Chart Quiz

Click for a larger view

The chart above is of the S&P 500 futures contract, daily close prices, for the past year (ending with the current price today, 4 June 2014, as of the time of this blog post). The pink/yellow/green lines in the price pane are 100-day, 200-day, and 300-day moving averages of price.

In the next pane we have daily volume. Notice how in the circled area the volume is significantly lower than average. Below that we have an RSI (Relative Strength Index) indicator. This is an oscillating indicator, meaning that the value is always between 0 and 100. The purple horizontal lines through this oscillator pane are the oversold (lower) and overbought (higher) levels. Basically, a trader uses this graph to see if the futures contract has been increasing or decreasing in price lately. If it has been going up a lot, it can be argued that it's a good time to sell, and vice versa. As with any indicator, fortunes have been lost trading blindly along with its output. One has to treat it like another voice in the committee.

In the bottom pane, we have an ATR (Average True Range) indicator. This is a simplified measure of volatility: the value of the True Range as a moving average over 14 days. The higher the ATR, the higher the day-to-day volatility.

I don't think I have ever seen the price action, the volume, and two unrelated indicators line up like this before.

So here's the quiz. Is this chart:

1. Indicating how healthy and bullish the market is?
2. Scary as hell?
3. Completely unrelated?

Bullet-Dodging

Intel (INTC), IBM, and Xilinx (XLNX) all reported earnings last night. Being the pessimistic contrarian that I am, I intended to buy puts on all three of these companies. In fact I was working orders to buy puts on Monday, but didn't get filled. I like to buy the puts a couple of days early, because experience with Research in Motion (previously RIMM, now BBRY) has shown that option cost goes through the roof shortly before an earnings announcement. Apparently the market makers are aware that earnings announcements move stocks, and so are building more expected volatility into the vega. So I exchange a couple of days of market risk for lower implied volatility cost, as long as I feel I'm getting a good price for the options.

Anyway, I didn't get filled on Monday, and intended to place my orders again on Tuesday -- I don't believe in GTC for options entry orders, that's the way to get a really nasty surprise after forgetting about the orders. But life intervened, and it completely slipped my mind until last night long after the market close. I went ahead and checked the price action on those three stocks this morning, and this is what I found:

• INTC opened at 23.47, down from its close of 24.15. Their earnings missed expectations by $0.005/share. My put would have increased in price by about 50% overnight.
• IBM opened at 198.27, up from its close of 194.55. Their earnings were $3.97/share, crushing the expected $3.77/share. My put would have decreased in price by 67% overnight.
• XLNX opened at 45 and rallied to 46 in the first 15 minutes of the trading day, up from its close of 43.53. Their earnings were 56c/share, handily beating estimates of 47c/share. By the time I got out of it, my put would have decreased in price by 75%.

That's a pretty big bullet my absent-mindedness helped me dodge! Just how big? Let's say I put $1000 into each of those positions:

• INTC: $1000 * 50% profit = $500 profit
• IBM: $1000 * 67% loss = $670 loss
• XLNX: $1000 * 75% loss = $750 loss
• Total Loss: $920 on a $3000 investment, or -31% overnight. Ouch.

Sometimes forgetfulness saves money.

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.

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. 

Thanks, Uncle Ben!

It's been a very long time since my last trading/investing post. I've continued to ride my CSMACO position (long SPY since May), and made a few covered call trades (Microsoft, Canadian Dollars were both good ones the last few months). And the Collaboration is Good trade has signaled an entry now and then in S&P Futures. Some I took, some I didn't, thanks to the distractions of moving across the country. I've also made some bearish bets on Salesforce.com (what is their revenue model really?) and Apple (haven't you hipsters run out of money yet?), which have not worked out too well. I trimmed back some of my poorly performing gold-related positions to offset some gains in other things immediately before the gold rally resumed - figures. But I still have a moderate stake in gold, so all is not lost. Overall it's been a tough but slightly positive quarter, but the trading has been pretty muted, and nothing interesting enough to write about.

But when it became clear, a few days ago, that the Fed was almost certainly going to announce a 3rd round of quantitative easing (QE3) in the September FOMC meeting, I knew I had to take a leveraged stake. Unfortunately real life kept me from finding time to enter a position until the last minute, but the market gave me the courtesy of a downtick on Sep 10th. This let me get a pretty good price on a sizable chunk of SPY calls, which I held through the announcement today.

Everyone knew QE3 was coming, and just about everyone was sure it was today. But there is a kind of gun-shy quality to this market: it reacts some to the rumor, but it prefers to wait for the actual news before making a decisive move. Call it what you will, but I like to think of it as a confirmation rally.

Going into the announcement, SPY was just about unchanged from yesterday, and random-walking market movements had already given me a small return on the calls. Sure enough Ben Bernanke announced QE3 and made a lot of meaningless bluster about "doing whatever it takes", etc etc, designed to give the masses confidences that he knows what he's doing and he'll make your life better. He doesn't, and he won't. But in the meantime, the entire financial system rallied: stocks, bonds, currencies (not the dollar, of course), commodities. Every single thing on my watch list is green today, except for the VIX. The S&P chart looks like a bottle-rocket going off.

I exited half the position at twice the entry price, meaning that I have my initial investment out and future proceeds are all profit. QE rallies usually take a few days to play out, so I'll hold the other half for a little while and see if I can improve the return a little.

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.

Dipped in Gold

With all the Arch Linux posts lately, loyal readers may be tempted to think I have given up the aggressive-investing game. Not true. I recently completed my trade of the year with those out-of-the-money GLD calls I wrote about back in August. I bought them for 25c a share, and sold them for various prices, a few as high as $8. All told, those calls netted something on the order of 800% return on premium paid.

As I exited the last of those calls, GLD was in the midst of its toughest correction in the past few years. I bought my first shares of GLD in 2009, but even looking back as far as 2006, I don't see a correction as violent or as deep as the one we just completed. Gold bulls were hit with a triple whammy: a technical double-top formation around the end of August was followed by the Fed failing to signal much more in the way of monetary stimulus. As the investment world started its usual flight to quality in the face of disappointing developments, the CME responded to the increasing volatility in gold futures by raising the margin requirements. Everyone in the trading community still remembers how margin increases sparked the recent Silver panic, and so it is no surprise that GLD gapped-down two days in a row in the last week of September. It shed 8% of its value in two trading days, which is a pretty dizzying fall for a physical commodity unaffected by droughts and floods like gold.

The gold haters came out in droves, claiming this was the "popping of the bubble", and giving target prices of $700/oz (about $70/share in GLD terms). I stepped away from leverage on GLD, which I had planned to do during the fall, anyway, since September-October has historically been a bad season for gold (I have no idea why, it's not like there's a harvest or something). I gritted my teeth and held onto my outright shares of GLD, the straight-up gold ETF, and GDX, the ETF comprised of gold-mining companies. And I bought a few more shares of GLD on the way down, but far too soon (169). I admit I started worrying that the bubble was popping, too, but those fears are past.

Does the chart above look like a bubble to you? I have added a 100-day simple moving average to the price of GLD over the past 3 years. Notice the double-top, with a high of 185, and the two days of down-gapping shortly afterward. But also notice that GLD stopped its free-fall at the 100-day trendline, and resumed the trend. That's not a bubble-pop, that's the start of the mania phase.

Here's another chart you might recognize, this time of the NASDAQ from 1996 through 2002. See how there are corrections back to the trendline throughout the 1990s? Some of them undoubtedly looked like The End at the time, but those corrections ended up looking like little squiggles in comparison to the mania phase starting in late 1999, and of course the multi-year sell-off afterward.

So I'm looking to buy dips in gold again, since I think we'll start another leg up in this market sometime around year-end. I've already bought some shares in GDXJ, an ETF comprised of smaller-cap mining companies, and some calls in GDX, expiring in January. Both are already priced higher than where I bought them, but I can't take credit for that -- it was just an effect of the risk-on-risk-off hokey-pokey the markets have been dancing since 2008. At the moment, we're putting a foot in, so all risky assets are going up. Later, we'll take it out, and they'll all fall again.

Why mining companies instead of gold itself? I mostly prefer to trade the metal on its own, so as to slightly reduce the vast number of variables acting on my investment, but we are entering Q3 earnings-reporting season. There will be a lot of bad news coming out of the tech industry (Google's blow-out notwithstanding), and a lot of good news coming out of the mining industry, as gold miners realize higher and higher prices for the more or less constant rate of supply they are pulling out of the ground. Also, mining companies have lagged behind gold prices during this bull market. If they close the gap, I'd like to be there to profit from it. And finally, dividends. Gold doesn't pay a dividend, but miners do. Consequently, I might look to buy a few outright shares of individual mining companies so as not to dilute my dividends through the GDX ETF.

I have some trades unrelated to gold in progress, too, but that's another post.

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.

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.

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)

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!

Keep Your Head Back

Let's lead this one with a chart, courtesy of BigCharts.com.  I'm using SPY here as a proxy for the S&P 500... mostly because I couldn't figure out how to hide the volume, and the index's volume is empty and boring.  The shape is the same, so it doesn't matter.  It looks a lot like the first 60 seconds on an awesome roller coaster.

Let's put this in perspective.  This is a 6-month chart, so it goes back through mid-September.  SPY was somewhere around 112 back then, and it closed at 126.xx today.  That's a 12.5% return over 6 months, or 25% annualized.  Wow, what a great stock market!  OK, yes, from the high of 134.xx one month ago on February 18, SPY is down 6%, or 72% annualized -- but of course if you really think it's going to continue at this pace for 11 more months, I have some swampland to sell you.  But let's look at the last month, shall we?

• Major unrest in the Middle East, including full-scale revolt in many of our oil suppliers, has caused Crude Oil futures to shoot up above $100/bbl (only $98/bbl today - what a bargain): well into production-drag territory;
• Japan suffered the worst earthquake in... what? forever? a long freaking time, anyway, and its nuclear plants are about to unleash a glowing hell on the Pacific Rim;
• The festering pimples in the European economy are starting to look like they're about to pop one after another: Ireland, Portugal, Greece, etc;
• The Federal Reserve's credibility is finally starting to be questioned, and major indications have started surfacing that inflation will be a bigger problem than people have been assuming;
• And Charlie Sheen, OMG.

Watching the activity in the market on Feb 23, I started worrying that we were about to see another Flash-Crash-type event.  The spreads were widening and the markets were looking really jittery.  I bought some puts on SPY, expiring in April.  I still have them, and I see no reason to sell them just yet.  I also have a bullish option spread that simulates a collar in NDX.  It's pretty deep underwater (duh), but this is a continuation of the collar trade I've been running for a long time, and I won't be changing it now.

Besides the stock market, what have been the other financial effects over the last month or so?  And just for fun, I'll talk about my activities where appropriate.

• The Canadian Dollar roared up and then slunk back, since the Fed-bashing started early on, but the flight-to-quality has taken over the last few days.
• I bought FXC (the Canadian Dollar ETF) today.
• The Ten Year Note, in a strong downtrend at the end of the year and trading sideways-to-down through mid-February, suddenly pointed its nose at the sky as of the end of last week and turned on the after-burners.
• By rights, the CiG trade should be short the ten-year note futures, but I opted for buying S&P futures instead, reasoning that the return on S&P should be more extreme than on Ten Years.  I was right.  I bought S&P on the close, and was just stopped out for my max loss a moment ago.
• Crude Oil futures traded as high as $107/bbl on March 7, and are back down to $97/bbl now in a pretty (but meaningless) isosceles triangle pattern on the chart.  Daily ranges expanded big-time, as the market tried to constantly adjust to unfolding events in the Middle East.  It's back down now mostly on Dollar strength, I think, but 97 is still far above the 85 it started from in February.
• Agriculture futures (corn, wheat, soybeans) all have the same triangle pattern as Crude Oil, without the big gap-up at the beginning.  Again, USD strength as everyone runs like hell into something "safe".
• I hold DJP, which is a commodity ETF which holds 33% energy, 30% agriculture, and 31% metals.  This is a long-term play against the USD that I put on back in January.  I have no interest in selling it at this point -- I only wish I'd bought a long time ago.
• Gold has traded pretty sideways recently, victim of the risk-on/risk-off tug-of-war that's been going on since Charlie Sheen started distracting us from trivial Middle Eastern matters.
• I've had big gold positions on for a long time, and just today I sold some calls that are due to expire on Friday, taking a small loss.  When the nuclear crisis in Japan finally settles down, I'll buy some more, because the dollar will suddenly seem like a bad idea again.

Oh, I also had a bullish option spread on SPX that I liquidated today for just about max-loss.  Option spreads are great because they let you define your max profit-loss range and sleep well knowing that you will neither make nor lose more than that range.  I had been fighting the uptrend in the stock market for 6 months, and finally capitulated with this option spread.  I told myself when I suffered a loss I would reverse direction and start doing bearish spreads instead.  That's tomorrow's trade.