Should I Go to Live Daytrading?

My last two weeks of simulated trading have gone very well. I'm trading in a disciplined and profitable fashion. Here are the results of my trading of the Australian Share Price Index Futures over this period (all amounts in Australian Dollars):



A movement of one point on the index results in a gain or loss of $A25. Commissions are $A5 each way. As you can see though I am profitable I'm only gaining a few points of movement a day. If I was prepared to give trades more leeway I could capture a lot more points. As the following statistics show I am averaging about $A250 a day, which is pretty much my medium term income objective:



But there is the potential to make much more. Mostly also I only made trades in the morning while some big moves happened in the afternoon. The trades also average out over each day, so that I only had one losing day and then only lost $A20. On average I made $A80 per contract or about 3.5 points. The z-score (t-statistic) for individual trades, which tests whether they are significantly different from zero is 2.21 and for daily totals 3.42. In both cases, based on the sample, the probability that the results are random is very low. I won about 3/4 of trades but am still seeing the average loss on losing trades being greater than average gain on winning trades.

This chart shows my "equity curve":



My Nikkei trading over this period has been even more successful, though it made far fewer virtual dollars. So what is the problem? This chart of all my simulated SPI trades shows what the issue is:



The first trade on this chart was made on 10th December. Things went well until two days of bad losses around the turn of the year. What happened then? I lost control, pulled stops and traded two contracts at once. In other words I blew up. The sample since then is relatively small. How do I know that I will retain my discipline with real money and not blow up again? The z-scores for the entire period shown on the chart are around 1.30 which leaves a moderate probability that the results are purely random.

You're probably wondering what the red line is. That's what the equity curve would look like if I had honoured the stops and not traded an extra contract.

AAPL Trade

Doing a small long AAPL trade. Price should rise into options expiry in theory after being beaten down - traders redeeming ITM put options push the price up as put writers cover their hedging short positions. And next Tuesday is Apple's earnings release.

First European Stock Investment

I bought 40 shares of Bekaert - a Belgian firm that mainly focuses on steel wire products (including tyre wires) as well as some high tech materials and coatings. They also have a research lab in China. The firm is 40% family owned and pays a decent dividend. An online acquaintance said he was investing and I think he is worth following on this. Yes I bought the shares on the Belgian Stock Exchange. With Interactive Brokers this is fairly straightforward. I just asked online for permission to trade Belgium which was instantly granted. I then placed the order in the usual way. Interactive Brokers then extended me a loan in Euros to cover the purchase. I didn't bother paying for Euronext data. You can trade an exchange without paying for the data through IB. Yahoo provide the data with a fifteen minute lag, which is good enough for long-term investing. If you are interested in European stocks the Yahoo UK site has far more information than the US finance site. I don't know why they can't link this info through to the US site. After all the UK site knew which stocks I'd most recently requested quotes for on the US Yahoo Finance site!

New Private Equity Investment

Yup, another new investment. ING Private Equity Access. I heard about this one from Enough Wealth. He sold 20,000 shares and still holds 80,000. I bought 6000. The stock is a fund of private equity funds. I am also invested in Allco Equity Partners, which is a single fund, though with its recent large investment in IBA it has more money in publicly listed stocks than private equity. My main reason for investing in IPE is that it is selling way below the book value of its investments. At some point hedge funds and private equity will no longer be the pariahs they've become since August and the price to book ratio should rise. I have more private equity investments on my watchlist. I only have 2.3% of my portfolio invested in these two stocks.

The larger question is whether the stockmarket is bottoming here?



Looking at the chart you can see three very similar candles at the end of the current move down and the previous two major moves down. On the other hand, the stochastics do not appear to be bottoming here. The model allows for up to 2 or so days of downside from here. The weekly chart has reached the lower Bollinger Band in a similar way to the 2006 and 2007 lows. However, in 2007 the market declined considerably after bouncing from the BB. There's not yet any good sign of a bottom in the McClellan Summation on a weekly chart. The same goes for the bullish percentage. So I am very cautiously adding these new investments here, putting 1% or less of the portfolio into each. I'm not doing anything radical yet.

New Investments

PeopleSupport and NDS. PeopleSupport is a takeover play. There is an offer for $17 on the table and it could be raised... maybe. The company's business is offshore outsourcing of services. I've owned NDS before, it's been beaten down in the recent market correction and seemed like a good point to buy in again. The company is majority owned by News Corporation and is in television technologies.

No Takers for the Trading Puzzle?

So far no-one has commented on the trading puzzle. The strategies are very simple. At the end of the week I will reveal all, whether I have any responses or not. I the meantime, my simulated trading of the Australian Share Price Index is going well and I am feeling more and more confident that maybe I really could do this. I will wait though till I have statistically significant results before going live. I am using very tight stops. The stops really define the risk/reward ratio and the size of the contract (near $A150,000) becomes less important. At the moment I am only getting a fraction of the return possible on a single contract because I am getting out of trades very fast. If I gave each trade more leeway I would have higher returns but also higher volatility or risk. I've averaged $A150 per day so far but recent days are much better than that. I'm also beginning to have some success trading mini-NIkkei contracts.

How Much Does it Cost to Get Married?

You hear a lot about $30k plus weddings. Our wedding will be small and simple. Having few guests obviously reduces costs. That's not on purpose, but our friends and family are scattered across the world. My mother and brother will be the only two coming from overseas, or out of town for that matter. Here is a rundown of our expected costs at this point:

Celebrant's Fees: $A400 - this includes filing our marriage registration etc.

Location: A mountainside in a nature reserve overlooking the city - free. If in the unlikely event that it rains that morning (most rain is in afternoon thunderstorms at this time of year) we will go to the restaurant where we are having lunch to hold the ceremony (again for free).

Snork Maiden's dress: RMB 3000 or so. Yes, made in China but not cheap :)

New shirt for Moom: $A45 - otherwise Moom will wear existing clothes.

Ring for Moom: We were quoted between $A400 and $A700 for an 18ct white gold V size (British ring size) comfort fit 4mm plain wedding ring. We now plan to pay $US250 for one from Blue Nile delivered to a friend in the US and then sent to us here.

Ring for Snork Maiden: Prices for a 3mm platinum comfort fit J size ring ranged from $A800 to $A1400. Blue Nile want $US465 for a 2.5mm ring that seems hard to order in Australia. BTW she doesn't have an engagement ring. But neither does my sister-in-law. My brother doesn't have a wedding ring. Fedex will charge $US72 to ship both rings to us in Australia from the friend in the US.

Photographer: $A260 for two hours of time with a CD of photos costing an extra $A300-500. Albums or prints would be for another price. Another photographer told us the minimum package was $A1480.

"Reception": Actually, lunch at a vegetarian Chinese restaurant. Probably around $A35 per person. We aren't sure on numbers yet but could be from 10 to 15. We spent $A100 on "research meals" to decide where to go :) Also plenty of petrol driving around checking out locations and restaurants, meeting the celebrant and photographer. Could be 200km? About $A40 of petrol. Probably throw in $A100 or so for some decent wine/champagne from a liquor store across the street at the lunch.

Hair - Snork Maiden said - "you have to get your hair cut anyway". At this point, she doesn't feel like getting special hairdressing or makeup for the wedding.

Flowers: Snork Maiden said: "Put $A100 for now".

So the grand total is: $US2865

This isn't counting the cost of my mother and brother getting here or staying here which will be a multiple of this. We are also going to Sydney for a week after the wedding (Snork Maiden hasn't been there yet, apart from the airport :)) and I'm not including that. Probably; late in the year we will travel to China, but that's a whole other story.

Trading Puzzle

The red in the chart is the NASDAQ 100 index. The blue and green are two simple trading strategies. The blue strategy has a beta of 0.84 to the index and annual alpha of 11.4%. The green strategy has beta of 0.69 and alpha of 24.0%.

What are the two strategies?

What is My Trading Niche?

I can't handle overnight trading. At least not any time soon. It makes me way to anxious. Wanting to stay up all night watching the US market. And then making bad decisions when I am tired. This morning I had the debacle of the stop order I forgot about. Now this afternoon I ended up selling out of the Australian market at the low point of the day (so far). I had the wrong type of warrant. These are so called "barrier warrants" that are delisted if the index hits the exercise price. They trade similarly to futures with a hard stop at the exercise price. But the price even a few points above the barrier is more than would be implied by the simple points difference between the current price and the barrier. The index fell to a a few points above 6000 and so I sold the warrant. Of course the index never got quite to 6000. It did go as low as 6000.2. And then it rebounded. So I sold at the worst possible point. I should have had a regular option style warrant or one deeper in the money. All the regular warrants are out of the money. The reason we even got near 6000 without me selling earlier is because I was in "swing trading mode" with the model set stop of a 1.25% loss. Last night I stayed up till after 4am watching the US market because I was anxious about the market. I can't go on like this. I know logically that the model in the long run makes money but I can't handle the short-term fluctuations unless I am staring at the screen. With daytrading, you can choose when you want to trade and when you are not trading just ignore the market (except maybe thinking about the opportunities you are missing). Maybe after daytrading for a while I can get back to swing or overnight trading, if I can build up some profits first. So next week I will be back to papertrading SPI and Nikkei daytrading and maybe again doing some real US trading either in the evening or early morning (no overnight Australian time position). I'll hold my positions in US stocks and options until the model says to sell them. I do seem to be able to handle those mentally for some reason.

I can use the model to decide on whether to look for long or short trades, but not be too wedded to it. I thought that econometrics based modeling is where I could have an edge in trading, but my psychology, at least at the moment, doesn't seem to be able to handle it.

P.S.

I was stopped out of my Nikkei trade too. Oh well. I have some ideas about what to do with the model along the lines some commenters have occasionally made. Sorry to be cryptic. But for now I am a daytrader (as well as an investor).

Dumb Tricks with Order Entry

I woke up this morning to find I had a short position in the NASDAQ futures I didn't know about! Unfortunately, the market was up. I closed the position for a $460 loss wiping out most of the profit on my Interactive Brokers account for the week.

How did this happen? I must have left in place a stop order I forgot about without a matched actual position when I went to bed. This is easy to do on the IB platform. My new enthusiasm for stop orders turned around and bit me :) I'm not used to having them in place so didn't pay attention when I logged out of my account. Oh well, I'm still up in trading for the month.

My other dumb trick was going long instead of short earlier in the session. This happens, but it is careless. My real mistake was not immediately reversing the trade. Instead I started justifying why a long would be better. I knew this was a bad thing to do and it was. In the end the market let me get out at a profit once Bernanke started speaking. But I wasted a bunch of time I could have been sleeping up till that point.

Jumping the Gun

I jumped the gun and went long the Nikkei and Australian Index before their models formally signalled to do so. I guess I was overenthusiastic to start trading them and was used to when I didn't have models for these indices and relied on the US models for direction. The US models were long already. The two Asian models are long at today's close. I obviously still need to improve my discipline!

My restaurant stock post has proven popular (according to Google Analytics). I kind of jumped the gun there on Chipotle Mexican Grill :) On a weekly chart it still doesn't look so bad. But the daily looks pretty horrendous. Until yesterday that is. I thought of doing a trade on it yesterday but had second thoughts, which was good as I was still too early to go long.

Annual Report: Asset Allocation

The table shows our asset allocation at the account and security level at the end of 2007 (before my recent flurry of trades). The split by currency is not perfect - for example the CFS Conservative Fund has foreign (to Australia) investments while Platinum Capital is partially hedged into Australian Dollars. "Passive Alpha" investments obviously have plenty of correlation with the market (I call them "passive alpha" to distinguish them from my own active trading). I include in this category all financial stocks and funds whose performance would be expected to contain significant sources of return which aren't pure stockmarket beta. This includes a fund of hedge funds (EBI), hedgefund like funds (Hussman, TFS, Platinum Capital), real estate funds (Challenger, TIAA, Newcastle), and private equity (Allco). The Clime fund (CAM.AX) is a long-only closed end fund but deliberately does not track market benchmarks and is very focused. My rationale for counting a stock like Interactive Brokers (IBKR) as alpha is that the majority of their income comes from market-making. If this isn't a source of alpha in the financial markets, I don't know what is. There are also fund management companies (Clime and EBB), a bank (HCBK), and insurance companies (Berkshire and Safety). Beta investments are more traditional mutual funds, which can be pure stock plays or diversified or even bonds, which have less stock market beta. We only had one trading position at the end of 2007 - Beazer (a homebuilder) put options. It was doing OK. I only have two non-financial stocks listed under "industrial stocks" - Symbion and FTS. I don't believe that I have an edge in picking individual stocks so I don't do much of it. But investing in a bank stock, for example, is a way of indirectly getting exposure to a financial asset class (loans) that is hard to invest in otherwise. All the other categories of accounts either support our lifestyle or investing (margin loans). By using margin loans we are 98% invested in long-term investments as well as having 6% allocated to trading, while having liquidity for everyday life.

The table doesn't split things down by retirement and non-retirement accounts. 47% of the total is in retirement accounts.

In retrospect, I have been too conservative in my beta investments in the last couple of years, though now it is beginning to pay off to some degree. On the other hand, my passive alpha investments, which had been doing well, took a distinct turn for the worse from the August "quant crisis" onwards. I plan to get more aggressive in my beta investments once there are some clearer signs of a bottom in the stockmarket. I'll also be adding new passive alpha investments and aiming over time to reduce the percentage allocation to Australian Dollars.

Thursday Trading Update

The NASDAQ didn't disappoint.

So I sold my remaining BZH put, bought 100 NCT and 1000 SPI (Australian Index) call warrants. This is my trading position now:

1 Nikkei Mini Future
1000 SPI 6000 Mar Call Warrants
2 QQQQ Jan 44 Calls
100 NCT
200 RICK
100 IBKR
100 SBUX

It adds about 0.14 beta to my portfolio. So hardly very aggressive.

The US models are long, the Asian models are on the cusp of going long.

I also bought back the BRK/B share I sold a little while ago (now have two again). But that's accounted for as an investment not a trade.

Another Trading Update

Just bought my first Nikkei Futures contract - a mini contract that is worth $13,000 or so. This is a model based trade, which I'll hold till either stopped out or the model changes direction. This is the smallest futures contract I can trade. I feel I am understanding my model better in the last few days since I integrated together the three separate programs and I am pleased with my recent SPI daytrading in terms of discipline. So I'll continue to trade the model as I started yesterday. I now have the flexibility to put model-based trades on in either US, Australian, or Japanese markets. Going forward I am likely to diversify across these to reduce risk further. Currently, the US indices are long, the Australian is still short for probably the next day, and the Nikkei is on the cusp of long or short. It's a borderline case. I might buy some FXI later too.

According to Bespoke Investment the NASDAQ index has gone up on the ninth day all eight times that there have been eight consecutive down days in the last twenty four years. Eight isn't a big sample of course, but eight in a row is interesting. Will the streak be broken. The model is pointing up. But it was pointing up yesterday too.

Using the Model to Trade Australian Warrants?

I've been papertrading the Australian Stock Index Futures and I think I am beginning to get the hang of it. This is daytrading. The contract is very big - more than $A150k and I wouldn't be happy trading it overnight any time soon I think. So now I have a model for the Australian market I started looking for an instrument to trade it. My first thought was individual large cap Australian stocks such as Commonwealth Bank, Woolworths, and AMP. I have done this before but it is too expensive.

The next obvious idea is to trade an ETF - STW - which tracks the SP/ASX 200 Index. To trade $A60,000 it would cost me $82 in fees each way in my margin account plus margin interest. The average model trade yields around 1% - so this is a big chunk of the expected $A600 profit. This amount by the way is roughly the value of an ASX SPI Mini Contract which is 2/5 the size of the full size contract. Unfortunately IB doesn't allow trading of this contract.

As is often the case in Australia, the solution is to go to the options or warrants (investment bank issued options that trade like stocks) markets. I would look for an in the money warrant that has little time premium to get as close as possible to trading a futures contract. Trading $A60k of underlying stock would involve a premium of $A3-4k. I would plan to trade this in an old non-margin account I have at Commonwealth Securities, which is linked to my Adelaide Bank CMT (money market fund). For trades under $A10k the fees ($29.95 each way) are the same as in my margin account but I avoid paying a little interest (the difference between the margin and savings rates). I've set up my trading screen there with the relevant warrant codes.

I'll let you know if and when I do this for real. If I do, I'll include this Australian account in my monthly trading statistics.

Trade Update

I sold half the SBUX position to take some profits and got stopped out of the QQQQ position. Before I went to bed I moved my stop up from $47.60 (as set by the model) to $48.15 - just below the low at that point for the day. It's good I did. The NASDAQ Composite is down around 50 points at the moment. The SBUX and BZH positions are up on the day but the others are all down now...

Cramer Revisionism

Cramer's revisionism. Cool video pastiche.

First Real Trade of 2008

The slow stochastics crossed over on NDX so the model is long at the close. My models have been doing very well recently. I now have four: NDX, SPX, Nikkei, and All Ordinaries. After integrating the three separate econometric models into one it's now easier to maintain models of more indices. Anyway, I sold one BZH put (I keep one) and bought 400 QQQQ, 200 RICK, 200 SBUX, and 100 IBKR. The idea is to put on a more diversified model based swing trade. For some reason also stock feel safer than futures. I also went long NQ in my papertrading - the short trade I closed would have made $3000. I'll continue paper trading Australian and Japanese futures too. Barron's recommended Starbucks at the weekend and I am also playing a bounce in the restaurant stocks idea. I shouldn't have sold all of my RICK and planned to buy back at the next low. So here it is. Same with IBKR. I'm accounting all of these as trades, though, rather than investments as I don't think this is the market bottom yet. I'm wary of Starbucks as an investment too. The stock looks cheap based on earnings and their growth rate. But those earnings are only growing through massive capital investment. As a result, SBUX's free cash flow is a fraction of earnings. And it is free cash flow rather than earnings that we should use to value stocks.

P.S.

I got a lucky break on this trade - right after the market close SBUX announced they are bringing back Schultz as CEO and undergoing a restructuring. The stock is up 8% last time I looked.

Annual Report: Income, Expenditure, and Net Worth Gain

Here are last year's number for comparison. Compared to last year we spent more than twice as much (even though we were only spending as a couple for the last 4 months of 2007) and did more saving in retirement accounts and less in non-retirement accounts.

Looking at 2007, we brought in $50,773 in after tax non-investment earnings not counting retirement contributions. We spent $55,582. So we spent $4,809 out of investment earnings. Expenditure was very high due to the last 4 months of the year being our expenditure as a couple and the move to Australia. Still we managed to keep about $17,000 of our investment income, which is more than twice as much as needed to compensate for inflation.* I also made $1,667 in contributions to my Roth IRA account which came out of after tax income. After taking this into account, our net gain in non-retirement accounts ** was $31,870. Reported net worth in these accounts increased $49,543 due to the addition of Snork Maiden's $17,672, which was merged into the accounts at the end of August.

Total retirement contributions were $16,244 including the Roth IRA contribution. Pre-tax earnings on the accounts were $10,635, taxes $1,002, and gains due to the rise in the Australian Dollar $15,263. These sum to a total of a $41,140 gain in retirement savings in US Dollar terms.

At first glance all these numbers look very healthy, both on their own and compared to last year. But expenditure is steeply up and I only expect it to be a little lower this year. And so much of the contribution to net worth growth came from the rise in the AUD which actually makes us poorer in Australian Dollar terms. That is unless we were to cash in our AUD gains, buy USD and the AUD would then fall back again. I'm not going to make a big bet like that but plan to continue to move towards having a smaller allocation to related investments. My next post will be the final part of this annual report, laying out our current asset allocation.

* I took away the tax credits from core investment income and then subtracted the spending from investment income to get this number. A quirk of my accounting is that investment income is shown pre-tax and other income is shown after tax. Other income is the sum of all after-tax non-investment income and net tax refunds. The tax credits on investment income include for example U.S. tax on dividends that is being deducted at source now that I live in Australia. I count the pre-tax dividend as investment income but as I don't receive the part that is deducted as tax I need to enter a line for tax credits in the accounts in order to find actual saving and net worth change.

** I don't call them "taxable accounts" as the earnings in Australian retirement accounts are taxed, though at a lower rate than regular income.

Annual Report: Investments and Trades

I've already reported on annual investment and trading cash flows and rates of return. Today, I break things down into how much was made or lost on each security, fund, future etc. I invested in or traded. It's all in this table, which is an annual version of the ones in my monthly reports.



Last year's results for comparison. Again, there are more investments towards the top of the table and trades towards the bottom of the table. As last year the largest amount of money was earned by the Colonial First State Conservative Fund and Option (option is the retirement version of the fund). But the second best investment last year - EBB and EBI - is the worst this year. Platinum Capital was also a good performer last year and a poor one this year. I made decent money trading US stock indices but lost on the Australian index. I made a really dumb trade in Salesforce.com. Last year, Newscorp and Hansen featured as dumb trades. Trades in Apple contributed nicely in both years (but I should have invested in Apple instead!). There are contributions from trades exploiting the housing-credit disaster - IYR, Toll Brothers. Lehman, and Beazer - all winners. My investment in HCBK and the TIAA Real Estate Fund worked out as plays on the best in real estate, while Newcastle Investments, decidedly did not work out.

Well all the rest is there for you to see in the table.

Move is Complete

Snork Maiden's stuff arrived today, finally, after quarantine delays. They found some insect in the container. Now our apartment looks like a mixture between a garage sale and the tomb of Tutankhamun.

I've found a way of integrating the three separate stochastic trading models I was running. So in future I will only have to run one model for each index which will make things easier. I'm still looking for the optimal way to use the output so that decisions could be of a black-box type with no skill involved.

December 2007 Report

All figures are in US Dollars (USD) unless otherwise stated. This month saw a fall in net worth in US Dollar terms partly due to the fall in the Australian Dollar and partly to poor investment performance due to the continuing decline in global stock markets this month. Both these trends were milder than last month. Net worth also decreased in Australian Dollars terms. Trading results were bad and I stopped active trading to focus on improving my trading performance using simulated trading.

Income and Expenditure



Expenditure was $3,547 - there were no exceptional expenses. There were $315 of implicit car expenses - depreciation and interest - so actual cash expenditure was $3,212.

Non-investment earnings ($5,924) included another refund of work-related expenses from Snork Maiden's employer. She also again got paid by her previous employer. We've told them to stop paying and we may need to pay this money back, but for the moment I am counting it as income. Snork Maiden's retirement contributions from her employer were $559.

Non-retirement accounts lost $6,052 with $1,414 of the loss resulting from the fall in the Australian Dollar. Retirement accounts lost $1,731 but would have lost only $405 if exchange rates had remained constant. This gain is due to the strong exposure to bonds in our retirement accounts and the stronger exposure to equities in our non-retirement accounts. Trading contributed around half the loss in the non-retirement accounts, but actually came out slightly positive in my Roth IRA.

Net Worth Performance
Net worth fell by $US4,759 to $US448,556 and in Australian Dollars fell $A1,161 to $A511,233. Non-retirement accounts were at $US237k. Retirement accounts were at $US211k.

Investment Performance



Investment return in US Dollars was -1.72% vs. a 1.08% loss in the MSCI (Gross) World Index, which I use as my overall benchmark and a 0.69% loss in the S&P 500 total return index. Non-retirement accounts lost 2.51%. Returns in Australian Dollars terms were -0.88% and -1.70% respectively. In currency neutral terms the portfolio lost 1.11%,. Summing up the year, we gained 18.35% (USD) vs the MSCI with 12.18% and the SPX with 5.5%. Our non-retirement accounts are up 21.68%. Australian Dollar returns were competitive with the SPX. In currency neutral terms we gain 9.8% for the year.



The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency gains appear at the bottom of the table together with the sum of all other investment income and expenses - mainly net interest. Trading resulted in some of the biggest losses - QQQQ/NQ and ES. Otherwise, no clear story emerges this month except that EBB.AX and EBI.AX continue to perform poorly.

Progress on Trading Goal

I lost $2,003 in trading . The loss is 6.92% of trading capital. The NDX was down 0.2% for the month. For the year, trading generated $9,749 or a gain of 35% vs. an NDX gain of 18.4%. So in the end I beat the market, but with a lot more risk and volatility.

Asset Allocation
Using the simple method of adding up the betas of each individual investment weighted by their portfolio allocation, at the end of the month the portfolio had an estimated beta of 0.47. Using a regression on the last 36 months of returns gives a beta of 0.81 to the MSCI or 0.60 to the SPX. Alphas are 0.55% and 6.44% respectively. A more sophisticated time series method yields a beta of 0.97 and alpha of 7.6% for the MSCI index. The extra beta generated by these methods is due to the correlation between equity returns and the Australian Dollar in recent times as a result of the "carry trade".

Allocation was 29% in "passive alpha", 66% in "beta", 6% allocated to trading, 3% to industrial stocks, 7% to liquidity, 3% to other assets (including our car which is equal to 2.8% of net worth) and we were borrowing 14%. Our currency exposures were roughly 60% Australian Dollar, 30% US Dollar, and 10% Other (mainly global equity funds).

Stops: The Key to Success in Day Trading

I wanted to give this post a positive title. All experienced traders know that the key to being profitable is to set stop losses and use them. Even a system which generates random entries to the market could be profitable if the exit strategy is systematic. If you set and use appropriate stops you can be profitable. Beyond that it is all about increasing profitability and/or reducing variance. I emphasized day-trading here because my model that uses daily data can be profitable without stops. In intraday discretionary trading you can't apply such sophisticated strategies. At least I can't. A black box systematic program maybe could trade without stops intraday.

Anyway, the point is that I know all this stuff but still make the mistake of not honoring my stop-loss even when I'm now trading with imaginary money. Here is my equity curve trading the Australian Stock Price Index Futures with virtual money:



The blue line is the actual equity curve and the red line what would have been if I had stuck with my planned stop. This looks a lot like my real money trading in recent months. A slow consistent climb followed by a fall off the cliff.

So why did I screw up? This chart shows the SPI futures:



They open at 9:50am Sydney time. Ten minutes before the stockmarket. The first five minute bar was red and my NDX and Nikkei models were short so I went short. Very quickly the market reversed and my plan was to exit if the market traded above the opening price, which would show that my idea that the market would trend down from the open was wrong. We can also see here that my stochastic oscillator crossed over and moved up, showing me that I am wrong on this idea that the market is going to go straight down. This should be a slam dunk to get out. So why didn't I?

When the actual stockmarket opened, the first five minute bar was up, but the second one was red:



I "hoped" that the market was actually going down here. This was just noise though as shown by the stochastics - and the first ten minutes of trading in the Australian market is pretty meaningless as each stock is opened in alphabetical order over the first ten minutes (the Dow Jones index is similarly meaningless in early trading in the US). So I should have just ignored this. But hope got me into a completely wrong train of thought that the market would turn down despite all the evidence to the contrary. 20 minutes in I even shorted a second contract at 6352 (the first was at 6341). Eventually, I capitulated above 6370.

I'm disappointed that I'm trading this bad even with virtual money. OTOH I can't wait till Friday when the Japanese market next trades to get practicing again on Nikkei futures.

U.S. Restaurant Stocks

Take a look at the charts of these U.S. restaurant stocks:

Starbucks
Cheesecake Factory
Darden
Ruth's Chris
Ruby Tuesday
Buffalo Wild Wings
Jack in the Box
IHOP
Brinker
Wendy's
Morton's
Benihanna
P. F. Chang
Texas Roadhouse
Peet's
Domino's Pizza
California Pizza Kitchen
Papa John's
CKE
J. Alexander
Cosi
Cracker Barrel
Krispy Kreme Donuts
Rubio's
Bob Evans
Denny's
Grill Concepts
Steak n Shake
Chuck E. Cheese
Panera Bread
Jamba Juice

This one was doing well till recently:

Einstein/Noah Bagels

There are plenty more once you start digging...

Mostly they look as bad as homebuilders or financials. I got the idea of checking this out after reading in some article about what a bad stock Ruby Tuesday is. There are some exceptions:

Yum Brands
McDonald's
Burger King
Chipotle

The first three are all low price fast food chains. These are doing well, but mid- and high-range restaurant stocks are doing terribly. Sign of recession?

Any Australian restaurant stocks?

P.S.

I found an Australian one - Domino's Pizza:



Not too hot either.

Goals for 2008

Yesterday, I reported on performance relative to my goals for 2007. I've discussed why I think my earlier goals for 2008 were unrealistic. So here are some thoughts on more achievable goals:

1. Increase Net Worth I'm not going to specify whether in Australian Dollars, US Dollars, or in currency neutral terms. Increasing net worth in all three would be nice but large fluctuations in exchange rates may make one of the goals hard to achieve. We can compute the change in currency neutral net worth by taking away the gains or losses for the month or year due to exchange rate fluctuation from actual net worth in either currency. Probably a gain in currency neutral terms should be the minimum goal here. We get a head start from Snork Maiden's employer's superannuation (retirement) contributions of around $A8.600 for the year. Failing to meet this goal means either that investment returns were -2% or worse roughly and we spent all of Snork Maiden's salary or that we are spending more than her salary and our after tax investment returns or some combination of overspending and/or poor investment returns.

2. Positive Alpha This goal says that our investment returns should on a risk-adjusted basis beat the MSCI World Index on a before tax basis. Beating the index (in a risk-adjusted sense) could be the only justification for trying to manage your money yourself (rather than buying a bunch of index funds) apart from educating yourself about finance through the process of managing your portfolio.

3. Increasing Non-Retirement Net Worth by More than the Index This is a much tougher goal to achieve. It requires substantially beating the index on a before tax basis and/or spending less than Snork Maiden's income. Again we can measure this in Australian Dollars, US Dollars, or in currency neutral terms.

4. Achieving Break-Even on Ameritrade and IB Accounts This was a goal for 2007. Though I made progress on it, I didn't achieve it. Things will have to be bad on the trading front in the coming year if I'm not to achieve this goal.

5. Making More Money from Trading I made more money from trading in 2007 than 2006, though not as much as I'd have liked. The goal for 2008 is just to make more again. I have two measures of trading income - the net non-investment gain on my Ameritrade and IB accounts (trading and net interest) and short-term capital gains reported on my tax return (which includes short-term gains or losses in Australia but excludes margin interest). Both numbers were about $US9,500 for 2007.

Trading Consistency

A very interesting blogpost about trading consistency. The bottom line is that you need to take as many trades as possible within your system guidelines to be consistently profitable as long as your expected profit per trade (expectancy) is positive. Which makes perfect sense statistically. Even my simulated trading of the Australian futures has a "profit factor" (total dollars of winning trades/total dollars of losing trades) of only 1.84 currently. I can find an average of 1-3 trades per day probably. But still around 95% of months would be expected to be profitable based on the somewhat simplified analysis in the article. But my real money NASDAQ/SPX trading is now only at a "profit factor" of 1.11. Not much more than half of months would be expected to be profitable. Which is what I saw this year roughly (7/12).

By contrast, Dinosaur Trader has a profit factor based on his daily results of 3.01. But still he had two losing months out of nine (78% consistency). That is a very negative outlier. According to the article, with 20 trading days per month consistency should be in the 97-98% range. I notice that the win percent in their simulations is very high compared to DT's or my own.

BTW DT's win percent is similar to mine: 64% but his win/loss ratio (how much his typical win makes relative to his typical loss) is 1.70. His trade by trade data might be quite different. On average he made $604 per day with a standard deviation of $2708. The t-statistic to test whether this mean is greater than zero is 2.81 which is highly statistically significant. In other words, it's not luck.

2007 Goals Review

We didn't meet any of the goals we set for the year but we did go a considerable way in the right direction:

1. Increasing net worth from $365k to $470k. We are ending the year around $450k which is around 80% of the way to the goal. The merger with Snork Maiden, quitting my job, and the move to Australia were unexpected events (a positive and two negatives for net worth). I also expected to inherit a small amount of money, which didn't happen yet - as it is still tangled in the German legal system. The Australian Dollar was extremely strong which helped raise net worth a lot. Given all this, it is pretty amazing we ended up anywhere near the goal.

2. Returning the combined value of my US brokerage (and Roth IRA) accounts to the value invested in them. At the start of the year I had $41k in these accounts but had invested $60k. In other words, I had accumulated losses of $19k. Now I have around $50.5k with $58k invested. Around 60% of the goal was achieved.

3. A vague goal was to achieve the $19k in goal 2 through trading. Later, I stated $18k as a 2007 trading goal. I made around $9,800 from trading in the end or about 54% of the goal. I was much closer to the $18k goal at the end of June.

Tomorrow, I will post on my 2008 goals, which will look very different.

Trading in the Zone: Review

I've now read Trading in the Zone by Mark Douglas. There are lots of reviews that give the book high praise. My review sounds very critical, but probably this is because I am already aware of a lot of a lot of the issues covered in the book through reading trading blogs such as Brett Steenbarger's.

The author is a trading coach but not a psychologist. He is right on the mark in describing the emotions and thoughts traders have which damage their performance but one of the weak points of the book is any of his discussion of how the brain works or any other science for that matter. We read of beliefs being conscious of themselves, the law of conservation of energy applying to such beliefs etc. Other weak points is that the first ten or so chapters could be much condensed. He only really gets to the point in the final chapter: "Thinking Like a Trader". It would also be helpful to have far more examples of actual traders that Douglas has encountered who illustrate his points. There are very few such examples. I can only think of two off the top of my head. Instead there are pages and pages of the single example discussion about a hypothetical boy who is afraid of dogs.

One of the key parts of Douglas' prescriptions for successful trading is to have total confidence in your ability as a consistent trader. What he doesn't address is the real possibility that your trading system stops working in terms of giving you an edge due to temporary or permanent changes in market conditions. What do you do then? How do you know that the edge is gone?

On the plus side he is right about the nature of the markets and the problems traders face and what is necessary to trade in a consistently profitable fashion. There is really only one exercise in the final chapter aimed at changing the trader's thinking. This is of course a very important exercise. One insight I did get was into the nature of "self-sabotage". Douglas says that our belief that other activities are more important or valuable than trading causes us to get distracted and not pay attention to the market and then make mistakes and lose money. This might be especially true once you had made some money - you might think - "OK now I can get back to more important stuff that society values more highly" - and then your profits are lost.

Though my comments here are mostly critical, I'd still give this book 4 stars if I was doing an Amazon.com review. It would be especially valuable for people who have gotten started trading and are experiencing their first round of frustration with not being able to hold onto profits.

Phoenix Market Neutral Fund Changes Managers

A follow up to the story I reported earlier this year about TFS Capital's approach to the directors of the Phoenix Market Neutral Fund, offering to take over management of the fund. It turns out that though Phoenix did not respond to TFS they did decide to change the manager of the fund. I can't find any more information on this event even on Phoenix's website.

Capitulation on Symbion

Primary Health Care (PRY.AX) extended their takeover offer for Symbion Health (SYB.AX). The takeover is for $4.10 in cash but Symbion is trading at $A3.98. Primary currently holds around 35% of the company. Healthscope (HSP.AX) whose previous takeover bids collapsed holds over 10%. I've been waiting for something new to happen in this ongoing saga while paying margin interest to fund my position. Symbion's board says to reject the offer but hasn't come up with any alternative. Maybe I could get more by hanging on, but that's not what the share price says so I prefer to take the certain $A4.10. I'll have to record a $A90 short-term gain as I bought 2000 shares at $A4.04 after the original takeover emerged and a long-term capital gain of $A3,578. I first bought into Symbion (as Mayne Nickless) on 17 February 2000 and that block is still on my books.

Trading vs. Investing

Snork Maiden commented on Tuesday's post "If we earned so much more from passive investments and long-term capital gains than from trading, maybe we should put more into those kind of investments and less into active trading?".

Well it's not so simple to make that judgment. We only have 6% of net worth allocated to trading vs. 61% allocated to other non-retirement assets. So the $31,691 we earned from longer term investments and cash represents a lower rate of return than the $9,294 we earned from trading. In fact the non-trading rate of return on assets (not equity) was just 11.5% while the trading rate of return was 34.9%. On the other hand, much more risk was experienced in earning the trading income. The Sharpe Ratio in trading for the twelve months of 2007 was about 0.49 while for all non-retirement accounts (including trading) it was 0.90 - in other words relative to volatility excess returns were around twice as high. Based on this, if unlimited leverage at reasonable interest rates was available it would be optimal to lever up the non-trading return instead of trading. On the other hand, the correlation between trading and total non-retirement investment returns is just 0.34. Therefore, it would make sense to have a diversified portfolio that included long-term investments and trading. Depending on preferences, probably the optimal allocation to trading would quite small and some leverage should be used in investing. And that is exactly what we are doing.

This argument is pretty obvious I think if you are familiar with "modern portfolio theory". This graphic illustrates this argument:



The y-axis is the rate of return - 34% for trading and 11% for investing. The x-axis gives the standard deviation of returns, 13% and 70% respectively. The curved black line is the "efficient frontier" - portfolios that allocate varying amounts to trading and investing. The shape of the frontier here is purely illustrative. If the investor has to put all their money into a mixture of investments and trading and can't allocate any to cash and also can't borrow any money then they are going to be at some point on this frontier. With 100% in trading they will be at the point marked trading and with 100% in investing at the point marked investing. Points to the left of investing or right of trading involve shorting one of the two asset classes. The points in between are more interesting for practical cases. Because of the low correlation between investing and trading allocating some money to trading at first raises returns by relatively more than it increases risk - in other words the efficient frontier is convex (up). As we allocate more and more to trading risk increases relatively fast compared to return. Where the optimal point is depends on the investor's preferences. More risk-averse investors will choose more investment and less trading.

If we can also allocate money to cash, the picture is different. Now, it is optimal for all investors to choose the portfolio marked with the green spot for their risky investments and combine this portfolio with cash investments along the green line. If they allocate 100% to cash they receive the risk-free rate (RF) but have zero risk - they are at the point marked RF on the y-axis. Again, where on the green line you invest depends on your level of risk-aversion. By the way, this simple investment theory says that the typical advice to invest more in bonds as you age or have greater risk intolerance makes no sense, unless we are talking about 90 day government bonds which are cash equivalents. All investors should have the same percentage portfolio allocations for their risky investments but different amounts of cash.

If we can borrow money - margin loans, mortgages etc - the picture changes again. Usually the rate we can borrow at is higher than the rate we can lend at and the optimal portfolio is marked by the red point where the red line is tangent to the efficient frontier. The red line starts out at the borrowing rate (BR) which is higher than the risk free rate. This means that if we are thinking about borrowing to invest it is optimal to choose a riskier portfolio to invest in. There is a quantum leap in thinking about risk between leveraged and non-leveraged investors. By borrowing money we have access to return-risk combinations along the solid red line. The more we borrow the higher the return, but the higher the risk. Still borrowing allows us to get higher returns for less risk than if we simply allocated more money to the riskier asset - trading. Again, which point on the line is optimal depends on preferences. We aren't borrowing a lot so we are still relatively risk-averse compared to a more leveraged investor.

There are three counterintuitive results here - examples of what makes economic theory interesting - everyone should have the same allocations to different asset classes once they decide how much to invest in risky assets - but if we borrow to invest we should go for a riskier underlying portfolio - and borrowing to invest is safer than trying to maximize returns by allocating more to high risk investments. All of these go against what most people would think is common sense on investing.

Trading and Investing Cash Flows for 2008

I'll be doing comprehensive reporting on the year's activity and performance later in January but as the mutual fund distributions are in for the year and I don't plan on doing any more trades with real money till the new year I can report on passive and active investing and trading income in terms of cash payments for 2007:



These numbers are for non-retirement accounts only and also do not include unrealised investment gains nor tax credits received. On the other hand, I don't deduct margin interest costs which were capitalised onto the loan principal. So these are the actual cash payments received that we could have had paid out to a bank account (and in many cases did). For long-term gains and takeovers I'm only counting the profits from the transaction though, not the entire cash received this year. At first glance the numbers look good with a 34.4% gain in investing and trading cash flows in USD terms and a 23% gain in Australian Dollar terms (all numbers to the left of the total column are in US Dollars). If you count the takeover of Powertel as a regular long-term gain, long-term gains realised also increased this year by 60%. Despite all my recent gloom trading income rose 56%. The problem is that I was in a much better position at the end of June regarding trading and unrealised investment gains have also fallen substantially since then. Total income is 24.1% of non-retirement net worth at the beginning of the year, which is similar to 2006's 22.8% rate. Again, this isn't our investment rate of return, which I estimate at 19.5% in USD terms including unrealized gains, tax credits, and margin interest, or only 8.3% in AUD terms (19.1% and 10.2% in 2006).

Looking forward to 2008, I am obviously hoping to do better on the trading front, though even repeating this years 56% improvement in trading income would still not give me very good results in absolute dollar terms. I expect mutual fund distributions to be flat or lower as it seems that the rate of payout has been unsustainable due to the funds selling a lot of their longer term holdings this year and I don't expect as large a gain in dividends in 2008 either. In short, I'm not expecting another 23% increase in cash flow and if it comes it will probably have to be from trading.

Neural Networks

Necessity is the mother of invention. In the last couple of days I've taught myself how to use neural networks to forecast time-series. Very helpfully, the econometrics package I am using - RATS - has a built in neural networks module, which is pretty easy to use. Reading some online papers by econometricans got me to see through the rather esoteric language used to understand that these are basically a specific type of non-linear regression model that isn't too far from some of things I've used in my academic research. I experimented with trying to forecast the stochastic oscillator but couldn't get anything better than I could with simple time series models. Now I am "training" a network to forecast changes in the NASDAQ 100 index using all the indicators that my existing model produces. The problem with the existing model is that there are several different indicators (there are three actual time series models for each index). Sometimes the direction is clear but a lot of the time, different indicators point in different directions. I've gradually developed ad-hoc rules for how to interpret the indicators in different situations but it is then very easy to second-guess and make mistakes. The neural network finds the best rules it can given the structure of neural net (explanatory variables, number of neurons etc.) and provides a simple long, short decision. So far the results are extremely good, but this is early days. Using this approach would add another layer of models to run every day but reduce the amount of time needed observing the market etc wondering what to do and whether the right decision was made.

In my simulated trading this week I did really well trading the Australian stock index futures (SPI) but not well trading the Nikkei. I think though I am beginning to get the hang of how to day trade the Nikkei.

Overall, it feels like I made progress this week, which is good.

Imaginary Money Almost Feels Like Real Money

In the past I found it hard to take simulated trading seriously. There was no real money at stake so it was hard to take seriously the need to use a precious resource time to monitor the market closely on those trades. I didn't feel any pain of losing money, it was just an experiment to see how things worked. But now simulated money feels almost like real money. The pain and anxiety of losing money is real the euphoria of winning is real too. To a lesser degree of course than when I win or lose real money. The reason I think is that now I feel my "trading career" is on the line and I really need to improve my skills and discipline. Each bad trade I do even under simulation is taking me away from that goal and that is the emotion I am feeling. Some emotion I think is necessary to make us care about the outcomes of trading. Too much of the wrong emotions are of course very detrimental. It's a delicate balance.

Wedding

Yesterday evening we met with a "marriage celebrant" and started the ball rolling for real on our wedding. It's going to be a very small and frugal wedding as these things go but things to plan or pay for begin to add up fast. So far we have the celebrant lined up and a dress for Snork Maiden that she got from China a little while ago. We've been thinking through some ideas and so far tried to check out two possible restaurants where we'd plan on having a lunch (we're planning at the moment to hold the ceremony in ate morning). The first restaurant turned out to have closed down and as we were already out we decided to go to another, somewhat disappointing, place. Last night we went to another which was better but still suboptimal. I guess these are "research costs" of the wedding :) We'll have plenty to do over the Christmas-New Year break in "purpose-driven sight-seeing". We are planning to have the wedding early in the new year so that Snork Maiden can then ASAP file for an Australian permanent residence visa.

Trading School

I'm not going to do any real trades for a while until I am satisfied that I've got my act together. In the meantime I'm in "trading school". Did 4 simulated trades so far this morning - two on the SPI (Australian Index) and two on the Nikkei. All have made money. For the Nikkei trades I am using a version of the rule of three - entering the trade with three contracts and then scaling out. The exits are all pretty random though, though I am trying to exit the last contract at my actual target based on the stochastics and/or using a stop. But it's helping - my second contract is being sold at a higher price than the third. This approach ensures that winning trades don't become losers, which is what often happens to me. Nikkei mini contracts are small enough for me to actually do this with real money. SPI contracts are so big it would be way too scary to enter with three contracts - I don't even have enough money in my account for that amount of margin at the moment!

Still, I am left a lot of money on the table in my SPI trades. Being able to scale out would have increased the rate of return.

Trading in the Zone

I walked into town this afternoon and bought a copy of this book at Borders (yes we have them here too). Luckily there was a copy available. The book is in twelve libraries in Australia including one of the public libraries here in the ACT, checked out till 20th January. But I want to read it before then and at my leisure so I thought it was worth the investment. I'll report on what, if anything I learn. Most people seem to say it is one of the best books on trading.

New Low

I traded the NQ futures this morning and lost more money. Again, going long when the model is short and the market already down a lot, hoping to catch a falling knife and then doubling up to two contracts from one when I was already down. All the mistakes I could make, I made. Now reached a new low in trading profit and loss for the last six months.

On the other hand, yesterday morning I made simulated trades in the Australian (SPI) and Nikkei futures. I made three SPI trades which were all winners for a total of an imaginary $A800 or so. In the Nikkei I made ¥5,500. That's more than I lost for real this morning. Why do I trade better with imaginary money than real money? It seems a lot of people have exactly this problem. I'm going to do more simulated trading later today. I think this is the best thing to do at the moment.

Yesterday lunchtime I met a guy who works with Snork Maiden. He does stuff with neural networks but hasn't applied it to time series. He is also interested in trading and has read quite a bit but hasn't actually even opened a brokerage account yet. I guess it was mostly me telling him how tough it is and what does or doesn't work. Later I met a PhD student at ANU who wanted to quiz me on one of my research areas and I also worked a bit on a paper I am revising with a former student in the US. More people here are finding out that I've returned to Canberra. I bumped into one guy who was riding his bike on campus. He used to work as a non-faculty staff member in my department. In the meantime he did a PhD and is now a lecturer (assistant professor) at ANU. We haven't met in five years but he recognized me stopped his bike and we had a chat. Another guy sent me some stuff about jobs here. I'm not willing to give up on the trading dream yet as I have barely gotten started on trying to trade Australian and Japanese markets during the day here. If that doesn't work for me either then maybe I'll have to admit defeat.

My emotions now are different than they were after other recent losses. Then typical I couldn't bear to trade for a while and felt very upset and despairing. Now I fee angry with myself and frustrated. It would have been good not to go right back in and trade today. I guess "revenge trading" is what screwed me up today.

Short the Nikkei

I've now estimated my model for the Nikkei and it is pretty successful in backtests. The model says to look for short-trades in the Nikkei on Monday. I probably won't start trading it though till Tuesday due to a couple of meetings I have during the day on Monday. Perhaps more on one of those meetings with someone interested in trading and modeling after we meet. A lot is happening this week actually. Should be interesting. I'll keep you informed.

P.S. The US models would suggest to switch to long Monday except that even if the indices were unchanged they would fall deeply into the oversold zone, which says to stay short. So only a very strong rally on Monday would actually show to get long. There is a reasonable likelihood of a positive gap up at the open Monday, that might be what you need to get long.

Back to Square One Again

I shouldn't boast on this blog about making money, because I tend to go ahead and lose it immediately. The chart above shows the profit and loss on my Interactive Brokers account from 14th November till today. On 13th November I suffered a major loss (of $1750) and since then I have been struggling to rebuild my account. I've now been through three cycles of consistently making money only to blow it all up again. The positive aspect is I'm only blowing up profits I made since that day and so in some sense the situation is stabilizing. Three losing trades contributed to last night's blow-up - the first was excusable though silly, the next two were just plain dumb - going long on a down day in the market and holding on hoping for a turnaround. I could have gotten out of these two trades with a decent profit, but let them turn into losers. One lesson I think is not to daytrade overnight. Most of these losses recently have occurred late into the night. One of my rules is not to trade in the middle of the US trading day as I find the direction of the market very unclear. I need to stick to that and currently focus on trading the last two hours of US trade and then Australia and probably Japan. In the winter here (northern summer) I'd trade the US open and Australia/Japan. Some day I'd get around to trading my model with trades over a few days. But right now, just getting any kind of profitability is the focus.

Japanese Futures

During the 24 hour global trading day stock indices appear to be most influenced by the largest market currently open as well as catching up on what the US markets did the previous day. The day starts in New Zealand, a tiny market, followed by Australia - either the second or third largest Asian market depending on who you believe and an hour later Japan comes online with Korea, followed later by Shanghai, Hong Kong etc. At 7pm Eastern Australian time (3am on the US East Coast) the major European markets including London, the largest, open. US stock index futures tend to track what is happening in the largest open stock market. This is particularly clear once the London market opens. Volume on US future usually increases substantially and often volatility does too as the futures begin to track what is happening in London. The same is also true of the Australian stock index futures to some degree - once Japan opens the Japanese market has a strong influence on Australia. At the moment I am trading US futures during the time that the London stock market is open in our evening here in Australia. I can get up to date data on the FTSE index from Yahoo's website. Unfortunately though Nikkei data is delayed by 20 minutes and this is one more factor making trading Australian futures difficult (other reasons are the large size of the contract, the often think market, the staggered index open etc.). Interactive Brokers can provide data from the Osaka Futures exchange for 1200 Yen a month (USD 10.70).

You can then also trade the Japanese futures. So I am thinking of trying this out, maybe next week. It could help me trade the Australian futures but also I might actually trade in Japan. I will have to see what the market there looks like before committing to the idea, with some paper trades first. There are two contract sizes available:

Full size contract:
Value = ¥1000*Nikkei (i.e. USD135k per contract)
Initial margin = ¥750k (i.e. USD6,700)
Tick size = 10 points
Commission = ¥500

Mini contract:
Value = ¥100*Nikkei (i.e. USD13,500 per contract)
Initial margin = ¥75k (i.e. USD670)
Tick size = 5 points
Commission = ¥150

The large contract is about the same size as an Australian futures contract and the minimum tick size is equivalent to one S&P futures (ES) point. That means that you are down the equivalent of 1 point immediately (plus commission) when placing a trade. Neither of those are good for me. The small contract though is about the third of the size of a NASDAQ futures (NQ) contract and the tick is equivalent to half an ES point. ES and NQ futures tick size is 1/4 point, Australian futures tick size is one point which is the equivalent to the ES 1/4 point. The mini contract might be an attractive day trading instrument. And I could really "day-trade" as opposed to "night-trade", which is what I am doing at the moment.

BTW, the CME-Globex exchange offers Nikkei futures, but they only trade when the Japanese stock market is closed!

P.S. After a bad start to the month I am now about back to breakeven on my Interactive Brokers account. Though right this minute I'm in an ES trade that is not going well :(

P.P.S. I signed up for the data and trading permissions and already have it! Very cool. There are plenty of contracts being traded and the discrepancy between the mini and full-size spread is real - how weird.

Volatility

I'm now turning to looking at volatility of stock prices and seeing if it could be a useful addition to my trading model. More sophisticated investors and traders and familiar with measures of stock price volatility derived from the implicit volatility expressed in options prices according to the Black-Scholes options pricing model. The VIX and VXN are the best known of these and measure the volatility implied by options on the S&P 500 and NASDAQ 100 indices. But one can also measure volatility directly from stock prices. The most straightforward would be a standard deviation of changes in the index. The problem with this and the reason why the options based indicators are popular is there will be a different result depending on how many observations are used to compute the standard deviation. This indicator also doesn't address intraday volatility. A measure of intraday volatility is Average True Range. True range measures the range of prices from previous close to close (and therefore includes any gaps in the range). ATR is simply an exponential moving average of this. A problem with this indicator is it is dependent on the level of prices. Of course we can simply divide true range by average price over the day to get a unit free measure of the daily range as a percent of price. The chart tracks a five day exponential moving average of this latter indicator.

The late 1990s and early 2000s were far more volatile than today with volatility peaking with an average of a 9% daily price range over the a five day period. As the post 2002 bull market took off volatility declined to very low levels and has now begun to re-emerge but not to the extent seen several years ago.

Why might volatility be interesting?

1. While mainstream finance theory claims that it is not possible to forecast stock prices (this is true though direction of stock prices may be forecastable) it is believed to be possible to forecast volatility in the short term. Typically ARCH (autoregressive conditional heteroskedasticity) time series econometric models are used. Being able to forecast volatility is a big advantage obviously in option trading and a reason I mostly avoid option trading except using deep in the money options as proxies for margined stock or futures. Volatility is not a component of futures prices which makes trading them a lot easier.

2. Stock prices are far more volatile when declining than rising. Market tops are more commonly characterised by narrow trading ranges that finally fail than by volatile "blow-offs". Market bottoms typically show violent intra- and inter-day fluctuations. If one forecast rising volatility - declining prices might also be associated with that forecast. Of course it makes sense that volatility is higher with declining prices -a rise in volatility implies a rise in risk and higher risk implies that lower prices are optimal - investors should pay less for a given amount of earnings with higher volatility assuming risk aversion.

At least volatility might explain some things about stock price behavior that my current completely price based model does not. So I'm going to do a bit of research on this. My first problem though is deciding on an appropriate indicator of volatility.

November 2007 Report

All figures are in US Dollars (USD) unless otherwise stated. This month saw a fall in net worth in US Dollar terms partly due to the fall in the Australian Dollar and partly to poor investment performance due to the decline in global stock markets this month. Net worth also decreased in Australian Dollars terms. Trading results were negative but I managed a significant turn around in the last few days of the month.

Income and Expenditure



I've introduced a breakdown of investment and trading income for the first time in this month's report. The two sum to "core investment income" which together with "forex" sums to "investment income". I've used different size fonts to try to express this relationship. Not sure that it works :) I've also broken out "core expenditure" which excludes work-related and moving-related expenses.

Expenditure was $6,680 but this includes a large work-related expense for Snork Maiden (which resulted in us effectively buying two thousand or so Australian Dollars (expense in US Dollars, reimbursement in Aussie) and port-handling charges in Sydney for both of us. Core expenditure was well under control at $3,280. This included $A59.07 of implicit interest costs of owning a car.

Non-investment earnings ($7,119) included the refund of the work-related expenses from Snork Maiden's employer. She also again got paid by her previous employer. We've told them to stop paying and we may need to pay this money back, but for the moment I am counting it as income. Snork Maiden's retirement contributions were $1180.

Non-retirement accounts lost $19,364 with $8,315 of the loss resulting from the fall in the Australian Dollar. Retirement accounts lost $6,917 but would have gained only $249 if exchange rates had remained constant. This gain is due to the strong exposure to bonds in our retirement accounts and the stronger exposure to equities in our non-retirement accounts. In AUD terms non-retirement accounts lost and retirement accounts gained for the month.

Net Worth Performance
Net worth fell by $US24,563 to $US453,326 and in Australian Dollars fell $A3,171 to $A512,406. Non-retirement accounts were at $US241k. Retirement accounts were at $US212k.

Investment Performance
Investment return in US Dollars was -5.50% vs. a 4.38% loss in the MSCI (Gross) World Index, which I use as my overall benchmark and a 4.18% loss in the S&P 500 total return index. Non-retirement accounts lost 7.46%. Returns in Australian Dollars terms were -0.96% and -3.01% respectively. In currency neutral terms the portfolio lost 2.26%, which is relatively good compared to the performance of the indices. YTD we're up 20.4% (USD) vs the MSCI with 13.4% and the SPX with 6.4%. Our non-retirement accounts are up 24.8%.

The contributions of the different investments and trades are as follows:



The returns on all the individual investments are net of foreign exchange movements. Foreign currency gains appear at the bottom of the table together with the sum of all other investment income and expenses - mainly net interest. My Australian funds all did horribly with Platinum Capital being the worst of all. I also suffered net losses trading SPI (Australian Share Price Index) and ES (S&P 500) futures but gained in NASDAQ trading. PSS(AP) is Snork Maiden's superannuation fund, where we are starting off with a loss...

Progress on Trading Goal

I lost $1,035 in trading following losses of $1,123 in September and $681 in October. The losing streak is depressing even though relative to net worth the numbers are small. The loss is 3.97% of trading capital vs a 6.69% loss in the NDX. My IB account lost exactly 6.69% for the month, though I gained 7.8% or $1,310 in the last week in this account. As far as my goal of achieving breakeven in my 3 US trading accounts, I have currently invested a net amount of $60k and the accounts are currently worth $54,230. At the end of 2006 the value stood at $41,042 so I have made progress even if it is slower than I would have liked.

Asset Allocation
Using the simple method of adding up the betas of each individual investment weighted by their portfolio allocation, at the end of the month the portfolio had an estimated beta of 0.42. Recent performance shows, though, that actual beta of my USD denominated returns is a lot higher than this. My time series estimate using the Kalman filter estimates beta to the S&P 500 at 0.90 and to the MSCI at 1.00. The reason for this is that the Australian Dollar is becoming increasingly correlated with global stock market returns due to the carry trade where traders borrow in low interest currencies like the Yen and buy high yielding currencies like the AUD and stocks. When their "aversion to risk" increases they sell both Aussie Dollars and stocks and buy Yen and US bonds.

Allocation was 29% in "passive alpha", 67% in "beta", 6% allocated to trading, 4% to industrial stocks, 6% to liquidity, 3% to other assets (including our car which is equal to 2.8% of net worth) and we were borrowing 15%. The biggest losses this month were in the funds that I have designated as "passive alpha". Those funds really contain a lot of beta of course too. I include all hedge-fund like and alternative investments under the "passive alpha" label and all long-only equity mutual funds under "beta". Our currency exposures were roughly 60% Australian Dollar, 30% US Dollar, and 10% Other (mainly global equity funds).

House Price Update

Thanks to financial reality for the graph. House prices continue to fall in the US. However a renewed decline in house prices is yet to get underway in Australia. There was a decline in prices in Sydney and a slowdown in other cities earlier in the decade and since then prices rebounded. The following are year on year changes for September 2007:



Data are reported on a quarterly basis by the Australian Bureau of Statistics. Only Perth is now showing the beginning of a slowdown though price actually rose in the last three months there.