Trading | Portfolio Yoga

Thoughts on Trading

I think I can understand what Bill Hwang is passing through these days. I went through a similar scene way back in 2007. One day I was on a high after hitting a jackpot and realizing that if I played it right, I could make a good living out of it and the next day (2 months later, but you know, time flies), I was literally bankrupt.

Like Bill, the cause of my own troubles were leverage though the strategy was different from what caused his doom. My leverage while high was supposedly safe since I was trading a safe option strategy that I thought I had perfected. Markets though seemed to believe otherwise.

As a broker, I have seen hundreds of investors like me coming to the market with great hopes only to be crushed mercilessly by the markets. I remember some study that claimed that most traders go bankrupt (or rather lose the entirety of their capital invested) in the first 6 months since they start trading. Of course, its one thing to go bankrupt and quite another to quit the markets – many keep coming back with new capital and new ideas hoping to strike it lucky.

As I write this, I was reminded of an old interview of Nithin Kamath (the only broker who is willing to showcase the dismal risk reward relationship for traders despite traders being his bread and butter)

Zerodha makes stock broking pay at Rs 20 – The Hindu BusinessLine

When I lay out the risks of trading, I am told that such risks exist everywhere and hence should not be overemphasized. But wrong are they. Entrepreneurship for example is hard and most parts frustrating but a lot of entrepreneurs are about to live an okay life without ever becoming the next Zuckerberg. Markets on the other hand rarely provide opportunities where you can live a good life by being a small trader and yet never encounter the bankruptcy kind of risks.

Between the time I entered the Stock Exchange Premises and today, I have heard numerous brokers biting the dust. Unlike clients whose death is fast and furious most of the time, the death of brokers (mostly small, rarely large) is more of death by a thousand cuts.

What is surprising is that brokers aren’t outsiders who could be excused as being naive to the risks of trading. Most of them have seen the story with their own clients and yet, the urge to trade seems to overcome the pain of the stories they have heard or experienced first hand.

Is it false confidence or is it bravado or something else I always wonder. What makes people who are otherwise the smartest in the room choose the most riskiest way to make money.

Trading is tough not because it’s one with 50-50 odds but one that has a negative sum game. Between the broker and the government, the winner makes less than the loser over and over and over again. This counts not to mention the fact that thanks to path dependency, the odds aren’t perfectly stacked in a straight line.

Sportsmen go into slumps. If one has not established himself by the time his slump comes in, he generally gets dropped from the national team and would have to work his way back (many just don’t get that second chances though regardless of how they perform). But at least they have the opportunity to play the game at a lower level, establish their form once again and keep knocking the doors for being allowed to play at the highest levels.

In trading, there are no local clubs where you can tune yourself up before competing with the big boys. Of course, there are courses you can take, books you can read among other things but finally, winning is more like getting into the IIT without actually having studied.

Then there are agent provocateurs. From the broker to the friendly twitter fellow who seems to keep winning everyday, one is always given the hope that successful trading is possible – you only need to keep trying.

One of the biggest hurdles for most traders is lack of capital. Most including myself tried to trade with a capital that just wasn’t sustainable for trading full time (and trading is always a full time activity regardless of what anyone else says).

When you find yourself in a hole, stop digging is a wonderful quote. Trading is addictive for after all there is no other business that can throw out cash like this does if you are on the right side. But recognizing when you are wrong is more important for that enables one to change the strategy or better off, quit trading before it damages one’s life.

Personally after more than 15 years of full time trading, I quit the exercise in 2017. Life has never been better. I recognized belatedly that right from my capital to my psyche, I wasn’t ready to be a trader regardless of how many systems I built or strategies I tested. I know of successful traders and this for me says that all is not lost. But I know way too many smart guys who have lost everything. I do know that I am not as smart as those guys and thank my stars for the change I could bring to myself.

I doubt writing about the risks of trading is going to change anyone’s mind for we all have strong opinions strongly held, but hey, if you are open to new thoughts, let this be one. As a stock broker, I haven’t seen a Rich Trader. Not that they won’t exist, even 1% of traders if successful can be a few thousand fellows if not more but they are as rare as they come.

Predictions, Probability and Position Sizing

Most of us know that Astrology is bunkum and yet that doesn’t stop us from reading what the astrology section of the Sunday newspaper. Reading that does no harm, Right. After all, its more of just keeping ourselves aware or more of a time pass in nature.

Prediction in markets happen regularly and here there are two types of prediction. The Implicit kind and the Explicit kind. Let me explain each with a example.

We trend followers are staunch believers in fact that future cannot be predicted and we can only rely on the past and take signals based on what we believe the trend is. But the moment we make a trade, we are Implicitly predicting that price will move in the direction our trade dictates. If it does, we have caught the right trend and we make money, if it doesn’t, we call it a Whipsaw, scratch out the trade and await a fresh signal for the next trade.

On the Explicit side are strategies such as Elliot which not only spell out where the markets should / shall go but also the time frame within which it will reach such a target. Take for instance this prediction by Mark Galasiewski, a very well know Analyst from Elliott Wave International

On April 13, 2009 speaking with CNBC TV18, he made a very famous predicition

See Sensex at 100,000 in 15 yrs: Elliott Wave International

The prediction contains two elements required to make a trade. A target price and the target time. Given these two parameters and assuming you have confidence in the said analyst, the next question would be, “How much to Bet”

On the day, he made that call, Sensex was close to 11,000 mark and hence this prediction if it were to come true would mean a CAGR return of 15.85%. Here is the thing, 15.85% isn’t extraordinary returns.

CAGR Returns since Inception of Nifty Bees (then managed by Benchmark and now by Goldman Sachs) is 16.62% (as of Aug 2016). While we don’t know whether the next 15 years will provide similar returns, we at the very least have a number we can work with.

In April 2010, Chris Roberts of Mizuho Securities Asia Limited made a similar prediction, this time we have a chart providing us a better guideline as well

But lets go back to 2009. Markets are down but definitely not out and you believe in the said analyst prophecy. So, what next – Buy Nifty / Sensex would be the way forward – but the bigger question is, how much to bet. Should you bet 10 / 20 / 30% of your existing portfolio or go all out and bet 100% or go still further, Sell your House and invest everything?

The reason why people are so attracted by Real Estate is due to not the percentage of returns (which has been good till very recent times) but the amount that one sees as the outcome. But unlike stocks, in real estate, the minimum required is way higher.

When people invest into houses / land, most of the time they are betting way more than 100% of their networth (since most go with a loan, its actually multiple times their networth). Would you do that with Sensex or Nifty (lets not take stocks since we all know that not all stocks are the same) and if not, why not?

The biggest fear is the fear of not knowing what the future holds, especially decades from now. While the same risk exists in Real Estate, we comfort ourselves saying that even if the worst happens, I still will be able to hold onto the asset.

Its a fact that most world markets have at some point or other seen a 85% draw-down from peaks. While our data (public) exists only from 1979 and has a max draw-down of around 50% thrice and in those times, even the guy who has strongest belief may find it tough to hold onto his investments let alone add.

A fun fact (Fun b/c I am not sure about the source of the data): Indian markets fell 73% from their peaks of 1920 and recovered only by 1945 (25 years).

Lets cut back to our original problem. If we have a forecast, how do you action the same? This question was what engrossed me in a twitter match when I replied to a particular prediction by a Analyst who is the head of Research at a major brokerage firm

There were essentially two questions that I posted.

What is the probability that we shall reach 9410 by Diwali
Based on that probability, what should be the position size of the same.

The analyst who made the above prediction came back with the following reply

“Isn’t position sizing matter of capital allocation and risk appetite rather than probability of success?”

In my opinion, probability of success is what should drive capital allocation and not the other way round. In the above example, I based on distribution of returns calculated that at best there was a 11% probability of 9410 coming into play in the next month. Using VIX, Vasishta (@Uptickr) gave a even lower probability of 5%.

Given the above numbers, what should be your bet size. Do note that since the original forecast was made, the markets are down 4% (target was 5.5% approx) making the original prediction look like a one to one on a risk reward basis

So, why is position sizing important? As @ReformedBroker tweeted the other day,

Replace the word hedge fund manager and place yourself there. What do you spend the maximum time upon?

Selecting the right securities are betting big when you think you have found the one that will provide the returns you think you deserve.

Switch on the Idiot Box and all you can see is analyst upon analyst predicting either where Index would be n days from now or which security should one buy.

Probability of Returns is always two sided. One way to calculate the probability of returns is to use Chebyshev’s Inequality, but that will still give you the probability of returns and not provide you with a way to determine how much position size should be taken based upon the historical reliability of your signal.

The simplest position sizing when you are dealing with a portfolio of stocks is to have uniform capital allocated to each and every pick.

But what if you are trading a single ticker like Nifty or Bank Nifty and come across predictions such as the one above? How do you decide how many contracts to buy for every Signal?

With Deepawali coming up, every Television channel will be pulling up every analyst they can to provide them with a view on the coming year and a list of stocks that investors should buy for the year ahead. So, should you go ahead and buy those stocks and if so, once again, how much should you be betting?

As Investors and Traders, we love predictions and if you are on Television, what better way to get noticed than make either a very dire forecast (like Marc Faber does every year) or make staggering bullish forecasts that once again make news.

While I have no idea if anyone has created a data set of predictions by brokerage houses and the error ratio’s, out in United States, Salil Mehta writing his blog Statistical Ideas, provided a humongous amount of data and aptly named the post as “Strategists: full of bull“. If some one were to do a similar anlaysis in India, I don’t think one would find any major difference in the hit rate of such predictions.

The key to position sizing in any asset class / stock / index / sector is conviction. Think of a experiment you can try out at home. Announce to your family members that you have 20 Lakhs with you and will invest that into buying a 1 Crore property (by taking a loan 4x your investment). If you are part of a normal Indian family, you should receive more queries on property than query on whether it makes sense financially taking such a big loan.

Now, what if a few days later say that you have dropped the idea of buying the home but will invest the same into market (remember, no loans, only investing what you already have saved). The reactions now will be way different and more or less you will be taken as a gambler who is out to destroy his savings.

The difference comes from the conviction we folk have in Real Estate / Gold vs investing in Equity. Conviction cannot be build while having faulty premises that fail at critical times.

Postscript: Thinking deeply, felt that unfair to name a single individual just because I was engrossed in a debate with him while the rest of the guys get a free pass. I have hence removed the tweet. My Apologies.

The Framing Effect

Framing Bias is a congnitive bias. From Wikipedia;

“The framing effect is an example of cognitive bias, in which people react to a particular choice in different ways depending on how it is presented; e.g. as a loss or as a gain. People tend to avoid risk when a positive frame is presented but seek risks when a negative frame is presented.”

Consider this example, posed by Dr. Daniel Kahneman, Nobel Prize-winning author of Thinking Fast and Slow:

1. Would you accept a gamble that offers a 10-percent chance to win $95 and a 90-percent chance to lose $5?

2. Or, would you rather pay $5 for a lottery ticket with a 10-percent chance to win $100 and a 90-percent chance of winning nothing?

Think before you choose either. Have you decided? No Peeking. So, comfortable with and believe you have made the made the right choice?

The answer is both are the same, but research says most people when presented with the above options and who think themselves as rational decision makers would opt for Choice 2. Why?

Because of the way the question has been framed you feel that buying a lottery ticket for just $5 is way better than a 90% chance to lose the $5.

The other day I wrote on why I believe that Individual Traders / Investors are better off not trading in Individual Stock Futures and in a way (which I really didn’t intend to) was framing it in a way that people felt that there was a way higher risk than what they perceived.

Before we get further, let first understand what stock futures are and why more people end up loosing than what a simple coin toss odds will foretell.

From time immemorial, people have taken on debt to try and achieve their goals earlier than what it would if one needed to save the whole amount. Think of a housing loan for instance. How many home buyers can afford to buy a home if they were required to put up 100% of the amount vs the current concept of putting up a small initial deposit and pay the rest with interest as time passes by.

If no one is allowed to take debt for buying their own house, the housing market will crash for the simple reason that disciplined saving is way tougher compared to the discipline of paying off the EMI since otherwise you may tend to loser ownership of that house and its not just the financial loss that will pain you but the ignominy of being seen as a failure by those who know you.

Now, lets come back to Stock Futures and how similar it is to the Housing Loan.

Lets assume that you believe that government will focus on Infrastructure and hence Infra companies that have been bogged down could see better days. Lets assume based on the above rationale, you choose J P Associates as the company you want to invest into.

Lets assume you currently have around 2.5 Lakhs that you want to risk in the market. The rational thing to do would be to spit that into 10 or 20 equal measures and invest each such measure into a individual stock. That would mean that you could buy 2170 shares of JP Associates if you invest 10% of your capital into that company (25,000) or 1085 shares if you were to allocate 5% of your money into the said company.

Lets for sake of understanding assume that you have done a lot of research and that research tells you that JP Associates will bloom in the future and given that its all time high is 339, if you are right, this stock could go way way higher.

Given this scenario, would you opt for buying 2170 shares or 1085 shares or would you think on lines of, given how much I know why not take a loan and pump in more money since the rewards will then multiply by the leverage factor.

Lets for a moment get back to the housing example. Two friends analyze the housing market and feel that its ripe for a big up move and they should take advantage of the coming boom. Person A saves a lot of money and finally buys a house without taking a loan for 50 Lakhs. Person B saves a small amount (10% of the value of the house) and takes a loan for the rest 90% and buys a house for 1 Crore.

With housing prices booming, lets assume that property prices acquired by both Person A and Person B have appreciated by 100%.

For Person A, its a pure doubling money. He had invested 50 Lakhs and sees a profit of 50 Lakhs. He is happy until he turns around and sees that Person B who put in 10 Lakhs is now seeing a profit of 1 Crore, 10x the investment. Given that both had done the same analysis, do you think that person A will really be happy with the outcome he is seeing now?

Lets get back to our JP Associates case. You feel that this being one sure bet, maybe you should bet it all – 2.5 Lakhs and wait for it to move up as your Analysis tells you it will. 2.5 Lakhs will get you 21,000 Shares. At this time comes in the Spider who tells you that why stop at 21K, when the same 2.5 Lakhs can get you exposure to 68,000 shares.

In earlier days (and even these days) brokers offer what is called margin finance where you buy stocks while putting up only a part of the investment. If you are right, your returns explode and who thinks that things can go wrong – always be Optimistic is what he have learnt in Life.

But for JP Associates, you don’t need a kind broker to help you. The exchange itself will provide a medium where you can borrow. All it asks you is that you fulfill the margin requirement as well as the day to day, Marked to Market difference.

If you are not exposed to Futures and Options, you may think which irrational fool will take that path, but then again all you need to do is visit a broker’s place and see for yourself how the herd behavior will influence one to take more risks that he should if had analyzed the whole scenario much more carefully.

So, now that we are convinced that JP Associates will move higher, way way higher and we aren’t satisfied with just a small token quantity, we convince ourselves that nothing will go wrong and jump into buying a single contract of JP Associates.

We are now proud owners (not in real sense) of 68,000 shares of JP Associates which means that every time it goes up by One Rupee, we are seeing a profit of 68,000 and since our capital is 2.5 Lakhs, we are up by a awesome 27% of our capital (remember, a Fixed Deposit gives you 7.5% for giving it money for a year). Man, we can start dreaming.

A couple of days later, comes a news item that a certain bank is proceeding with confiscating certain assets of JP Associates and the stock promptly goes down like a brick. Theoretically that shouldn’t cause a problem, after all we have put in 2.5 Lakhs right and even though the stock is down 10% from our entry, its just a loss of 68,000 and big as it may sound, we still have 1.80 Lakhs available.

In 2007 when housing prices started to fall in the United States, those who have taken loans to buy their houses found that many banks had started to ask for them to make up the difference (since most housing loans were to the extent of 100% of the property value). But having invested everything they had, how the hell were they to come up with more money. By 2008, prices had fallen so much that even those who had paid back a lot found that their house value was lower than they still owed to the Bank. With job losses, many were forced to relinquish their homes, something they had paid a lot for (in monthly installments) while getting back nothing.

Back to our JP Associates trade. While we think we still have money, we are actually in negative equity since NSE demands that you plonk up 2 Lakhs as Margin for every contract you wish to hold. Given that we had 2.5 Lakhs to start with, with the loss of 68,000, you are now having a debit balance of 18,000.

Depending upon your broker, you will either see him closing out your position without even giving a chance for you to replenish the amount or shall call you up and ask you to immediately replenish or else position will be cut. Either way, you will need to put in more money to hold that position.

But if we had invested the whole capital we had, where else can we bring fresh capital from? I have seen clients Beg or Borrow from others in the hope of maintaining the said position. In fact, years earlier, I myself had come to face a very similar situation and its in those situation you not only realize who your real friends are but realize how stupid you have been with your money.

But that is for later, what comes first is the requirement of more capital. If you can bring it in the time they provide, your position will be saved, else, its closed and regardless of how JP Associates moves from here, you will have nothing to lose or gain.

So, when I said 95% of clients on the longer term end up loosing, its not because they were stupid but because most of them were financially unprepared. When you use Leverage, its a double edged sword and yet people believe that only one edge is what matters to them without focusing on the dangers brought by the other edge that could cut your neck in no time.

Stock futures are a good product if you can use them wisely (more on that in another post) but if you are using it as a quick way to becoming rich, Good Luck. The 5% who are out there eating up the losses of the rest 95% losses (remember, futures is a Zero sum game) know for sure that Luck can only last so long. Some point or the other, you will throw in the towel after having seen your capital being decapitated several times.

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so. – Mark Twain

Travails of a Trend Follower

Over the last few decades, Trend following has really taken off with a lot of believers flooding the streets so as to say. After all, if I were to sell you with charts like the one below, why would you not be convinced about its benefit

But then again, I choose that particular chart out of the 1000’s available because I could use it to show what I wanted to show. Selection Bias / Survivor Bias and what not come into picture the moment I select a single or even multiple instruments from a set of data.

But trend following is tough and this makes one starting to question premises even when we can show from history that what is happening is exactly something that has happened in the past and will happen in the future as well. But, past is the past and the future is unknown. Present is the key and our emotions aren’t really concerned with either the past or the future but the moment on hand.

Yesterday for instance I had a debacle day for me. In the morning my stops got stopped out and I went long. Well before the close though, I once again got stopped out and went back to the original short mode. But markets had not ended and while I did not get any fresh signal markets did move a lot higher than the point that my longs got stopped out and I went short once again.

This is a rarity for my system with system exiting 2 trades in a single day being just 5% of the time, but it hurts and not surprisingly is the costliest (per trade) whipsaws as the chart below will showcase

What is striking in the above chart is that whenever the trend ends fairly soon, you end with negative results that are the primary contributor to the adverse win-loss ratio most trend following systems have. In the above system for example, if you are in the trade for more than 7 days, the probability that you shall still end up in a loss is pretty low. The chart below plots the same

Its amazing to see how not a single trade (out of 365 in above example) could close in +ve if the reversal happened in the first couple of days. Once that hurdle is crossed, the probability keeps going lower until it hits zero and stays there.

Since 1996, Nifty has moved up by around 8000 points. But if you were a trader, you could have gained that 8000 points by being rightly positioned on just 36 days (which is just 0.70% of the total number of trading days). If you were having a trading system that traded daily, if you slept for the first 10 years (1996 – 2006) and applied your theory on just those 36 days, you will have in theory outperformed all 99.3% of the other days (all this being theory, but please bear it with me for a moment).

In other words, you could have been long since 1996 and gained exactly the same points as some one who entered and exited daily on just 36 occasions. Of course, if only we knew about these 36 days in ahead, why would we bother would be the question in your mind and you are absolutely right.

But think on the contrary you were long for all the time and yet were out of the market on those 36 days. What would you be staring at? You would be looking at having the same capital as you did 20 years ago.

Now, lets take a trend following system equity curve. What is the cost of missing a few trades (which inadvertently turn out to be the best trades you could have taken)?

As can be seen above, more the trades you miss, lower the returns. Since the number of trades scrutinized above is around 365, missing 15 trades is missing only 5% of the Signals and yet the returns can be disastrous. You could always argue that maybe the trades you missed weren’t the best but the worst and hence the returns actually are better. But if you could do that in real time, your success rate will be closer to 100% since you can easily over ride all bad trades similar to the way many advisors just remove their bad calls while showcasing their good ones.

So, given this relationship, why do traders still try to skip few trades in the hope that those skipped will be a loser and hence be advantageous. Think of a coin toss. Theoretically odds of a fair coin falling either on its head or tail is 50:50. But if you were to toss the coin n number of times, you can get streaks of heads or tails. But does that change the probability of the next coin toss to something like 40:60? Of course not.

Trend following systems have a average winning of 40 trades vs losers of 60 in a sample of 100. But that doesn’t mean anything since you can have 10 or 12 or even 20 consecutive losers without one single intermittent win. But does that really change the overall ratio? I say Nope. It still remains 40:60 in favor of Losers.

I keep hearing various remarks about how you should know when to ride the system and when to over-ride, how one should not take a trade before a big event (which is actually of a lower risk compared to the risk of the Unknown event we take when we carry positions home everyday), how January is not a good month for longs among various other theories.

When you have a loser after loser, its easy to believe a lot of nonsense that gets sprouted. But as showcased above, data indicates that missing can cause more harm than participating in each and every trade. All we can control is Risk and that is better controlled by modifying our position size than by skipping a few trades.

Should Retail Investors / Traders indulge in Derivatives

Twitter is a place for discussions, collaborations, fights and what not. Today’s post has much to do with one such discussion which more or started when while replying to a friend, I put it out that I was long in Nifty (as we dwelled on how markets may behave on Monday following the carnage (if one could say that) one saw in Dow on Friday).

Vijay Pahwa commented on the tweet and tweeted “Even the best of traders lose money. A layman shd focus on investing in stocks. No trading system can predict mkts!”. Well, for starters he thinks too high of me to place me in the same box as the best of traders. If anything I hope I am above average (especially since I have survived) and not in the bottom of the bracket.

This comment started a new thread on its own and in one such tweet, he tweeted the following

While I don’t know the source of the 95% (am told by various brokers its even higher), I have to agree with at least the first part of the statement. Second part is questionable given that there is so much of Survivor bias in the data we have and one never knows which fund will have lost money regardless of how long one held the same.

A google search provided me with what could be the Worst Mutual Fund “Ameritor Security Trust” which lost money despite being in the market for 50 years. If you think India is different, think again. CRB Mutual Fund was closed after 20 years with investors getting back 64% of what they invested.

Given the evidence, the question that naturally comes is whether a retail investor should ideally dip his toes into the world of derivatives. While I have been a trader for the last many years, if there is something I agree with the naysayers, it would be that most of them have no business to take part in that trade.

But human greed is tough to conquer. When one thinks there is a opportunity in a certain stock, would you just buy what you can afford (Cash Segment) or try to leverage it (using either Futures, Options or Margin Trading – provided by a lot many brokers) to make the best of the situation?

While I trade in Derivatives, I trade only in Nifty and not Individual Stock Futures. But Stock Futures are the more famous cousin in India where it out-trades Index Futures (measured in Turnover) by nearly 3 times. In fact, Stock Futures turnover is higher than even Stock Options turnover showcasing the bias that has meant that liquidity begets liquidity and there is hardly any trades in majority of the stock contracts.

Stock Futures has had a interesting history in the United States. From Investopedia I learn that Stock futures were in fact banned from 1982 until 2000 and though it trades today, the volumes are way lower than what you see in Individual Stock Options.

In India though, Individual Stock Futures has been the rage. Then again, where else on earth would you see a retail trader having access to a contract worth 5.7 Million (MRF, near its peak) without there being a iota of necessity with regard to whether he is even financially fit to buy such a contract. If you thought, that was excessive, you should have seen the contract value of Gaur Gum hit the roof when it climbed an astonishing 2000% in just around 18 months. Since contract is for specific quantity, there is no revision.

For instance, when MCX started offering Gold contracts, the value of 1 Kilo (its normal contract) was around 8 Lakhs. Today, the same contract has a value of 31 Lakhs. With SEBI revising the minimum lot value from 2 Lakhs to 5, a lot of stocks have so absurd a quantity that its enticing to the retail investor to try his luck and see whether he can make it big.

Unlike delivery based investments where you can lose only what you invest, when you deal in futures you can lose a lot more. While risk is limited when you buy options, that is theoretically not comparable since you cannot really bet big on options without taking the risk of having a large part of your capital wiped out. For instance, while there is high risk in stocks, you can bet 10 / 20 or even 40% on a single stock,the probability of you being wiped out (especially if you are buying Index Stocks) is pretty low, in Options, you can get wiped out pretty easily.

Trading attracts the best of the minds since its a constant challenge and winning means that you are literally the member of a high class club with very few long term members. But trading is not even comparable to other endeavors since the risk is asymmetric.

Just as I was about to write this post, I came across this very view by Eric Peters

Trading is tougher than most realize, the odds of success are fairly small and when that window of opportunity opens, very few have any stamina (financial or otherwise) left to take the big calls that would lead to the big gains.

If you were to count the number of advisors who offer you the recipe for success in markets, you quickly realize that this is a market for selling shovels to gold diggers. Brokerage houses survive thanks to Sepculators, more so those who do it in Stock Futures as they have very small holding periods are liable to churn excessively.

While I have no clue as to what might be the optimal number of trades, for me it comes to (based on my system history), 1 trade in a fortnight. As Adam Grimes blogged and I quote,

“On some level, professional trading is boring, and it should be. What we need is structure, routine, and a methodology that points toward repetitive elements of market behavior. What we don’t need is excitement. Be a bricklayer.”

Trading is not for the fainthearted, nor for those looking to make some quick bucks, not for those who cannot afford to spend the time required (its a full time job regardless of how little amount you trade) and definitely not for those who think its a path to glory and riches.

People love the story of Jesse Livermore but forget the fact that he went bankrupt not once but twice. Having had a close encounter myself, its amazing that people think that bounce back is easy. Its not and generally ends with the trader abandoning the markets rather than come back in force.

To conclude, in my opinion, its not Leverage that kills but the inability to understand and handle the risk that finally kills the trader. Leverage in the hands of a able trader is a opportunity, in the hands of a speculator, its a self-destruct button.

If you aren’t a full time trader, stay away from derivatives and at the very least you can enjoy the up’s and down’s of the market for a long time to come (regardless of whether you actually make money or not). There is no such thing as hand-holding out here.

Start of a New Bull Market?

A Bull market in the markets is one of the best times to be invested as stocks more or less follow the herd (going up) and regardless of when you enter, opportunities are available in one sector or the other.

But getting when a bull market started is easy only in hindsight and never when we are literally at the starting point since we tend to discount the bad news and focus on the charts / positives in the earlier era while focusing on the negatives this time around making us believe that a bull market couldn’t possibly start in this environment.

One of the benefits of being a trend follower is that we do not believe we can predict the market on where the future lies and hence the best we could do is try and be with the larger trend that is in force.

When the bull market started in 2003, there was a real gloom in markets with no one feeling confident of the future, let alone think that we were at the start of one of the greatest bull run we had ever seen. In 2009, people were so shaken by the rapid fall of 2008 that they couldn’t believe that markets could climb so fast so much.

The current scenario cannot be really called the start of a new bull market since the fall we saw in 2015 can be seen more of a reaction to the over expectations that got build up as Modi came to Power, but given the fact that technically we did get into a bear market (what ever definition you used), we now need to focus on whether those bear market signals are well and truly invalidated.

Bull / Bear markets have no clear definitions and so one needs to use multiple such definitions and arrive at a conclusion. So, lets take a look at some of the definitions and where the market is trading currently.

The 20% Rule

One of the simplest rules, it basically says that we enter a bear market when markets drop more than 20% from the peak and enter into a bull phase when we rise 20% from the lows.

Nifty 50 entered the bear market when it dropped 20% from its peak in Jan 2016. While markets final low was another 6.65%, theoretically speaking this bear market was very much a truncated one despite signs of all around gloom and doom.

When Nifty crossed above 8190, it also meant a rise of 20% from its bottom hence invalidating the bear market and suggesting the start of a new bull market.

2. The 200 DMA / EMA Rule

Markets are in a Bear Phase when below the 200 days average is one of the better known ones. While the first break below the 200 DMA happened in March 2015, it was never a smooth ride with the many chops. Even recently, one saw plenty of chops till it broke out.

3. The 13 by 34 Weekly Rule

While moving average crossovers are well know, many a well known technical analysts use this to determine the trend of the market. Once again, this comes with a fair bit of risks (Whips).

4. The Ned Davis Rule

The Ned Davis rule of a a bull market requires two things to happen. A Bull Market requires a 30% rise in the Dow Jones Industrial Average after 50 calendar days or a 13% rise after 155 calendar day.

While Nifty 50 is up greater than 13% from its low, its still just 60+ days from the low. Another 10% rise too could trigger this rule though by that time, Nifty 50 will be closer to 9000 (8872 to be specific).

5. RSI on Weekly

Now, this is not really a rule of Bull Markets, but when RSI on the weekly moves above 60, it showcases strong underlying momentum and one that can carry. Here is a Nifty chart with previous Buy / Sell signals (Arrows)

And finally, my own Trend Indicator went into Strongly bullish mode a week ago.

Only in hindsight can we really know whether this would be a great time to enter or not, but at the moment, my money is on being bullish rather than try to predict whether this will whip and the down-turn will continue. Remember the saying

“the early bird catches the worm but the second mouse gets the cheese”

No Risk = No Gains

Does Golden Cross Work

Friend, Nooresh Merani uploaded a video (Youtube Link) where in he literally questions using Golden Cross as a trading / investing tool. While I see loads of skeptics who believe Technical Analysis is Bullshit, I found it disappointing that Nooresh does this since he is a expert in Technical Analysis and runs courses and sells newsletters based on application of Technical Analysis on markets.

Unlike say Elliot or Market Profile, strategies like Moving Average Crossover do not require one’s reading of the charts to decide whether its a Buy or Sell. The strategies that can be tested are generally Binary in nature with clear cut logic behind Buy & Sell which cannot be disputed.

His main reasons for not believing is due to

Huge Lag between time when market hit a low or high and the Signal
Whipsaws which eat away a huge chunk of capital

Both indeed are true. Moving Average systems lag and you can never catch the bottom or the top. But as investor, are you looking to buy at bottom / sell at top or looking to maximize the amount of time you can spend in market when conditions are favorable and out of market when its not.

Lags can be removed by using a smaller multiple for crossover, but that in turn means more trades and hence more slippage / transaction cost and taxes. For example, if you were to test the smallest MA cross (3 by 5) on Nifty 50 since 1990, you will get 405 trades (Long only). On the other hand, for a similar time frame, using a higher multiple like the Golden Cross (50 by 200) would have given you just 14 trades.

A simple Buy & Hold from say 15th September 1993 (on Nifty) would have given you 7330 points. On the other hand, if you used a MA Cross such as the Golden Cross, you will have ended up with 6600 points. In other words, it will not be beating the Buy & Hold returns.

But while we are exposed to markets 100% of the time when we do a Buy & Hold, we aren’t when we use a system such as the Golden Cross. In fact, we are in the market for only 60% of the time. In other words, for 40% of the time, your capital can earn at the very least Liquid Bees earnings as it awaits the arrival of the next signal.

But the biggest advantage is that when markets go down like they did in 2000 or in 2008, you shall be sitting pretty in cash. So, while a Buy & Hold investor can reap a bit more, he will also have to endure a lot more pain. How much pain? Well, let this chart show you the same in picture format

The chart above plots the draw-down the equity curve would have faced when you just bought and held (Blue) vs using the Golden Cross (Red).

As you can see, while the Blue lines test the 50% (loss of half the maximum capital reached) multiple times, with a simple system such as the Golden Cross, you are able to avoid the risks with draw-down barely moving above 20%.

The comfort it provides to be sitting in cash when everyone is neck deep in losses and wondering if the world will shut down tomorrow is hard to describe.

Yes, a moving average system may not be the best tool if you are a active trader willing to take big risks and spending time on the screen. For all others though, this provides the simplest way to participate in bull markets as and when they come.

Below is list of all trades that you would have taken if you had used this system (a few theoretically since Nifty did not exist until 1996).

Being a systematic trader, for me the biggest advantage of systems that can be tested and validated is that I can risk big. After all, only way to win big is to bet big and for betting big, you need to be sure the odds are in your favor (not in every trade, but overall).

The current Golden Cross may whip and hit the trader / investor with losses. But, that is the way trend following works. You lose 6 out of 10 trades, but the 4 you win more than make up for the losses. If you are searching for a holy grail, you won’t find it in Systematic Strategies at the very least.

Share this:

Share this:

Share this:

Share this:

Share this:

Share this:

Share this: