19 Things Your Suburban Millionaire Neighbor Won’t Tell You

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The Long Term Case for Stocks

Something to refer back to when I’m faced with market volatility..

The long term case for stocks

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Casino Royale

The philosophy of systemic trading just became clearer to me over the past few days.

Over the past couple of months, I’ve asked myself the question – if every trade is an independent, random event, much like a coin toss, how can one ever hope to be profitable in trading a so-called “system”? What if the Efficient Market Hypothesis (EMH) pundits are right? A coin toss is an independent event – the odds of Heads or Tails coming up are always 50/50, regardless of the history of tosses. Anyone who tells you that there’s a “system” of betting whenever there has been a streak of 3 Heads in a row is bullshitting you. (The same logic applies to the weirdos who claim to be able to predict the outcome of Roulette tables or lotteries based on which numbers have come out before)

A trading system comprises of hundreds and hundreds of trades – each one with its own probabilities and risks – any trade is a random event. But here’s the clincher – even though the outcome of any individual trade is random, the outcome of a LARGE COLLECTION of such trades is no longer random. When you put a large, statistically significant bunch of uncertain events together, they paradoxically give rise to a certain outcome.

Skeptical? Think about how casinos make money. At any given time, a casino is the counterparty to hundreds of bets: blackjack, roulette, craps, slot machines, etc. Each individual bet is uncertain, and there are thousands of variables that a casino cannot control – how much a gambler bets, when she hits or stays, what the dice rolls will show, etc. Yet, put them all together and we all know that a casino is GUARANTEED a profit. As long as people keep coming to play, profits roll in month after month after month.

The secret is in the EDGE. Each individual bet, while it is uncertain, gives the casino a minuscule edge over the gambler. In blackjack, it could be as tiny as 2%. Yet that 2% is enough to make money – of $40m in bets, the casino walks away with a cool, guaranteed $800,000. Not bad. This edge takes into account all the big winners, the high rollers, the big losers, the small losers, the smart gamblers that walk away with $50 in profits, etc. Put everyone together and the public effectively hands the casino its edge.

Going back to the coin-flipping example, perhaps a trading system is more like a coin flipping game with slightly better odds. Perhaps you will win $1.01 for every Head that comes up, and lose $1.00 for every Tail that appears. The edge, in this case, is 0.5*1.01 – 0.5*1 = 0.005, or 0.5%. You don’t know the outcome of any given flip. In fact, you could hit a streak of losses and hit 10 Tails in a row. But you know that if you keep playing over the long run, you’re GUARANTEED a profit of 0.5%.

So what’s the edge in my chosen trading system? It’s as simple and fundamental as Newton’s First Law of Motion: An object in motion stays in motion in the same direction unless acted upon by an unbalanced force. Prices tend to keep going where they’ve been previously going. This isn’t some hypothetical belief that I’ve plucked out of thin air, academia has unequivocally shown that autocorrelation exists across all asset classes. Today’s prices aren’t a random, independent coin flip, they’re dependent on yesterday’s prices, and are likely to be in the same direction.

One musn’t confuse an edge with probabilities. An edge has 2 elements – payoff and probabilities:
Edge = (probability of winning x payoff of winning) – (probability of losing x payoff of losing)

You could win only 1/3 of the time, but if your payoff is large enough to compensate for the low probability, you have an edge. In fact, that’s how the majority of trend-following systems work. Trends only appear about 30% of the time, but trend-following allows you to keep the profits large when they DO appear, which more than compensates for the many tiny losses that the system might incur. Hence, a trend follower is never dependent on any single trade or even a streak of trades to make or break her. A trend follower acts on every single trade, every single opportunity, not caring about the outcome of any single opportunity, because she knows that every single opportunity, good or bad, adds to her count and helps her get into the “long run”, where there’s a certain, guaranteed outcome. She knows that if she sticks at it, she’ll come out on top.

Double Dip Recession?

A blogger on Seeking Alpha gives ten reasons why we’re headed for a double dip recession. Sadly, I don’t think it’s too far from the truth. I called the double-dip recession last night while having dinner with my mother (yes, my mother) before reading this article.

I’d like to be wrong, because I just started my first post graduate job today. Weird feeling to be an adult.

Been spending the past month researching an old trading philosophy and new trading systems. A few software bugs have slowed me down a bit, but I’m making a little bit of progress every day. More updates to come!

Investing Advice from a Cartoonist

So yesterday I was really depressed from an exam, and in need of some humor. (Seriously, what is up with an education system that tries to screw you over?)

Here’s what made me laugh.

Quant World Cup Predictions!

Place your bets everyone! According to JP Morgan’s quant models, England will win the World Cup. It’s also interesting to note that the model predicts England to be the winner even though it determines that the strongest team is Brazil.

Then again, before you go running off to your local bookie, remind yourself that JP Morgan came up with RiskMetrics to model Value at Risk – which is widely thought to precipitate the financial crisis once firms relied too much on it.

It’ll be interesting to take a look at how their World Cup model works though, and to see how accurate it really is. Okay back to studying about non-central distributions now – fun!

Told You So…

The financial press are commenting on how the Dow fell “only” 3% today.
US market regulators announced an investigation into “unusual” trading activity.

Some people say that it was caused by a human error (that somebody put in a “billion” instead of a “million” when typing in a sell order) but I don’t think so. And neither does this article.

I don’t think today’s fall was “unusual” at all – from my post yesterday, I thought it was pretty damn obvious that the market was going south.

I knew I should have shorted when I saw it coming, but I’m currently out of the market. (Which may have been a good thing – what if my system was long?)

What I Think

Apologies for my superextended absence – doing a Master’s program AND handling a whole bunch of extracurriculars left me no time for serious finance stuff. Besides, it’s my last year as a student and I wanted to concentrate on having fun. But as the academic year ends, most of my other distractions have more or less ended, leaving me with a renewed interest in the markets again. Once my exams end in like a month, I should be ready to blog actively again.

To make up for my absence, here’s my analysis on where I think the market is going:

Extended, spectacular, unjustified rise + classic head-and-shoulders + break below 50-day MA = near perfect setup for a market downturn. While I don’t usually advocate the use of technical analysis (I don’t believe in patterns unless they can be tested), the head-and-shoulders is almost unmistakeable in this picture. Think of the investor psychology: bulls have tried to make a new high, failed, they pushed higher and failed again, and finally made a last feeble attempt but were quashed by the bears. It’s also said that the longer the consolidation, the more important it is – this consolidation has been going on for about a month now. Furthermore, the past two days have seen tremendous downward pressure, just the right conditions for a break down.

I’m still a rookie at anticipating market movements (especially calling tops and bottoms), but I’m bearish on the market now. (Actually I’ve been bearish for the past 2 months but kept getting proved wrong) We’ll see if I’m right this time.