Classical Arbitrage Strategies Explained

Now that I have described pair trading, the next topic of interest lies in “risk-free” arbitrage strategies. Due to generally limited literature, this subject remains heavily veiled behind institutional trading.

Classical arbitrage defined

Classical arbitrage applies to any business strategy where one exploits market inefficiencies for a risk-free, self-financed profit. Discrepancies in offered values of same underlying commodities/services present the said “market inefficiencies”.

I had provided some examples a while ago on the blog. They present some direct and practical business models or trading schemes applied by real life people.

Are they really entirely risk-free?

No, but it takes much less effort to control the risks arbitrage strategies face, as profitable trades occur regardless of market movement or volatility exposure. In other words, common risks associated with naked stock positions disappear.

Liquidity, price impact, and transaction costs (associated with transaction sizes) generally become manageable via adequate calculations. Mathematical finance helps to optimize arbitrage strategies via things like linear programming or vector space representations, but to become basically profitable (just not maximized), anyone with basic algebraic understanding can manage it.

Do you need huge capital to apply arbitrage strategies?

No. Many opportunities exist for traders of all levels of account sizes. Though of course the larger the trades, the more insignificant transaction-costs become which makes rewards more attractive.

Quick example:

A NZ company is listed on both the NZSX and ASX, and today at close you see the following prices for the stock:

(Hypothetical prices)

· At NZSX: $10.00NZD/share

· At ASX: $10.50NZD/share

You sell 300 shares short on the ASX (requires $3,150 cash in account), then buy 300 shares of the stock long on NZSX. When prices converge you close both positions.

· Total initial cash requirement: $6,300

· Total profit: $150

· Total transaction cost (at $30/trade): $120

· Total net profit: $30

At $30/trade, the brokers here charge way too much, hence making arbitraging in this manner not-so-attractive.

So, with a few thousand dollars, anyone can make money in these markets regardless of market movement.

Reasons why not all traders apply these strategies

Some simply do not understand it or never bothered looking it up. Then for others, the returns remain too low. While arbitrage strategies offer double digit returns per year with very low-risk, ambitious traders aim for much higher targets.

Exceptionally high returns require strategies of highly active management and innovation. Though once found, the mentioned arbitrage models do not look attractive anymore. I have met traders who make over 1% per day, consistently, so yes it is all possible.

Option Volatility & Pricing by Sheldon Natenberg (Book review)

"Option Volatility & Pricing: Advanced Trading Strategies and Techniques" by Sheldon Natenberg presents straightforward, practical concepts valuable for both equity and derivative trading. Understanding derivative mechanics leads to deeper insight of the underlying securities, this book explains the why’s and how’s.

Some reasons you should learn option trading

1. Selling out-of-money Covered-Calls allows for potentially significant enhancement to long term underlying stock investments.

2. If you want to short a stock, but it is not available due to various reasons. You can still pull it off with options, via a “synthetic position” where you long a Put and short a Call of the same strike price.

3. Option pricing involves volatility of the underlying security. Understanding how volatility works remains a key to optimizing “trend following” stock trading systems.

4. Arbitrage, gaining profit regardless of underlying market movement or volatility, becomes possible coupling options with stock trading. Though still not entirely risk free due to issues with liquidity, price impact, etc., returns via arbitrage present consistently positive returns if applied diligently.

Some helpful points from the book

1. Basic option details

2. Volatility defined (without too much advanced mathematics so that you can understand it even if you have had nothing but basic algebra)

3. Forecasting underlying security movements via volatility

4. Option strategy payoffs

5. Strategy payoff comparisons as regards to underlying market conditions

6. Arbitrage strategies with options and underlying securities

Read it

Out of a sea of speculative, reiterated content, Option Volatility & Pricing gives some unbiased and actually-useful information without the car sales-pitch. You might even find it at the library (like I did at school). So take a seat, with your favorite beverage at arm’s reach, and go through it.

Protection against NZ investment fund losses

NZ investors can eliminate risks connected to volatile market exposure; it just takes a little bit of ingenuity. The following idea applies to holders of financing company shares and “buy & hold” funds like the various Kiwi-Saver pools (and those two frozen ING funds).

Main risks from naked market exposure

The existing investment vehicles available in NZ hold positions in American debt and stocks off the NZSX and ASX (New Zealand Stock Exchange and Australian Securities Exchange). They all correlate highly with American economic conditions. As history has asserted, financial systems experience indistinct but nevertheless apparent cycles, a potential downturn imposes heavy losses indirectly for these NZ investments.

The next wave of housing loan defaults will occur in California, as ARM rates reset, failure of American lenders will follow, then Wall Street, and etc. Sooner or later the detrimental impact will cause mentioned NZ funds to crash. This will lead to “round 2” of market free falling, except this time it could become worse than that of last July as pessimism among institutional traders escalate. When it hits, some investors could lose everything.

The fact that some NZ financing companies (or funds at ING) have frozen withdrawals presently suggests they are aware of the coming storm, and want to try bullying the investors into taking losses instead of themselves. (Public investors should voice the outrage in this, but that is for another article).

Protection, insurance against said risk

Downside bets against the shaky, high risk, American borrowers and credit market participants provides a crude, but logical method to hedge against failure of investment funds in NZ. Taking short positions against these counterparties who sold the debts to NZ financing firms basically takes out the possibility of losing everything, because now the investor becomes protected, or hedged.

What you could do is demand for a detailed list of all invested vehicles from the existing investment manager, this would allow for precise hedging. As a client, investor, risk taker for them, you have the right to this information. I would suggest you contact the security commission if the firm holding your money tries anything “funny”.

Potential Scenarios

Say you have $1,000 invested in a NZ financing company and you do not want to risk losing it all, you decide to take a $1,000 worth of short positions in a basket of investment banks and mortgage brokers such as Merrill Lynch (ticker symbol: MER), Countrywide Financial (CFC), and others with respect to your NZ investments. The following possibilities could result.

1. One of the American firms becomes bankrupt. You take large losses in NZ investments, and make huge gains on the short American positions. It cushions the loss dramatically, and allows for potentially profitable result.

2. The US Federal Reserve saves American firms from going belly-up, but nevertheless, they lose value due to unprecedented credit issues. You get your returns from the NZ credit investments on maturity, and make additional profit off the short positions in America.

3. The market stays sideways until your NZ credit funds mature. You make your returns off them, and break even on the short positions.

4. The whole credit-crunch thing blows over, however unlikely it seems, and the market rallies once more. You make large profit in the NZ/ASX stock market funds, and finally able to withdraw from the financing companies, but take a loss in the short American positions. This will result in break-even, or a small loss.

The bottom line remains, the above scheme takes out the possibility of you losing everything from these extremely high risk investment funds in NZ. All said and done, your hard earned money deserves better management than these passive, inept or intentionally deceptive business entities.

NZ fund managers provide little value

Having learned some bits and pieces of how Wall Street functions, one eventually realizes the limited benefits or merit held by mutual fund managers. Buying, holding, and praying in the stock markets (or “share-markets” coined by New Zealanders) does not require any know-how, in fact a few clicks of the mouse can get it done.

Many New Zealanders have gotten ripped off from these investment businesses, and this rampant ploy has become increasingly apparent as an economic downturn descends. A deeper look reveals the involved managers as either incredibly inept, or intentionally deceptive.

Basic business models

The NZ publicly available mutual funds make money off management fees exclusively, and largely no incentive charges. While this sounds more attractive than the usual 2&20 (2% management, 20% incentive) off typical hedge funds, the NZ management teams have absolutely NO motivation to provide investors with a positive return. They make their money either way.

Buying and holding. That leaves basically most of the days freely available for advertising, widespread promotions, with sometimes misleading salesmanship. They display charts off historical growth periods (frequently cutting off downturn phases), and entice mom and pop investors signing agreements where the fine print explains ineffectual irrelevance of said pitches.

They exist to provide a false sense of security and sanctuary for the uninformed investor. Management and front-end load (entry) fees equate to guaranteed losses for the investors, and the non-active trades often result in worst transaction prices off the exchanges. A lack of liquidity results in slow and sometimes very costly withdrawals in volatile markets, in some cases frozen accounts. You get the drift?

Why do they oppose “market timing”?

The mutual funds understand that if you, the diligent and open minded trader, become informed of how the markets actually work their fallacies and shortcomings become obvious. They maintain that only “long term buying and holding” (with no exit plan) could yield rewarding profits, because as long as the public stays in the dark this business industry remains afloat.

Are they more informed?

When it comes down to it, they simply do not know any better than you or me. Whatever stocks they decide to “buy, hold, and hope”, usually result from not-so-educated guesses. These people might have had more experience writing up fudged reports, but that is it. Yes, fudged track records have become pretty common in this industry, do not trust them.

As the NZ economy correlates positively with US, these forms of funds suffer just as much as someone who bought the stocks or ETFs on their own. (See chart for NZ Telecom stock performance compared to the US S&P500 Index, ticker symbol “^GSPC”)

This means these so-called experts expose investors have no skills or intentions of mitigating inherent risks from long term stock holding.

What can you do?

Investments, like any business, will likely succeed as your expenses become lowered. Even if you still believe in the “buy, hold, and pray” schemes, going through a direct access broker offers much lower fees. My current broker charges only $1+ $0.0025/share per transaction.

If you do run into an investment run by a seemingly competent manager, do your homework and get to know underlying strategies applied. Just keep in mind that if it is simply buying and holding, you can make higher returns on your own. Here you can find an article on trading ETFs on your own, and how you could greatly increase returns selling options of invested stocks.

More NZ financing companies set to fail

As America prepares for the next wave of credit market troubles (The trillion dollar mortgage time bomb, Isidore 21/4/08), New Zealand financing companies face heavy damage as well. The logic behind their failures remains simple, yet profiting off the coming disasters require a bit of work.

NZ financing company business model

Roughly 20 NZ financing firms have fallen in the past half a year, alongside private investment funds heavily positioned with debt instruments. Despite the lack of transparency and obscurity of management qualifications, it has become highly probable that their businesses models entail mostly high risk debt securities from American investment banks.

More will fail

Due to the above, it becomes plausible that these poorly managed funds hold a highly positive correlation to US credit conditions; in other words, when Americans default on their car, credit card, home, or student loans, NZ financing companies take losses alongside Wall Street. While Ben Bernanke may attempt to remedy the impending storm, US Federal Reserve will not save NZ firms, where mom and pop investors take harest falls.

Profiting off their collapse

With such negative outlooks, downside bets on these firms carry very attractive reward/risk ratios. The NZSE has not developed mechanisms for short selling yet, but it is possible on the ASX. One could look for NZ financing firms listed on the ASX to take on short positions. As soon as the companies fail, values of their stocks will drop to nearly nothing and provide short sellers great returns.

If available, loading up on option spreads would require more meticulous strategies but at the same time offer higher potential returns due to leverage. Reverse butterflies, calendar spreads or even simple straddles could allow investors to exploit the coming volatility spikes (regardless of underlying stock price direction).

Some work becomes required in areas of research besides fundamentals for optimal entries and exits. Other means probably exist to exploit their coming demise, and simply require a bit of searching. In the mean time, local NZ mom and pop investors would do well to stay alert of these debt instrument pools and make more prudent money decisions.

Active Value Investing: Making Money in Range-Bound Markets, Book Review

This book provides little value as Vitaliy Katsenelson displayed limited knowledge of the financial markets, due to either lack of experience in actual trading, or simply book-selling ruse. The ideas unoriginal and largely convoluted, readers could potentially end up performing worse.

Questionable Theme

Simply put, Katsenelson suggests that if you apply his wisdom, while if and ONLY if the said market happens to move within a range, i.e. if the volumes of initiated buying and selling orders remain roughly equal, you can “invest” profitably. So basically if you happen to guess correctly about the future market movement (it is “range-bound” roughly 1/3 of the time according to him), you can make money (roughly 1/3 of the time).

What the hell is that? Making money infrequently, and losing your shirt most of the time sounds like a bad deal. The markets could only move up, down or sideways, even a plain old guess could provide a winning rate of 33%. The content within the book revolves around the above theme, and therefore do not offer any substance of value.

Not Recommended Reading

Books like these offer deception rather than enlightenment. The concepts mislead as they create the impression that traders only profit in “right market conditions”, which implies a heavy role of luck inherent in successful trading, and if you depend on luck instead of actual relevant skills to trade successfully, you are no better than a losing gambler.

Intepreting Financical Media

To apply financial news as a source of sentiment analysis, one must examine motivations of media sources. Despite that most information off financial news services present nothing but reiterated historical events, unfolding their incentives could mean the difference between losing and winning for common investors.

Wall Street Objectives

Financial institutions operate on a purely profit-driven basis, and it drives every single decision they make, including content pushed through mass media. In other words, they have no incentive to divulge effective information for the public, retail audience, and their personalities offer either clueless-ness or outright deception.

The above explains partially why those who react to financial news (which simply turns out trend-following) tend to buy at tops and sell at bottoms. Listening and trying to take media information verbatim does not usually end well.

Applying Financial Media for an Edge

Go against it. All of it. An “expert” opinion known throughout the mediums of radio, TV, internet usually asserts a naive guess or purposes of influencing the masses. By the time American media started spreading negative sentiment this year (off the credit market issues begun last July) short term losses had already reached an end.

The explosion of unenthusiastic opinion influence meant buying at the large institutions, and they can do so at bargain prices as remaining public investors sell off. Reversed scenario also occurs frequently as industry insiders plan to liquidate.

All said and done, the Gods of financial markets favor investors with enough conviction to turn against publicly pushed sentiment. Following the crowd often hurts, just like everything else in business.

Pair Trading Explained

Market neutral, pair-trading strategies allow traders to reap profit off stock markets regardless of directional forecasting. It embraces simple principles, though the reward does not come easily.

Basic Tenet

Some institutional traders consider Pair-Trading a type of statistical arbitrage (like this one). It first takes two stocks or ETFs of very high positive correlation, i.e. they basically move in concert, and when their prices deviate you short the high, long the low, and close both positions for a profit when (and if) their prices converge.

The fundamental steps entail importing historical prices into statistical software, and then enter when they diverge by 2-3 standard deviations, closing positions if and when prices converge later on.

Main Risks

No adequate exit strategy if the pair never converges. Remember Long Term Capital Investments run by those Black-Scholes Nobel Prize winners? They lost a fortune betting on a pair of oil based stocks.

Too much time may lapse before convergence. Naturally if it takes several years for a pair to converge, the loss in opportunity cost may become quite significant.

Potential volatility may cause margin issues with open positions. To effectively manage this, potential reward becomes lowered, an uncomfortable trade off.

Liquidity issues still stand, especially with short positions becoming potentially squeezed. Some could argue that having a pair highly negatively correlated may solve this issue, yet while working with large volumes, liquidity and price impact matters will not go away.

Profitable?

Yes it can be, but not via simply entering and exiting based on guesses. It takes meticulous planning and active execution. It will not generate all winners, but as long as you can provide yourself a statistical edge, it will work.

Tent Cities in US

I had never realized how bad it has gotten in the US until this.





A real eye opener. Yet they still understand little of how unscrupulous mortgage brokers and bankers had brought this about. As expected the uninformed remain at the bottom of the food chain.

US Banks Face Unprecedented Challenges

The Federal Reserve numbers do not reassure investors to date. As seen above non-borrowed reserves have never reached a negative value until this year.

The possibility of some banks defaulting has become quite high. I think it would help for you to keep an eye on financial performance of whatever bank(s) you currently work with, and making contingency plans in case your current bank’s books start to look shaky. It pays to stay alert.

Enhance Stock Investment Return via Option Selling

Long term investors could produce increased return (or lessen the same amount in losses) from selling call options. The concept of derivative trading may intimidating some learning investors, just read on and I will show you why this works and carries very-low risk.

Call-Option Basics

A Call-option gives you the right, not obligation, to purchase the underlying stock at the strike price; a Put-option does the opposite but right now we only take interest in Calls. Each option contract (according to CBOE regulation) carries 100 shares of the underlying stocks.

So, trading 1 contract of IBM Call-option gives you the right to purchase 100 shares of IBM at the strike price before the option contract expires (usually 3^rd Friday of expiration month). The value of traded option contracts is termed the “premium”, the price that option buyers pay, and option writers receive.

(The most renowned option exchange today operates at CBOE, Chicago Board of Option Exchange. They provide a brief and concise primer on options. Spend half an hour on it and you will understand all the fundamentals.)

Out-of-money Call-Options

The option “money-ness” describes the relationship between the strike price and underlying value. For Call-Options, this means a strike-price higher than the underlying price, e.g. holding an IBM call-option contract with strike at $110 while IBM sells at $105/share. The premium decreases to zero for out-of-money options at expiration.

Writing Out-Of-Money Call-Options

When you write a contract of Calls, you become obligated to sell 100 shares of the underlying stock at strike price IF assigned (this happens randomly, and infrequently according to statistics). This naturally requires tremendous risk management if you do not own shares of the underlying. However if you do hold sufficient underlying stock positions (i.e. covered), this tactic could prove very worthwhile.

Detailed Example

Let’s say you own 100 shares of QQQQ (closed at $44.28 on 4/11/08). You could consider selling a contract of Calls with strike price ≥$45 expiring in May. Last quoted Bid for a $45 Call stands at $1.16, and you decide to write 1 contract.

The following possibilities will ensue for the 3^rd Friday of May.

1. QQQQ lowers in value to say, $41/share, and you lose $328 on the ETF position and the options expire worthless. Due to premium gained on the written Calls; you reduce that loss by $116.

2. QQQQ remains at the same price of $44.28, and you made no return on the stock position, and the options expire worthless. With the premium earned, you make a risk-free profit of $116, roughly 2.6% of the underlying position.

3. QQQQ increases to say, $48/share, and you gain $372 on the ETF position, lose $300 on the written option position (IF assigned), and end with a net profit of $72. Yes in this case your profit could become lower; nevertheless it is still about “taking profit”, not a loss.

So, this scheme reduces risks and increases your probability of success (2 out of 3 net-profitable potential scenarios), and you can pull it off easily. Pretty good, huh!

Capital Protection (Dollar Risk Free) Risk Management Scheme

The capital-protection scheme simply means that by the end of the performance period, even in the worst case scenario that you lose EVERY SINGLE TRADE (Murphy’s freaking Law, where ‘if anything could go wrong, it will go wrong.’), your original capital remains preserved. Yes it is possible, practical, and easy to pull off once you understand the numbers.

Basic Run-Down

Allocate majority of capital into an interest collecting instrument, and trade with only the remaining amount. By the end of the investment period, even if the trading resources become lost, the original amount becomes regained from the interest gained on the investment.

Execution Details

First you need to find a low risk investment. In today’s financial environment that means government or bank backed savings account or bonds. Here in NZ, the average banks here offer rates as high as 8.9% a year for these debt instruments that comes to roughly 6.5% after tax.

Let’s say you have $100k of capital to start with, and you want to have at least that amount by the end of a 1 year investment period in the worst case scenario. All the while you find a bank that provides 5% interest rate for a CD or Term-Deposit (termed here in NZ). Next step lies in tweaking the numbers to find the amount assigned for trading.

x= Risked Amount for Trading

$100k-x= Interest Bearing Investment

0.05= 5% interest over 1 year

($100k-x)0.05= x

x=$4,761.90

$10k-x=$95,238.10

So, this means out of $100k, you can invest $95,238.10 into an account for 5% return, and apply $4,761.90 for risk involved trading. By the end of the year, even if you blow the $4,761.90 entirely, you’ll still have $100k.

Of course if you lengthen the investment period to 3 or 5 years, the amount available to trading becomes much larger due to compounding of invested capital. This is how the “capital-protection” investment funds operate.

Risk had become averted from dollar to time value. Pretty easy right?

Forex Bucket Shop Deceptions

Cash exchange rates, an Over-The-Counter (OTC) instrument, has become an easy-profit tool for many private business ventures, calling themselves legitimate Forex brokers. However they promote it, the business model reeks.

Selling Fantasies

Every ad starts with some wild claims of something along the lines of “Make $5,000 a week sitting at home!”, “Easy money from Forex!”, or anything else with excessive amounts of exclamation marks, you get the drift. They entice people with fantasies where truth lies away in distance.

What is the truth?

Unlike centralized exchanges (e.g. NYSE, AMEX, CBOE, and etc.), OTC item prices settle upon agreement of two private parties, unregulated. The Forex brokers understand this and exploit it for profit.

These bucket shops trade against the clients, i.e. they serve as market makers and more often than not take the other side of trades against clients. They understand statistically that most financial market traders perform with negative expectancies, hence making trading against a losing crowd profitable business. This aslo explains why they target and welcome financial industry newbies so much.

What about the ones smart enough to eventually trade profitably? These brokers operate to preserve capital, and they resort to whatever means available and prevent consistent winnings off any client. Software disconnects, lagging/fraudulent price quotes, unfilled orders, or simply account banning have become some, certainly not all, common bucket-shop practices.

The above explains why most Forex brokers have incentives for clients to lose, and hence not legitimate. It has given Foreign Exchange trading a bad name, though it can become lucrative still, just not through the typical bucket-shops.

Trading Forex Away From Bucket-Shops

Electronic Centered Networks, ECNs (like ARCA or BatsTrading), allow traders to interact without market makers. These types of brokers charge very low commissions and have only incentives for clients to trade profitably.

Foreign Exchange options also provide profit driven opportunities for those adept in forecasting exchange rate moves. Centralized on option exchanges, these derivative instruments not only provide valid markets, the added leverage promotes higher potential returns.

Regression outlier trading via Excel

Now that we know how to import data into Excel, let me explain a simple technique for an edge the public crowd largely remains clueless of. I used to apply it myself but not today as I now utilize strategies that require less patience, and hence release of this information does not conflict with my own trading interests.

Basic Concept

This analysis basically exploits statistical outliers. Exponential growth does not sustain (but decay does), both in nature and financial markets. Fundamentally, exponential growth of stock prices occur when the public crowd drifts off to fantasy land and keeps buying while institutional traders await to take profit.

To exploit this phenomenon, you search for growing stock(s) and make downside bets as prices surpass exponential levels. A second degree polynomial regression analysis makes this possible. Profit taking, or short-covering, occurs when price returns to the regression line. See below for steps.

Steps

1) I have decided to use data for SPY from 2001 to today, basically from the beginning of the last bull market.

2) With daily “High” prices studied and highlighted, click on the “Chart Wizard” button. (Because the strategy calls for downside bets, the optimal entry levels would lie in the historical-high statistics.)

3) Choose XY (Scatter Graph)

4) Keep clicking “next” until you see “As New Sheet” or “As object in”, and choose As New Sheet, and name it whatever, in this case “SPY Regression”, and press “Finish”.

5) Once the chart becomes opened, click on “Tools”, then “Add Trendline”, and pick Polynomial, order “2”, and then hit “OK”.

6) Now the chart holds the regression line nicely for the historical data, woohoo!

Applying This Edge

• The regression line must curve upwards
• Take short position(s) as price jumps up way above the regression line
• Cover position(s) as price reverts back to regression line

As I’ve stressed in the past, do NOT apply a hard stop loss. That would seriously hurt performance. Remember that this strategy only works on the downside, not upside. If you do not understand why betting on failure has a higher expectancy, read this post.

Good trading.

Importing Yahoo Stock Data into Excel

MS Excel can sort historical stock data off finance.yahoo.com. Though limited, the tools available provides average investors an advantage over those new to the game. I will expand on this in the days to come.

Here's a quick guide. I'll try and upload pictures to simplify the steps further.

1) OK, first you must get your data off finance.yahoo.com
I will type in "spy" for the S&P based ETF, and press "enter".

2) Once on the SPY page, you'll find the link for "Historical Prices" on the left side pane. Click on it.

3) Then scroll down and click "Download to Spreadsheet"

4) Choose MS Excel to open up the downloaded file.

5) Now comes the tricky part. Yahoo Finance typically provides the data from the most recent til the earliest. For adequate analysis, we need the most recent at the bottom of the page. To do this, first find the number of data, then key the first two in a new column, starting at the highest.

E.g. I have 3,824 days of historical data imported, so next to the latest 2 dates, I keyed in 3,824 and 3,823.











6) Now highly both numbers, and click at the bottom right hand corner of the highlighted box. It will do an automatic completion of the numbers for you automatically.











7) Then highlight all involved columns, and click on "sort", A-Z. And voila, the numbers are all better.


(Send me a message if you have trouble getting this done, and I can send you my sample excel file.)

I will post some simple statistical edges you can gain via excel based analysis in the next few days. Good luck.

1% Per Day, Futures Trading

There's a trader who displays his daily returns, spread-trading e-mini futures contracts (see below link). For all who believe financial instrument trading is about making tedious 10-20% a year, think again.

Forum Link

This is what I mean with finding and exploiting statistical edges, market inefficiencies. It's a lonely road, but rewarding. Don't stop learning.

Trading With Conviction, Dealing With Distractions

OK, I know it is damn difficult to trade with an up bias these days with this entire media constantly projecting nothing but gloomy outlooks. Mentioned in “about popular bearish sentiment”, by the time the uninformed crowd has mostly got on board with downside partiality, not much more selling pressure exists in the near term future.

Sticking to the Freaking Plan

My own strategy called for bullish trades this week, but I ended up making a lot less than I should have due to distractions from the media. Projections about the jobless report earlier today made it particularly scary. Yet if I had ignored it all and stuck to the plan, my return this week would have resulted at least twice as much.

Bad Economic Report, Up Stock Index

So we have a whole lot of people on the unemployment line according to the latest study, and the stock market rallied today. What does that mean? It means the financial media, underlying economic speculations don’t mean squat to profitable trading.

It’s time to wake up and pay attention only to liquidity and supply/demand, things that actually affect price moves. All this misinformation pumped by the media, or so-called experts, and trader-wannabes… they make me sick.

Ignore them, trade with confidence. (of course don’t forget your risk management, too, hahaha)

Profitable Stock Trading Scheme Design

Trading stocks for consistent profit takes serious business planning and execution. The same goes for investing as it is simply trading with longer time frames. This post includes some of the very important areas to cover.

Trading Tactic of Little/No Competition

If your trading strategy came off some website or book widely available to the public, it probably does not perform well. Statistical edges, market inefficiencies exist and evolve with respect to general investor crowd behavior; therefore it does not help if you play as a part of the publicly uninformed.

Do the homework, learn statistics, probability related theories, arbitrage theorems, and maybe look into derivatives. The answers lie where the crowd overlooks, obviously.

Keep It to Yourself

As mentioned above, if the crowd adapts existing market inefficiencies may corrode away. It is the same concept as copycats try to compete with other business industry leaders (mentioned here), once a trade secret becomes publicly known. With that, it pays to stay discreet.

Price Based Stop-Loss Scheme Hurts Performance

A popular mainstream concept of a contingency exit strategy yet provides little value. It takes thinking outside the box to get around this. I have written about some creative entry/exit tactics just to show that many possibilities exist besides the publicly pushed ideas.

Preservation of Capital

The risk management must function in the manner that even in the worst case scenario, where anything that could go wrong does go wrong, you would still survive. Better to live and fight another day than to blow up due to some emotional whim.

How is this possible? Just put most of your money in a low-risk interest collecting investment (e.g. bank bonds, short term treasury bills, etc.), and make it so that your net income off interest will exceed trading capital. This way, even if you blow the trading account, you would still end the period with a net profit (before inflation).

(I will discuss this capital management scheme in detail at another post.)

Discipline

Discipline promotes flawless execution. Though it may seem hard at first, if you truly understand how your strategy “works”, then it becomes smooth sailing. Perhaps sometimes a little bit of patience could help, but the anxiety goes away once you get the nature of financial markets.

Thinking Openly

You must learn to think in terms of probabilities, possibilities, instead of absolute certainty. A different way of thinking often leads to novel thoughts, ideas, and creative designs.

It all helps.

Lessons from Unsuccessful Stock Traders

Many stock traders operate with a negative expectancy, and learning not to repeat their most notable mistakes could help new traders get a head-start in the game. Any one of the mentioned slip-ups would interfere with potential successful.

Insufficient Prerequisite Education

Developing successful strategies for trading (or investing, which is simply trading in longer time frames) absolutely requires at the minimum a profound understanding of general statistics and probability theory. It only takes one semester of college, or a small number of books via self-learning. The added knowledge alone could transpire fulfillment and associated happiness.

Lack of General Planning

No planning, no profitable trading. It is that simple. The act of putting in orders seems so effortless, that many fall into the illusion of getting rich quickly staring at the charts dumbfounded. It does not work that way.

Like any business start up, only a properly designed business plan could contribute to a potentially profitable venture, especially in the highly competitive world of finance. Only realistic estimates of revenue (trading profits), expenses (transaction fees, bank wire costs, utilities, living expenses and etc.), and effective risk management could make the business model practical.

Crowd Mentality

As the majority does not perform well in this industry, following popular trends logically destines less-than-optimal outcomes. The major financial websites, TV news releases function to sway the general public toward certain sentiments. Allowing these external influences direct one’s own strategic convictions then naturally leads to losing trades, like most of the crowd.

Lack of Discipline

Once a plan has formed, only flawless execution could get this kind of business up and running. A lack of emotional intelligence hurts performance.

Getting in front of the monitor on time, staying alert, avoiding fat-finger mistakes (e.g. keying in a wrong ticker symbol), holding onto positions while waiting for exit strategy to unfold are some of the crucial parts of a profitable trading system. Most fail to control urges such as sleep, boredom, anxiety, fear, etc. and end up losing money.

Gaining Experience and Winning

A successful businessman had once quoted “I’m successful because I learned from experience.” When asked how he gained experience, “by making mistakes.” Learning off mistakes from others is truly a privilege, and only after adequate education could one begin to formulate a practical plan for success. While difficult and tedious, it is not impossible.