Friday Update

I finally exited Leucadia National after they announced they are converting into an investment bank and will sell some of their private equity assets and change their name to Jefferies. It has been one of my worst investments losing just under USD 4k (there have been some far worse ones though...). I got in too late just as the financial crisis was getting underway and the company never recovered. Previously, it had an excellent track record and was referred to as a mini Berkshire Hathaway. I bought some more shares in 3i instead, which has been a good investment.

I have been doing more work on improving my trading model and more on trying to trade it. The options I am willing to buy - i.e. the maximum loss is bearable - have too much time decay and so the market can go up and I end up not making money. I about broke even over the week due to this and various stupid things I continued to do. I stayed up last night trading the market, though that is not something I should do. The market was beginning to go up after initially falling and I decided for some reason that shorting put options on expiration day would be a good idea. I shorted a 2650 Friday 13th S&P put and bought a 2625 Friday 13th S&P put. This exposed me to a maximum USD 1300 loss. Of course, the market immediately turned around and started going down. As it reached 2650 I sold short a futures contract as a delta hedge. Then the market bounced and hit the stop I had subsequently put in place at 2650. And then it went back down again... In the end, I actually ended up about USD 20 on the trade :) But it was quite nerve-wracking. I don't know how ERN sells lots of put options all the time without trying to determine market direction or "buy reinsurance" to make it an options spread.

Next week I am thinking to experiment with futures contracts with options collars to limit both the upside and downside. Using options you can have a much tighter effective stop and not worry about the market coming down, hitting the stop, and then going up again. The downside is that the upside has to be limited or the cost of the put option (or call if short the futures) is too much. So, you sell a call (or a put) to defray the cost. I think for a reasonable net cost it's possible to have a little more upside than downside, though as the model does have an edge it's not strictly necessary to have more potential upside than downside. I am thinking of buying a put 10 points (E-Mini S&P) below the entry price into the futures contract and selling a call 20 points above. The maximum downside is then something like 13 points (USD 650) and the maximum upside 17 points (USD 850). Another downside is that if the market is flat, you lose 3 points (USD 150).

The only issue is if both options are out of the money at expiration I will have a naked futures position without a stop at the end of that day's session. I guess if the market hasn't moved in a decisive manner up to that point then maybe it won't suddenly, but I need to be up in time to put on a new options position.

The model is neutral for Monday. The different predictors point in different directions.

Another idea I had is that it is easy to adjust the ASX200 index for franking credits. S&P have a franking credit adjusted index but it only goes back to 2011 and has some weird features, like only reinvesting the dividends once a year. If you get the monthly values of the total return or accumulation index - which includes dividends but not franking credits and the price index which is without dividends, you can calculate the monthly dividend yield. The dividend yield can then be grossed up for franking - this will exaggerate franking a bit as some companies pay unfranked dividends. The return including franking credits matches the MSCI World Index gross total return since the financial crisis in 2009 very well:

My performance is also given pre-tax includes estimated franking credits. A major reason why I am lagging the index is presumably management fees.... You can see though that my returns about match the ASX in the last five years, despite the drag of management fees. This is by investing more in funds that do generate alpha. The black line is a simulation for the "target portfolio".

Exited First Model Based Trade

The futures market started crashing when the People's Daily said that Xi Jinping's comments on openness to trade did not apply to the US. I exited my trade when the S&P 500 was down 1% on the day, based on a 1% stop loss. I made USD 245 on the trade, which was roughly equivalent to 1/3 of an S&P 500 futures contract. So it's about 1/2% on the underlying stock. I was up about USD 650 at the close of Tuesday's regular market.

I am continuing to fine tune my model strategy. It's different to how I traded a decade ago but following similar principles. When I deem the market is overbought I remain long (with a 1% stop) unless one model says that we will exit the overbought situation. Another indicator shows when we enter overbought. The mirror image applies to oversold - remain short with a stop. When neither overbought or oversold, I use the average of 4 predictors. This combination, if executed perfectly would have returned 37% since January 1st. It would have returned far less in the generally bullish market in 2017.

Despite this, I have some further research ideas to test out to see if they can provide a more theoretically satisfying signal. One of the 4 signals in the composite makes no sense whatsoever, but it has done really well since the beginning of this year.

The inverted head and shoulders formation still remains in play unless the market falls below the right hand shoulder:

Notice the higher volume on the left shoulder than the right, which is a classic sign of a head and shoulders formation. The alignment of the recent highs perfectly along the white line is also a classic sign. P.S. 12 April Long again for 0.75 cents slippage.

More Trading Model Research

Even with all my old notes it is hard to reconstruct the trading rules I was using a decade ago. I have put that on the "back burner" while developing new approaches. I realised that I can actually make predictions on the level of the index. My model predicts the change in an indicator. I can solve for the index level that will generate that level given some assumptions. If there is little change in the index it's best not to trade. If a big move is predicted it is worth trading. The tests I've done so far are good, though it needs systematic backtesting. Using this approach the NASDAQ 100 index is projected to rise to 6555 on Monday up from 6433. That is a big move up. This will set up the price action of the last two weeks to be a "head and shoulders bottom". Based on that there should be a new uptrend over the next couple of weeks or so. Of course, my model can only project one day at a time. As this hasn't been extensively backtested yet, I think I will sell a put spread that limits my potential losses to less than a 1% stop loss on a futures contract would.

P.S. 9 April
After looking at my options (pun intended) I decided instead to buy a call option. Specifically a June 2018, ES-Mini 2800 call. This is an option on the ES-Mini futures contract. This option has currently a delta of about 0.16 - for a 1 point move in the futures contract it moves about 0.16 points. So, it is equivalent to going long USD 22k of stock instead of USD 130k. Also, the most I can lose is the USD 500 that the contract cost. The likely loss if I am wrong is more like half of that or about 1% of the implicit position. So, this is like a built in stop loss.* Because the option expires in a couple of months, the time decay shouldn't be too bad, but I will need to investigate further whether longer-dated options make more sense.

I just found it impossible to find a risk-return trade off that I liked with selling put spreads. The net amount of premium I would have received was just too great relative to the potential loss.

* This is particularly attractive for holding a position over the weekend when a stop can't be activated. The CME Globex market trades 24/5 not 24/7. Not that I'm planning to hold this position that long, but for future reference.

Reviving Old Trading Models

I dug into my computer files and updated the trading models I last used 10 years ago. One of them which is fairly simple flashed a strong warning sign at the January high in the market. It does tend to have false positives where it is fooled by a very strong trend into thinking that that is a top in the market, but this time the market actually did fall of course after the warning. This is a very negative signal. There was a minor buy signal at the recent low about a week back but there are typical several buy signals on the way down in bear markets. I had been looking for signs of a recession before taking de-risking action in a big way on our portfolio - for example, an inversion of the yield curve. There hasn't been any sign of a recession. But Trump's trade war and the Fed's unwinding of its inflated balance sheet are having a negative effect on the market.

I have another much more complex model that attempts to forecast the day ahead direction of the market - despite what standard investment theory says, that the stock market is a random walk and can't be predicted this is actually possible to some degree with some insight from econometrics into how to turn it into a predictable problem. I updated the model using the last ten years of data and reoptimized the parameters - they hardly changed. That is a good sign. However, though I have all the past predictions and the trade directions I decided on based on them, I can't remember how I used the model to actually choose market direction. Unless I can find something I wrote about that, I'll have to reverse engineer that from scratch.

P.S.
I found a folder of handwritten research notes on my trading model from 2006-8 in my home office. This should help a lot.

P.P.S.
I predict the US will go into recession in 2019. In 2007 the stock market peaked in Summer-Fall but the recession didn't really get started till Bear-Stearns failed in March 2008. In 1999-2000 the stockmarket peaked in March 2000 but the recession didn't really get going till September 11, 2001.

Types of Trading

There are lots of types of trading. Some of the important strategies are the following:

1. Market-making: A market maker profits from the bid-ask spread in the market, selling at the ask and buying at the bid. This is very apparent in options markets where there is usually a big bid-ask spread. They can hedge their "delta" risk by buying or shorting the underlying security - for example for futures options they can buy and sell futures contracts. For individual stocks - if they are trading a diversified basket they can again hedge using futures contracts (or ETFs). It is possible for individual investors to make markets in small and illiquid stocks - ie. selling at the ask and buying at the bid, but it is a very slow process waiting for people to trade with you.

2. Arbitrage: This exploits pricing anomalies, for example between futures contracts and ETFs for the same underlying index. Short one and buy the other. Occasionally, there are big arbitrage opportunities such as the famous Palm case.

3. Mean reversion: These are generalizations of arbitrage. For example, buying closed end funds (listed investment company in Australian) when they are selling below net asset value and shorting them when they are above. I've done this quite a lot with Platinum Capital (PMC.AX - just selling when above NAV - but actually there is a CFD you could use to short the stock). This is arbitrage between the value of the portfolio and the price of the fund. Statistical arbitrage is a market-neutral mean reversion trade where stocks that have risen in value are shorted and those that have fallen are bought. It was pioneered by Ed Thorp.

4. Selling option premium: This relies on the time decay of options. Most options expire worthless and risk aversion means that buyers should pay in net to reduce their risk. So option sellers should on average win. Again, delta risk could be hedged away in theory. The simplest case is covered calls where the trader buys a stock and sell a call - though actual delta hedging is a lot more complex than that.

5. Information trading: Here the trader knows information that they think will move the security. For example, recently I bought shares in IPE because Mercantile did. I assumed correctly that their analysis must have shown that the underlying portfolio was worth more than the stock price. This is a kind of mean reversion/arbitrage of course and is could also be seen as investing. Even after the company released news of the sale of Threatmetrix to Elsevier, the price didn't immediately move to the new higher NAV.

6. News trading: Here the information is not yet known but a trade is placed to take advantage of it. For example, if I know that Apple Computer will release their earnings but I don't have a hypothesis of which way it will move the stock, I could buy both calls and put options in the hope that a big move will make one increase by more than the other decreases. This seems pretty close to gambling - option prices should take into account the size of likely moves, so you are gambling that the move will be bigger than the market thinks.

7. Trend following/momentum trading: This is what most people think of as trading. The trader tries to take advantage of market momentum. This is the approach taken by many managed futures funds. Much online trading advice is based on this.

8. Hedging: These traders trade to hedge their investment or business positions. For example, an airline buying oil futures contracts to guarantee their future price of oil or an option buyer hedging an investment portfolio. The latter might also sell options to fund the hedging puts.

What have I missed? This paper has an interesting discussion of types of traders.

First Futures Trades Since 2008

I transferred some money from my Australian bank account to Interactive Brokers to do some practice trades. I haven't traded futures since 2008 and so just want to get used to doing trades again. I did 2 very quick daytrades, shorting the E-Mini S&P. The first trade I got out where I got in and so I lost $4.10 the cost of commissions. On the next trade I made 1 point or $50, so I made $46.90 net. I was very nervous while doing the trades even though I am trading with a stop that is transmitted at the same time as my order and is only one point above my sell price, so the most I can lose is $50.  The contract value is $130k (about my pretax annual salary :)), so short selling that much stock does make me feel nervous despite the stop. I've just got to get used to this again as I am thinking of doing more systematic trading again and doing it properly this time. When I traded before, I had lots of winning trades but my winning amounts were small relative to my losing amounts. If I can fix that I could trade profitably.

March 2018 Report

The first of the new style reports. A second losing month, but thanks to (listed) private equity investments, we beat the ASX200 index.

The Australian Dollar fell from USD 0.7794 to USD 0.7680. The MSCI World Index fell 2.15%, and the S&P 500 2.54%. The ASX 200 lost 3.77%. All these are total returns including dividends. We lost 1.20% in Australian Dollar terms and 2.64% in US Dollar terms. So, we outperformed the Australian market and underperformed international markets.

The best performing investment in dollar terms was IPE.AX, a listed private equity fund, which gained AUD 9.8k in the continuing rise after the acquisition of Threatmetrix by Elsevier. I sold my holding in IPE prior to the stock going ex dividend, as I didn't want an AUD 11k income tax bill. I then bought back even more shares than before as MVT.AX were recently still acquiring shares.

The worst performer in dollar terms was not surprisingly CFS Geared Share Fund, down $18.6k. The best performing asset class was private equity, which gained 7.12%. The only other asset class with gains was hedge funds, up 0.57%. The worst performing asset class was large cap Australian stocks down 3.01%.

We made a little progress towards the new long-run asset allocation:

Total leverage includes borrowing inside leveraged (geared) mutual (managed) funds. The allocation is according to total assets including the true exposure in leveraged mutual funds. The "improvement" in allocation, came partly due to market movements and partly due to investment activity. We invest AUD 2000 monthly in a set of managed funds, and there are also retirement contributions. Then there are distributions from funds and dividends. During the month, I also:

• Sold out of Clime Capital (CAM.AX)
• Bought a small amount of Oceania Capital Partners (OCP.AX, listed private equity)
• Did the trading in IPE.AX
• Bought more units in the Winton Global Alpha fund (managed futures - in the commodities category)

Over time we've been reducing our exposure to large cap Australian stocks since the post financial crisis high:

New Era in Moomin Valley

In a few months we will reach "financial independence" - our annual spending will be feasible with a little less than a 3% p.a. withdrawal rate. About 60% of this was due to our own efforts working, saving, and investing over the last 24 years and 40% from inheritance. I never depended on receiving the inheritance, which is why I saved so hard. Because I knew finding an academic job could be very hard when my initial short-term contracts ended, I saved up to 50% a year at times. This allowed me to live for a year in 2001-2 without working for pay, traveling around the world looking for work. Similarly, when we moved to Australia, I could experiment with trading in the financial markets while exploring alternatives.

On the other hand, I think I was willing to take more risk based on the probability that we would receive a substantial amount. In the case of the financial crisis in 2008-9, I took on too much risk. The pressure of trying to make a living from trading with a small amount of capital combined with the volatility of the financial crisis was too much and I decided to stage an academic career comeback, which has been very successful.

The other half of the financial independence equation in the blogging community is usually "retire early". I don't have any plan to do that any time soon. I like the research side of my work and I have my teaching etc organized so that going forward it shouldn't be too hard - I only need to teach during one half of the year for now. As things are at the moment, it would be hard to find a better job than this. So, it doesn't make any sense to sacrifice my salary. I am actually exploring a potential career move to another bigger city. That job would have more admin and maybe no teaching. Introspection tells me that I wouldn't like to retire currently.  On the other hand, Moominmama is pretty frustrated with her work at the moment and so now has options to take a break and consider alternatives.

On the other hand, our spending is growing by more than the rate of inflation and I expect that to continue. So the current 3% withdrawal rate would become more than a 3% rate over time unless investment returns are very good, which does not seem likely. Continuing to earn some money does sound good in those circumstances.

Is continuing to work limiting our location choices? At the moment, I don't think there is another location that we would both agree on and which would make practical sense. We have to consider education opportunities for little Moomin. So, moving to a small town in Australia does not sound like a good move from that perspective. The nice parts (with good education) of the two biggest Australian cities are extremely expensive and would take us out of the financial independence zone. We definitely would never move to Moominmama's home country (she doesn't even want to visit at the moment). Moominmama is not enthusiastic about moving to either of my home countries. One is too cold and dark as far as she is concerned (Northern Europe) and the other too foreign and dangerous (Middle East). That leaves Southern Europe as a sensible or feasible alternative, but I don't think we want Moomin to grow up speaking Spanish or French? I think it would be hard for Moominmama to learn those languages too, though not difficult for me. So, continuing to work is not stopping us from making a move to another location that we could or would want to make.

So, for now not much will change, but this blog will change. I plan to stop reporting actual earning, spending, and net worth figures. Going forward, all numbers will be in percentage terms only. When the vast majority of our net worth was the result of our own work and effort I was happy to report those numbers, and reporting, even though it is mostly anonymously, helped keep us on track. But now that so much of our net worth has not come from our own efforts and we don't have the goal of achieving financial independence anymore, I don't want to report the numbers any more. On the other hand, I'm not going to erase the existing blog.

Our long term goal now is to pass on at least as much wealth in real terms to the next generation as we received from the previous one. My parents also inherited more than 2/3 of their eventual net worth, though they also saved and worked hard to build up wealth in earlier years. They eventually passed on what they inherited.