August 4th, 2009
Friday, July 24th, 2009
Successful system trading, in spite of the financial rewards, can be frustrating. A quantified mechanical model will take many decisions off the table. Yet, various issues, particularly the psychological approach to the issues, will always be in play.
Ed Seykota in the book, “Market Wizards,” writes, “Systems trading is ultimately discretionary. The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change. These decisions are quite important, often more important than trade timing.”
It seems most sophisticated traders are aware of the fact that a system needs to be properly quantified and tested before trading. The sample size of the trades needs to be large. These traders are familiar with the terms of curve fitting and optimization. I wonder, however, how many traders continue to study the model as they trade their equity. How many understand the logic behind the entries, stops, exits, and money management techniques. How many are adjusting position size to meet expanding and contracting volatility and changes in market correlation.
Seykota also points out in the book, “Market Wizards,” that at times, “The markets shift from trending to non-directional price action. These systems become unprofitable and under-capitalized. The trader without experience will be shaken out. Longevity is the key to success.”
It is this discretionary knowledge that examines the risk and helps build one’s confidence. Without this understanding, doubt will come into play and longevity compromised. A draw-down will inevitably force a decision based on emotion and not sound trading principles.
It is in our human nature to prefer pleasure, and avoid pain. In spite of our natural instincts, good trading sometimes requires us to act against our natural inclinations. We must do what is necessary, not what is comfortable.
Tags: commodity trading system, mechanical system trading, system trading
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August 4th, 2009
Tuesday, July 28th, 2009
I think successful traders realize a few important things that escape the failures. It doesn’t seem to matter if they trade discretionary or with systems, they all seem to know that the market is the boss. They are defensive and have a great deal of respect for risk. They all tend to manage risk and let reward take care of itself. The failures are for the most part completely focused on the reward, usually at the expense of risk.
Also successful traders share similar attitudes toward expectation for reward. They, for the most part, believe there is a risk premium over the hedger that is available to the speculator. They are also well aware that they are not entitled to it, only that it is available. Second, they believe that the rate of return is tied to the cost of money. Finally, they view their jobs to be a long term process to obtain that return without risking a drawdown beyond what they can handle, or the random risk of ruin. The failures tend to think there are returns consistently available at the higher levels of 50% and 60%. Unfortunately they find out the hard way that they must be more realistic to survive.
There is nothing magical that I can share with our readers. The reality is that trading is one of the most challenging endeavors that you will ever undertake. Get a precise logical plan. The logic behind the method you choose is critical. It is impossible to trust the interpretation of past data where logic is absent. Then proceed with realistic expectations, understanding that you will encounter more obstacles than you might imagine. Accept the real risk. Previous draw downs are simply a statistical guideline to potential risk and not the true risk. True acceptance of risk means you know you can lose your money. The good news is that this freedom should allow you now to think in probabilities as opposed to being driven by emotion. Also seek help. Get smart people around you. Get aligned with other traders or a firm that can help you work on these concepts.
Tags: commodity trading
Posted in commodity trading | No Comments »
August 4th, 2009
Wednesday, July 29th, 2009
I just read a very interesting book. It is called “Sway”: The Irresistible Pull of Irrational Behavior. 
Max Brazerman is a professor at The Harvard Business School and introduces his new students to a game at the beginning of the semester. He auctions off a $20 bill with only two rules to the game.
1- The students must bid in increments of $1 and
2- The winner wins the bill but the runner-up forfeits his bid.
So the bidding begins and builds rapidly. However, without realizing, the two students with the highest bids inevitably get locked into a battle for the $20 bill. Somehow the mind-set goes from playing to win to playing not to lose.
“Students are pulled by both the momentum of the auction and the looming loss if they back down- a loss that is growing greater by the bid. The two forces, in turn, feed off each other: commitment to a chosen path inspires additional bids, driving the price up, making the potential loss loom even larger” say the authors Ori and Rom Brafman.
They go on to explain that there are three elements to the auction. The first is the optimistic stage ….the easy lure of the free lunch. This gives away to the second stage where the front runners now realize they could be in trouble. It is here where the loss aversion meets commitment. The final stage of course is digging deeper and deeper unwilling to let go.
I found it very interesting that our natural response is irrational. It seems the deeper we get in the more we dig. This loss aversion also seems to be amplified when it meets commitment and is a powerful force in our decision making. We have all been faced with the manageable loss in trading and should act rationally to control that loss while it is still small. However, when we don’t realize we are being swayed and we are focused on avoiding the loss….. our commitment to stay with it gets stronger. That is when small becomes large and even catastrophic.
We can guard against this to a certain degree by determining our loss before we play and always check our commitment at the door.
Incidentally, if you are wondering just how much these Harvard MBA’s paid for the $20 bill……….the record level was $204…..so far.
Tags: trading discipline, trading psycology
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August 4th, 2009
Friday, July 31st, 2009
In a 2004 groundbreaking study from The Yale School of Management’s Center for International Finance titled “Facts and Fantasies about Commodity Futures”, Drs. Gary Gorton and Ken Rouwenhorst show that not only are commodity futures negatively correlated to stocks and bonds, but also that commodity returns are greater than bonds and have about the same average returns as stocks. 
The real surprise, however, is that commodity futures returns had a lower standard deviation (lower risk) than stock returns for the 43 years they studied. This study also confirmed that commodity futures work best when needed most in a portfolio. This is mainly because stock and bond returns are negatively influenced by inflation, where commodity futures benefit from inflation. In other words, during periods of inflation or expected inflation, stock and bond returns underperform commodity returns.
Anyway you look at it; these reports legitimize commodities and challenge the “too risky” myths that have been adopted over time. Perhaps all the stories of lost assets can be attributed to two risky behaviors of investing, unacceptable leverage and poor risk management. However, these risky behaviors have nothing to do with the core properties of commodity futures.
To receive the full Yale School of Management’s report, “Facts and Fantasies about Commodity Futures”, click here to email me and enter “Yale” as the subject. The report will be sent in a PDF format.
Tags: commodity markets, commodity trading, forex markets
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July 23rd, 2009
Monday, August 3rd, 2009
In Michael Covel’s book- Trend Following, the legendary trader John Henry is quoted as saying:
“We can’t always take advantage of a particular period. However, in an uncertain world, perhaps the investment philosophy that makes the most sense, if you study the implications carefully, is trend following. Trend following consists of buying high and selling low. For 19 years, we have consistently bought high and sold low. If trends were not the underlying nature of markets, our type of trading would have very quickly put us out of business. It would not take 19 years or even 19 months of buying high or selling low ALL of the time to bankrupt you.
Nevertheless, trends are an integral, underlying reality in life. How can someone buy high, sell low, and be successful for two decades unless the underlying nature of markets is to trend? On the other hand I’ve seen year after year, brilliant men buying low and selling high for awhile successfully and then going broke because they thought they understood why a certain investment instrument had to perform in accordance to their personal logic.”
Tags: commodity trading, forex, john henry, trend following
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