Right on Target

On December 14, 2012, gun violence erupted in Newton, Connecticut. A lone gunman entered a school and killed 20 children and 6 teachers and administrators. The topic of gun control, both pro- and anti-, had already been a fairly hot one; now, it was the leading conversation topic on everyone's minds. Folks lined up predictably: conservatives generally tended to be against it, citing quotes like "guns don't kill people, people kill people," and the 4th Amendment; liberals were equally vocal from the other perspective, quoting statistics from countries with strong gun control legislation, as well as making emotional appeals. Stocks of gun makers slid, as the market anticipated changes that would be negative for their bottom lines.

One such gun maker was Smith & Wesson, perhaps the best-known American gun maker of all time. Smith & Wesson can be traded via its holding company, Smith & Wesson Holding Corp (SWHC). Just a week or so before, SWHC reported earnings higher than analysts had estimated, and raised guidance for 2013. Regardless, SWHC stock dropped from its high of $11.25 to $9.40 in two of the days leading up to the Dec 14 violence. Afterward, SWHC slid even further, closing at $7.79 three days later.

On December 19, 2012, President Obama gave a press conference discussing various topics, including the Dec 14 tragedy and the possibility of gun control in the future. The full transcript of that speech can be found on the Washington Post website. The chatter on facebook, where I do most of my crowd-watching because of its raw knee-jerk flavor, universally agreed that massive gun control measures were coming; some people opined with satisfaction, others with chagrin. I watched this flood of prognosticating carefully for the next two days. The daily traded volume of SWHC eclipsed any other volume spike that year by about 60%, including the massive two-day 37% rally it enjoyed in September, 2012, following a truly magnificent earnings report.

On December 21, 2012, I bought SWHC at $8. My reasoning was that the entire nation was overreacting in its prediction of the policy outcome. Call me cynical, call me contrarian, call me cold and heartless, I don't care. But I saw a stock that had no business being nearly 30% lower with rising profits. I also saw that many conservatives were taking the President's comments as a call to buy guns before it became too difficult to do so. SWHC continued to bounce around on Dec 21, closing just 10c above my purchase price. I said at the time that I would hold it as long as necessary to get a good return out of it. I had a soft mental stop price of about $7 to start worrying, and a pie-in-the-sky profit exit of about $16: double my money. I didn't expect $16, of course, but if it got there, I would take the money and run.

In the second week of January, I traveled to Salt Lake City, UT, for my annual ski trip. One evening after skiing, I proposed that we go to a local gun range and store for some target shooting. John and I did so, and the place was so packed that we gave up and tried the next night. We arrived a little earlier and found the store a little less crazy but still very, very busy. And folks weren't just looking, they were buying. I asked the store owner why he thought it was so busy, and he looked at me and chuckled, saying, "why do you think?" We had fun shooting, and I went home feeling very optimistic about my investment.

January 16, 2013, was a big day for SWHC: it opened at $8.40 and closed at $8.91, seeing a high for the day of $9.25. During the ensuing price action, I placed an order to sell covered calls against it: targeting a strike price of $10 with a March expiry. I wasn't filled that day, but early the next my calls sold for 55c/share. When I do covered-call trades, I like to discount the purchase price by the amount of the premium; thus my effective buying price for SWHC was now $7.45, 22c/share lower than the low on Dec 18 at the height of the gun control sell-off.

On March 5, 2013, SWHC hit its high since the December sell-off, peaking at $10.63 and eventually closing at $10.22. That evening it missed estimated earnings, and subsequently sold off into the options expiry weekend, closing at $9.21 on March 15. My covered calls expired worthless that weekend, and I started working a new covered call order the next week. In retrospect, I could have maximized my profits by selling $9 strikes in January instead of $10 strikes. But of course that would have required me to see the future, which I cannot do.

I sort of lost track of my SWHC position for almost a month, refreshing my covered call order in mid-April, and finally getting filled on April 25, selling June expiry calls with a strike price of $9 at 45c/share. This brought my effective purchase price down to a nice round $7/share.

I hoped for similar price action to the previous quarter, since that would allow me to sell even more calls at strike prices above my purchase price, but alas the next earnings report was much more positive, and I was assigned my calls over the June 21, 2013, expiry weekend. I was out of SWHC at $9/share, with an effective purchase price of $7/share. That's about 28% in 6 months. Maybe I could have squeezed a little more money out of this trade, but considering I would forget about it for months at a time, I'm pretty happy with it.

Contrarian investing is not for the faint of heart. I have doubled down on GLD calls three times now during the 9-month bear market we've been experiencing, and it seems that Bernanke has a personal vendetta against my position. But sometimes, when the world is screaming "Sell" at the top of its lungs, it is very profitable to accommodate them. This was one of those times.

The Dangers of Stubbornness

A facebook friend enjoyed the comment I made in my previous post: "Or else it's the beginning of a downtrend, and your position is doomed - you can never tell which." Reading her comment on facebook, I started to reply in place and realized I had a lot more to say than a couple of lines.  So I'll put it here.

As I said earlier, the Collaboration is Good trade is a mean-reversion trade.  This is actually a misnomer, as there is no "mean" the market is returning to; a more accurate term would be "trend-reversion", but the industry uses the terms it uses.  In any case, the general principle is that when a market is in a long-term trend, and has a short period (the length of this period varies by market) of returns counter to that trend, a correction back toward the long-term trend is more likely than a continuation of the short term counter trend.  I realize for most readers, that makes very little sense, so let me illustrate.

Example: A Rubber Band

Go get a rubber band - say a medium-sized one about 4 inches long, and hold it in your left hand at a stationary height. With your right hand, grasp its other end and stretch it a few inches downward and release it.  It snaps back, but not too violently, right?  Now stretch it a lot farther than you did before - to something like 12-14 inches.  Notice how you feel the band begin to fight you, equaling out the force of your hand with its own elastic properties?  OK, release it, and notice how much faster it returns to slack.  In fact, it probably bounced up past the fingers of your left hand - in finance, we call this over-correction.  It may have snapped your fingers, too, which provides a good object lesson on why you shouldn't take my blog commentary as advice.

The problem with the rubber band example is that the market is not being held stationary in someone's left hand.  Because of the vast chaos and complexity that exists in the capital markets, there is plenty of room for contrary viewpoints.  One of these is the Random Walk Hypothesis.  In a nutshell, it states that the market cannot be predicted, and any apparent successes in doing so are simply luck.

Counter Example: The Coin-Flip Fallacy

Imagine we have a fair coin for flipping, one that gives heads 50% of the time, and tails 50% of the time.  Now, if we flip this coin 3 times and then report its results in percentage terms without giving the flip count, it will look terribly weighted toward one or the other (67%/33%, or even 100%/0%).  As we flip it more and more, though, we naturally expect it to approach 50/50.  Does that mean that a long run of all heads makes tails somehow more likely?  Of course not - any reasonably aware person can see that the results of any given flip of the coin are independent of all previous flips.

But when roulette players mutter about a particular number being "due", isn't that the exact same thing?  As the number of variables increase, the complexity goes up; this, in turn, makes the game look more and more beatable.  Now how much more complex is the capital market system than a game of roulette?  If it is indeed just a random environment, no human has the ability to intuitively detect that - we're just not wired that way.

I was once forced to "prove" to a previous employer that die rolls in a craps game were independent of each other.  I put it in quotes because the only thing that constituted proof, to him, was a complete model of the entire game that he could run various betting systems on until he managed to convince himself it was just a negative expected-value game of chance.  This man was a trader - none of us are immune.

I personally prefer to believe that the market is not random - instead, it is the numerical result of millions of complex and confusing variables and herd psychology.  Whenever I evaluate a strategy, I try to understand the underlying causes for the apparent pattern. If I can't identify any, I find it very difficult to trust the predictive nature of the strategy.

Real-World Data Sample

Starting in March, 2009, the S&P (proxied here by SPY) enjoyed a massive 14-month, 85% rally.  One leg of that rally started in July and ended in October. Backtesting reveals that CiG would have signaled a buy on September 28, after 3 days of counter-trend price movement.  That time period is visible here, with a couple of trendlines to help remove some of the noise (click the picture for a larger view).  For the curious, yes there were other signals - profitable ones - near Aug 17 and Sep 2.  But they had more bowl-shaped corrective rallies, and thus were not as clear an example as Sep 28, took its profits after a single day.


Here is a zoomed-in view of SPY at the time of the trade signal.  I've overlayed a Relative Strength Indicator to help illustrate the stretching rubber band effect that CiG is designed to capture.

As you can see, SPY built up three days of upward corrective pressure, shown by the red counter-trend line. Finally, nearly all that pressure was relieved on Sep 28 with a 19-point (in the futures) rally. CiG would have signaled a buy on the close of Sep 25 (Friday), and a flattening sell on the close on the next trading day, Sep 28, booking a $950/contract profit.

Double-Down or Go Home

Essentially, the reasoning behind doubling one's investment in a trade that has lost money goes like this:

1. I still think the trade will work out and be profitable; in fact, I feel that it is more likely to have a winning result now that the security I'm trading is even more incorrectly priced.
2. Given that the probability of success is higher now than when I originally entered the trade, I should allocate more capital to it.

Notice that there is a very fine line between this reasoning and the degenerate gambler's muttered mantra, "If I can win one big bet I can make back all my losses." A very fine line indeed.  Also bear in mind that doubling down is a reasonable possibility only for trades that revert.  Such an attitude for a trend-follower or an option spreader would quickly lead to the end of the trader's career.

Even if it makes sense for the trade at hand, it ultimately is a Martingale.  If a trader decides to take this approach, even after some soul-searching and healthy self-doubt, he ought to first clearly define his risk-management rules.  The truly dangerous nature of a Martingale, to the plan-deprived, is that at any given moment during this trade, booking the loss looks worse than taking on a little more risk.  Notice that the reasoning above doesn't ask two important questions: can I bet a greater slice of my financial life that my model is flawless and applies to this situation? and do I have more capital to allocate?

CiG doesn't attempt to answer these questions - good strategies shouldn't presume to be that comprehensive.  Instead, it does not allow increasing position size within a security, and limits the list of securities traded; it also has predefined stop-loss limits.  When the limit is crossed, the position is closed and the loss is booked.  Period.

Even if a trade is good, even if the market is irrational and you have positioned yourself to take advantage of it when it returns to normalcy, you may not have the required funds to reap those benefits.  As John Maynard Keynes famously said: markets can remain irrational a lot longer than you and I can remain solvent.

And that, my friends, is the Risk of Ruin.

Victory From the Jaws of Defeat

It's been another exciting week in the markets.  Last Friday, the CiG trade sent up a buy signal on S&P Futures.  At the close, I dutifully bought at 1297.  Monday morning, all looked well as the market opened nearly unchanged and immediately rallied a couple points; that would prove to be the best price this position would ever see.  It fell the rest of the day, closing at 1285.25, a loss of $587.50/contract.  Tuesday looked great for a while, accelerating upward overnight to 1292 and reaching a high of 1295.5 - only a $75/contract loss - before giving it all back again in the last 2 hours of trading, ultimately closing at 1284.50, down another $50 from the previous day.  Wednesday was uneventful but painful, opening at 1282.25 and closing at 1277.5 - total per-contract loss: $975, ouch.  But then something interesting happened.  Another buy signal came along, this one on Russell 2000 Futures, giving me a decision to make.

In a previous trade a few weeks ago, I found myself in a similar situation: S&P had continued to move down for a couple days after initiating a position, costing me losses and threatening my stop-loss; then Russell signaled.  In that previous trade, I elected not to take the second entry signal, reasoning that in a real money account I probably wouldn't have or wouldn't care to risk additional margin on what I knew to be a highly correlated market.  That time, I watched as the Russell rocketed up the next day - I think I ended up scratching the S&P position, and missed a $1500 winner in the Russell.  After thinking about it some, I realized that a secondary entry like that is an even stronger signal.  CiG is a mean-reversion trade, entering a buy order when the market has sold down too much.  When it moves down even further, even more correctional pressure builds up, indicating a higher probability of the market returning to (or near) its previous range.

Or else it's the beginning of a downtrend, and your position is doomed - you never can tell which.

Since I try to learn from my trading mistakes (my many, many trading mistakes), this time I decided to take that secondary signal.  I bought Russell Futures at the Wednesday close for 787.  Thursday was the corrective rally I'd been looking for, with Russell reaching a high of 796.70, and S&P a high of 1294.  When it was clear I was seeing my rally, I changed my stop-losses into trailing stops so that I wouldn't have to babysit the position (I do have work to do, after all).  When the market started to sell off hard after 2:00pm, both of my trailing stops exited me from the trade at better prices than if I had waited for the close: 1289.50 for the S&P ($375/contract loss), and 794.10 for the Russell ($710/contract profit).

NeighborTrader pointed out that technically there was no exit signal in either product, and he's right.  But it was clear to me that the corrective rally had come and gone - staying in the trade any longer was asking for trouble, in my opinion.  Sure enough, Friday was another down day, with the S&P and Russell closing at 1269.75 and 779, respectively - representing a total stop-constrained loss of over $2000/contract.

I'll take a $365 profit while avoiding a $2000 loss any day, won't you?

*POP*!

It has been a busy month, and except for my mechanical trades (an update on those is coming soon), I haven't found the time to wander around looking at areas of the market that I don't usually trade.  About a week ago, though, I realized that I had heard a lot of buzz around the office about silver.  A month ago almost none of our traders were interested in trading silver futures, and now suddenly I was hearing about it from several different directions.  Curious, I brought up a chart.

(Silver ETF through May 2, 2011)

This, ladies and gents, is a bubble.  Having lived through the economic aftermath, we all have heard of the Tech Bubble of 2000 and the Housing Bubble of 2008.  Smaller financial instruments like silver don't get capitalized names, dates, and a lot of mainstream attention, because they don't push the economy around.  But here's a couple more from recent memory: the Oil bubble of 2007-2008, and the Agricultural bubble of 2007.  In the charts below, I have helpfully included the bubble-popping aftermath for 20/20 hindsight, which I held back in the Silver graph again (for the impatient, there is a full chart near the bottom of this post).

(Nasdaq ETF Apr1999-Apr2000)

(Oil ETF Mar2007-Jul2008)

(Commodity ETF Jan2007-Mar2008)

Sadly I can't find an ETF that captures the housing bubble well, but here is an excellent chart from another blog (thanks to James Parsons).  I haven't verified the source data, but it looks more or less correct.  The volume isn't pictured; in the context of home prices, that would be the real estate sales activity.  I could go do a bunch of research, but I won't.  We all remember the "flipping" craze of 2006-2007, right?

Housing prices 1970-2010, nominal and inflation-adjusted

In all of the charts above, notice the accelerating prices near the end of the bubble, and the corresponding accelerating daily volume.  This represents the "final blow-off phase", where everyone just has to be involved in this instrument.  Retail amateur investors do not belong in a frothy market like the ones pictured above, but the siren song of water-fountain stories about how Bob from Accounting doubled his money last month is a powerful draw.

In 2000, I had been reaping the rewards of the Tech Revolution, as I saw it, by working as an independent consultant on the side, more than doubling my salary by charging consultant rates and putting in 20-30 extra hours a week.  I suddenly realized that a lot of people had been making a lot of money in the stock market for a long time, and I was determined not to miss out on any additional free money.  I started reading the Motley Fool and buying more or less any stock that made a new high, with no regard for earnings (there weren't any) or prices.  I came late to the party, like most investors did, but I was convinced this New Economy (remember that?) was one that would love me and my technical mind, cradling me in its hammock of cash.  So I bought Yahoo at $120.  When it fell to $100, I listened to the Buy&Holders telling me what a great new bargain it was offering me, and I bought more.  When it fell to $60, I bought more.  When it fell to $40, I made my last purchase while gritting my teeth.  I don't remember where I sold it, but it certainly wasn't higher than $15.

I learned a lot in the next 8 years.  In 2008, when stock valuations were ridiculously high, the housing market was quietly imploding, and credit was rapidly shrinking, I heard a sudden increase in questions from people not involved in finance about how to get involved in finance.  I had doctors, dentists, and engineers wanting to argue with me about where oil was going in the next 5 years.  I had people telling me that $1.5million wasn't that much to spend on a 4-bedroom house with no land, and besides, you could just sell it for $1.8 in a couple of months! Suddenly everyone was a speculator, and everyone was loving the party.  Meanwhile I was reading economic analysis by folks like the Head Economist at Merrill Lynch, who was pointing out how silly it all was.  Every week he bemoaned the rapidly accelerating speculative frenzy, and forecasted a recession with increasing certainty and severity.  Finally in the summer 2008, I think in August, I decided it was time to take a position.  I bought puts on SPY, a lot of them.  I made about 800% on that trade; no, that is not a typo.  The money I made in that trade did not make up for the money I lost in my stock-index retirement accounts, but it certainly helped.

So a week ago, when I suddenly woke up and realized that I was seeing the top of a bubble in silver, I bought puts in silver.  I didn't buy many, because I'm unfamiliar with the market and I don't want to extend myself too far into a clearly volatile situation when I don't know what fundamental forces might be driving it.  Well, it turns out to be speculative craziness.  The CME decided to increase the margin requirements on its silver futures contract (SI), because it was seeing bigger daily ranges and was concerned that too many small speculators would be unable to make margin, leading to a meltdown (irony?).  Silver immediately turned about 120 degrees and headed straight for the floor.  I bought my puts the day after that announcement, so I missed the first big down day.  But here's the full-year chart of silver I held back at the top of this post:

SLV through present day

Is that not the most perfect bubble chart you've ever seen???

Two days later, I had more than doubled my money on the puts.  I sold a little less than half of them for more than I paid for the full position.  Now that remaining part of the position is worth more than twice my original investment.  In just a week, I'm up over 350% overall.  I like to use options for short-term directional plays like this, because I get leverage and limited risk.  I bought options worth about 4x more than I would normally initially invest in anything, and I spent about 5% of that on premium.  That 5% of the notional value is my maximum loss; leveraged out, I'm risking 20% of a unit of capital on this play.  It carries a high risk of loss, since the option really can (and often does) go to zero, but the leverage carries with it a high reward potential. 

Disclaimer:  it's tough to make money buying options.  It usually only works out well when there is a sudden violent movement - in the right direction - of my underlying stock/ETF/etc.  The problem, though, is that the probability of a sudden violent movement is captured in the term "expected volatility", and that's one component in the price of the option.  Just as you would pay more for car insurance if you had a history of vehicular homicide, you'll pay more for a put option on a stock that has a history of portfolio homicide.  So buying options usually loses money, and the art is to control that money loss and not let the option price go to zero.  But when they make money, oh boy.  I can turn a 30% drop in silver into a 350% profit.  That makes up for a lot of lost option bets.

This is usually where someone (you know who you are, Dad) tells me that I'm "profiting off the misery of others".  I see it a different way.  Do we all remember how it was the Evil Speculators that caused the 2008 crash?  Well, it's those same Evil Speculators that drove the silver price up above all reason.  Keep in mind, the catalyst for bursting this bubble was the CME increasing its margin requirements.  Do you really think that increased margin requirements are going to stop a hedger from buying silver futures because he needs a few truckloads of silver in a few months?  Of course not.  Do you think it would seriously impair the normal healthy speculation activities of the professional trading firms that provide markets to the hedgers, thus facilitating the modern financial system, as is their Patriotic Duty?  Certainly not - most trading firms have millions, if not tens of millions, in their margin accounts.  The only people severely affected by increased margin requirements are small-size speculators with underfunded accounts:  those 1-lot and 2-lot traders that are in there driving up the volume and generating water-cooler war stories.  These guys are cruising along with $10,000 to $50,000 in a futures trading account, and they're sitting at their desks trading silver all day long when they should be doing something productive.  This is why the Chinese are winning, people.

Think of it as weeding.  Sometimes you have to kill off some buckthorn so the oaks can thrive.  Think of me as a chipper/shredder.

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!

CiG Finally Closed

As I mentioned in my previous post, the Collaboration-is-Good trade signalled a Buy on S&P Futures on Tuesday at the close.  This is a fade trade -- others might call it a mean-reverting trade, but it isn't really, since there is no "mean" we're reverting to.  By fade trade, I mean that it buys on strong dips of otherwise up-trending markets, and sells on strong rallies of otherwise down-trending markets.  So when S&P Futures shed 28 points on Tuesday after trending up quietly and strongly for months, CiG jumped on it. 

I bought S&P futures in my fake-money account at the close on Tuesday for 1314.50.  Wednesday close was 1305.25 (down another 9.50) and Thursday was 1302.25 (down another 3).  If I had simply held that position throughout that time, by Friday morning it would have been down $612.50 per contract, or about 11%.  But I didn't. 

Wednesday morning before the stock market opened, I saw the hard sell-off at 2am from the mess in Libya, and I decided that although futures had come mostly back that night, I should move my stop up to 1312.  Sure enough right after the open, the S&P sold off and hit my stop.  I got a little lucky on the execution, and sold it for 1312.25, saving $12.50/contract in losses.

By the close on Wednesday, the trade was still signalled, so I rebought at 1306, starting at -$112.50/contract.  Thursday was quieter, moving mostly sideways and a little down, and my trailing stop-loss of 10 points ($500/contract) was never hit.  It was still a down day, however, so the trade stayed signalled.

Friday morning, my tour de force of trading skill failed me.  I saw that the rally had finally started, and I wanted to set a closer stop before heading off to work.  Somehow I mis-entered the price, and instead of putting in a stop order to get me out on another big sell-off, I accidentally sold at the market, then 1311, for a reversal in fortune to +$137.50/contract.  Nice to have a profit, for sure, but I didn't want out at that point.

After arriving at the office, I kept an eye on the market and managed to buy back in at 1310 about an hour before the markets opened.  I then set a 5-point trailing stop, which is generally way too little room for this trade, but I was pretty skittish of the stock market by this time; and got to work on my day job.  Somewhere around 11am, after rallying all morning, there was a little market dip that closed me out at 1313, for another $150/contract.  I saw no reason to press my luck further, and closed the trade.

Total profit: $287.50/contract, or about 5% on margin capital.  If I had not been so skittish with my stop order on Friday, the close signal would have come in the afternoon at around 1318.75, profiting $575/contract, or about 10%.  On the other hand, my discretionary trading had a positive impact: if I had just bought on Wednesday afternoon and held on, the trade-prescribed 100-tick stop-loss would have just barely not kicked in at the low on Thursday, so my open-to-close profit would have been $225/contract.  So to recap, my discretionary trading was good, but I got a little more nervous on Friday than I should have.

Making the decision to violate the rules of a mechanical trade in real-time is always a tough judgement call.  Mechanical trades are useful for finding entry and exit points when an emotional human might not be able to pull the trigger on his own.  But blindly following them is not a long-term profitable decision -- despite my active trading behaviors, I believe in an efficient market most of the time.  In this context, that means that if there were a profitable mechanical trade out there, someone has already done it so much that it has been used up. 

By carefully considering whether now is the time to stray off the path laid out by the mechanical trade plan, and using the plan to question his decisions and lend some objectivity to their logic, an experienced trader can enhance his returns.  I'm not experienced enough to do that reliably, but in this case I had the help of NeighborTrader to reason out the pluses and minuses of each individual trading decision, and it worked out very well.

Collaboration, it seems, is indeed good.

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.

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.