R (and the market in general) was going through ahorrendous July in 2002. After three down days from Wednesday to Fridaythe week before, Monday July 22, reached a high of 41.92 before closing at40.00, and the low on Tuesday reached 39.17, staking out a range of 7 percent between those two days. A buy signal was triggered for Wednesday,July 24 (Figure 18.3), at 39.11. Wednesday was an up day, as was Thursday.So the system exited the trade at the close on Thursday at 41.88 for a profitof 9.47 percent.USAI, 2/5/03 Monday, February 3, 2003, USAI went from a high of 22.58to close near its low at 21.88. The next day the stock gapped down and continued to fall further, hitting a low of 20.73 before closing at 20.99. The nextday, Wednesday, February 5 (Figure 18.4, page 197), the system buys at theopen of 21.68. Note that although Wednesday closed down from the open,it was still an up day, closing at 21.34. So it was the first up day, with Thursday then being the second consecutive up day, closing at 23.21 where thesystem sells for a 7 percent profit.
ResultsFor the results of applying this system to all Nasdaq 100 stocks for June 30,1998, to June 30, 2003, including deletions from the Index during that period, see Table 18.3.
TABLE 18.3
Wednesday Reversal Applied to NAS 100 StocksAll Trades
All TradesAverage Profit/Loss %Average Bars Held
5,8022.59%5.04
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
3886 (66.98%)7.87%3.2842
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
1916 (33.02%)–8.31%8.5116
4199_P-18.qxd
12/30/03
3:27 PM
Page 196
196
TRADE LIKE A HEDGE FUND
44.2044.0043.80
43.6643.6043.4043.2043.0042.8042.6042.4042.2042.0041.8041.6041.4041.2041.0040.8040.6040.4040.2040.0039.8039.6039.4039.2039.0038.8038.60
Volume
600K500K400K300K200K100,000
FIGURE 18.3
PIXR on July 24, 2002.
4199_P-18.qxd
12/30/03
3:27 PM
Page 197
The Wednesday Reversal
197
24.6024.4024.2024.0023.8023.6023.4023.2023.00
22.8922.8022.6022.4022.2022.0021.8021.6021.4021.2021.0020.80
Volume30.00M20.00M10.00M
FIGURE 18.4
USAI on February 5, 2003.
4199_P-18.qxd
12/30/03
3:27 PM
Page 198
198
TRADE LIKE A HEDGE FUND
SimulationFigure 18.5 shows a simulation using 2 percent of equity per trade. I wantedto see how many of the weeks were profitable. The top bars represent profitable weeks; the bottom bars represent unprofitable weeks. Out of 260weeks, 175 were profitable, with the average return per week at 0.76 percent and a standard deviation of 3.07.
SHORTING WITH THE WIDE-RANGEWEDNESDAY REVERSALAs has been demonstrated throughout this book, shorting is just not a winning strategy in either bull or bear markets. Many short-selling funds evenproduced negative results in 2001 because of the huge spike that occurredon January 3, 2001, due to the first interest-rate cut. A 5 percent move in themarkets is enough to cause serious damage to a short-selling fund wherethe risk of loss is unlimited. However, when people are extra giddy in the earlypart of the week, the market likes to take a little back, and the potential forreversal is highest on a Wednesday.
The Wednesday Short System• Short when Tuesday’s close is 1 percent higher than Friday’s close andWednesday’s open is higher than Tuesday’s close. Short the open onWednesday.• Cover on the second close of two consecutive down closes.
ExamplesQQQ, March 7, 2001 Friday, March 2, 2001, the QQQs closed at 46.70,followed by two days that both gapped up but closed somewhat flattishwith their opens. Tuesday closed at 49.40, 5.7 percent higher than theFriday close and then proceeded to gap up another several percent.Wednesday morning, March 7 (Figure 18.6, page 200), when QQQ opened at50.40, 50.40 turned out to be the high of the day. Shorting then and covering after two consecutive down closes resulted in a cover on Friday at theclose at 45.10 for a profit of 10.52 percent. Note that although Wednesdaywas down from open to close, it actually was a positive day for QQQ overthe Tuesday close since it closed on that Wednesday at 49.42, 2 cents higherthan the Tuesday close but already a nice profit for the system.
4199_P-18.qxd
12/30/03
3:27 PM
Page 199
199
FIGURE 18.5
Simulation.
The Wednesday Reversal
4199_P-18.qxd
12/30/03
3:27 PM
Page 200
200
TRADE LIKE A HEDGE FUND
52.0051.5051.0050.5050.0049.5049.0048.5048.0047.5047.0046.5046.0045.5045.0044.5044.0043.5043.0042.5042.00
41.8141.5041.0040.5040.0039.50
Volume
120M100M80.00M60.00M40.00M20.00M
FIGURE 18.6
QQQ on March 7, 2001.
4199_P-18.qxd
12/30/03
3:27 PM
Page 201
201
The Wednesday Reversal
QQQ, November 6, 2002 As seen in a previous example, Wednesday,October 30, 2002, had triggered the wide-range Wednesday reversal system. Although that system sold QQQ for a nice profit on the Thursday close,the market continued to rally with three more consecutive up closes. TheQQQs closed on Friday, November 1, at 25.25 and then had two more upcloses before closing on Tuesday, November, 5 at 26.10, several percenthigher.Wednesday, the 5th (Figure 18.7), the QQQs gapped higher, opening at26.29 and continuing higher, closing at 26.47 despite dipping as low as 25.64during the day. The dip was a foreshadowing of things to come as the nexttwo days the market gapped lower before the trade was closed out at theclose on Friday at 25.07 for a 4.64 percent profit.
ResultsSee Table 18.4 for results of the Wednesday QQQ short system, March 24,1999 to June 30, 2003. The table shows a 1.87 percent average profit pertrade with an accuracy of 2/3.The greater Tuesday is higher than Friday’s close, the better the systemworks. For instance, instead of looking for Tuesdays that are 1 percenthigher than Friday’s close, if we look for Tuesdays that are 2 percent higher,we get the results shown in Table 18.5 (see page 203). The accuracy improves to 72 percent and the average profit per trade goes to 2.04 percent.The system also works fine if you change the Wednesday condition toany day but Wednesday. See Table 18.6 (see page 203). The accuracy stayslargely the same, but profit per trade goes down significantly.
TABLE 18.4
Wednesday QQQ ShortAll Trades
All TradesAverage Profit/Loss %Average Bars Held
331.87%5.21
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
22 (66.67%)4.66%2.646
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
11 (33.33%)–3.72%10.363
4199_P-18.qxd
12/30/03
3:27 PM
Page 202
202
TRADE LIKE A HEDGE FUND
26.8026.6026.4026.2026.0025.80
25.65
25.6025.4025.2025.0024.8024.6024.4024.2024.0023.8023.6023.40
Volume
100M80.00M60.00M40.00M20.00M
FIGURE 18.7
QQQ on November 6, 2002.
4199_P-18.qxd
12/30/03
3:27 PM
Page 203
203
The Wednesday Reversal
TABLE 18.5
Wednesday QQQ Short—VariationAll Trades
All TradesAverage Profit/Loss %Average Bars Held
252.04%4.12
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
18 (72.00%)4.35%2.399
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
7 (28.00%)–3.90%8.572
TABLE 18.6
Wednesday QQQ Short—VariationAll Trades
All TradesAverage Profit/Loss %Average Bars Held
800.89%5.22
Winning TradesAverage Profit %Average Bars HeldMaximum Consecutive Winning Trades
53 (66.25%)3.53%3.7410
Losing TradesAverage Loss %Average Bars HeldMaximum Consecutive Losing Trades
27 (33.75%)–4.28%8.153
CONCLUSIONBasically, it is not the case that Wednesday is the only day one can do a reversal trade. But it is certainly the best day by a long shot and makes themost intuitive sense. Momentum is hard to sustain for a straight week, so itmakes sense that the middle of the week is the time when momentumbreaks down.It is worth spending time testing variations of the Wednesday system.As an example of the type of exhaustion that tends to occur on Wednesday,consider the following pattern:
4199_P-18.qxd
204
12/30/03
3:27 PM
Page 204
TRADE LIKE A HEDGE FUND
• Short when QQQ is gapping up between 0.5 percent and 1.5 percent,the open today is less than the open yesterday, and it is Wednesday.• Cover on 0.5 percent profit, or at the close if not profitable.So, in other words, we are getting a big gap up, the market is excited, butdespite the size of the gap, the market is still not going to open higher thanthe open was yesterday. The result is 17 of 17 successful trades with an average profit of 0.5 percent per trade.While it might often seem like the end of the world on a Tuesdayevening, or the beginning of the next humongous bull market, you can besafely assured that Wednesdays often play the role of the Great Humiliatorand set these thoughts to rest. By patiently waiting for these moments andfading whatever trend started in the beginning of the week, one can have ahigh probability of a profitable second half of the week.
4199_P-19.qxd
12/30/03
3:28 PM
Page 205
TECHNIQUE 19
What DoesNot Work?
would assume that most people reading this book have also read manyother investment books recommending various systems and techniquesfor “beating the market.” In Technique 20 I recommend my favoritebooks and you can take or leave that list with a grain of salt. Each personhas his or her own style and approach and should find the support to suitthat approach. My own personal opinion is that knowing the history, science, and art of any field in which you seek to become one of the top 1 percent of players is critical for success.When Bobby Fischer was 13 years old, he was an above-average chessplayer but certainly not someone who seemed destined to become theworld champion and, perhaps, the greatest player ever. At that time he basically disappeared for about a year or so and did an intensive study of thegames of Wilhelm Steinitz, the world chess champion of the last twentyyears of the 1800s. Why did Fischer do this? In terms of technique thegames were outdated. The openings Steinitz played were rarely used inmodern tournament play, even in the 1950s when Fischer was a teenager.And yet, by studying those games, finding flaws where prior annotatorshad not, and doing a detailed analysis of the techniques, Fischer was able toimprove his play to an extent that at the age of 15 he was suddenly theyoungest U.S. champion ever, as well as the youngest grandmaster ever. Inaddition, he taught himself enough Russian so he could read the Sovietmagazine, 64, which contained analyses from Russian grandmasters overthe latest opening theory. By combining a scientific study of the history ofchess with intense research into the modern techniques of the day, he wasable to so clearly surpass his colleagues that from the age of 15, until
I
205
4199_P-19.qxd
12/30/03
206
3:28 PM
Page 206
TRADE LIKE A HEDGE FUND
perhaps even now, they have never been able to touch him. That is thestory of mastery in a nutshell.Chess is a game, and there is very little money attached to being goodat that particular game. Often, when a child becomes an adult, the pleasuresof games move to the background and other endeavors take over. When itcomes to making money for yourself, for your family, or for your clients,the competition is unbounded. There are hundreds of thousands of investors from all over the world every day trying to take money from you.Disregarding the argument of whether it is a zero-sum game, clearly it isbetter for your competitors if you lose money and they make money. Nobody will feel bad if you get wiped out. Others will move up to take yourplace. And every day investors get wiped out. The Yahoo! message boardsare littered with these people. As well as the halls of Nobel Prize winnersand people who are successful in other fields that now turn their attentiontoward investing and find that success now eludes them.In this book I mention a few of the techniques that I have used and willcontinue to use to make money for myself and my clients. I highly recommend that people test for themselves these techniques both through research and through active trading. I am confident that they will stand up tothe test. That said, I also think it is important for people to research theirown ideas and also to learn what does not work. Along with keeping a detailed and catalogued database of the techniques and patterns that I havetested that work, I also keep track of patterns and ideas that do not work.Following are a few of those ideas
GUT“The market feels like it’s going down from here.” Perhaps the best feeling abeginning trader can have is that feeling she gets when she senses the market is going to go up, she buys, and, like magic, it goes up. Note that I said“beginning trader.” This technique of relying on feeling does not work. It hasnever worked for anybody. Perhaps the best tape reader ever, Jesse Livermore, died bankrupt at the receiving end of his own gun. Yes, it can work 9times out of 10. Amazing streaks can happen. But the 10th time you will loseeverything. You. Will. Lose. Everything. If you are not a serious investor butspend much time talking to your broker, ask yourself if he is trading basedon his gut. I have nothing against brokers, but The Making of a Stock Brokerby Edwin Lefevre (Fraser, reprinted in 1999), written in the early 1900s,sums it all up. Do not trade on gut or listen to anybody who does.
4199_P-19.qxd
12/30/03
3:28 PM
What Does Not Work?
Page 207
207
CONFIRMATIONIn many of the techniques described in this book you will be buying stocksor the market as they are going down, or shorting/selling them as they aregoing up. In other words, buying low and selling high. Can they get lower?Sure. In fact, most of the time they will. Many books out there suggest an alternative to this approach: why not buy stocks after they hit bottom andalready start to move up? I can smack myself in the head! Why didn’t Ithink of that?!For instance, suppose a stock gaps down below the prior day’s low.Why not just buy the stock after it hits bottom and goes back over the priorday’s low? Not only that, you can even buy it higher like when it goes backthrough the prior day’s low and passes it by one or two ticks. This is realconfirmation that it is going to move up, according to many of the authorsout there. In my own tests on this particular idea and other similar ones, Ihave not found this so-called confirmation to be the case. The higher up youbuy in many situations, the more money you have left on the table (or themore money you have lost).I do not mean to make light of the technique of waiting for confirmation. It does have the appearance of being cautious compared with “catching a falling knife.” However, with proper testing and research you can timeyour purchases to have much better results than if the market or a stockhas already bounced several percent back up. I do believe the techniquesrecommended in many great investing books have perhaps been successfulin the past. But since the late 1990s there are many more players in thegame. The hedge fund world has gone from 100 hedge funds averaging $5Meach to 5000 hedge funds averaging $100M each. Prop trading shops withhundreds of day traders in each one have popped up all over the country.Many more people day trade from their homes. These people are not lettingyou wait for confirmation.On the Web site RealMoney.com, the excellent columnist “Rev Shark”has brought up a very good point, however. It could be the case that excellent money management lessens the pain in many systems that cannot be asthoroughly researched as others. For instance, many technical analysistechniques require some degree of subjectivity to identify the patterns thatare appearing in the market. Using a method to limit losses is critical, particularly if part of one’s plan is to use trading techniques that are not backedup by rigorous research.
4199_P-19.qxd
12/30/03
3:28 PM
Page 208
208
TRADE LIKE A HEDGE FUND
CANDLESTICK PATTERNSI have really enjoyed Steve Nison’s books on Japanese candlesticks andhighly recommend them to anyone interested in learning more about thesebasic market patterns. I also think that for many years these techniquesworked in the markets, but they simply do not work anymore. If anything,so many people anticipate the effects of the candlestick patterns and attempt to game them that often the reverse of what is predicted by the particular pattern ends up happening. That said, an invaluable way to gain adeeper understanding of the markets is to test every candlestick pattern outthere and see for yourself.
SEASONALITYThe Stock Trader’s Almanac by Yale and Jeffrey Hirsch (Wiley, 2003), isone of my favorite books. Each year it comes out with new information,new quotes, new ideas for how the market responds throughout the year todifferent events. Seasonality does work if you can identify a seasonal pattern before anyone else does. However, I think this is largely impossible.What ends up happening is that as soon as someone realizes that everyyear the day before Memorial Day is up, then everyone realizes it. Thenusing seasonality as a system no longer works—too many people anticipating it. A great example is the January effect. Once people realized theJanuary effect (the tendency over the past 80 years for the markets to go upin January) was real, they started buying in December. It became the December effect. Now it has become more like the October effect with hugeup moves in recent Octobers. By the time this book is out, it might be theSeptember effect. Who knows? Another seasonal-based idea is “Sell in Mayand Go Away.” Well, as of this writing anybody who followed the strategywould have missed out on 100 percent moves in many stocks this year.
LOW P/E, HIGH P/EBelieve me when I say I am not trashing fundamentals. If one is a buy andhold investor, then the best strategy you can use is to find undervaluedcompanies that are growing (this part is key), buy them, and look at themevery two or three years. Truly the way to riches is to somehow identify thenext Microsoft or Berkshire Hathaway and ride it all the way to the top. Asludicrous as this sounds (and I cannot claim to know how to do this), somepeople did do it and made themselves millionaires many times over.
4199_P-19.qxd
12/30/03
3:28 PM
What Does Not Work?
Page 209
209
At the 2003 Berkshire Hathaway annual meeting, I met a guy whobought 200 shares of Berkshire in 1976 for around $70 a share. He told methat a year later, when the stock had doubled, he sold half his position.Great trade—100 percent in a year. Now his remaining 100 shares are worth$7.5M. I asked him why he bought the shares in the first place. He hadheard about Warren Buffett’s successes in Buffett’s hedge fund. He likedthe insurance business and trends in the insurance business, and he just decided to make a bet. That’s it. Nothing fancy. Did he get lucky? Sure he did.But his story is a great example of how buy and hold can work.So what does this story have to do with P/E? Answer: nothing. P/E really has no use when it comes to valuing a company. I highly recommendthat people check out the Forbes article written by Ken Fisher titled, “TheP/E myth” for more on this topic. The article can be found on the Web athttp://www.forbes.com/global/2002/1111/074asia.html.WCOM had a P/E in the low single digits when it was revealed that itwas corrupt to the tune of several billion dollars and ended up filing bankruptcy. Many deep-value investors were writing articles at the time aboutwhat a great buy WCOM was because of its low P/E. And many high P/Estocks continued to flourish in both earnings and stock price throughoutthe recent bear market, eBay being the best example. Building a marketneutral portfolio of long low P/E stocks and short high P/E stocks is probably the quickest way to personal bankruptcy, and I do not recommend it asan investing technique. If it were that easy to invest then everyone would berich.But shouldn’t a company be valued based on its future cash flows? Yes,I certainly believe this. But don’t look at lagging P/Es to determine those future cash flows. Instead, analyze demographic trends about where the customers are coming from for different industries. Warren Buffett is notbuying Dairy Queen, manufactured housing companies, convenience storedistribution companies, and such because of their price over cash flows,but because we have an ever-increasing lower middle class in the UnitedStates so that regardless of the economy, his customer base for these companies is going to increase. Companies like Allergan, the maker of Botox,have not gone up this year because of their current cash flows (althoughthey hope that those cash flows are growing), but because the number ofnew customers in their target demographic (women age 45–55) is increasing by one million every year regardless of the economy.Was the Internet a bubble? There certainly was an IPO bubble as investment banks continued to pump out supplies of shares even after demand for those shares had topped out. But the reality is that thedemographic of Internet users went from 0 commercial users to 300Maround the world in fewer than five years, and some companies (eBay,Yahoo!, etc.) stood to benefit and will continue to benefit.
4199_P-19.qxd
12/30/03
3:28 PM
Page 210
210
TRADE LIKE A HEDGE FUND
In addition to the trends mentioned above which I still feel are only intheir beginning stages there is also the trend of technology now being outsourced to India, Malaysia, Singapore, and, eventually, China. As opposedto the United States, these countries also have large birthrates that guarantee that the number of people from the ages of 20 to 40 supporting the number of people hitting the age of 70+ will stay at a healthy ratio. Who willbenefit? Who will lose? Focus on solving this puzzle, not doing a Yahoo! finance search on companies with low P/E. That approach will not make youmoney.
BUYING AND SELLING OPTIONSPeople buy options because they want leverage on their purchases. Peoplesell options because they want income. You should not do either. If you canconsistently pick successful stocks, then you do not need leverage thanksto the miraculous power of compounding. And the idea of making incomeby selling naked calls or covered calls is a lot more complicated than popular authors would lead you to believe. The commonly told lie is that 90 percent of options expire worthless, so you might as well sell them all day longand pocket the money from selling them before they go to zero. For thesake of your own personal sanity, stop these efforts, particularly withouttesting and research. Sophisticated arbitrage strategies using options dowork, but they do not work for dilettantes.
CONCLUSIONOK, enough negativity from me. I do think that the investing world is verybig and that many, many techniques can work if followed with the appropriate discipline and money management. There is no shortage of playersout there, each playing his or her particular strategies: mutual funds thatbuy and hold, hedge funds that trend follow, short sellers that provide liquidity, and so on. If you have a technique that, through testing, you feel willwork, there will be no shortage of players who will take the opposite sideof your trade.
4199_P-20.qxd
12/30/03
3:28 PM
Page 211
TECHNIQUE 20
ReadingList
n every sport, science, art, or game (and arguably trading and investinghave elements of all four) it takes years of sacrifice and endeavor toachieve the highest levels of proficiency and success. In investing, therewards are so great and the competition so fierce that you have to beaware that anything less than 12 hours a day for years and years will guarantee that you will never achieve those rewards.Much has been written about achieving mastery in a topic. Clearly, talent is an important factor, but it is, perhaps, the least important. Usuallypeople who achieve mastery in a topic cite several different reasons fortheir success:
I
• Incessant practice. When Michael Jordan failed to make his high schoolbasketball team, he practiced shooting every day until he knew that hewould not experience that failure again. Anatoly Karpov, former worldchampion in chess, spent eight hours a day studying the game for eightsolid years before achieving grandmaster strength.• Thorough knowledge of the history of your field. Every great artist hasstudied the works of the masters from the past 10 centuries. Everygreat chess player can recite the games of Paul Morphy, the worldchampion from the mid-1800s, by heart. In investing, knowing the history of ideas, studying the rises and falls of the market since its inception, and reading the biographies of the great investors over the pastdecade cannot help but improve your ability to survive the current markets. Studying in detail the masters who have come before you is critical in any venture at all. I really believe the only way you can end up211
4199_P-20.qxd
212
12/30/03
3:28 PM
Page 212
TRADE LIKE A HEDGE FUND
developing, testing, and cultivating your own opinions and ideas is ontop of the foundations built by the others before you.• Ability to deal with failure. The only people who do not win in thisgame are the ones who quit. IASG, the Institutional Advisory ServicesGroup, maintains a Web site tracking all of the top commodity tradingadvisors (CTAs): http://iasg.pertrac2000.com. I like to check this Website occasionally to see how all the competition is doing. One time Icame across a fund that was down 22 percent its first year of businessand only up 3 percent in its second year. I cannot imagine the painthose guys must have gone through. But 18 years later Dunn Capital isone of the biggest CTAs in the database with over $1B in assets and anannualized return of almost 20 percent. There are countless examplesout there of hedge fund managers who sat through painful drawdownsbut stuck to their systems, did not deviate, and managed to comethrough the other side with amazing success both for themselves andtheir clients.That being said, I am providing the following reading list made up ofbooks I have enjoyed and that I feel have helped me to help you on yourpath to mastery as well