CS|MACO Wakes Up

On Thursday morning, the American Association of Individual Investors' Sentiment Survey showed that 38.5% of their (paying) members reported being bullish. This was up 2.8% from the previous week. At the end of the trading day on Thursday, SPY closed below its 200-day moving average, down $5/share, or 3.5%, from Tuesday's close.

This close below the 200-day moving average caused CS|MACO to signal a position-closing trade. Don't remember what CS|MACO is? I don't blame you - it's been very quiet since May, when it went long SPY. As a primarily trend-following trade, the longer it holds a position the more likely it will make serious money. But unfortunately, it also means it will give back a large proportion of its profits when the market turns against it.

This position was typical. CS|MACO signaled a buy on May 10 when the folks who feel obligated to pay AAII for the privilege of filling out a weekly sentiment survey reported that they felt profoundly un-bullish (only 25.4% of them were optimistic). That entry at 136 was about 1/3 of the way through a down-move in the S&P that bottomed on June 4 at 128 (closing price), only to rally throughout the summer to a high of 147.20 (closing price) on September 14 - one of my favorite days of the year. Since then the volatility of the S&P has been increasing and it has been drifting lower through a series of bounces. I knew it was only a matter of time until the 200-day moving average was crossed.

CS|MACO will stay out of the market until one of the following occurs:

• AAII comes out with a bullish number below 27.5% (buy signal); or
• SPY closes above the 200-day moving average again (buy signal); or
• SPY closes below the 200-day moving average, and it in turn closes below the 300-day moving average (short signal). That will be a while.

Just for fun, here's a little chart that plots the weekly prices of SPY (taken on Wednesdays) and the AAII bullish sentiment number. I've limited the time range to be the period of CS|MACO's latest position; that is, May 10-Nov 8.

Including dividends, CS|MACO is up about 4% on a Return on Investment basis since its inception in September 2010. Not a great track record, but I'm sticking with it for now. 

CS|MACO: Out At Last

The CS|MACO trade has been long SPY since Mid-March, entering back then on excessive bearishness on the part of the survey-responding individual investors of the AAII (Association of American Individual Investors). It finally exited this morning on excessive bullishness from those same investors. Since it's been such a long holding period, a review of the trading methodology might be in order.

Every week, the AAII solicits a survey from its members about how they feel about the market that week - bullish, bearish, or neutral. Then they publish the percentages of each of those numbers on their website in time for trading on the open on Thursday morning. Long-term analysis has shown that these respondents get more bullish the higher the market goes, regardless of other factors, and they get less bullish the lower the market goes.

My own back-testing indicates that there is a significant skew to the results, which I think is best explained in the psychological terms of a typical "amateur" investor. Having been burned before, this investor remains bearish or neutral until the market is so strong that he can no longer deny its strength. Then he flip-flops his opinion, deciding that it's a bull market after all, and buys shares. As the market rises and falls, he is unable to separate himself from his position, rationalizing his losing days and patting himself on the back for his winning days - despite being a passive holder of shares who didn't really do anything. When the market enters a downtrend, he continues rationalizing his position longer than he should, telling himself it's okay because "it's a long-term trade," or "it's a minor correction," or "they're just shaking out the weak hands." He remains bullish until the moment of capitulation, finally selling his shares in despair.

This is a classic investing behavior that is driven by the sunk-cost fallacy. This dilemma is usually explained in terms of movie tickets: you bought the tickets, but the movie sucks and you want to leave. But you don't leave, hoping against all odds that it will get better, because you don't want to "waste" the price of the ticket. While this example is very easy to understand, and most of us have experienced it directly, it doesn't map perfectly to an investing situation. So let me attempt to redraw it.

You bought shares in a company, excited because you felt that they were developing the next great product sure to be on everyone's list during the Holidays, and you reckoned the stock was under-priced. Unbeknownst to you, the management team was running the company into the ground by taking crippling salaries and under-funding research and marketing. For months, the stock slid steadily lower for no apparent reason. Your initial investment fell by 10%, then 20%, then 30%. Every month, you reviewed your holdings and couldn't bring yourself to sell, because:

1. Rationalization: Maybe when that new product comes out, things will be different. Rebuttal: What was your target return on that product at the beginning? 20%? 40%? What kind of a return do you need to get now just to get even?
2. Rationalization: If you sell now, you'll never make the money back that you've lost. Rebuttal: If you sell now, you can invest in something else with a higher probability of return, enhancing your chances of profiting from now on.
3. Rationalization: You bought this company because you felt it was under-priced. Now it's an even better bargain! Rebuttal: Imagine how great a bargain it will be when it goes bankrupt.

Does any of this sound familiar? I'm not immune: I bought Yahoo in 2000 for $100, $80, and again at $40 before I finally capitulated and sold at $20. That sure was a good tax write-off. But I digress.

This psychology is important to CS|MACO because the trade seeks to get long when the typical investor described above finally gives up and dumps his shares in despair. This is the moment of capitulation, and it generally marks the bottom of a correction in the market. Because most individuals are long-only investors, using the inverse doesn't work so well: it makes no sense to get short when everyone is exuberantly bullish. Also, long-term up-trends are much more common than long-term down-trends - market corrections tend to be much faster and more violent because of the pain-avoidance behavior described above.

Since long-term up-trends involve ever-higher bullishness on the part of investors, it is frequently the case that the AAII survey gets so bullish that CS|MACO gets an exit-long signal long before the end of the trend. The MACO component compensates for these premature exits by keeping the trade long as long as the daily close price is higher than the 200-day moving average, and the 200-day moving average is itself higher than the 300-day moving average.

As a matter of fact, the rally that SPY has been enjoying since its low on October 4 is very close to reaching that 200-day moving average. So with a little more buying and a little less bullishness (aka irrational exuberance), CS|MACO might find itself right back in that position.

So how did it do this time around? Including dividends, it's a 3% return. It's not a tremendously exciting strategy.

Another Flurry of Trades

Remember a couple of days ago I said I thought the stock market was overpriced and due for a correction?  Well I certainly didn't expect it so suddenly.  Since my blog post on 2-August, the S&P has shaved off 6% of its value, dipping as low as 1163.25 (futures) on an intraday basis.  This intraday low represents a -13% peak-to-trough return in the past month. Meanwhile gold rallied hard (at first), making me very glad I hadn't taken my entire call position off.  I had another flurry of trades the last couple of days, most of them defensive.

S&P 500 (proxied by SPY) since 1-Jan-2011

Yesterday, my GLD calls were close to triple the price I paid a few days prior.  I was working a 400% profit order on 25% of them to secure a profit and let me continue to ride the train as long as I could.  As they hit their high, rumors emerged that big London-based hedge funds were getting margin calls on their gold positions.  Our company's market analyst mumbled the announcement about the rumors (a frequent problem lately), and NeighborTrader and I thought he said that the CME was raising its margin requirements on gold futures.  Either way, gold immediately went into a hard sell-off, and I was reminded of what happened to silver when the CME raised its margin requirement a few months ago.  Now gold today is a very different market than silver then, but that wouldn't stop a mini-panic from pushing gold down and keeping it there until my calls expired worthless.  To control the cost of this possible outcome, I sold enough calls to guarantee a profit, getting a trade price only 4c below the high.  Immediately afterward, the calls sold off and are now trading 33% lower.  Whew!  I still hold a little less than half my initial position at about double my purchase price, and if I let it expire worthless I will still make 6% profit - enough to cover commissions.

Gold (proxied by GLD) since 1-Jan-2011

The day after SPY opened below its 200-day moving average, causing CS|MACO to close its long SPY position, the AAII released its weekly investor sentiment survey.  Over 10% of investors stopped being bullish this week, which was enough to get a Buy signal out of the CS component.  Buy + Flat = Buy, so yesterday I bought SPY back at 124.30, which seemed great at the time (it was 3.50/share lower than where I sold it), but isn't looking so wonderful now that SPY is trading at 120.

I was working target exit orders on both of my SPY put positions, which I mentioned in the previous post; I never dreamed both of them would fill yesterday, but then yesterday was an unusual day.  Despite making a combined 56% on those puts, by the end of the day I was kicking myself for not holding the second batch until the market stabilized.  I left a significant amount of money on the table: the position I sold for $7/share is now worth $10.50/share, and the one I sold for $6/share is now worth $8.25/share.  Sigh.  NeighborTrader pointed out that I can't always sell the high, and I suppose he's right.

Yesterday crude oil dropped by $5.50/barrel, or -6% *on the day*.  If you need any confirmation that the global economy is slowing into a new recession, this is it.  Demand for crude waxes and wanes based on industrial activity, and the capital markets are exceptionally good at predicting and magnifying changes in demand.  When crude sells off hard over several days, it's a very bearish economic signal.  On 26-July, crude oil futures hit a high of 100.62/barrel.  Today's low in crude was 82.87: -18% in less than 2 weeks, a very bearish signal indeed.  I had an order working to buy USO at $35, which was filled yesterday during the craziness.  I'll buy more when I think we're near the nadir of the recession.

Oil (proxied by USO) since 1-Jan-2011

After the massive sell-off yesterday, I came in this morning expecting:

1. a better than expected monthly payrolls number
2. a big number-driven rally in the stock market
3. a post-number sell-off to yesterday's close price or lower by the end of the day.

In fact I was so sure about this that I bought Nasdaq futures at about 7:15, 15 minutes before the number.

What happened was:

1. a better than expected payrolls number (+117k/9.1% vs expected +85k/9.2%)
2. a big number-driven rally (S&P rallied about 19 points, Dow rallied about 280)
3. the craziest roller coaster of a day I've seen since the Flash Crash; S&P has had a 60-point range, Dow has had a range of about 460 points.  It closed 3 points below yesterday's close.

I sold back my futures immediately after the number for a $430/contract profit.  It's nice to be right every once in a while, and it's even nicer to be able to make a little money doing it.

The final trade of the day today was that Xilinx (XLNX) sold off enough to hit my target exit on the put position I've had there for a while.  At last glance, I sold the high price of the day in that option market.  That doesn't really make up for the SPY puts, but it's a start.

A Bunch of Trades

This morning, the SPY opened below its 200-day moving average after flirting with it on an intraday basis for the past three sessions.  This signalled "Exit" in the MACO component of CS|MACO, and so I closed the long SPY position at the open for a price of 127.80.  I changed the entry criteria a few months ago after doing some backtesting, and under the updated rules, CS|MACO would have bought SPY back in September 2010 for around 112.  Unfortunately, in real life I can't go back in time, so the SPY position only yielded about $1/share due to its much more recent entry.

The CiG trade has seen me in and out of S&P Futures several times this last month as the stock market went through its daily gyrations.  The trades have mostly been profitable, but it has been a challenge to risk-manage the positions when the stock market has opened up and closed lower, or vice-versa.  This debt deal nonsense going on, coupled with the worrisome economic numbers coming out lately, has the market on edge.  CiG is long S&P and underwater right now, and not far from its stop-loss on the current position.  As a counter-trend-fade trade, CiG is always destined to get hurt when the long term trend reverses instead of simply correcting.  Times like this one are built into the profit expectation, which makes them easier to take.  I am actually using a small number of SPY calls as a proxy for S&P Futures this time around, because CiG called for a long position on Friday amidst swirling rumors about debt ceiling activities over the weekend.  Since stop-loss orders don't work on Saturday, I felt something with a defined maximum loss was a good idea.  I spent the same in premium as I would have lost with a stopped-out position, which lets me keep the trade on no matter what the market action... in exchange for lower profits, if I ever see any.

Speaking of on-edge markets, I bought some deep out-of-the-money calls on GLD during the height (so far) of the debt ceiling circus.  My reasoning was that if the talks really broke down and no deal was formed, then the country's debt rating would be immediately downgraded, the stock market would crash, the economy would head straight into recession again, and the Fed would pledge QE3 to try to policy our way out of this gigantic mess we created for ourselves.  Panic + money printing = inflation expectations + falling dollar, and Gold would climb a wall of worry.  Having some leverage on the only thing likely to rally in that environment would help control the bleeding in my portfolio.  This was (almost) a Black Swan trade, and now that the clowns in Washington are getting back into their tiny car, I'm working to exit the position, starting with getting out of about 25% of the contracts at a 20% profit today. Considering what else would have happened if this position made a lot of money, I'm pretty glad it didn't come to pass.  But with lowered profit expectations, I still should be able to deleverage for a nice profit on the trade.

Despite my taking my finger off the big red button, I still don't have high hopes for the economy. I think the stock market is terribly overvalued (when don't I?), and we are so close to slipping into another deep and painful recession right now that I feel like I need to protect myself against a big market sell-off.  Back in May I bought some puts on SPY, and then took a lot of heat on them.  I was OK with this, as I was more interested in catching a big long-term sell-off throughout the summer than in a small short-term correction in the late spring.  We have now closed below the 2011 lows (125.28 on March 16), so the puts are starting to fulfill their roles as portfolio hedges.

In the midst of all the other excitement going on the last month or two, I sort of forgot about the Iron Condor.  Luckily for me, I placed some target-profit exiting orders before I forgot about the position.  While I ignored the trade the Russell oscillated up and down, taking out my exit orders and then returning to nearly unchanged before I went and looked at it today.  So I discovered a half-sized, well-centered, and very profitable Iron Condor position when I finally bothered to look at it.  Since it had already depreciated past my target for the trade and most of the way toward maximum return, I went ahead and closed it out the rest of the way, opening an Oct 860/870/690/680 IC while I was at it.  This "forget it and get lucky" approach is not a good one, but it happened to work this time.

One trade that didn't work out as I'd hoped was Office Max (OMX), which reported earnings this morning before the stock market open.  Historically, the stock has done very poorly on earnings announcements, and they were only expected to break even in the latest quarter.  Between that and the general skittishness in the market, I felt puts on Office Max were a low-risk play with a high probability of an overnight profit.  This is similar to how I like to play Research in Motion (RIMM) around earnings.  Office Max beat expectations with a 7c/share profit, however, and OMX quickly rallied 18% on the open.  I took the loss on the puts and moved on.

Quick Position Run-Down

• I have a Wal-Mart bond as well as a couple of Illinois muni bonds to control my portfolio volatility.
• I have a long position in a commodity ETF (DJP), which is primarily energy, metals, and agriculture - this is a "China needs stuff" long-term investment.
• I still have a sizable position in GLD call options, as well as long-term holdings of GLD and GDX - to take advantage of this record-setting gold bull market and to partially protect against a market apocalypse.
• I have an investment-grade corporate bond ETF (LQD), which is designed to capture the strength of companies relative to people, without being directly correlated to the stock market.
• I have puts on SPY at both the 129 and 126 strike level; not a huge number, but enough to turn my trading screen green on ugly days like today.
• I have recently started accumulating exposure to oil via USO.  I've been watching crude-oil futures every day at work for months, and I feel like buying USO on big crude dips is a good idea.  I bought my first batch when oil dropped below $95/barrel, and I'll buy some more during the next recession.  Maybe a lot more, since this is also a long-term "China needs stuff" investment.
• I have puts on Xilinx (XLNX), and I'm working an order to close the position for a 125% profit.  This position has hung around longer than I would have liked, but it is finally starting to work itself out.  It started out as an earnings season pessimism trade and turned into a general bearish trending position.
• I am long the Canadian Dollar ETF (FXC), which I bought at par.  This is another US Dollar hedge, and I don't have a specific plan for when to close this position.
• I'm still long Microsoft (MSFT) from a long time ago.  I keep looking for opportunities to write covered calls or something against this position, but the collectable premium is so bad that I can't justify the risk of losing the stock at ex-div, even though the yield is only 2%.  I really need to unload the stock soon, though, as its membership in the DJIA guarantees a rough couple of years when the recession hits.  Mental note: get on this one.
• I have a small position in inflation-protected treasury bonds (TIP), as another hedge against inflation getting away from Uncle Ben.
• I also have a small position in Verizon (VZ).  I took half of it off a few months ago, and have been working a target exit ever since.  Meanwhile, the dividend yield on the stock is 5.5%, which is easy to procrastinate getting rid of.

Revamping CS|MACO

NeighborTrader and I have been talking a lot about back-testing lately.  Back-testing is when you take a bunch of historical price data, and push it through a trading strategy to generate buy/sell/close signals as if you were running the strategy at that time.  Then you see how the strategy did, and try to extrapolate how it might do in the future based on those results. Ever hear the phrase: "Past performance is no guarantee of future results"?  Well, the same applies to back-testing, but a little information is better than no information at all.

NeighborTrader back-tested the CiG trade before he ever talked to me about it last fall, and he's been combing through data ever since to find more trades he can run.  I've been meaning to do the same with CS|MACO for quite some time, and I finally did this weekend.  I learned some interesting things, and I found a few changes I want to make.

I grabbed daily historical prices for SPY from January 1993 through March 2011.  I also grabbed the AAII sentiment data for that same period of time.  I wrote myself a little Python script to collate the data together, and then plugged all of that into a spreadsheet that created signals just like my present-day trading spreadsheet.  To this, I added some calculations to figure out the results of the trades, and compare them to simply buying SPY and holding it. 

As designed and outlined in this post, CS|MACO underperformed SPY over the 18-year period from 1993-2011.  Then I abstracted away all of the parameters so I could change them easily, and started playing around.  Next I evaluated various time periods based on the sort of market they covered: I looked for bullish and bearish periods, triangular moves up and down, and sideways choppiness.  I compared CS|MACO against SPY in bottom-to-bottom and top-to-top time periods, as well as a simple 5-year rolling time period throughout the 90s.  Once I had a feel for how CS|MACO behaved in various market scenarios, I started changing the parameters, and learned some things.

The first thing I learned is that the 25/200 moving average crossover component of MACO is far too responsive, and tends to trade into choppy sideways markets, losing money on every reversal.  To catch the really big trends, much bigger moving average periods, and more similarly sized periods, are far better: 200/300 seemed to be a good mix.

The next thing I learned is that the arbitrary 10% collar I have on the CS component is about right, but only for the buy signal.  This outcome was fascinating, and I think it gives insight into individual investor psychology.  If I'm right, it means that the CS buy signal (which is based on below-average levels of bullishness in the survey) is a leading indicator while the CS sell signal (which is based on above-average levels of bullishness in the survey) is a lagging indicator.

Bear in mind, this all just my viewpoint: I think we as humans tend to invest our emotions as well as our money, and we are very slow to accept that we are in a losing position and get out of it.  On the other hand, we are much quicker to jump into a new position if we think there is opportunity there.  The vast majority of us do not short-sell anything (my father thinks it's un-American and somehow Satanic), and so statistically, investors tend to become bullish faster, and become bearish much slower.

To handle this lopsided behavior, I changed things so that I could control the bullish/bearish thresholds independently.  Then I tried turning one and then the other off by setting them so wide that the indicator could never reach them (+/- 100% certainly works).  I discovered that turning CS off entirely made things worse: MACO, by itself, is not a winning strategy.  Actually, let me be clear: it does have positive returns, but it does not beat SPY itself.  Turning on only the buy (bearish investors) signal had the most positive effect. 

So, how about the results?  In rolling 5-year periods, CS|MACO was profitable in just about all of them - can't say that for SPY, not by a long shot.  When it beat SPY, it beat it badly; when SPY beat it, it wasn't nearly as big a difference.  The best part is that CS|MACO tended to diverge up from SPY in down markets, and pace it fairly well in up markets.  It really only lost ground in prolonged sideways chop markets.  And by prolonged I mean like longer than a year of nothing but sideways chop - that's pretty rare.

A big danger of back-testing is sample bias, also known as curve-fitting or false optimization. This is where you optimize your strategy against all the data you have, and assume that tomorrow will just like your data sample.  In a perfect world, we would like to use a sample of, say, 1995-2000 to train our strategy, and then make sure it still works from 2000-2011 before committing real money to it.  This is called split-sample testing.  However, I feel that the behavior of the markets and the attitudes and psychology of the individual investors have changed somewhat over the last 18 years.  For me to find a strategy that works well in the 90s, and expect it to continue working in 2012 and beyond, is naive.  So I have to flirt with that sample bias problem, but I try to watch for it and be aware that it is always there without falling into it.

Below is a graph that compares SPY to CS|MACO for the whole 1993-2011 period.  SPY is the red line, and CS|MACO is the blue line.  Notice how when SPY suffers, CS|MACO profits.  This makes it a very viable strategy for running alongside a standard retirement account holding index funds.  And for me, that's just perfect.

(click for the original size)

Not The Spreadsheet's Fault

Two weeks ago, CS|MACO gave me a Buy signal when AAII.com released a bearish investor sentiment report -- bearish investors correspond well to short-term market bottoms, that's why we call it Contrary Sentiment.  The moving-average crossover component had no strong feelings either way, so the CS-based Buy signal was allowed to generate a system-wide Buy.  I dutifully bought SPY near the open price in my paperMoney account.

A week later, as the market rose, investors relaxed their concerns somewhat and found their bullish mojo again.  37.7% of them gave the thumbs-up to the world, which was outside of the Buy range, but not above the 41.5% required to close the trade.

Finally last night, a new report came out at 41.8%...just high enough to get a close signal.  But now SPY was above its 25-day moving average, which in turn was above the 200-day moving average.  So while CS went from Buy to Flat, MACO went from Flat to Buy.  Flat+Buy=Stay-Long.

If I had managed to put the numbers into the newly-fixed spreadsheet correctly, that's what I would have done.  Instead, I fat-fingered the 200-day moving average, entering 4119.49 instead of 119.49.  The spreadsheet was a little taken aback by this sudden 4000% spike in the long-term moving average, but kept a stiff upper lip about it.  "Guess you better sell, boss," it said.  I sold.

Hey, I got a great price, getting out about 35c above the close for the day.  But first thing tomorrow I'll have to get back in.  And I'm betting that the Employment Situation Report tomorrow an hour before market-open is going to send the S&P up sharply, causing a gap-up in SPY that will cost me for my stupidity.

Can't blame the spreadsheet this time... garbage in, garbage out.

A Little Success

I had some tough trading days this month, so it's nice to have the kind of success that makes it all feel easy.

In Motion, but In Which Direction?

Research in Motion (RIMM), maker of fine Blackberry-branded devices, is a company built on a fad.  Corporate users relied on their "crackberries" for years, especially when travelling or otherwise out of the office.  But Apple's iPhone was Blackberry's first serious competitive threat, and the flood of Android devices were the second half of the one-two punch.  The fad is over, and RIMM is shrinking. 

For some reason, the investment community doesn't seem to have accepted this obvious fact.  Analysts still talk in breathless whispers about RIMM's upcoming tablet devices (I'm betting it'll suck), and the amazing experience provided by its latest phone operating system refreshes (evolutionary, blah).  Many otherwise intelligent hedge fund managers still treat RIMM like a tech sector bellweather, buying it up on every positive rumor, selling it off again on every fundamental stumble.  As far as I'm concerned, RIMM is as relevant today as Digital Equipment Corp was in 1997.  Unfamiliar with DEC?  I rest my case.

Just like an eccentric hermit who occasionally ventures into the big city for a group therapy session, RIMM lovers are periodically snapped back to reality.  This check happens quarterly, when RIMM reports earnings.  This is my opportunity for one of my very most favorite short-term trades: buying puts on RIMM just before earnings come out.  I have had varying success lately, as bubbly investors drunk on excess Fed liquidity shrugged off what could only be described as luke-warm results.  But overall I believe the trade is a good one, and I had another opportunity for it this week: RIMM reported its latest earnings on Thursday after the market closed.

I bought puts on Tuesday, and when the market rallied, taking RIMM along with it (thus reducing the price of my puts as well as the delta), I bought more on Thursday.  RIMM closed at 64.09 on Thursday, just before its conference call.

Don't ask me how RIMM did last quarter: I don't know and I don't really care.  But I know they disappointed both in their top-line revenue numbers ("oh but look at the continued cost-cutting!" the analysts said) as well as their outlook for the next quarter and rest of the year ("they're in a retooling phase, just like the late 90s!" the analysts screeched)*.  Ms. Market would have none of this posturing and spin management, and she sold that sucker off by 11-12% in after hours trading.  The next morning, RIMM opened at 57.17 (-10.7%), and my puts were up about 80-90%.  Hapless investors who haven't yet learned not to listen to analysts started buying the stock up, topping it out at 58.40 (-8.9%) about an hour after the market opened. 

2-day, 5-minute chart of RIMM showing the 11% drop after earnings

By the way, the first hour of trading is known in the professional trading community as "amateur hour."

I exited some of my puts pretty early, in case the rally had legs, and in doing so I took all of my investment out of the trade - the remainder of my puts were pure profit.  Later in the day, as the dead-cat bounce pattern continued to take shape, I exited the rest at a slightly higher price.  Total return: 90% in 3 days.

* I distinctly remember reading that exact comment ("retooling phase... just like the late 90s") on Thursday night after the release, on a news item linked from Yahoo Finance.  I remember noticing that the related links section at the end of the post included Jim Cramer and other well-known "pundits".  I also remember the analyst giving an unequivocal Buy! recommendation based on how he saw the market reacting the next day (he expected a lot of buyers to step in, for some reason).  Now that the market has spoken, essentially confirming what the overnight traders knew already, somehow I can't find that article anywhere.  Too bad, I would have included a link to it.

CS|MACO: Unnaturally Quiet

First the good news: the AAII sentiment survey for March 23 did indeed reflect a more bullish flock, but insufficiently bullish to make the CS|MACO trade exit the next morning.  Meanwhile, SPY rallied above its 25-day moving average, so I now have a Hold signal from CS and a Long signal from MACO.  Unless CS goes all the way to Short, or SPY sells enough to get a Flat signal from MACO, I can stay in the trade.  SPY is already up nearly 3% from where I bought it on Thursday morning.  One of these days I'll do some more formal backtesting and maximum-drawdown analysis so I can leverage this trade up, but for now I'm content to let it just time an unleveraged entry and exit.

The bad news (and here, my poker friend Missy will start snickering if she's still reading) is that I discovered on Thursday that my spreadsheet that does all the calculations and boils the numbers down to Long/Hold/Exit/Short had some serious flaws that caused CS|MACO to miss two entry signals for smallish winning trades this fall.  Oops.  A craftsman is only as good as his tools, I guess.

The Condor Has Landed

My April Iron Condor managed to finish legging out of its bullish wing at a reasonably good price on Friday, completing the exit of the trade and profiting a nice solid $1.10/contract.  I never had to take any risk-management positions - just reduce quantity on the initial position as I worked my way out.  I'm looking for a good entry point for the May IC, but volatility is back down in the doldrums again.  I'll have to wait until the market gets skittery about something again - if that means skipping until June, so be it.

CS|MACO... Finally!

Mea Culpa

First, I need to relate a painful but valuable lesson I learned last week.  In my previous post, I said that the CiG trade had fired a Buy signal on S&P Futures.  As a fade strategy, the CiG trade frequently signals trades that I view as bat-shit crazy.  It takes some teeth-gritting and reminding myself that this is fake money in order for me to be able to enter the trade sometimes.  Last Wednesday was one of those times.

I dutifully entered the trade, but I put a $500/contract stop-loss order in, instead of the $1000 that the script calls for.  I congratulated myself a couple of hours later when my stop-loss was hit, closing me out for a $500 loss, on saving the other $500 dollars.  Well... go look at a chart for S&P Futures.  My max unrealized loss that evening would have been about $700, and over the next two days we had a sizable rally.  By the time the exit signal arrived, the trade as designed would have been up over $2000/contract, a big return.  Instead, I was sitting on the sidelines with a $500 loss.  My "judgement", in this case, cost me a total of $2500/contract.  Ouch.

So why did I go against the trade as back-tested by NeighborTrader?  My rationale at the time was that this was a fundamental market move, and we were in uncharted territory that couldn't possibly be handled by back-testing.  OK, fair enough, and that's what judgement is for.  But I took the wrong action based on that judgement: instead of tightening my stop, which cut my max loss by 50% but increased my probability of experiencing that loss by far more than 100%, I should have opted not to place the trade at all.  If my comfort level with the risk is insufficient to execute the trade as designed, I should avoid the trade entirely - not cripple it and damn it to fail.

My conclusion was invalid, even if my assertion (these unprecedented times are likely to cause the trade not to work) was valid.  But what about my assertion?  If we want to look at unprecedented times, let's look at May 7, 2010, the day after the "Flash Crash" (I hate this term, by the way).  CiG would have similarly fired a Buy signal at the end of the day that day, and the exit signal would have come two trading days later, for a profit of over $2200/contract.  And here's the thing: NT back-tested this trade before May 7, 2010.  That's out-of-sample data, and thus can't be discarded as sample bias in his back-testing.

So my assertion -- unprecedented times invalidates the trade signal -- was invalid, and my conclusion on how to act on it -- tighten the stop -- was invalid as well.  Look, I'm not perfect, but if I had gotten either thing right, I'd feel a lot better about it.  Anyway, $2500 lesson learned: either follow the trade, or don't do the trade - don't adjust the trade on the fly based on my gut.

Oh, and you may recall me mentioning that "by rights, I should be short Ten Year Futures, too". That trade, if entered, would have made another $1250/contract over the course of three trading days.  Sigh.

CS|MACO

Last Wednesday night, not long after my stop-out, AAII's sentiment survey for March 17 was posted, and those inversely prophetic investors had some pretty negative things to say about the market.  Bullishness dropped all the way to 28.5%, just below the CS Buy signal level of 31.5.  With SPY trading between its 25SMA and its 200SMA, the MACO component was giving a hearty "meh" signal.  Buy + don't-care = Buy.  So I bought a unit of SPY the next morning... at 128.  SPY is still in MACO's "meh" territory, but up 1.66/share from my buy price; AAII publishes another weekly survey overnight tonight.  If my individual investor peers recognize the cessation of the downtrend last week and get more bullish ("bullisher"?), I might find myself selling SPY on the open tomorrow morning.  But they'll have to get a lot "bullisher" - 41.5% or more - for me to take my profits and go home.  We'll see.

General Thoughts

As regular readers of this blog know, I run multiple trades in my paperMoney account at ThinkOrSwim.  Besides the ones mentioned above, I also have a bullish NDX option vertical spread on to simulate a collar, a bearish SPX option vertical spread, an Iron Condor in RUT (Russell 2000) and naked-long SPY puts.  I'm also looking for a dip in gold to buy back some GLD calls, after having exited my March calls before expiration.  The problem that I am starting to run into is that I have too many trades on the stock market - and many of them are nearly perfectly inversely correlated.  The worst offenders are the bearish SPX and bullish NDX spreads.  CiG and CS|MACO only hold positions once in a while - but the option spreads are there all month long, every month.

This false diversification doesn't benefit me at all - if they were real trades I would be spinning my wheels spending commission on an expectation of about 0 profit.  In a paperMoney account, this isn't so bad, because I can use the excuse that I am looking for profitable trades: the unprofitable ones will never "go pro" into a real money account.  But this is kind of a hollow argument, because any of these trades can be profitable or unprofitable, depending on the market conditions.

This issue bears more consideration.

And a Micro Rant

"They", whoever they are, changed the Nasdaq-100 ETF's symbol from QQQQ to QQQ last night.  WTF???  Didn't they just change it from QQQ to QQQQ a few years ago?  Make up your minds!

Predestined for Failure

Old Business
As I have noted recently, I am running about two to three days behind posting my trading activity.  There are a number of excuses for this, of course, and none of them all that valid.  I have also lagged behind in reading the blogs of others, and this morning I read an excellent post from one of my favorite options bloggers, Mark Wolfinger.  Unfortunately for my Iron Condor trade, I read it 11 days late. 

In this post he discusses the correct strike-pricing for protective debit spread adjustments.  He states several times that one should never buy farther OTM options than the iron condor itself, and that's exactly what I did.  Over the next few months, I need to reflect on this and tweak my adjustment strategy.  I'm hoping using this advice will help flatten out my returns, because I'm experiencing somewhat more volatility and stress than I would like, given the low income potential of this trade.

The AAII Sentiment Survey for 12/15/2010 still shows some very bullish investors out there, although slightly fewer than last week: 50% are bullish, down from 53% on 12/8/2010.  As expected, this results in a continued no-position for CS|MACO, which doesn't participate in trends that are fueled by investor mania.

New Business
I bought some Research in Motion (RIMM) puts this morning at the last minute.  I generally like to buy these a week or two before the earnings release, but I wasn't paying close attention and missed out.  RIMM has always been one of my favorite shorts during earnings season, and I personally think that they have no future without a major retooling of their business.  Nobody talks about "Crackberry" anymore, now it's Android this and Android that, with the occasional fan-boy crowing about iPhone coming to Verizon (still).  I was expecting RIMM to admit a further reduction in its market share, disappoint on earnings numbers, and guide lower for next quarter.  But that didn't happen, and when I left the office in disgust, RIMM was up 5%.  So tomorrow I'll unload the put for a 50% loss and move on.

Another put position I entered today was Kinder Morgan Energy Partners (KMP).  KMP owns and manages energy transportation and storage facilities in North America.  It has a positive correlation to natural gas prices, but not a dramatically high one because its income is fee-based.  Thus KMP's income fluctuates more with demand for natural gas than with natural gas itself.  KMP has a big dividend yield: 6.3%  So why short it?  Oh let me count the ways:

1. Jim Cramer loves it, and he usually loves at the top and hates at the bottom.
2. They have a $22B market cap, revenue of $8B, $192M in cash, and $13B in debt.  Debt is more than 50% of the market cap, and nearly 68x higher than cash reserves.  That means they're using debt to finance their dividends.
3. Quarterly earnings have declined 10.8% since this time last year, to $1.25/share.  Dividends are $4.44 per share, so they're also paying more in dividends than they're earning in profits.
4. They need to quadruple their profits in order to cover those dividends, but the highest praise that Cramer can come up with is that high dividend stocks are good in a rising interest rate environment.  Yes, true.  But that doesn't solve KMP's internal fiscal problems.

This stock needs to fall.  I bought some March 2011 puts on it, and I'm working orders to buy some more on a rally.  I don't know when it will fall or how far, but my puts are there to profit when it does.

Last but not least, I bought some calls on GLD (Gold ETF) today, expiring in March.  If the current short-term sell-off continues, I'll buy some more.  I'm looking for a GLD price above 150 by expiry.  That would be a massive return on the call investment.

Now I Can Afford That Operation

The CiG trade, which bought Eurodollars on an entry signal a week ago, finally gave an exit signal on Monday at the close, so I exited the position by selling GEH1 at 99.59.  That gives a $75 profit.  Since I trade this in paperMoney, I wasn't paying a great deal of attention to how much I should trade, but this one really brought that home.  The risk of one Eurodollar contract is not equal to the risk of one S&P contract - not even close - and the margin requirements reflect that.  Eurodollars carry a margin requirement of $877.50 per contract, while S&P futures require $5625 per contract.  In order to take the same amount of risk, I should be trading 6-7 Eurodollars for every contract of S&P I'm willing to commit margin for.  If I had, this $75 profit would have been $450-525... very similar to the $500 I made on the S&P signal.

In other news, one of my Iron Condor exiting orders also filled on Monday, closing out my remaining 660/650 put spreads.  This leaves my protective debit put spreads on with nothing to protect, and it also tilts the delta into the negative territory again: -20.  With December expiry coming this weekend, and with implied volatility near its 52-week lows, it seems best to close this one out.  I'm working orders to close the two call spreads - the original 810/820 and the kite-component 830/840, the naked long 820-call of the kite, and the protective 630/640 put debit spreads.  Since my current position still has positive theta, though, I see no reason to rush things.  Either way the market moves it will approach my exiting limit orders, so hopefully over the next week or two we'll get a little end-of-year waggle so I can squeeze out a few cents per contract on the way out.  If not, I have a month before I have to make a final decision.  Once theta goes negative, or if delta gets uglier, the pressure will be on to make that decision a bit sooner.

I've had a limit-sell order working on Microsoft for a few weeks now, and it filled today.  I'm still a believer in the stock, but I bought quite a few shares of it when it was depressed, so I'm just rotating some capital out to bring my position value back down where I want it to be.  Readers of my facebook notes will recall that I had 5 "units" of capital in Microsoft.  This sell brings me back down to 5 units of capital in position value.

I'm expecting another increasingly bullish (for me that means bearish) sentiment survey this week, released tonight sometime.  If that's true, CS|MACO will still stand by and watch the Fed Cheerleaders... er, I mean Stock Market... without getting involved itself.

Such a Slacker

I've been distracted most evenings lately from the four Xbox games I picked up during Black Friday madness, and so it has taken me even longer than usual to record thoughts, trades, and rambling nonsense.  As if that weren't enough to eat up my attention, the Bintgoddess and I just received our HTC Incredibles we ordered through Amazon Wireless, and I at least have been spending more time than I should customizing and moving into my new phone.  I had intended to switch from AT&T+iPhone to Verizon+Android when my contract ran out in August, but the Bintgoddess' pre-pay plan ran out of minutes, and we could save more money to switch us both to a family plan now, despite the early termination fee from AT&T.  With nearly free phones (1 cent each from Amazon Wireless) and free 2-day shipping, the choice was pretty clear.  And yes, Amazon did charge my credit card $0.02.  Silliness.

Iron Condor
The January 2011 Iron Condor position has required some adjustment to keep it close to delta-neutral recently.  Recall that I opened a 650/660/810/820 iron condor on Nov 8, and then adjusted it Nov 16 by buying a 630/640 put spread.  Since we're into December, I'm now erring on the side of closing positions rather than opening them - but I'll still increase a position if it's the right thing to do for the risk or the greeks.

The stock market had been rallying pretty hard the last week or two - in fact, it has been rallying pretty hard ever since the day after I put on that downside protection.  This is not a surprise - it's just how I roll: don't believe me? watch me play poker on Full Tilt sometime.  But I digress.  With the stock market rallying and delta going pretty negative, it was time for some upside protection.

First, I bought back about half of the 810/820 call spreads for 1.40: a very reasonable 10c loss.  This moved the delta up about halfway to where it needed to be, but gamma was still pretty negative.  Another up-move and the position would be in trouble again, so I beat the rush and put on a Wolfinger Kite Spread.  Specifically, I bought back an extra 810 call for 3.70, and financed that by selling four 830/840 call spreads for 50c each.  Not only did this bring delta to a nice manageable level and give me some much-needed upside protection, it also significantly improved my max-loss on the upside.  Of course if MDW is reading this blog, he's probably seething that it isn't a perfect Kite Spread - I should have sold the 840/850s, or reduced the sales by 1 contract.  Tough.  I am convinced this was the right trade to make, whether it can rightfully be called a Kite or not.

The next day, I took advantage of another rally to buy back a few of the 660/650 put spreads for 45c.  This lowered delta a bit again, but like the previous day's adjustment, it really helped out in the max-loss department.  The total position now has a nice flat S-curve to it, and theta miraculously is still 13.  So a sideways market for the next 30 days should net me about .25 per contract - that may not sound like much, but that's 2.5% margin-return on a monthly trade.

It's also about time to be looking for a February trade, but I'll learn my lesson from January and wait for volatility to come up a bit.  Using paperMoney is nice, because I have so much fake margin in there that I can make trading decisions without having to be concerned about margin.  If I want to put on February before taking off January, so be it.  Doing that with real funds would take some very careful money management... or more money than I have.

CS|MACO
Still very bearish signals (53% are bullish as of last night, way too many for my taste) from investors, who happen to be right this time about the market as it sustains an uptrend, and bullish signals from the trend following MACO component.  As a result, it still waits in (fake) cash.

CiG
Eurodollar futures (GEH1) gave a bullish entry signal on Tuesday, so I bought them at the stock market close for 99.56.  Trading Eurodollar futures is similar to watching a bad horror movie: long periods of mind-numbing boredom punctuated by moments of pure terror.  So far I'm in the boredom phase - two days after buying them, I'm up 3 ticks.  W00t!  No exit signal yet, so I wait.

CS|MACO last week

Last week, SPY closed below its 25-day moving average on Tuesday, so I closed the CS|MACO long SPY position Wednesday morning.  Wednesday, SPY rocketed higher, closing back above the 25-day; but the AAII.com survey also came out Wednesday after the close, and individual investors have gotten bullish enough again to make the CS component bearish.  Bearish plus Bullish = Flat, so CS|MACO is once again on the sidelines.

CS saved money that MACO would have lost, since SPY has closed lower than Wednesday the succeeding two trading days.  These periods of consolidation, where SPY hovers around even for a while, can get expensive.  I'm glad I have those individual investors to fade.

Mini-Rant
Speaking of fading individual investors, the topic of conversation over coffee at the office this morning was privatization of Social Security so as to give individuals the ability to manage their own retirement investments.  The general consensus is that this would be a great thing... for us professionals.  Investing well is hard: like any other probability-based activity, looking backwards in time at what you should have done makes it look very easy.  But actually doing the right things traveling into the future takes a great deal of effort, discipline, time, and -- dare I say it -- luck.
I'm trying to stay away from the political quagmires around dinking around with Social Security.  Whether I'm for it or against it doesn't change my premise here, which is that individuals managing their own money, in the aggregate, will severely underperform just about any index you care to use.  Despite my "morons" tag I throw in whenever I talk about individual investors, it isn't because they're dumb.  It's just that they have other things on their mind than investing.  The folks taking the other side of their trades (i.e. fading them), on the other hand, are professionals.  They spend all day every day thinking about markets, and most of them have vast resources at their beck and call for maximizing their return.

The reason investment banks such as Goldman Sachs have done so well and generated such staggering amounts of wealth is because they're playing against amateurs: you.  So the next time you get the urge -- if you ever get the urge -- to argue for the privatization of Social Security, think about who is more likely to profit in a trade between you and Goldman Sachs.  If you answer, "Me! I am! I'm above average!" then I applaud your confidence.  But please don't be insulted if you find me on the other side of some of your trades.

Trading Diary for Nov 19

CiG
On Tuesday, I closed a losing CiG trade at the open based on a view that the S&P Futures (ESZ0) were going to sell-off throughout the day.  It turned out I was right, and by the end of the day CiG had given a new Buy signal.  Following this signal with real money might have been psychologically difficult, since all Tuesday long the market was acting like the sky was falling; but that's the essence of a buy-the-dips strategy, and with paperMoney the buy decision was an easy one.

I closed that second long ESZ0 position on a standard CiG exit signal yesterday afternoon for a $900 profit.  I ended up with a $500 profit per $5500 in margin for the whole trade starting on Friday, which ends up being an overall above-average winning signal.  If I had gritted my teeth and held on instead of getting out Tuesday morning and getting back in Tuesday afternoon, the trade would be down $87.  Going with one's gut usually doesn't work this well, so I'm not sure whether to be proud of myself or not.  But I'm glad it worked out this time.

Yesterday's market was a perfect inverse of Tuesday's: everything was coming up roses, and nothing could ever stop the stock market's inevitable return to massive wealth-generating territory.  You know you're a contrarian if you read that last sentence and a little voice in your head screams "SELL"; in this case that was exactly the right thing to do.  At 9:05 CST, ESZ0 was back down to 1188.00, right back where it was when I dumped it on Tuesday.

I wonder if I'll get another buy signal today...

CS|MACO
On Wednesday, results from a new Independent Investor Survey were released and posted on aaii.com.  Not surprisingly, the rapidly falling S&P markets over the past week soured the backward-looking investors' outlook for the future; the bullish percentage dropped all the way to 40%, a massive 17.6% drop from the previous week.  This was enough to move CS from "initiate sell" to "no initiate, no exit".  Meanwhile, the bullish MACO signal had evaporated on Tuesday when SPY closed below its 25-day moving average.  So that meant the trade went from being locked flat due to opposing Sell!/Buy! signals to being flat due to apathetic meh/meh signals ("meh" is an official trading term I just made up that means "no clear view either way").

Yesterday, however, SPY shot up past its 25-day again and closed above it; this gives a clear new "Buy!" signal from MACO, and CS won't change its opinion until next Wednesday.  I should have bought SPY on the open today, but quite frankly I forgot all about it.  This calls for another official trading term to be thought up: I'll call this "psychological slippage".  In this case, however, I saved myself a little money since SPY was about 50c cheaper than yesterday's close when I realized my mistake and opened the position.  I'll take it.

Big News for Boring Trades

It's been a busy few days.  The CiG trade finally fired a signal on Friday, but I was in Colorado all weekend so I didn't have time to write it up.  Then I came home with a head-cold just in time to support a major roll-out at the office that went pretty wrong.  By the time I got home last night all I wanted to do was sleep.  So now here we are.  Excuses excuses.
 
Saving Money While Asleep
First the CiG trade on Friday.  You may recall I decided to run it on S&P futures as well as treasury note futures, because I feared that treasury notes would bore me to death.  On Friday, it signaled a buy-on-close on the S&P, so I did.  Things were looking good Monday morning, but not good enough to reach the target exit signal.  By this morning, the whole world was fleeing from risk again and the stock market opened significantly lower.  Since there are no clearly-defined stop rules, I decided to sell the position for a loss shortly after the stock market opened.  I felt that what we were seeing was not a momentary blip but in fact a setup for a selling day.  I was right: I sold the position at 1188 at 9:00.  At the 3:00 close, ES was down to 1176.

Because CiG tries to buy on dips, though, it had another buy signal come out on ES today.  Pleased at my ability to dodge at least some of the sell-off today, I decided to get back in with a new long position at the close.  So I'm still long from Friday, but I took a 12-point ($550/contract) hiatus.  That's almost a winning trade all by itself.  Not a bad money-saving siesta.

No joy in treasury note futures yet.  Yawn.

Insert Spy Pun Here
CS|MACO, another boring trade, is finally starting to see some life.  It has been locked flat while SPY has rallied over the last 3 months, due to the bearish signal coming out of the contrarian investor sentiment component and the bullish signal coming out of the moving-average-crossover component.  One of those two opposing forces was removed today when SPY closed below its 25-day moving average, breaking the SPY>25MA>200MA relationship that has been in place since October 4.  That's not a sell signal yet, though, because the terms of the trade state that I won't enter a position on the removal of a signal.  I need the CS component to affirm its bearishness tomorrow after the close before I can short this puppy.

A Boring Iron Condor is a Good Iron Condor
Unfortunately, this one is starting to get a little exciting.  When I opened the position I groused about my poor judgment a little bit regarding the low price I was paid to initiate.  Sure enough, the VIX almost immediately rallied while RUT flagged, causing my delta to increase as I rode the curve down toward my put spread.  Delta of +16 this morning, so time to adjust already.

It seems ridiculously early to be thinking about exit orders, but I could buy back my call spreads for only 60c already; so I put in some limit orders to buy back at 20c.  That doesn't help my delta, but it does lock in a profit on half the trade - and with some careful adjustment the other half might not cost too much.

As for the put spreads, I looked at the mouse-ear like I used last month and decided it was overkill: RUT was 710 or so when I was adjusting, and my put spreads are 660/650s.  A mouse-ear would throw my delta so horribly negative that I would have to buy back most if not all of my call spreads to contain it.  Plus it was crazy-expensive, at $21.

The next thing I looked at was simply reducing the call spread position.  That would certainly help the delta and the feel of the position, but I felt the cost was a little high.  A variant of this is to roll the call spread down a few strikes, also increasing the position a bit to finance the roll.  This increases risk, and I wasn't happy with the outcome or my perception of the risk-reward trade-off.

I also looked at Wolfinger's Kite Spread, which involves a naked long OTM put and a credit put spread even farther OTM with 3-4x the size on it for financing.  That had some real potential, but it really hurt the theta.  Ultimately I decided I could achieve my delta goals and flatten the value graph best by putting on some 630/640 debit put spreads.  I bought just enough (at 1.90) to get the delta under +5.  By the close, the delta was back up to +5 again, but that's within my parameters.

Boring News for Big Trades
I'm still not holding GLD calls, and I'm glad.  I'm looking for bargains in some of the mining companies right now, but I haven't had time to look very hard yet.  Earnings season is upon us, and if I can capture a couple of positive earnings surprises before the event-driven IV goes through the roof, I'll be a happy camper.

January Iron Condor

As I planned on Friday, this morning I closed the rest of my December RUT iron condor position for a total profit of 86c per original contract.  I opened the December position on 6 October, so that means I had just about an 8% return on initial margin over the past month.  By normal investing standards, that's an amazing return, but let's put this in context: the same strategy lost 7% on its November position and just under 2% on its October position.  To a normal buy & hold investor, this is pretty frightening levels of risk; to a professional in the futures industry that plays poker and trades options on the side, 8% in a month is bordering on boring.  All a matter of perspective.

On 15 October, I made a pretty big delta adjustment by buying a 760 call.  The original call spread was 770/780, so this is what is known as a "mouse-ear" adjustment.  This is one of the most expensive adjustments that can be made, but also one of the most effective.  I feel like given the market action during that time I should have taken a less extreme approach, but after the prior two losing months I was a little gun-shy.  Despite leaving some profit on the table by solving a minor problem with a big hammer, my confidence definitely benefited from a nice smooth month of price action resulting in a near-target profit.

I also opened a January 2011 position (650/660/810/820) this morning, although with implied volatility as low as it is I don't feel that great about the price I managed to get for it: only a 2.90 credit.  This is a little on the low side, and that reflects the low VIX environment that we're in.  I probably should have waited until VIX popped back up some, but this puts me into unfamiliar territory: I know that a good price during this time-frame is about 3.50, but I'm not quite sure what a good price is a week or more from now.  Rather than sail into unfamiliar waters, I chose to limit my profits over the next month or so.  I'm not sure that was a great decision, but I will persevere.

This is why we paper-trade.

By the way, if anyone tells you how easy it is to make money with Iron Condors, don't believe them - and definitely don't give them any money to manage.  It is a very difficult strategy that takes a lot of creativity and experience to manage effectively.  I'm certainly not an expert, and it might be tempting to discount my assertions of how difficult it is; but clearing companies' databases are littered with busted accounts that jumped into the trade without an appreciation for its subtlety and dangers.  I am determined to learn this trade and how to profit with it, and to succeed where so many others have failed.

Speaking of boring trades, CS|MACO is still dead-locked flat as CS is screaming short and MACO is screaming long.  Remember I said a trending market is not CS|MACO's friend? Yeah.  The other boring one is the trade I wrote up in Collaboration is Good, which apparently I haven't named - let's call it CiG.  No trades in 10-year note futures there, either, so I think I'll start running it in S&P and Eurodollar futures also.  I ran back through the chart for the last couple of weeks, and it wouldn't have traded anyway, so I haven't missed anything.

Collaboration is Good

NeighborTrader has been making some comments lately about a trade he has been backtesting.  At first, he was trying to work out a way to make it an intraday trade so that he could run it at the office as part of his job.  A fairly new trader like him tends to prefer that route, because he has a lot more resources to throw at it sooner if it goes well than if he has to save his money to cover the margin.  Unfortunately for him, after playing with a lot of different variables he came to the conclusion that the trade worked best on daily charts, which means long-term holding times.  Since our firm has a day-trading culture and isn't really set up from a risk-management standpoint to hold trades for more than a few hours, that pretty much precludes him running it as part of his job.

Knowing that I've been running long-term trades in paperMoney, he chatted with me yesterday about his trade and the methodology he was using to backtest it.  I have to admit, I'm pretty impressed at how rigorous he's being with it considering: (a) he has no academic or professional experience with formal backtesting; and (b) it's something he's doing for himself on the weekends and committing very little capital to.  He even went so far as to buy historical data, something most of the guys at the office don't do for their big trades.  He also bought a book to learn proper backtesting methods to minimize the chance of sample bias and curve-fitting.

Since it's his trade, I don't think it's right for me to go into it in detail on a public blog.  He gave me all the information I need to run it myself, and suggested some products to run it in, and I plan to do so, although I can't think of a good name for it right now.  But I'll leave the parameters a little hazy to protect his intellectual property.  Suffice to say that it is pretty similar to CS|MACO in that it looks to enter positions contrary to market consensus, but only to do so when it isn't fighting a strong trend.  It seeks to buy dips and sell spikes, and it's purely technical, using indicators widely available on most charting packages.  It also trades very infrequently, so I might have to run it on more than one product just to avoid being bored.

He's been running it in S&P-500 Futures (it needs a lot of leverage to succeed, and he understands futures very well since that's his job) and a couple of other products.  He just exited a trade in it today for a nice fat profit.  Since I already have CS|MACO running on SPY (the S&P-500 ETF), and I have other trades running on other equity indexes (Iron Condors on Russell, Collars on Nasdaq-100), I think I'll run it against US Treasury 10-year Note Futures.  This trades at the CME since they merged with CBOT, and it's available in paperMoney. 

Speaking of CS|MACO, it's been quiet for a while now.  Individual investors have stayed bullish (they've been right for once), and SPY has stayed above its 25-day moving average.  Long+short = flat, so I've been watching this whole move from the sidelines.  The last couple of weeks haven't been good for any trade except iron condors, with the stock market going pretty much sideways.  Something has to give with CS|MACO soon, though, because the 25-day moving average and the closing price are converging.

So Much For That Plan

Gold for Cash
In my last post, just two days ago, I briefly outlined my plan for disposing of my GLD Dec calls.  I said that I wanted to hit a price or time target, and when either thing happened I was out.  Of course the very next day gold prices dropped 3%, and then another 2% today, wiping out 20% of the value of my calls.  I'm not quite sure what's going on, but that was outside my comfort zone, and I dumped the calls today for quite a lot less than I planned.  Now that I'm out, I'll detail my price/time limits a little more.

I bought the then-ATM calls over the summer for $5/share of GLD, believing that gold would appreciate in the fall.  Boy did it, and it wasn't long before I was able to sell less than half of them for about $11/share.  That took my initial investment off the table, and I kept the rest riding.  I saw them reach somewhere around $17/share at their high, and I had a price target of $25/share to get out of the rest.  That was pretty aggressive, but I also had a time limit.

Uncomfortable, as I said on Tuesday, with the many small indications of a coming correction in gold, I wanted out soon.  I think most people are idiots (see the CS part of the CS+MACO trade), and when everyone's bullish, it's time to sell.  Worse, literally the whole world is hanging on QE2-related verbiage expected in the minutes from the FOMC's meeting on November 2 & 3.  That economic release is doomed: QE2 is already fully priced in, and all the Fed can do now is disappoint.  At the very least, all the IV comes out of the options after the announcement because the inflection point will have passed.  I definitely wanted out by Nov 2.

I have assumed for quite some time that I am riding a bubble forming in gold, and I swore that unlike the turn-of-the-century tech bubble, I would neither miss the run-up nor hang on for dear life during the pop.  That's why I have been in and out of leveraged gold positions via calls for the last year or so, and that's why I'll get back in after the mid-bubble correction makes everyone hate gold again.  I'm pretty bummed that I gave up so much of my profits by dumping today, but I still made about 150% on the trade since August, so I have no major complaints.

Speaking of CS+MACO...
Adding to the bearish signals this week, AAII published its survey results yesterday after the close: more people are bullish again.  With the CS portion screaming "sell!" and the MACO portion insisting "buy!", CS+MACO is still flat and will stay there for at least another week.

I Spy a Crossover

I'm running a mechanical trade in paperMoney on SPY that is based on Simple-Moving-Average Crossovers.  I just started running this trade, but I did a little back-of-the-envelope backtesting before I started and I really liked the way it performed over the last couple of years.  Since the 25-day SMA crossed the 200-day SMA to the upside today, it bears mentioning.

There are two competing indicators in this trade: moving average crossovers (MACO) and individual investment sentiment, which I use as a contrary indicator (CS).

Moving Average Crossovers
MACO is bullish when the SPY daily closing price is higher than the SPY 25-day SMA, which in turn is higher than the SPY 200-day SMA.  MACO is bearish in the opposite situation: when SPY closes below the 25-day SMA, which in turn is below the 200-day SMA.  In any other closing price configuration, MACO is neutral/flat.

If this was where it ended, this would be a classic long-term trend-following trade.  It would have killed in 2009, and been killed in 2010.

Contrary Sentiment
The American Association of Individual Investors publishes a set of weekly indicators based on surveys of their members.  They give the percentage of their responding members that are bullish, bearish, and neutral.  I have arbitrarily chosen the bullish indicator, and I use the prior calendar year's average value as a midpoint - this year, that midpoint is 36.8%.  I then set the entry lines 10% above and below that value.  I get a new value from AAII every Wednesday, when they publish the survey.

CS is bullish when the surveyed value is below (yes, below) the low entry line, bearish when the surveyed value is above (yes, above) the high entry line, and signals "exit" when the surveyed value crosses the midpoint.  I basically use it to fade individual investor sentiment, because I think most people are morons - especially those who spend money on a membership to a website so they can donate their time filling out surveys.

So when that bullish indicator is above 46.8%, CS will initiate a "short" signal, remaining in "short" state until the indicator drops below 36.8%.  When the bullish indicator is below 26.8%, CS will initiate a "long" signal, remaining in "long" state until the indicator rises above 36.8%.  I'm trying to only place bets against other investors when it is more or less universally agreed upon how great/shitty the world is.

As a momentum-fading indicator, CS kills in sideways markets like most of 2010 has been.  It gets killed in trending markets like 2009, where everyone got really excited and stayed really excited while the stock market rallied a gazillion points for no reason.

Putting it all together
Now I aggregate the signals thus:

• If both CS and MACO say "flat/neutral", my position is flat
• If CS and MACO disagree (long/short or short/long), my position is flat
• If CS and MACO agree on a position (rare), I take that position
• If one says "long" and the other "neutral", I'm long (but see below)
• If one says "short" and the other "neutral", I'm short (but see below)
• If there was a disagreement (long/short, short/long), and MACO goes to neutral/flat, I do not initiate a position until the next CS survey release is in the "initiate" zones.  I do not "back into" positions.
• I only use closing prices for the MACO portion, and I trade the next day on the open.  If SPY gaps back through into neutral territory before the open, I treat it as no signal.  This basically just makes the backtesting easier.

In my backtesting, I compared various combinations of CS and MACO to a simple "buy and forget" strategy, resetting the entry price on 1 January each year.  I found that CS tended to keep MACO out of trouble by catching the tops and bottoms of the market trends really nicely.  On the other hand, MACO would keep CS from gritting its teeth and fading a long-term trend for a huge loss.  In fact, as a long-term trend asserted itself, CS would gradually drift into neutral territory, allowing MACO to get a position on and chase the trend.

The combination I describe above didn't consistently beat the "buy and forget" strategy, but: (a) it was a lot more fun; (b) buy-and-forget is what we all already do in our 401(k)s anyway - this whole trade is a diversification, in my opinion.  And, honestly, it has beat the snot out of "buy and forget" so far this year.

Where are we now?
The last entry signal in CS was "short" on 16 September, when the survey came out 50.89% bullish.  It has since drifted lower.  The most recent survey on 30 September was 42.5%, which would not cause a new position, but it remains "short" because we haven't gone through 36.8% yet.  We get a new survey tomorrow, and I'll go out on a limb and predict that it will remain above 36.8%.  In fact, for double-or-nothing I'll predict an up-tick from last week.

MACO, on the other hand, has been flat/neutral since 2 September, when SPY closed at 109.47: above the 25-SMA of 109.09 but below the 200-SMA of 111.79.  SPY has been trading above both of its moving averages since gapping higher over the weekend before 13 September, and today it finally dragged the 25-SMA higher than the 200-SMA at the close, generating a "long" signal:

• SPY Close: 116.04
• 25-day moving average: 112.46
• 200-day moving average: 112.05

With MACO transitioning from "neutral/flat" to "long", there is a disagreement so the trade is flat.