It’s a bit disconcerting to learn “The bill permits the Treasury Department to issue enough bonds to fund the government's operations and programs until mid-February. The Senate will vote again on the issue Jan. 20” Yahoo News). At this point, the lack of any debt-reduction proposals has become sadly expected.
LAURIE KELLMAN (AP) then went on to say “Obama must sign the measure into law to prevent a market-rattling, first-ever default on
So why would the Associated Press plant fear of default into the readers? It’s to probably rally support for the (reckless or intentional?) excessive borrowing by the few people who run American congress. How will this end? Badly I bet.
OK, so UAE has banned Sunday London Times from disclosing actual debt figures. The state's future appears bleak. Let's see how it affects the rest of the world.
UAE existing debt
Figures are from Zero Hedge,
United Arab Emirates (via Bank of America - Amortization figures only):
Total Debt: $184 billion
of which...Dubai: $88 billion
Abu Dhabi: $90 billion
Dubai:
Due in:
2010: $12.0 billion
2011: $19.0 billion
2012: $18.0 billion
2013: $ 7.5 billion
2014: $ 5.5 billion
Abu Dhabi:
Due in:
2010: $ 8.5 billion
2011: $14.7 billion
2012: $10.0 billion
2013: $12.4 billion
2014: $ 9.4 billion
UAE:
Due in:2010: $22.0 billion
2011: $34.7 billion
2012: $29.0 billion
2013: $20.3 billion
2014: $14.9 billion
HSBC Bank Middle East Limited: $17.0 billion
Standard Chartered Bank: $ 7.8 billion
Barlays Bank Plc: $ 3.6 billion
ABN-Amro (RBS): $ 2.1 billion
Arab Bank Plc: $ 2.1 billion
Citibank: $ 1.9 billion
Bank of Baroda: $ 1.8 billion
Bank Saderat Iran: $ 1.7 billion
BNP Parabas: $ 1.7 billion
Lloyds: $ 1.6 billion
According to Warren Buffet (The Snowball), while technological novelty has advanced mankind in general, its investments usually end badly. He mentioned some empirical evidence of this at a private talk, from cars to airplanes.
Cars and planes
They are no doubt a couple of seriously significant inventions from the last century. Around 2,000 car companies existed at one time, and out of those, only a handful (Ford and sort of GM?) stands today. The rest have pretty much all gone belly up, taking shareholders down (enriching short sellers).
No single air travel business has generated greater-than-actual-rate-of-inflation returns for its investors, notably the ones who have gone bankrupt. Given that business schools, parents, and TV preach creativity, industrial revolutions and stuff, naturally the question comes, “what gives?”
Good ideas still have limits
Management conflict of interest, miscommunications, competition, idealistic albeit inadequate budgeting, are but some profit making hurdles an innovative product/service idea itself can not overcome. Another point from Buffet, as these “new technology” firms push for esoteric products/services, the complexity in estimating their actual, intrinsic value does nothing but increase UNCERTAINTY.
The negative correlation between VIX and major stock indexes advocates that uncertainty leads to price drops. It is pretty clear cut, and again mainstream belief took the wrong side.
The stochastic calculus based interpretation of stock returns offers a glimpse of institutional perspective and indirectly reveals how buying and holding leads to a negative expectancy. While numbers and symbols may look intimidating initially, they tell a very simple story.
Variable definitions
The excerpt comes from Stochastic Calculus for Finance Vol1.
S0: Stock price at time step 0
S1: Stock price at time step 1
r: risk free interest rate (usually off treasury debt)
S1(H): Stock price at time step 1 if “heads” were to occur off a random coin toss
S1(T): Stock price at time step 1 if “tail” was to occur off a random coin toss
p: probability of H occurring
q: probability of T occurring
u: multiple applied to S if H occurs (e.g. S1(H) = 2S0)
d: multiple applied to S if T occurs (e.g. S1(T) = 0.5S0)
Note: p + q = 1, so they are collectively exhaustive
Formula 1.1.8 displays “expected” probabilities for future price moves.
Slower than actual rate of inflation
The expected returns adjust simply with r. The “risk free” (questionably) debt instruments usually offer the lowest of interest returns compared to institutional, private loans. As way more money becomes created via institutional and private borrowing, the actual rate of inflation is naturally greater than whatever return off government debt.
Credit risk ignorance makes the model impractical
The binomial pricing model assumes all listed companies to operate with infinite lifespan. Is this belief viable for actual money management? I’d say not. By the way this also invalidates general portfolio theory, sorry Markowitz!
While some revealed, many issues remain to be addressed with quantitative financial theories. Until academic ideas become aligned with empirical evidence, traders must search out personal, unique ways to remedy quantitative model weaknesses to become/remain profitable.
Many successful full time, professional traders engage entire days on one or two stocks or futures exclusively. No matter how little of an edge this practice offers, learning traders should grasp and take up whatever is available.
Floor Traders
On the exchange floors, the same traders engage in the same security day in and day out. This means that over time, their behavior could display patterns and therefore exploited by the retail trader who spends all his/her time on the associated stock or future.
Reduced Transaction Costs
This should be obvious. Operating a successful business requires expenses to remain at the absolute minimum, and so does trading on a professional level.
Reduced Mistakes
Everybody makes mistakes, and they cost money, at least in the amount of transaction fees. Volatility measure errors, fat finger mistakes like buying instead of shorting or keying in the wrong order volume become rare once the trader becomes familiar with the security.
Diversification Is Obsolete
The permanently optimistic analysts on TV or radio still scream about the well aged concept of diversification. The whole idea was created by an academic, not a professional security trader, decades ago. The highly correlated environment today, along with the credit contraction have created risks that were entirely overseen or intentionally ignored to deceive the public.
Either way, logical, profitable solutions always lie within something that the masses do not realize or engage in. At this moment, majority of the publicly uninformed still embrace the concept of “diversified portfolios” to reduce risk; didn’t turn out that way though for the past year, did it?
In 1979, Victor Niederhoffer turned $50K into $20Million within 18 months, and became one of the first traders known for quantitative perception. Like any other business, his performance has had ups and downs throughout the decades, and perhaps we could all learn something from the experiences.
I came across this article a few days ago, and it really begs the question of practicality concerning quantitative finance developments today. Mr. Niederhoffer had assumed that stock markets generally moved upwards, a fundamental concept behind current theories in mathematical finance, and this belief had hurt his performance.
Stock prices drift downwards, too
The assumption that stock fundamental values generally stay static while risk-free interest rate serves as an upward drift parameter, i.e. value added via inflation, simply does not apply for actual, realistic market behavior. Companies fail, and more often than not speculative bubbles become mistaken for genuine added value.
Ignoring “unlikely” risks, weaknesses of applied mathematical models, generally makes blowing up a statistical eventuality (Mr. Niederhoffer had blown several hedge funds, but had always managed to get back up and fight another day). No matter how infrequently storms occur, boats are built to withstand the heaviest of them. So should your trading strategy.
Change of paradigm
Fundamentally and statistically, it does not take much for businesses to fail, and yet it requires everything for a moment or two of success. Business and liquidity cycles all point to very dissimilar perspectives than that of Mr. Niederhoffer, or the typical public investor.
It does not matter if your convictions are right or wrong, your objective remains to come out profitable. Pride plays no part in the markets. With that, maybe it is time to take a deeper look into your risk management, so that you WILL survive the worst of times.
Several fundamental, logical grounds make long term stock investments more viable than real estate. As investments initiate with general objectives of selling later down the line for an increased amount, added value means everything.
Added Value Explained
Potential buyers in the future, especially those with rationality, would only offer higher prices for the same commodity/security/land, if they recognize additional value on top of whatever the original investors had acquired. This could mean new products, higher demand, brand name, intellectual property, land, and etc.
Real Estate Offers Little Value Growth
Aside from discovering gold, oil, or dinosaur bones in the backyard, the land itself offers absolutely no added value. The building itself actually depreciates over time, and requires additional expenses (or risks for the investor) for upkeep.
Inflation backs this illusion of consistent growth over time, and collective investor sentiment determines short term price fluctuations. Nevertheless, prices always revert to the mean, i.e. they come back down to the expected, inflation adjusted value (minus depreciation on the building). John Villareal explains this concept clearly at the Super Genius.
Businesses Operate To Increase Value
Stock investors own shares of the company. With each venture, active, determined people toil every single day with the objective of value enhancement. Therefore, despite the short term up or downside swings, companies operate to exploit every opportunity to add value for shareholders in the long run and some do it quite rapidly.
Of course even for long term investors, risk management remain crucial for success. Investing itself equates to that of a self run business where value improvement lies at the end of the road.
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:
(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.
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 3rd 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 3rd 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!
As the hedge fund industry continues to grow, the markets have turned increasingly volatile today. This logically hurts the less-informed retail investors as it forces more price instability related risks onto their positions even in bullish periods.
Growth of Hedge Funds
Presently, the hedge fund industry exceeds $1 trillion, and still expanding as money managers attempt to squeeze every drop from the apparently saturated market. The investment vehicles utilized range from equity, commodities, debt instruments, to derivatives of all forms. Some make directional or market neutral bets while others attempt arbitrage. Nevertheless, the relative large sums create significant price impacts with each order.
Increased Risks for Public Investors
Prices move as a result of relatively large initiated orders, and the hedge fund industry does just that. This evermore evident phenomenon hurts the uninformed investors as it leaves them literally “buying at tops and selling at bottoms”, due to a lack or delay of information.
Wall Street rumors and news releases tend to reach fund managers first, where the public usually stands last in line. This creates unfounded risks in present industry condition as the price affecting hedge funds have first dibs on most relevant information, and they usually take action before the mainstream crowd to preserve or amplify returns.
Volatility from Hedge Fund Sentiment
With so much more capital influenced today, vague rumors or corporate press releases all potentially trigger backbreaking ripples across these secretive investment pools. Collective fund management sentiment has created unprecedented power in the industry, as seen in the present liquidity issues faced by “prime” mortgage backed investment vehicles.
Back in 1998, a quasi-recession resulted from the fall of Long Term Capital Management, a hedge fund run by two Nobel Prize winners. Their failure, a loss of “only” $4.6 billion, had caused such market turmoil that many individual investors had lost fortunes, some everything.
When ratings agencies downgraded General Motors debt to junk bond status in May of 2005, the shock throughout the hedge fund industry caused a steep correction in the major indexes. Only after awareness of GM solvency, along with heavy buying from the public, did this near-catastrophe go unnoticed.
Solutions for Individual Investors
Without an edge, statistical or information regarded, the uneducated investors face sharp negative expectancies in the present financial environment. The solution requires a bit more work than ever before, like any other business. Do the researches, study how the hedge funds and Wall Street institutions function, learn the math, become informed. When it comes down to it, follow the money and you will not mind the work.
Several means remain available today to avoid or minimize risk involved with business failures for the equity holders. According to business survival statistics I had listed in the past (Stock Market Downside Bets), it moves below 50% after five years of operations. Managing this form of risk is crucial for the long term bullish investors.
Exchange Traded Funds
Making mutual funds obsolete, these listed baskets of goodies have become available to the general public with a variety of underlying stocks or commodities without the hefty management fees. The commodity ETF’s such as silver, gold, or oil pose virtually no risk of bankruptcy outside of the expected volatilities.
Insider Transaction Analysis
If the insiders have expressed way more volume in selling than buying in the past few months, it means they believe the price will likely dip. Since they always know more about the business operations than the public, their sentiment usually carries some weight.
Investment of Short Positions Exclusively
This would allow the investor to reap exceptionally large rewards off corporate disasters. It usually couples with heavy volatility, e.g. Bear Stearns stocks had gone from $54 to $3 over a single weekend this month (Mar. 08). A statistician speaker at the Auckland University of Technology had mentioned that one in four corporations experiences a calamity that it will never recover from, every 5 years.
This type of investment naturally completely mitigates the risk of loss from business failures, and carries a positive statistical expectancy. But it carries unique forms of risks and takes a much more active management to pull off.
Basic Options
If bullish, a basic position in a call option or leap would allow for unlimited profit potential, yet limited loss due to lowered cost of the option contracts. Of course, the game with options compared to underlying stock/commodity trading resembles that of chess with checkers. A whole variety of strategies exist to profit off underlying price or volatility swings. The serious investor would find value learning about options.
Final Words
As shown, it all simply takes a bit of research and discipline, and average investors can preserve capital, mitigate financial misfortunes. Like everything else good in life, a little bit of diligence could go a long way.
Long investment positions of corporate common stocks carry inherent risks. Advisers, agents like to avoid this subject as it requires more profound considerations via the client investor, and understanding it would reveal the often unjustified entry-costs and management fees.
Risk of General Market Downturn
The stock markets have a positive correlation to general economic swings, and wield at least a couple of bearish years each decade. This leaves the probability of stock markets ending each year at higher levels of 70-80% at best. The industry analysts, advisers or brokers facilitate public ignorance of this easily in bullish periods, where any stock seems to rally effortlessly with the illusion that no forms of risk exist.
Realistically, just the opposite is true. The longer a certain stock has rallied continuously, the more likely institutional holders look to take profit (i.e. sell) before the bearish period commences, or perhaps they know something that the public does not. Of course they need chumps to provide liquidity and buy off them, the role usually played by the general public; this is where the financial advisers and brokers do their magic and sell the “risk-free” sentiment, where “Of course it’ll go up!”
Risk of General Volatility Even In Bullish Periods
Prices do not move in nice smoothed curves, but rather ugly zigzags as result of constant quasi-auction based trading on the exchange floors. Even in a bull market, the general fluctuations occur and the simple attitude of ignoring this risk and “focus on the far horizon” typically ends in mediocre or terrible performance.
Accurate assessment of potential loss due to volatility could require a lot of number crunching, but simple methods exist as well. The ATR, or
Risk of Corporate Bankruptcy
Stocks from Enron or WorldCom had performed well in the bull market of the 90’s, and their demise never appeared obvious until the selling began. This risk always exists in long term long side stock investments, and it increases with length of holding period.
In other words, longer held stock positions carry higher risk of losing close to 100% of the associated value according to historical statistics. Longer held short positions face higher risk of getting squeezed short, i.e. the original lender of the shares demand them back, but even that has a lower loss potential than the upside bets.
Consistent Investment Profit Takes Work
Solutions exist to mitigate or limit the above mentioned risks. Taking short positions, applying market-neutral strategies, arbitrage schemes are some of the many options available to the retail investors. Investment managers who does not acknowledge or disclose these issues imply incompetence or dishonesty, and probably do not deserve the hefty fees.
It takes dedicated self-education, then planning and flawless execution to win in this game. Like many other good things in life, complex, but not impossible. I will discuss some of these solutions in a future article.
