”
“The media sometimes makes hedge
Kroijer’s sentiments about the industry are ultimately belied by
funds sound like this $2 trillion ‘dark
his use of the words “us” and “we” when discussing hedge funds. “Don’t make us the villain for everything that happened, be-
menace,’ where everyone gets together
cause we’re not,” he says. “That always annoys me — the sugges-
in a back alley and decides what to do.”
tion that somehow hedge funds caused the [2008] crash. First, I don’t think they did, and second, it’s a little too easy for some of the politicians to place blame there. We’re an easy villain because
Lumping all hedge funds together is like comparing apples to oranges to bananas. “You’re investing in a firm and person,” Kroijer explains. “I’m
we’re opaque, the successful ones everyone hears about make staggering amounts of money, and we frankly don’t do a good job of defending ourselves. If you’re a politician, that’s great. Except
often in the position of speaking about hedge funds as being un-
that there’s never been a taxpayer dollar, pound, or Euro that’s
der one umbrella — in my 30-second slot, I don’t get to differen-
gone to bail out a hedge fund.”
tiate — but I don’t know anything about fixed-income arbitrage, black-box investing, or silver vs. gold. But they’re all the basis of
The future
hedge funds.”
Kroijer fully acknowledges the pre-2008 hedge-fund environment
And that, he adds, is the raison d’etre of funds of funds. ACTIVE TRADER • March 2011 • www.activetradermag.com
continued on p. 60
59
Active Trader Interview
was something of a bubble — too much money in too many
“It’s more as hobby, really,” he says of the portfolio model. “I
funds doing too much of the same thing — but he also points
followed up and did a great deal more work on it. But it’s slowly
out market forces ultimately went to work on the industry:
taking on a life of its own. Lots of people say they optimize port-
“Something like 2000 hedge funds went out of business in 2008
folios, obviously, but in terms of a very cheaply created optimized
and 2009,” he notes. “That’s a healthy sign. If you don’t do a good
product constructed from existing indices, it’s a struggle to find
job, you go out of business.”
[information], and it’s certainly not mass distributed. A couple of
Are the 2000-2007 days gone for good? The world has undoubtedly been transformed since Kroijer ran his fund, but even
the large index providers have been very keen to move the idea forward.”
though he thinks the hedge-fund industry’s challenges are large, he says they are not insurmountable. “I think the industry will have to prove its worth,” he says. “And that’s a fee question, as well as answering why the industry wasn’t as protected in 2008 as everyone thought it was. If it can do that, there’s no reason growth can’t continue.” However, he
“You nd a nugget of information, an angle in the market you don’t think other people are doing, and it’s a real asset.”
adds: “But it’s a pretty high bar to clear.” As he notes, it’s not as if investing itself has died, just that a certain model may have fallen out of favor. “There will always be investing, it might just be other sectors
The portfolio Kroijer describes consists of globally diversified equity ETFs (he also suggests adding corporate and government
— whether it’s renewables, commodities, or whatever,” he says.
debt exposure), with downside risk potentially protected by deep
“It might not be called market-neutral special situations hedge
out-of-the-money (OTM) put options.
funds (the focus of his former fund ),” he says, laughing. “There’s
“For simplicity, I have started with equities only, and the
been massive growth in hedge funds, but at the same time, as big
allocation is driven by correlations — projected standard devia-
as people say the industry is, we’re not [as big as] banks, after
tions — and expected returns, which is driven by the standard
all.”
deviation,” he explains. “In a more advanced version, you would
Kroijer recounts taking part in a recent panel discussion about banks. Among the participants were representatives of UK-based banks, each of which Kroijer says had balance sheets comparable to the total world-wide assets of the hedge fund industry. “Just think about that,” he says. “There is room for growth.”
clearly include bonds and other asset classes.” Kroijer says a basic portfolio of this type could be put together using six or seven indices. “The number really depends on how accurate you want to be vs. the hassle of setting it up,” he notes. “The weightings would be set through the optimization process, although you would
Creating your own alternative investment
probably have some restrictions to avoid ‘corner solutions’ that
After illustrating how difficult it is for end investors to outper-
look nothing like the real world — such as Thailand being 98
form in a fund-of-funds situation, Kroijer concluded his book
percent of the equity portfolio.”
with thoughts on how to create a long-term investment portfolio
Kroijer points out the portfolio should be constructed accord-
with the potential to outperform the market while avoiding nasty
ing to an individual investor’s circumstances, with the overriding
episodes such as 2008-2009.
goal of acquiring the least-expensive exposure, factoring in taxes
60
www.activetradermag.com • March 2011 • ACTIVE TRADER
The end run of a fund
and trade fees. For some investors (again, he is thinking globally), futures may be preferable to ETFs, for example. He also mentions add-ons investors could use to further tailor the portfolio, such adjusting for their other investments — for example, avoiding a particular country’s stock index if all your other assets are in that country. “You should really set up a whole structure where the exposure is tailored to the underlying investor,” he says. “Some should do ETFs, some futures, some index funds, some individual stocks, etc.” Kroijer adds the option element is not essential to the model. “In fact, it’s highly likely you would end up not using options,” he says. “Statistically speaking, it rarely makes sense to do it systematically because it is far too expensive. The skew is huge and liquidity is not great. That point was more a theoretical one that you would love to have protection against correlations spiking in times of crises.” But don’t look for Kroijer to run his own hedge fund any time soon. “You know, it was just an amazing experience, but I don’t think I’ve missed it enough to want to go back to doing it,” he says. “I think it’s one of those things that you have to want as much as you’ve ever wanted anything, and put your whole heart into it. I can see how that might perhaps change one day, but for now, no. That’s why it’s worked out really well to be on the boards of some hedge funds — it’s not quite the same, but I do get some of the buzz.” ◆
Kroijer describes his former hedge fund, Holte Capital, as a market-neutral special-situations fund. He focused on nding trade opportunities through detailed analysis of company fundamentals most traders never get within a mile of uncovering, let alone understanding. “We did a mix of things: a fair amount of merger arbitrage and intercatalyzation trades (trading different share classes or holding structures ), as well as restructuring situations — debt restructuring, legal cases, or other transformative events. Another area we developed was multiple pair trades [between] industries — shipping and oil rigs, particularly.” The approach reected Kroijer’s interests and strengths. “I love doing stuff like that. You nd a nugget of information, an angle in the market you don’t think other people are doing, and it’s a real asset.” The rm’s run came to an end in 2007, triggered it part by a bad (but by no means disastrous) trade that triggered a modest drawdown and an initial large investor redemption. Kroijer made the decision to pull the plug. Within a span of ve months, he had voluntarily returned the last investor funds — early in 2008 before the nancial crises kicked into high gear. The initial trade lost about 4 percent, and several other trades ultimately pushed the drawdown to around 10 to 12 percent, which is when the rst redemption occurred. Holte had become known as a low-volatility fund, so this relatively tame drawdown likely caught investors a bit off guard. Although this episode unfolded after Holte had increased its leverage (something investors had been requesting “for ages”), it was still at fairly conservative levels, according to Kroijer. “My frustration was that we were essentially doing the same thing we always were, but toward the end were nally [leveraged] the way we probably should have been all along,” he says. “The point is, it probably should not have [caught our investors off guard], as we had been painstakingly communicating that we were taking leverage up. In reality, I think the redemptions had more to do with their interpretation that I did not have the appetite to continue — something a couple of them told me privately afterwards.” Indeed, after the initial loss, some of his investors, whom he also considered friends, took Kroijer aside and asked him if his heart was still in it. “There’s no doubt I was burnt out — I’d be the rst to say that — and if you read between the lines there were some issues at home also that weren’t great,” he says. “Those all played together to make it a good decision to call it a day when I did — which, I don’t know, might have been fortuitous timing.” (As mentioned in the rst installment of the interview, Kroijer actually found himself wishing he was in the market when the panic unfolded, curious to see how his fund would have held up.)
ACTIVE TRADER • March 2011 • www.activetradermag.com
61
THE TRADING BUSINESS Strategies of Trading
Handling IRS notices and exams If you nd yourself confronted with an IRS notice, learn how to proceed to avoid tax trouble.
BY ROBERT A. GREEN, CPA
R
ecently, the IRS has been making life more difficult for traders. In 2009, it announced major new tax-exam programs on the upper income. (Upper income is defined as those making more than $250,000 per year.) Those making more than $1 million per year face even more scrutiny. The IRS also announced closer examination of passthrough entities, C-corps, global businesses (on transfer pricing), and foreign offshore accounts. I’ve noticed another disturbing trend in IRS exams: the new computer-generated mail exam. In this case, IRS computers flag a taxpayer based on standard averages, and the computer generates an exam notice requesting tax documentation. These scary IRS notices force taxpayers to engage professionals at additional costs. Filing a tax return correctly with the right bells and whistles and fewer red flags is crucial for your 2010 tax returns.
What can you do? The first tip in dealing with the IRS is to get help before preparing your tax return. Adopt strategies to reduce red flags and explain your trader tax status and treatment in well-written footnotes accompanying the return. A proper trader tax return filed on time will generally not be questioned, except for those with large net operating loss (NOL) carrybacks, which tend to draw 62
IRS attention. Large NOLs based on weak trader tax status should be carried forward instead. In this more challenging IRS environment, I suggest all traders — especially part time, losing, and less-than-hyperactive full-time day traders — form an entity in order to file a separate entity-level tax return (with trader tax status) apart from their individual tax return. The IRS won’t be as skeptical about trader tax status on entity tax returns because W-2 wages are reported on separate individual tax returns. Traders get the shaft on using tax forms. Business trading expenses are reported on Schedule C (Profit or Loss from Business), but trading gains and losses go on different tax forms — Schedule D (cash method) or Form 4797 (MTM). Traders should tie the two tax schedules together with income transfers and explain trader tax status in footnotes. Historically, the IRS has higher audit rates for Schedule C businesses because many cash businesses under-report income. Business traders
All income is taxable and needs to be reported, whether or not a third-party reports it to the taxpayer. www.activetradermag.com • March 2011 • ACTIVE
TRADER
should use separate tax-filing entities such as partnerships, LLCs, and S-corps in lieu of Schedule C (sole proprietorships) to reduce this risk. Another important strategy for individual traders is to transfer trading gains to Schedule C to do away with a tax loss and show a break-even business. Net trading income on Schedule C invites questions on the self-employment (SE) tax. Some traders err in thinking they don’t have to file taxes, or that they can procrastinate. Perhaps they think their trading losses offset their other income, such as consulting fees. They may be counting on using ordinary trading loss treatment — based on qualification for trader tax status and a Section 475 MTM election — but this could present problems. If trader tax status and Section 475 MTM is denied, traders might only be allowed a $3,000 capital-loss limitation, which may lead to a significant amount of taxes owed. The new IRS rules call for a 100-percent penalty on the tax due. It’s more important than ever to deal with your tax matters on time.
If you’re a “good customer” —
meaning you have large trading gains and pay taxes on them — you can safely be a little more aggressive on business-expense treatment. Tax exam notices If the IRS or your state’s department of revenue contacts you with questions or a notice of tax due, or to schedule an exam, don’t panic or reply on your own. Consult a trader-tax professional and proceed under this person’s advice, either representing yourself (the inexpensive approach) or by engaging the expert as your tax representative, with power of attorney. Your direction should depend upon your financial resources and the complexity of your case. If you simply made an error on your tax return but you clearly qualify for trader tax status and elected Section 475 MTM on time, you may be able to fix things quickly with a little expert
ACTIVE TRADER
• March 2011 • www.activetradermag.com
advice. On the other hand, if you’re a close call on trader tax status and potentially messed up your MTM election or other matters, engage your trader tax expert to be your formal tax representative. In some cases, a CPA may decline to be your representative if he or she thinks you aren’t entitled to relief — perhaps because you clearly botched the MTM election.
Exam reconsideration Traders can reply to the IRS with a “reconsideration” request, asking the IRS to close its exam before it gets under way. If the exam was prompted because a trader filed a Schedule C with a loss even though the trader had trading gains in excess of expenses, the trader should be able to get the exam closed (assuming he or she easily qualifies for trader tax status). Other types of notices or exams can be closed with little work, too. The solution can be as simple as filing a corrected tax return with the proper tax treatment, i.e., filing Form 4797 rather than filing MTM losses incorrectly on Schedule C, and including a detailed footnote. IRS notices may include questions about business status. But these agents often use standard questions geared to assess “hobby-loss” treatment. Trader tax status requires the intention to run a business, thereby trumping the hobby-loss rules. Note the hobby-loss rules are part of Section 469 “passive activity loss” rules. Under the “trading rule” exception, a trading business is exempt from Section 469, which means an IRS agent can’t apply the hobby-loss rules to a trading business (with trader tax status). The reconsideration reply letter should state the exam isn’t necessary because of your facts and circumstances. Next, explain how you qualify for trader tax status. State that your business expenses are very low compared to other businesses. Make it clear you have no cash income (which is the IRS’s main focus point on small business exams) and that your 1099-B and supplemental information show all proceeds and many elements of net income. Demonstrate that you have good accounting for your securities transactions and more. Proceeding improperly can jeopardize ordinary-loss treatment, deny business expenses, and leave you with capital-loss treatment, which can increase your tax bill significantly. Inappropriate responses may also lead to stiffer penalties and less opportunity continued on p. 64
63
The Business of Trading
for penalty abatement requests.
Exams, appeals, and tax court If you’re faced with an exam, it’s smart to be represented by a trader tax CPA or tax attorney. You should have little to no contact with the IRS agents. Don’t meet the IRS agent in person or answer his or her questions directly. This is what a tax expert is for. Help your expert by providing all the information needed in an organized manner. If you have a difficult agent and supervisor in the exam process who refuse to understand the nuances of trader tax, it’s often wise to “agree to disagree” at the exam level and take your case to the next level — the appeals process. During an appeal, trader tax status and MTM treatment may be realized, provided you elected MTM on time. Sometimes, to negotiate an appeals agreement, it’s wise to accept disallowance of some business expenses so the IRS feels justified in its exam efforts; winning trader tax status and MTM is much more important. Appeals officers often focus on the big picture, such as trader tax status, and they may skip over expense items. The last resort is tax court — often an expensive and more grueling process than a tax exam. If you go to tax court, you must show you acted in one manner or another contemporaneously and that you didn’t change your position in hindsight, which costs the IRS a lot of money. A common example of this mistake is skipping a timely MTM election because of capital-loss carryovers, and later stating you elected MTM on time. The IRS will disallow MTM on technical grounds and easily win in tax court on this issue. There’s a legal procedure to file a MTM extension within six months of the original election due date. But this procedure is expensive and unlikely to win MTM. It involves the private letter
The IRS wants to raise tax revenue by nding more unreported income, rather than having to rely on Congress to raise tax rates or deny deductions. 64
ruling process, and to win you must demonstrate no hindsight or prejudice to the government and unusual and compelling circumstances. The IRS recently published streamlined methods for obtaining advanced approval on tax positions that may prove helpful.
Don’t be intimidated Yes, the IRS is a heavyweight, but don’t be intimidated. Traders are small businesses but they are non-cash businesses with few dollars in expenses, so you certainly shouldn’t be scared if you have a strong case for trader tax status. If you’re a “good customer” — meaning you have large trading gains and pay taxes on them — you can safely be a little more aggressive on business-expense treatment. Conversely, if you’re a “bad customer” — for example, a perennial money-losing or part-time trader — it’s wise to be more conservative, since the IRS may be more prone to deny your trader tax status. In this case, consider skipping a NOL carryback refund return. Rather, carry the NOL forward instead, when it will cause much less attention from the IRS. Or, try to absorb your ordinary loss with a Roth IRA conversion. If necessary, you may also consider other less attractive, but useful alternatives to trader tax status, such as trading in your retirement plans and deducting reasonable trading expenses within them.
Don’t let the IRS file your return If you trade securities, the IRS receives a 1099-B that shows only proceeds, and it will surely send a tax notice claiming all or most proceeds are income. That tax notice will have tens or hundreds of thousands of dollars in back taxes, plus interest and a full assortment of nasty penalties. Contact the IRS before it contacts you, enhancing your chances of reduced penalties. Interest is statutory and it can never be abated. File your late tax returns as soon as possible, reporting your capital losses correctly, thereby making your tax notice balance due disappear. Plus, you can then carry over capital losses to subsequent tax years, which isn’t possible unless you file the prior year tax returns. Don’t wait more than three years or it will be too late to apply these capital-loss carryovers. www.activetradermag.com • March 2011 • ACTIVE
TRADER
What’s new?
If you can’t pay your taxes on time, at least file on time and request an installment plan. You can make corrections later. Failing to file a tax extension (calculated in good faith) is a mistake because the “late filing” penalties are much higher than the “late payment” penalties. Be honest and forthright with the IRS; don’t ignore it. Forget about cheating on your taxes with offshore and tax-free state schemes. Remember, all foreign bank accounts over $10,000 at some point during a year also must be reported annually on Form TDF 90-22.1 due by June 30 of the following year. The IRS has a major program under way to catch offshore tax cheats. Also, keep in mind the penalty for not filing an income tax return has increased to the smaller of $135 or 100 percent of the unpaid tax.
Be honest and forthright with the IRS; don’t ignore it. Forget about cheating on your taxes with offshore and tax-free state schemes. Avoid bad advice The sad reality is a large percentage of active traders don’t handle their tax affairs properly, or they’re underserved by trusted “professionals.” A part-time accountant working in a locally branded tax storefront may not be qualified to deliver trader tax services. We have seen many cases where traders have gotten into tax trouble using a general tax store. Some of these firms offer audit guarantees, but they don’t pay back taxes or for a new CPA to fix things. That’s a hollow guarantee. The IRS recently proposed new standards for tax preparers to address what it perceives as too much bad advice coming from tax preparers who don’t have sufficient education or experience. The proposed tax preparers’ requirements include registration, competency tests, continued professional training, and complying with a set of ethical standards. CPAs are exempt because they already reach and exceed these standards, but most storefronts
ACTIVE TRADER
• March 2011 • www.activetradermag.com
While the old rules still apply to the 2010 tax-ling year, new legislation requires brokerage rms to beef up reporting on Form 1099-Bs for securities traders (which currently only report proceeds) in 2011. The new 1099-B rules require additional report- ing of average cost basis and short-term vs. long- term treatment on securities. As a result, the IRS will be able to double check net trading gain or loss reporting more easily. This 1099-B rule change may actually help trad- ers. In the event of noncompliance, the IRS nor- mally mails jeopardy tax bills to traders, discount- ing all missing cost basis information on 1099-Bs. These 1099-B rule changes are part of a major new IRS initiative to close the tax gap. It wants to nd more unreported income, thereby raising tax revenue, without relying on Congress to raise tax rates or deny deductions. The tax-compliance gap in this country is too high; to close it, the IRS is compelling agents to report more income information on Form 1099s. The IRS can then match 1099-B (and other tax information docu- ments such as W-2, K-1, and more) to tax returns, thereby nding tax cheats or inadvertent errors. Also, the 2010 health-care legislation included a controversial new rule requiring 1099s for all business payments more than $600. That could be reversed in 2011, before its effective date in 2013. and many enrolled agents don’t. In the end, far too many active traders miss out on trader tax benefits — they don’t deduct allowable business expenses or elect and use ordinary-loss treatment on time. They overpay their taxes and don’t receive the tax refunds they’re entitled to. Even when they do most things right, they file a return with a red flag, causing an IRS and/or state exam. You need an experienced trader tax expert in your corner from day one to handle this challenging IRS environment. ◆ For information on the author, see p. 8.
65
THE Economy
U.S. economic briefing FED LEAVES RATES UNCHANGED
FIGURE 1: QUARTERLY GDP PERFORMANCE
Minutes: Federal Open Market Committee Date and time: Dec. 14 at 2:15 p.m. Summary: While the FOMC stated the
economic recovery had continued through its December meeting, there was little else positive noted. The current environment is still hampered by high unemployment, which constrains household spending, and tight credit. “Employers remain reluctant to add to payrolls,” the committee said in its statement. “The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.” The committee announced it would once again hold the target range for the federal funds rate at zero to 0.25 percent. The following tables compare the S&P 500’s daily and weekly responses to economic releases as well as historical behavior since 1997 (or earlier). The S&P rallied only slightly after the FOMC’s announcement, but gained 0.53 percent over the following five days.
Q3 2010 marked the fth st raight month of economic growth since the economic downturn, which began in 2008. Source: Bureau of Economic Analysis
FIGURE 2: PAYROLLS VS. UNEMPLOYMENT RATE
RATE CHANGES
Report day Five days later
S&P 500 reaction
Historical moves since 1994
0.09%
0.35%
0.53%
Non-farm payrolls increased at a slower-than-expected rate, but unemployment dropped. Source: Bureau of Labor Statistics
Seasonally adjusted
0.44%
FIGURE 3: OVERALL VS. “CORE” INFLATION GDP GROWTH CONTINUES IN Q3 Report
Gross domestic product for Q3 2010 (Third)
Date/time
Dec. 22 at 8:30 a.m.
Actual
2.6%
Previous
2.5%
Consensus
2.7%
S&P 500 reaction
Historical moves since 1994
Report day
0.34%
0.03%
Five days later
0.41%
0.34%
66
Price levels remained mostly unchanged year-over-year, except for PPI, which dropped 0.8 percent to 3.5 percent. Source: Bureau of Labor Statistics
Not seasonally adjusted
www.activetradermag.com • March 2011 • ACTIVE
TRADER
PPI MAKES UNEXPECTED JUMP Report
Consumer Price Index (CPI)
Date/time
Dec. 15 at 8:30 a.m. 0.1% (core 0.1%)
Actual Previous
0.2% (core 0.0%)
Consensus
0.2% (core 0.1%)
CPI
S&P 500 reaction
Historical moves since ‘80
Report day
-0.51%
0.08%
Five days later
1.05%
0.14%
FIGURE 4: ISM MANUFACTURING INDEX
Report
Producer Price Index (PPI)
Date/time
Dec. 14 at 8:30 a.m. 0.8% (core 0.3%)
Actual Previous
0.4% (core -0.6%)
Consensus
0.5% (core 0.2%)
PPI
S&P 500 reaction
Historical moves since ‘94
Report day
0.09%
0.05%
Five days later
0.53%
0.31%
Despite falling slightly over the summer months, manufacturing sentiment remained high in 2010. Source: Institute of Supply Management
FIGURE 5: S&P 500
After an erratic November, the S&P gained throughout much of December and into the new year.
ISM ENDS STRONG IN 2010 ISM manufacturing index
Report Date/time
Jan. 3 at 10 a.m. 57.0
Actual Previous
56.6
Consensus
57.3
Seasonally adjusted
Source: eSignal
S&P 500 reaction
Historical moves since 1997
Report day
1.13%
0.28%
Five days later
1.10%
0.28%
FIGURE 6: MARKET REACTION TO ECONOMIC REPORTS EMPLOYMENT RECOVERY SHOWS SLOW PACE Employment
Report Date/time
Jan. 7 at 8:30 a.m.
Non-farm payrolls Actual
113K
Previous
79K
Consensus
162K
Unemployment rate Actual
9.4
Previous
9.8
Consensus
9.7
S&P 500 reaction
Historical moves since ‘94
Report day
-0.18%
0.13%
Five days later
0.78%
-0.08%
ACTIVE TRADER
The S&P gained just over 1 percent on the release of the ISM report, during the rst trading day of 2011.
• March 2011 • www.activetradermag.com
67
STOCKS Snapshot All Snapshots are as of Jan. 4. Active Trader’s Snapshot tables summarize the trading activity in the most actively traded stocks, ETFs, and futures. The informa- tion does NOT constitute trade signals. It is intended only to provide a synopsis of each market’s liquidity, direction, and levels of momentum and volatility.
STOCK
SYMBOL
VOLUME
Positive one-year performance Las Vegas Sands LVS 31.64 M Apple AAPL 12.18 M Hecla Mining HL 13.7 0 M Ford Motor F 55.55 M MGM Resor ts Inter nation al MGM 27.4 3 M Fifth Third Bancor p FITB 12.6 0 M Comcast CMCSA 15.35 M EMC EMC 14.02 M Oracle ORCL 27.29 M eBay EBAY 11.50 M Halliburton Company HAL 10.82 M Altria Group MO 10.90 M The Home Depot HD 11.25 M Verizon Communications VZ 15.33 M Vale VALE 15.85 M General Electric GE 55.11 M Taiwan Semiconductor TSM 1 1.33 M Weatherford Intl Ltd. WFT 11.88 M US Bancorp USB 11.28 M AT&T T 20.51 M Wells Fargo WFC 27.66 M Exxon Mobil XOM 18.95 M News Corp. NWSA 10.62 M QUALCOMM QCOM 11.48 M Lowe's LOW 13.72 M Intel INTC 43.38 M Wal-Mart WMT 11.29 M Negative one-year performance Banco Santander STD 10.81 M Petroleo Brasileiro SA PBR 16.45 M Nokia NOK 16.47 M Seagate Technology STX 10.41 M Hewlett-Packard HPQ 17.79 M Cisco Systems CSCO 62.25 M Bank of America BAC 185.93 M NVIDIA NVDA 12.77 M Mar vell Technology Gro up MR VL 10.50 M Morgan Stanley MS 11.64 M Research In Motion RIMM 11.02 M Chesapeake Energy Corp. CHK 11.66 M Microsoft MSFT 49.16 M Dell DELL 18.30 M Merck MRK 13.91 M Pfizer PFE 37.45 M Corning GLW 11.24 M JPMorgan Chase JPM 30.65 M Johnson & Johnson JNJ 10.14 M Yahoo YHOO 13.35 M Alcoa AA 22.53 M Annaly Capital Management NLY 13.04 M Applied Materials AMAT 10.67 M
68
1-YEAR RETURN
10-DAY MOVE / RANK
20-DAY MOVE / RANK
60-DAY MOVE / RANK
VOLATILITY RATIO / RANK
158.00% 57.32%
0.53% / 33% 2.82% / 85%
-2.63% / 5% 3.48% / 33%
27.96% / 35% 12.66% / 39%
.13 / 13% .10 / 23%
57.12 % 49.06%
-3.23 % / 100% 3.15% / 84%
-4 .81% / 10 0% 4.38% / 24%
56.65% / 56% 27.23% / 62%
.14 / 20 % .11 / 23%
42.0 4% 32.9 4%
6.97% / 3 0% 4 .03% / 2 5%
15.60 % / 69% 13.13% / 80%
13.13% / 18% 18.98% / 82%
.14 / 7 % .19 / 0%
32.25% 31.55%
2.34% / 26% 1.27% / 30%
8.93% / 67% 5.05% / 67%
24.75% / 99% 16.26% / 89%
.09 / 2% .06 / 2%
29.12% 22.56%
-0.62% / 100% -3.75% / 36%
9.56% / 61% -3.44% / 62%
12.43% / 28% 15.68% / 30%
.05 / 0% .08 / 0%
21.77% 21.59% 19.06%
-1.49% / 63% -3.10% / 100% -1.51% / 100%
-3.11% / 27% 1.41% / 13% 3.99% / 35%
13.88% / 28% -0.49% / 50% 8.72% / 23%
.12 / 18% .30 / 85% .09 / 13%
17.11% 14.99%
6.97% / 90% 6.42% / 80%
12.98% / 100% 4.55% / 55%
13.19% / 81% 11.31% / 34%
.36 / 87% .29 / 82%
14.52% 1 3.68%
5.14% / 40% 2.43 % / 21%
11.44% / 72% 6. 22% / 41%
8.70% / 56% 21.9 1% / 90%
.19 / 8% .1 4 / 3%
12.56% 10.72%
-0.49% / 50% 2.37% / 0%
1.10% / 6% 8.56% / 56%
25.44% / 67% 19.95% / 80%
.12 / 2% .10 / 0%
9.45% 8.65%
2.57% / 72% 5.15% / 50%
5.58% / 100% 10.12% / 69%
5.88% / 39% 21.97% / 88%
.30 / 83% .13 / 2%
7.31% 7.07%
3.71% / 80% 3.88% / 80%
5.03% / 37% 5.40% / 76%
16.34% / 56% 8.00% / 55%
.14 / 23% .26 / 43%
4.06% 3.89%
3.09% / 74% -3.91% / 100%
5.48% / 58% -1.05% / 16%
13.87% / 40% 8.19% / 40%
.11 / 45% .20 / 27%
2.67% 2.18%
-0.38% / 0% 1.86% / 100%
-2.53% / 70% 0.51% / 18%
8.35% / 21% 0.66% / 10%
.09 / 0% .33 / 100%
-37.87%
0.95% / 0%
-1.57% / 3%
-18.54% / 89%
.13 / 0%
-23.28% -18.47% -18.07%
8.99% / 82% 9.70% / 100% 0.61% / 8%
6.82% / 71% 9.37% / 69% -0.47% / 12%
6.63% / 84% 0.28% / 1% 21.15% / 20%
1.04 / 97% .32 / 67% .08 / 0%
-16.42% -16.35%
4.15% / 100% 4.59% / 94%
1.82% / 19% 5.62% / 40%
6.03% / 41% -8.72% / 58%
.36 / 90% .23 / 55%
-15.89% -14.80%
12.84% / 84% 10.20% / 93%
22.34% / 100% 8.66% / 37%
8.04% / 100% 45.21% / 96%
.49 / 83% .18 / 22%
-14. 20% -13 .52%
- 4.88% / 65% 8.42 % / 89%
-10.46 % / 100% 11 .47% / 97 %
8.0 6% / 35% 12. 44% / 98%
.1 8 / 13% .4 6 / 50%
-9.49% -8.70%
1.06% / 0% 3.39% / 11%
-6.68% / 89% 16.27% / 81%
19.73% / 45% 13.75% / 88%
.06 / 2% .24 / 0%
-7.76% -7.01%
1.00% / 11% 2.45% / 70%
4.65% / 47% -0.09% / 0%
14.32% / 91% -0.02% / 0%
.09 / 0% .11 / 3%
-3.63% -2.92%
-0.41% / 17% 4.77% / 85%
3.12% / 62% 7.01% / 97%
-1.52% / 34% 3.03% / 19%
.12 / 0% .29 / 80%
-2.55% -1.41%
0.79% / 10% 10.54% / 100%
2.03% / 24% 10.66% / 86%
3.81% / 18% 12.34% / 100%
.10 / 0% .46 / 25%
-1.00% -0.65%
1.38% / 88% 1.90% / 42%
1.85% / 39% 1.60% / 23%
0.19% / 0% 14.50% / 21%
.23 / 78% .08 / 0%
-0 .54% -0.34% -0.29%
11.8 5% / 100 % -4.98% / 100% 2.72% / 0%
1 6.05% / 9 5% -4.51% / 100% 7.30% / 62%
28 .16% / 87 % -2.03% / 71% 18.19% / 56%
. 29 / 50% .85 / 100% .07 / 0%
www.activetradermag.com • March 2011 • ACTIVE TRADER
ETF Snapshot ETF
SYMBOL
LEVERAGE
INVERSE
VOL.
1-YEAR RETURN
10-DAY MOVE / RANK
20-DAY MOVE / RANK
60-DAY MOVE / RANK
VOLATILITY RATIO / RANK
27.05 M 7.97 M 3.72 M 8.19 M 5.36 M 42.82 M 10.01 M 9.46 M 14.08 M 4.96 M 8.04 M 7.96 M 52.44 M 10.54 M 5.67 M 15.67 M 11.9 3 M 6.34 M 51.75 M 6.71 M 7.44 M 135.48 M 2 0.94 M 5.93 M 4.84 M 4.57 M 64.67 M 13.20 M 12.22 M 16.75 M 4.97 M 27.09 M 13.90 M 5.20 M
62.55% 56.80% 38.59% 30.60% 23.82% 22.21% 21.98% 21.81% 21.59% 21.53 % 20.54% 20.20% 19.70 % 17.65% 16.99% 15.04% 13 .79% 12.87% 12.74% 11.71% 11.67% 11.20% 10.20 % 10.10% 9.79% 7.29% 6.30% 5.29% 4.69% 3.03% 2.88% 1.75% 0.94% 0.50%
1.29% / 11% 1.54% / 0% 2.43% / 25% -0.21% / 0% 0.16% / 0% 0.12% / 0% 3.80% / 35% 1.56% / 35% -0.27% / 0% 5.22 % / 100% 1.81% / 50% -2.56% / 60% 1.2 9% / 32% 2.85% / 45% 1.02% / 38% 3.70% / 75% 2.79% / 4 5% 5.69% / 50% 4.62% / 93% 1.87% / 65% 2.07% / 10% 1.91% / 45% 2.70 % / 75% 1.65% / 65% -0.20% / 50% -0.19% / 100% 4.73% / 65% 8.10% / 100% 0.41% / 20% 1.42% / 50% 1.43% / 79% 12.72% / 70% 4.49% / 100% 0.73% / 13%
-1.46% / 100% 10.48% / 20% 5.64% / 34% -0.50% / 100% 0.48% / 2% 3.00% / 10% 8.00% / 63% 3.09% / 43% -3.13% / 100% 2.81% / 30% 0.85% / 5% -7.49% / 100% 2.64% / 34% 4.64% / 59% 0.31% / 3% 2.13% / 31% 3. 23% / 2% 11.11% / 81% 2.68% / 39% 3.06% / 27% 3.75% / 41% 3.44% / 45% 3.14% / 58% 2.55% / 46% 1.84% / 33% 2.59% / 33% 7.39% / 85% 4.26% / 67% -2.82% / 29% 2.40% / 25% 1.43% / 66% 19.75% / 82% 1.01% / 0% 3.24% / 75%
27.94% / 40% 43.83% / 45% 23.35% / 38% 11.60% / 10% 9.55% / 19% 13.20% / 45% 19.25% / 55% 8.93% / 40% 2.35% / 17% 4.9 9% / 11% 2.76% / 16% 3.00% / 10% 11. 09% / 36% 13.92% / 78% 15.46% / 42% 3.98% / 8% 1 6.81% / 5 7% 12.29% / 87% 4.52% / 10% 9.70% / 52% 12.32% / 62% 8.96% / 53% 7.72 % / 64% 5.88% / 43% 3.83% / 24% 8.91% / 47% 10.71% / 95% 2.49% / 7% -10.27% / 63% 2.90% / 6% -0.68% / 35% 29.14% / 90% -0.26% / 6% 3.64% / 26%
.16 / 20% .08 / 0% .08 / 7% .08 / 7% .06 / 13% .06 / 2% .10 / 0% .05 / 0% .25 / 43% .24 / 7 7% .28 / 42% .23 / 28% .07 / 15% .28 / 65% .03 / 0% .28 / 68% . 11 / 10% .24 / 10% .28 / 68% .08 / 17% .09 / 0% .09 / 2% .24 / 3 8% .09 / 13% .06 / 3% .12 / 7% .23 / 10% .47 / 100% .13 / 0% .14 / 28% .28 / 55% .27 / 12% .27 / 53% .11 / 12%
16 .17 M 3.93 M 25.64 M 4 .39 M 4.18 M 9.49 M 20.77 M 16.69 M 6.79 M 4.37 M
-65. 72% -47.61% -46.03% -45 .96% -4 4.06% -39.68% -30.04% -26.07% -6.48% -0.52%
-2 .39% / 0% -1.50% / 0% -12.19% / 65% - 5.41% / 3 0% - 5.65% / 35% -2.76% / 35% -3.71% / 35% -1.94% / 57% 0.08% / 0% -1.55% / 50%
-10.7 6% / 12% -7.29% / 15% -18.08% / 86% -10 .83% / 47 % -1 1.16% / 5 3% -5.76% / 37% -7.64% / 56% 3.88% / 25% -0.37% / 14% -0.48% / 7%
-3 5.23% / 4 7% -24.70% / 48% -28.58% / 93% - 26.33% / 57% - 25.56% / 56% -20.69% / 38% -17.56% / 56% 18.11% / 58% 5.34% / 45% 2.14% / 93%
.03 / 0% .03 / 0% .13 / 7% .05 / 0 % .05 / 0% .05 / 8% .06 / 2% .21 / 15% .17 / 12% .32 / 88%
Positive one-year performance iShares Silver Trust Small Cap Bull 3x Shares Ultra QQQ ProShares S&P Select Retail SPDR Fund S&P Select Cons. Disc. SPDR iShares Russell 2000 Index Trust ProShares Ultra S&P 500 S&P Select Industrial SPDR Fund SPDR Gold Trust iShares MSCI Hong Kong Index iShares DJ US Real Estate Index Market Vectors Gold Miners ETF PowerShares QQQ Trust iShares MSCI Taiwan Index Semiconductor HOLDRS Vanguard Emerging Mkts ETF S&P Select Energy SPDR Fund SPDR KBW Bank iShares MSCI Emerging Market S&P Select Tech. SPDR Fund S&P Select Materials SPDR Fund S&P Depository Receipts iShares MSCI Japan Index Fund Diamonds Trust S&P Select Con. Staples SPDR S&P Select Homebuilders SPDR S&P Select Financials SPDR iShares MSCI Brazil Index Fund iShares Barclays 20+ Yr T-Bond iShares MSCI EAFE Index Trust S&P Select Utilities SPDR Fund Financial Bull 3x Shares iShares FTSE/Xinhua China 25 S&P Select Health Care SPDR
SLV TNA QLD XRT XLY IWM SSO XLI GLD EWH IYR GDX QQQQ EWT SMH VWO XLE KBE EEM XLK XLB SPY EWJ DIA XLP XHB XLF EWZ TLT EFA XLU FAS FXI XLV
3x 2x
2x
3x
Negative one-year performance Small Cap Bear 3 X Shares UltraShort Russ. 2000 ProShares Financial Bear 3x Shares Large Cap Bear 3x Shares ProShrs UltraPro Short S&P500 UltraShort QQQ ProShares UltraShort S&P 500 ProShares UltraShort 20+ Yr Tr. ProShares United States Oil Fund PowerShrs DB USD Indx Bullish
TZA TWM FAZ BGZ SPXU QID SDS TBT USO UUP
3x 2x 3x 3x 3x 2x 2x 2x
Leverage: “2x” = double leverage; “3x” = triple leverage. Volume: 30-day average daily volume. 1-year return: The percentage price move from the close one year ago (250 trading days) to today’s close. 10-day move: The percentage price move from the close 10 days ago to today’s close. 20-day move: The percentage price move from the close 20 days ago to today’s close. 60-day move: The percentage price move from the close 60 days ago to today’s close. The “Rank” fields for each time window (10-day moves, 20-day moves, etc.) show
yes yes yes yes yes yes yes yes
the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direc - tion. For example, the “Rank” for 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the “Rank” eld shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the “Rank” eld shows how the most recent 60-day move compares to the past one-hundred- twenty 60-day moves. A reading of 100 percent means the current reading is larger
ACTIVE TRADER • March 2011 • www.activetradermag.com
than all the past readings, while a reading of 0 percent means the current reading is smaller than all previous readings. These figures provide perspective for determin- ing how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the short-term volatility (10-day standard devia - tion of prices) divided by the long-term volatility (100-day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.
69
FUTURES Snapshot MARKET
SYMBOL EXCHANGE
VOLUME
OPEN INTEREST
10-DAY MOVE / RANK
20-DAY MOVE / RANK
60-DAY MOVE / RANK
VOLATILITY RATIO / RANK
E-Mini S&P 500
ES
CME
1.49 M
2.38 M
1.93% / 40%
3.54% / 52%
9.03% / 54%
.08 / 0%
10-yr. T-note 5-yr. T-note
TY FV
CME CME
960.1 484.1
1.26 M 946.4
0.06% / 0% 0.02% / 0%
-2.44% / 56% -1.68% / 47%
-5.51% / 97% -3.29% / 96%
.16 / 10% .18 / 20%
EUR/USD 30-yr. T-bond
EC US
CME CME
302.6 265.3
162.3 518.5
1.43% / 57% 0.72% / 25%
-0.14% / 6% -3.18% / 52%
-4.34% / 91% -9.69% / 88%
.24 / 70% .15 / 7%
Crude oil Eurodollar*
CL ED
CME CME
270.2 247.4
279.0 801.6
0.01% / 0% 0.06% / 29%
0.00% / 0% -0.13% / 41%
8.13% / 41% -0.20% / 83%
.13 / 8% .53 / 95%
E-Mini Nasdaq 100 2-yr. T-note
NQ TU
CME CME
192.5 206.4
335.0 612.8
1.14% / 21% 0.03% / 40%
2.51% / 32% -0.05% / 13%
11.12% / 36% -0.13% / 67%
.07 / 5% .44 / 68%
Corn Gold 100 oz. E-Mini Russell 2000
C GC TF
CME CME CME
127.2 132.8 91.7
644.3 323.5 308.1
1.50% / 0% -0.53% / 29% 0.62% / 0%
7.11% / 10% -2.63% / 100% 3.15% / 17%
15.18% / 26% 2.49% / 20% 13.14% / 41%
.13 / 18% .27 / 52% .06 / 0%
Natural gas JPY/USD
NG JY
CME CME
117.2 102.5
140.0 108.2
10.20% / 91% 2.15% / 67%
4.03% / 24% 0.80% / 3%
27.88% / 98% 0.10% / 2%
.71 / 100% .60 / 95%
Mini Dow GBP/USD
YM BP
CME CME
79.6 88.8
76.8 77.5
1.89% / 75% 0.50% / 40%
2.34% / 39% -0.92% / 14%
6.14% / 44% -2.31% / 68%
.09 / 5% .34 / 47%
AUD/USD Soybeans
AD S
CME CME
79.2 86.3
110.2 194.5
1.29% / 56% 4.12% / 37%
0.66% / 18% 6.29% / 31%
1.82% / 2% 20.65% / 72%
.24 / 65% .19 / 18%
CAD/USD Silver 5,000 oz.
CD SI
CME CME
69.8 58.1
96.3 71.2
1.86% / 87% 0.52% / 0%
0.34% / 23% -0.76% / 0%
1.36% / 23% 27.71% / 41%
.52 / 63% .18 / 23%
Wheat Sugar
W SB
CME ICE
40.8 41.0
202.2 235.3
2.57% / 20% -4.62% / 100%
-0.48% / 0% 5.08% / 0%
9.73% / 25% 23.21% / 10%
.24 / 42% .29 / 60%
Soybean oil CHF/USD
BO SF
CME CME
44.8 38.9
88.5 41.1
3.40% / 40% 1.69% / 30%
6.18% / 30% 3.42% / 45%
21.94% / 50% 1.46% / 3%
.14 / 8% .41 / 95%
RBOB gasoline Heating oil
RB HO
CME CME
38.2 40.6
58.9 68.0
1.52% / 11% 0.68% / 11%
3.09% / 13% 1.24% / 7%
11.48% / 37% 9.84% / 42%
.10 / 0% .11 / 8%
Copper Soybean meal
HG SM
CME CME
27.7 25.5
98.7 48.2
3.88% / 15% 4.64% / 53%
9.01% / 69% 6.15% / 44%
15.75% / 40% 16.32% / 88%
.22 / 43% .29 / 40%
U.S. dollar index MXN/USD E-Mini S&P MidCap 400
DX MP ME
ICE CME CME
18.0 25.7 20.6
25.9 122.1 95.0
-1.57% / 50% 1.47% / 100% 0.52% / 0%
0.13% / 0% 0.59% / 13% 2.90% / 10%
2.62% / 78% 1.50% / 19% 12.55% / 50%
.33 / 90% .20 / 17% .05 / 2%
S&P 500 index Live cattle
SP LC
CME CME
24.4 9.2
277.7 51.7
1.94% / 40% 3.31% / 50%
3.53% / 52% 2.71% / 41%
9.02% / 54% 11.12% / 94%
.08 / 0% .59 / 85%
Lean hogs Coffee
LH KC
CME ICE
9.8 8.6
57.9 88.8
1.61% / 0% 4.28% / 13%
13.09% / 91% 14.72% / 83%
3.72% / 56% 35.46% / 93%
.24 / 43% .25 / 18%
Nikkei 225 index Cocoa
NK CC
CME ICE
8.9 8.4
39.9 70.0
1.21% / 50% -0.64% / 25%
2.36% / 33% -0.10% / 0%
8.14% / 58% 7.01% / 70%
.14 / 17% .43 / 53%
Crude oil e-miNY NZD/USD
QM NE
CME CME
7.3 6.8
4.1 26.0
0.00% / 0% 3.48% / 57%
0.00% / 0% 0.22% / 0%
8.14% / 43% 1.84% / 17%
.13 / 8% .59 / 90%
Mini-sized gold E-Mini EUR/USD
YG ZE
CME CME
4.6 5.0
3.6 4.3
-0.35% / 14% 1.43% / 57%
-3.14% / 100% -0.14% / 6%
1.90% / 18% -4.34% / 91%
.26 / 47% .24 / 70%
Mini-sized silver Fed Funds**
YI FF
CME CME
4.3 2.5
3.2 36.8
1.51% / 11% 0.00% / 0%
-1.23% / 100% - 0.01% / 55%
28.03% / 40% -0.0 3% / 88%
.16 / 22% . 00 / 0%
Nasdaq 100 Natural gas e-miNY
ND QG
CME CME
1.8 2.1
15.6 4.7
1.14% / 21% 10.27% / 91%
2.51% / 32% 4.01% / 24%
11.12% / 36% 27.95% / 98%
.07 / 5% .71 / 100%
Feeder cattle Dow Jones Ind. Avg.
FC DJ
CME CME
2.0 0.5
11.6 5.8
0.23% / 0% 1.89% / 75%
2.11% / 24% 2.34% / 38%
12.32% / 100% 6.14% / 44%
.10 / 0% .09 / 3%
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based on pit-traded contracts. Volume figures are for the most-active contract month in a particular market and may not reflect total volume for all contract months. *Average volume and open interest based on highest-volume contract (December 2011). **Average volume and open interest based on highest-volume contract (March 2011). This information is for educational purposes only. Active Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Active Trader assumes no responsibility for the use of this information. Active Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.
70
www.activetradermag.com • March 2011 • ACTIVE TRADER
KEY Concepts Momentum (or “price momentum”): A generic term used to de-
Variance and standard deviation: Variance measures how spread
scribe the rate at which price changes, as well as the name of a specific calculation. Rate of change (ROC) is simply an alternate version of this basic indicator. The implications and interpretations of these two studies are identical. Momentum/ROC are similar to oscillators, such as the relative strength index (RSI) and stochastics, in that they are generally intended to highlight shorter-term price momentum extremes (overbought or oversold points). The most common calculation for momentum is simply today’s price (typically the closing price) minus the price n days ago: (Ptoday – Pn days ago). The most basic ROC formula is today’s price divided by the price n days ago: (Ptoday /Pn days ago). Alternate calculations for rate of change are 100*(Ptoday /Pn days ago) or (Ptoday – Pn days ago )/Pn days ago. Except for scaling, the resulting momentum and ROC indicators are the same; momentum simply expresses price change as the difference between two prices, while ROC expresses price change as a percentage or ratio.
out a group of values are — in other words, how much they vary. Mathematically, variance is the average squared “deviation” (or difference) of each number in the group from the group’s mean value, divided by the number of elements in the group. For example, for the numbers 8, 9, and 10, the mean is 9 and the variance is:
Sharpe ratio: Average return divided by standard deviation of
returns (annualized).
{(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = 0.667 Now look at the variance of a more widely distributed set of numbers: 2, 9, and 16: {(2-9)2 + (9-9)2 + (16-9)2}/3 = (49 + 0 + 49)/3 = 32.67 The more varied the prices, the higher their variance — the more widely distributed they will be. The more varied a market’s price changes from day to day (or week to week, etc.), the more volatile that market is. A common application of variance in trading is standard deviation, which is the square root of variance. The standard deviation of 8, 9, and 10 is: sq. rt. 0.667 = .82; the standard deviation of 2, 9, and 16 is: sq. rt. 32.67 = 5.72. ◆
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news providers. Interactive Data Corporation has released eSignal 11, a redesigned version of the core eSignal software. The new version features an improved intuitive interface that allows users to focus entirely on market analysis and trading and offers a range of customization options. Users can choose from among a variety of colors and default settings for menus and toolbars, or create or import their own themes. Tabbed, multi-page functionality allows users to move between the data sets essential to trading style. Users worldwide can access support in their native languages. Company profiles, financials, earnings estimates, analyst ratings and other key information can be viewed in a single window. New capabilities enable viewing, sorting, and scanning for opportunities while in a Watch List, as well as displaying technical indicators, and pre-built and customized studies from the eSignal Formula Script (EFS) library. The new Trade Manager allows users to view current market depth and enables single-click trading to place or modify orders. Users can develop multi-level money management strategies with customized combinations of profit and protective stop orders, including break-even and trailing stops. For a complete list of eSignal features, please visit www.esignal.com/esignal or call 510-723-1765. ◆ 71
TRADER’S Bookshelf
Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading
Peter L. Brandt Hardcover, 304 pages John Wiley & Sons Using a diary format, Brandt provides a play-by-play of 21 weeks of his 2009 trading, revealing what the experience was like and “communicating the uncertainty that surrounds every trade and the discipline required to make tough decisions in the face of losing money.” The author also touches upon his philosophy of speculation, market analysis, trade identification and selection, risk management, and the methods and rules he has used to trade successfully. Each trade includes charts, an analysis of the trade, and a detailed account of how it unfolded.
Perry J. Kaufman Hardcover, 320 pages John Wiley & Sons How do you make profitable trades when there are no obvious trends? This book addresses the realities of trading “when markets make no sense, when price shocks cause diversification to fail, and when it seems impossible to hedge[.]” Author and trading system developer Perry Kaufman presents strategies and systems for profitably trading in directionless markets, as well as those experiencing constant price shocks. Among its topics, the book details how to exploit new highs and lows, hedge primary risk components, find robustness, and craft a diversification program.
Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market into a Casino
TradeStation Made Easy: Using EasyLanguage to Build Profits with the World’s Most Popular Trading Software
Jim McTague Hardcover, 264 pages FT Press
Sunny J. Harris Paperback, 744 pages John Wiley & Sons
This book starts with the premise that “equity markets are now high-speed casinos rigged against individual investors.” The author, Barron’s Washington editor Jim McTague, writes about the “twin causes”: high-frequency traders and blundering regulators. The book dissects why the Flash Crash happened, and why it will happen again, and explores “rational strategies for profiting in this terrifying new environment.” Trader’s Bookshelf is a forum to announce new trading and financial books. Listings are adapted from company press releases and are not endorsements or recommendations from the Active Trader Magazine Group. E-mail press releases to:
[email protected]. Publication is not guaranteed.
72
Alpha Trading: Profitable Strategies That Remove Directional Risk
Endorsed by TradeStation Technologies, the book’s goal is to cover the essence of programming in TradeStation’s EasyLanguage and provide an easily understood guide to TradeStation that also provides tips for the user in designing a personalized trading system. Noting that TradeStation’s computer language can be “confusing, especially for the novice,” the author focuses on a consistent set of data and an elementary system throughout. Putting the basics of EasyLanguage in perspective, and accessible even to those with little computer experience, the book is designed to enable users to write simple and intermediate programs “that will accurately express your theories and ideas about whatever market interests you.”
Attacking Currency Trends: How to Anticipate and Trade Big Moves in the Forex Market
Greg Michalowski Hardcover, 304 pages John Wiley & Sons A guide for reading long-term trends in the foreign currency market, the book argues that to thrive in the marketplace, traders must “anticipate, enter, and stay with trends in the foreign exchange market.” The author explains the attributes of successful traders and discusses the tools and techniques traders need to read the markets and identify when a market is in a trend. Trade entry, position management, and exit techniques are also explored. Technical tools discussed include moving averages, trendlines, and Fibonacci levels.
Technical Analysis For Dummies, 2nd Edition
Barbara Rockefeller Paperback, 360 pages John Wiley & Sons Since the publication of the first edition of Technical Analysis For Dummies, readers have been faced with many changes to the investment landscape, such as new interest rates, looming bank crises, and adjusting market climates. This updated edition includes information on the new indicators, handson applications for real-world situations, as well as practical examples to help investors make better trading decisions. Rockefeller goes beyond the fundamentals and helps readers spot investment trends and turning points, determine how markets are performing and make decisions using real data, and improve profits and portfolio performance. ◆
www.activetradermag.com • March 2011 • ACTIVE
TRADER
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ACTIVE TRADER • March 2011 • www.activetradermag.com
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75
TRADING Calendar
March
LEGEND CME: Chicago Mercantile Exchange
CPI: Consumer price index
1
ECI: Employment cost index FDD (first delivery day): The rst day on which delivery of a commodity in fulllment of a
2
Q4 productivity and costs February ISM non-manufacturing report
4
February employment report LTD: March forex options; April cocoa options and March U.S. dollar index options (ICE)
FND (first notice day): this is the rst day on which a clearinghouse can give notice to a buyer of a futures contract that it intends to deliver a
5 6 7
commodity in fulllment of a futures contract. The
8
clearinghouse also informs the seller.
FOMC: Federal Open Market
9 10
Committee
GDP: Gross domestic product ISM: Institute for Supply Management
LTD (last trading day): The
11
14
January trade balance January business inventories February retail sales LTD: March orange juice futures (ICE); April coffee options (ICE)
LTD: March corn, wheat, soybeans, soybean products, oats, and
rough rice futures (CME); March forex futures
16
17
February CPI, production and capacity utilization, and leading indicators March Philadelphia fed survey LTD: April crude oil options (CME); March index futures (CME); March index and equity options
A day where equity options,
18 76
January wholesale inventories LTD: March cotton futures (ICE)
February PPI and housing starts FND: March lumber futures (CME) FDD: March lumber futures (CME); March forex futures LTD: April platinum options (CME); March cocoa futures (ICE)
Quadruple witching Friday:
and index futures all expire.
(CME); March orange juice futures (ICE)
15
index
equity futures, index options,
FDD: March heating oil, RBOB gasoline, and pork bellies futures
FOMC interest-rate announcement FND: March U.S. dollar index futures (ICE) LTD: March lumber futures (CME)
PMI: Purchasing managers
PPI: Producer price index
January consumer credit FND: March pork bellies futures (CME)
12 13
nal day trading can take place in a futures or options contract.
FND: March heating oil and RBOB gasoline futures (CME)
3
futures contract can take place.
Also known as rst intent day,
January construction spending February ISM manufacturing report FND: March orange juice futures (ICE) FDD: March crude oil, natural gas, gold, silver, copper, platinum, palladium, corn, wheat, soybeans, soybean products, oats, rough rice, and T-bonds futures (CME); March sugar, cotton, cocoa, and coffee futures (ICE)
LTD: April orange juice options (ICE); March single stock futures
(OC)
www.activetradermag.com • March 2011 • ACTIVE TRADER
REPORT TIMES Economic release
Release time (ET)
GDP
8:30 a.m.
CPI
8:30 a.m.
ECI
8:30 a.m.
PPI
8:30 a.m.
February new home sales
Productivity and costs
8:30 a.m.
24
February durable goods FND: April crude oil futures (CME)
Employment
8:30 a.m.
Personal income
8:30 a.m.
25
Q4 GDP (third) March University of Michigan consumer sentiment
Business inventories
8:30 a.m.
Durable goods
8:30 a.m.
Retail sales
8:30 a.m.
Trade balance
8:30 a.m.
28
February personal income LTD: March pork bellies futures (CME); April natural gas, h eating oil, RBOB gasoline, gold, and copper options (CME)
Housing starts
8:30 a.m.
Chicago Fed national activity index
8:30 a.m.
29
March consumer condence LTD: April natural gas and March gold, silver, copper, platinum, and palladium futures (CME)
Production & capacity utilization
9:15 a.m.
Leadin g indicato rs
10 a.m.
Consumer condence
10 a.m.
University of Michigan consumer sentiment
10 a.m.
Wholesale inventories
10 a.m.
Philadelphia Fed survey
10 a.m.
Existing ho me sales
10 a.m.
Construction spending
10 a.m.
Chicago PMI report
10 a.m.
ISM report on business
10 a.m.
ISM non-manufacturing report on business
10 a.m.
New home sales
10 a.m.
Factory orders
10 a.m.
Federal budget
2 p.m.
Consumer credit
3 p.m.
19 20 21 22 23
February existing home sales LTD: March coffee futures (ICE) LTD: April crude oil and T-bonds futures (CME)
26 27
30 31
FND: April natural gas futures (CME)
February factory orders March Chicago PMI FND: April gold and platinum futures (CME) LTD: April heating oil and RBOB gasoline futures (CME)
April 1 2 3 4 5 6 7 8
March employment report and ISM manufacturing report February construction spending FDD: April crude oil, natural gas, gold, and platinum futures (CME) LTD: April live cattle options (CME); March cocoa options (ICE)
FND: April heating oil, RBOB gasoline, and live cattle futures (CME) March ISM non-manufacturing report
February consumer credit February wholesale inventories FDD: April heating oil and RBOB gasoline futures (CME) LTD: May sugar futures (ICE); May coffee and cotton options and April U.S. dollar index options (ICE)
ACTIVE TRADER • March 2011 • www.activetradermag.com
The information on this page is subject to change. Active Trader is not responsible for the accuracy of calendar dates beyond press time.
77
