VIEWPOINTS OF A COMMODITY TRADER

Readers of the Viewpoints blog know that I don’t give quite the credence to the “expert” forecast as I do a good solid trading methodology, risk management and respect for the role of randomness. This does not mean however, that you should ignore the various scenarios that could unfold. It is always healthy to ponder the possibilities without attaching yourself to a specific outcome. 

Forecasting is a very difficult thing to do, especially in such dynamic and complicated systems like the financial markets. It does seem however, that some are better than others when it comes to predicting.

Felix Zulauf is the founder of Zulauf Asset Management based in Switzerland and is well known for his appearances in Barron’s annual roundtable. Zulauf has nailed the secular bear market downturn and 2009 upturn about as well as anyone.  More importantly, he has been nearly flawless in connecting the dots in the macro picture.  From the de-leveraging cycle that led to the downturn to the government stimulus that led to the upturn – Zulauf has been remarkably prescient.

At the 2008 Barron’s Roundtable, Zulauf recommended investors purchase gold and short stocks due to concerns with the consumer.  He remained bearish throughout the year.  At the 2009 roundtable Zulauf said stocks would bottom at some point in the second quarter after making a new 2009 low.  He got aggressive and said stocks would rally after that.  His recommendations to purchase oil, gold and emerging markets were home runs.

Here are his recent comments from the 2010 roundtable:

“We are in the early stages of a deleveraging process, which is marked by a shift from maximizing profits to minimizing debt. It is a multiyear process. The U.S. consumer is in bad shape, and the U.K. consumer is even worse.”

“Central bankers themselves are somewhat afraid of what they have been doing. Politicians are worried about public-sector debt. Therefore, the authorities will try to step away slowly from their stimulation efforts, because this policy isn’t sustainable. That’s the risk for the markets.”

“The U.S. stock market has enough momentum to rise another 10% or so. But the authorities will start leaning the other way as they see signs of economic growth in the first two quarters, and possibly a jump in inflation. That could push the market down.”

“China is in a dangerous situation. Credit growth is the one factor that all the bubbles that burst had in common. Because China isn’t an open economy, the bubble there can probably keep inflating longer than it otherwise would have. But the Chinese can’t escape the laws of economics. If China’s bubble bursts, it would cause a second hit to the world economy, and that would be terrible.”

“In the past five years, the individual investor has been hit by two bear markets in stocks and a severe bear market in housing. He is just done. You see it in fund-flow statistics. Money is flowing into fixed-income investments that are perceived to be safe.”

“The euro is about 20% overvalued relative to the U.S. dollar. It could trade down to $1.25, from $1.45. You can see how the weaker members of the European Union are getting squeezed.”

“Governments and central banks will continue to support the economy. Short-term interest rates will stay low.  Bonds aren’t attractive.”

“Previously I advised buying financials and metals. Now the financials are done, perhaps for a couple of years. Bank balance sheets aren’t repaired. It’s just camouflage. Today I like emerging markets and natural resources.”

“The real danger comes from mid-2010 through 2011. This won’t be a conventional business-cycle expansion, but a bumpy road. The economy will look like a square-root sign followed by corrugated sheet iron. The good news is the potential collapse of the system has been avoided. It was an open question for a while.”

“We’ll enter another bear-market cycle. I don’t know how low it will go. In March the market made a cyclical low in valuation, but it wasn’t a secular low. When the market makes a secular low, lack of interest in equities will be high.”

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THE Lloyd’s Prayer

Our Chairman,
Who Art at Goldman,
Blankfein Be Thy Name.
The Rally’s come. God’s Work Be Done
On Earth as there’s No Fear of Correction.
Give Us This Day Our Daily Gains,
And Bankrupt Our Competitors
As You Taught Lehman and Bear Their Lessons.
And Bring Us Not Under Indictment.
For Thine Is the Treasury,
The House and the Senate
Forever and Ever.
Goldman.

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Here is an interesting video of Trader Salem Abraham and Howard Lederer, legendary poker player. They discuss the similarities in managing a good poker hand and a good trade, and how folding bad hands in both cases is the key to success. 

Howard Lederer is known as “the Poker Professor” because of his demeanor, analytical style and long history of wins. He is known for his focused, calm demeanor at the poker table; he has stated that he has applied Zen wisdom to his poker playing. He has won two World Series of Poker bracelets and two World Poker Tour titles. In 2008, he won AUD1.25 million by winning the $100,000 No Limit Holdem Challenge, billed as the world’s most expensive tournament buy-in, at the Aussie Millions. As of 2009, his total live tournament winnings exceed $5,200,000. 

Here’s another post and video with Howard Lederer.

Salem Abraham is the founder of Abraham Trading Company (ATC). Abraham’s trading methodology is a 100% systematic, long-term, trend-following approach, implementing filtering techniques that avoid trends with adverse risk/reward characteristics.

Abraham says “While the goal is to capture long-term trends, the system only enters the market during periods when the risk/reward of a trade is heavily in the trade’s favor. If unacceptable risk characteristics exist, the system will even avoid trends that have a positive profit expectation. The end result is a trading method that has historically provided exceptional returns that are uncorrelated to traditional stock and bond investments.” 

“Over the last few years the markets have become choppier, and many traders’ returns are suffering. In ATC’s continuing research efforts, a technique was discovered that helps to identify these choppy markets and keep the system out during these periods. ATC modified its system with a filter, added markets to the portfolio, and made other changes that will continue to help performance in non-trending markets, while simultaneously not penalizing returns during trending periods. All the models tested are robust with very few degrees of freedom/parameters.” 

“A myriad of proprietary statistical techniques are looked at that include analyzing multiple time period subsets, market-by-market as well as sector analysis and correlation, risk/reward analyses, parameter degradation studies, slippage analysis, and drawdown analysis.” 

“Experience helps in developing a successful trading system. The most common and most dangerous error made in system development is curve fitting. One thing we have learned over the last 15 years is that curve fitting cannot be understood by theory alone. There are many statistical traps that can only be learned by trading systems real-time.” Read related post

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Anyone can get old, all you have to do is live long enough – GROUCHO MARX

This is a rather humorous yet profound Groucho Marx quote that I recently read. It reminded me of trading, where the quote might be “Anyone can make money, all you have to do is stay in the game long enough.”  Same thing, I guess, just live long enough.

The problem seems to be that this is a lot easier to say than do. The lure of easy money is a powerful aphrodisiac. We are constantly lured to the latest success of a fund or trading system, or worse yet, the advice of the recent “expert”, only to find they have rocky periods as well.  No one makes money all the time and the markets have the uncanny ability to make fools of those who keep chasing the dream. I’m sure there are countless examples of people who switched from this fund to that fund, only to see the one they sold go up, and the one they bought go down.

Wouldn’t it make better sense to become as knowledgeable as possible about a few reliable approaches that would exploit trends in the various asset classes and then stay with them until there is a legitimate reason to make changes? Isn’t it only reasonable to assume that ALL methodology has flat and down years and that it is part of the process of winning to have losing periods?

Below, I list the year end stats on some of the most formidable trend following organizations. Notice where 2009 was a very rocky year for some. Does this mean they’re finished, or is that kind of volatility routine for that program?

This is why it is important to be knowledgeable about your program. Is the volatility routine or a red flag? In the case of John Henry or Clarke, isn’t it reasonable to assume if you can earn a 90% return, that perhaps you will see a 30% draw down?

In the case of Rabar or Saxon that same 30% might be a red flag since these programs are designed to produce more steady returns with lower draw downs. Should we be upset when Saxon doesn’t have 90% years?

Anyway, I think it is safe to say that what you are doing has a lot to do with……….. How you are doing. 

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Here is a recent Audio Interview (today) with Jim Rogers who always has some interesting insights as to what is going on in the financial world. Here he shares how he position sizes, why people see bubbles everywhere and the Wall Street machine.

Click below to listen:

JimRogersPodcast2.1

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Wisdom is meaningless until your own experience has given it meaning and there is wisdom in the selection of wisdom – BERGEN EVANS Author and Professor

Those of you that follow this blog know that I am a big fan of a definitive trading plan. Having a plan however, does not equate to success, there are still limitations. One limitation is the small account. Unfortunately, the small account has many more obstacles to overcome to be successful than the large account. Let’s take a look at why that is the case.

Most commodity futures have underlying collateral value in the tens or hundreds of thousands of dollars. A gold contract for example is worth $113,000 today and crude oil is $82,000. When you add low margin requirements and increased volatility into the equation, you have a recipe for small speculation disaster.

So, what makes the larger account fair better in the long run?

Well, to name a few reasons, large accounts can afford to trade virtually any opportunity, at any time. There are 75 to 100 or so liquid commodity markets worldwide, and should buy or sell opportunities emerge, a large account can easily afford the margin and risk to trade them all. In addition, they can scale into and out of positions. This is in stark contrast to the small account where prudence dictates only having exposure in a limited number of markets with one contract.

Also, large accounts are not restricted from trading contracts whose volatility is relatively high. For example, a gold trade today with a 5% cash stop would translate into over $5600.00. That happens to be a little over one half of 1% of a million dollar account, yet over 11% of a 50K account.

Now, the devils advocate would say that “I wouldn’t use such a wide stop”, but it’s necessary to use expanded stops in expanded volatility to avoid being stopped out by “noise”. Also, as the contract becomes more valuable, the risk to trade it increases. Gold is not $400.00 anymore it’s $1130.00 per ounce. A 10% move now is close to three times the dollar risk of $400.00 gold.

To stay with the gold example, we run an in-house volatility filter that is currently suggesting that gold has $1238.00 of daily noise (around 12 dollars). So, if you are trading gold and would like to be “outside the noise”, 3 standard deviations would suggest a stop at $3714.00 (around 37 dollars). Even this wider stop does not insure anything, as we all know markets frequently make 3+ standard deviation moves on a routine basis.

So, in a nut shell the 50k account trading gold would have to risk close to 7.5% of his account (per trade) to hopefully stay in the game of trading gold. Good luck with that.

So, how can we trade a smaller account that has the probability of success equal to the large account?

One approach we have explored, and now successfully trade, is the concept of building a model that employs multiple systems, and multiple markets, along with an effective filtering process and risk management controls.

Let’s elaborate.

The process of running multiple systems over many markets will generate a fair amount of trades (like the large account). The filtering process, and the risk controls however, allowed us to filter down the many trades to a few “higher probability” trades. Since the small account cannot take on all the trades, it is the next best approach. This strategy attempts to identify a limited percentile of all the markets it tracks as being the best candidates, using a systematic process to select the few that the small account can handle in terms of volatility and risk.

The portfolio selection process is dynamic as opposed to static (like the small account). This means that from day to day the basket of markets we would trade can change due to strength, weakness and/or volatility changes. We feel this keeps our trades limited to only those markets with the best risk adjusted potential. This allows us to evaluate a very large portfolio (like the large account) while still keeping the number of trades and margin requirements very low to address the small account.

Monitoring a very large portfolio is critically important because if you initially limit yourself to a predetermined small portfolio, how do you know that those markets will be the best markets in the future? (Hindsight bias portfolio selection is a form of curve fitting and is a major downfall of many traders). If an exceptional opportunity develops in a market outside of your predetermined portfolio wouldn’t you want to take advantage of it? By trading with this type of strategy you don’t arbitrarily rule out any market that may perform well in the future and you have eliminated the tendency to pick a portfolio based merely on past performance (curve fit) considerations. See related post

If anyone would like to see more detailed research, feel free to contact me.

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Crigger: Let’s switch gears and talk industrial metals. Do you think China will continue to drive demand into 2010?

Sperandeo: I think they will, and if I were China, I’d be selling my Treasury bonds and I’d be buying things like copper and platinum and palladium—other industrial metals, like aluminum, etc., that you need to produce. Especially with interest rates at zero. So if China gets that, then you’ll have a real bull market. Buy the stuff, not the paper.

Crigger: Recently both China and Russia have publicly called for a move away from the dollar as the world’s reserve currency. Do you think this will ever happen?

Sperandeo: I do think it will happen. It’s not easy, because with the nature of the U.S. dollar as a world currency and acting as reserves to many banks and loans, there are just not enough assets to take the place of the dollar right now. But I believe it will eventually occur.

Crigger: What takes the dollar’s place?

Sperandeo: It will be a basket. Not just one currency, but a multicurrency basket. I would guess gold would be in there for sure.

Crigger: In terms of regulation, where do you come down on the debate? Do you think position limits would be useful for the commodity markets?

Sperandeo: Well, I think indexes should be exempt for sure, because that’s how institutions get exposure. But the bottom line is: Every 30 years, you will get an attempt like the Hunts trying to corner silver, for example. But it’s very few and far between, with the regulations the way they are now. They’re very rare. The only reason a bureaucrat would want to change things is so that he could promote more of the printing and borrowing of money that commodities offset. So they’re trying to have their cake and eat it too.

Crigger: What do you think is the best strategy for investors approaching the commodities space?

Sperandeo: It’s got to be a long/short strategy. So whether it’s indexes—we have indexes that are long/short—or it’s a managed futures approach, you should take a long/short approach. With long-only, you don’t go anywhere. You just don’t make money. 

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I would like to take this opportunity to thank our subscribers and to wish you all a wonderful and prosperous 2010.

Vince Lombardi once said, “It is a reality of life that men are competitive and the most competitive games draw the most competitive men. That’s why they are there – to compete. The object is to win fairly, squarely, by the rules – but to win.”

Well, we have seen another year come and go and I hope most of you will continue to compete in the most interesting and challenging game in the world. As far as I am concerned, there is nothing like the trading game.

To wrap up 2009 here are a few words of wisdom from Viewpoints Of A Commodity Trader for 2009.

“Analysis can be equated with poker. Security analysts carefully follow the table talk of the game and examine the up-cards. Although analysts effectively follow and communicate these two aspects of the game, they either ignore or ineffectively guess at the other major element-the down-cards.” Read Full Post

“The most important rule of trading is to play good defense, not great offense. Every day I assume every position I have is wrong. I know where my stop risk points are going to be. I do that so I can define my maximum possible draw down.” Read Full Post

“Gamblers think they are betting on red or seven but in reality they are betting on the clock. The loser wants a short run to look like a long run so the odds will prevail. The winner wants a long run to look like a short run so the odds will be suspended.” Read Full Post

“Many major problems people have in trading are caused by their expectations – of where the market is headed, how much money will they make from this trade, etc. One thing I learned that has helped me: it is wrong for a person to enter any market with any preconceived expectations.” Read Full Post

“The great danger is in confusing courage with bravery. The market is no place for heroics. That is for another battlefield. In the market place it often takes more courage to live than it does to die. The greatest courage is the one that lets you graciously admit that you are wrong when you no longer have a good reason to trade. The courage associated with the hero often destroys the courage that is needed to be successful. I have witnessed cases where temporarily successful traders have lost their touch because they lost their courage.” Read Full Post

“As people find out more about a situation, the accuracy of their judgments is not likely to increase, but their confidence does increase, as they fallaciously equate the quantity of information with its quality.” Read Full Post  This can cause us to put the blinders on when we see negative information. It can also cause us to have a larger position than we should, or be over weighted to one position. Most important, it seems the more we overestimate what we think we know, we simultaneously underestimate what we don’t know ……the downside risk.  

“Great decision makers aren’t those who process the most information, or spend the most time deliberating, but those that have perfected the art of “thin slicing”- filtering the very few factors that matter from an overwhelming number of variables.” Read Full Post

“We have seen how good we are at narrating backwards, at inventing stories that convince us we understand the past. In spite of the empirical record we continue to project into the future as if we were good at it, using tools and methods that exclude the rare events.” Read Full Post  Funny isn’t it, since the big, rare, unpredictable events are precisely what shape the world. Events like the automobile and the World Wars, the internet and the Beatles.

“Systems trading is ultimately discretionary.  The manager still has to decide how much risk to accept, which markets to play, and how aggressively to increase the trading base as a function of equity change.  These decisions are quite important, often more important than trade timing.” Read Full Post

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Likeness to the truth is not the same thing as truth – SOCRATES 

A set of statistics that suggest a positive expectation (a system) is quite helpful when sailing the seas of uncertainty. In fact I believe most traders need a definitive plan to assure discipline. 

We need to look at the various measurements of risk and reward. We look at average winners, average losers, returns and draw-downs. We examine the numbers further to calculate Kelly Expectations (bet size), MAR Ratios and Monte Carlo distributions.

These are the tools that help us understand the system. On the other hand no matter how many numbers we crunch we cannot replace randomness with systematic probability. We can not quantify the future.  

Socrates once said that “likeness to the truth is not the same thing as truth.” Truth to the Greeks was basically law, something that had to be proved. All the back-testing in the world does not prove anything. 

These past statistics do not remove future randomness. At best they will give us some likeness to the back-test (or what we think is the truth) and we must manage the risk to make sure we are on that path. 

What is potentially more dangerous than the information which makes up the numbers, is how we feel about the accuracy of the numbers. In the real world, randomness plays a much stronger role than we would care to believe. Arrogance about potential accuracy can lead us to overestimate what we think we know and underestimate future randomness. This is how you blow up. 

The markets are constantly changing. There are new markets available to trade. Markets dry up in liquidity. There are shifts in volatility and correlation. Sometimes a combination of these things can happen at the same time. A system without a risk management component will not be able to properly identify these changes and unfortunately most vendors have not built any risk management into the equation. I think that is potentially dangerous. 

When you choose a number of these systems you will still be faced with how they will interact with each other. You have the risk of volatility and correlation shifts in the markets that you will be trading but you will also have the risk of correlation between the systems. 

This is what destroys most approaches, not the systems, but the way the systems were managed. A system that holds up in a rigorous back-test is at best “The One-Eyed King.” An approach that can see, but does not see everything we would like it to see. The good news is if we are aware of that fact we will be forced to manage that fact. 

I strongly believe we need a platform to monitor what is going on when we are in trades. The volatility of a market upon entry can be quite different than the volatility of that market one week or one month later. This holds true of correlation between markets, as well as correlation between systems.

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Here is a 2009 article by written by Chuck LeBeau:

Back in the late 1960s, I was a young commodity broker at E. F. Hutton and Co. Our office was a brand-new high-tech office (for its time) that was considered the “flagship office” for E.F. Hutton.

In this office about 30 brokers and as many clients shared one very large boardroom, and there were no private offices. The brokers had elegant and expensive desks, and the clients had a comfortable seating area in the front of the office where they could hang out and watch the tapes and monitor our state of the art commodity “clacker board.”

Sitting at my desk near the front of the boardroom, I could read my Wall Street Journal and keep track of the commodity markets without looking at the board. By just listening to the rhythm and tempo of the mechanical clicks as the prices changed, I could easily tell when anything important was going on, because the tempo of the clicks would increase noticeably.

Just in front of my desk were a half-dozen comfortable sofas facing a high mahogany-paneled wall with the tapes and the “clacker board.” A gallery of traders, mostly retired “old-timers” who were trading real commodities like grains and pork bellies, lounged around on the sofas plotting their charts and talking about life and the markets. They typically arrived early to get a good seat in their usual spot and then spent the day trading, exchanging commentaries and offering unsolicited advice to one another on any subject.

For the most part, they were a very sociable group who would take coffee breaks together and greeted each other on a first-name basis. These traders enjoyed the elegant atmosphere and treated our well-appointed boardroom as their private men’s club. (Were you aware that women were not allowed to trade commodities back in those days? My, how times have changed!)

One of these “old-timers” kept to himself and was not interested in becoming a member of the friendly and often boisterous social circle. He usually sat quietly by himself, intently watching the price changes on the commodity board and holding an old glass Coke bottle up near his ear.

The vintage-shaped Coke bottle had been emptied many years before and now contained only a 12-inch tube of bent and broken radio antennae, which extended awkwardly out of the top of the bottle.

Keep in mind that in the 1960s no one had yet heard of cell phones, so the purpose of this Coke bottle was a real mystery to everyone. When the trader would talk to the bottle from time to time, all the heads would turn, and the traders nearby would try to listen to the conversation. But the trader spoke very softly, and no one was able to eavesdrop on his conversations with the bottle.

The traders knew that the fellow with the Coke bottle was a client of mine, and eventually a representative of the group came to me and said they were extremely puzzled about this guy and his Coke bottle and asked me if I knew what was going on. I didn’t know the purpose or meaning of the Coke bottle, but I was as curious as anyone was, and I promised I would find out. The next time the client came back to my desk, I promptly placed his order and then politely asked him about the Coke bottle.

With a serious expression and no embarrassment, he explained to me that the Coke bottle was an inter-planetary communication device that had been given to him by aliens. He said the aliens were very interested in our commodity markets and they often gave him trading advice from their various observation points on other planets. He said he had just had a message from Mars and they were buying soybeans, so he had also purchased soybeans. After revealing his unique trading methodology, he returned to his seat and resumed his whispered conversations with the Coke bottle.

As soon as I revealed my discovery of the meaning of the Coke bottle to the other traders, all attention was immediately focused on the Coke bottle trader and the soybean market. The soybean market proceeded to go the wrong way, and the trade from Mars was eventually closed out at a loss. The other traders had no sympathy and were quick to begin ridiculing the trader and to poke fun at his beliefs.

The next trade, however, turned out to be a big winner, and the Coke bottle trader went from sofa to sofa telling his story and pointing to the clacker board while waiving his Coke bottle and bragging about the profitability of his most recent message from outer space. Because he was making money now, his previous critics had to endure his bragging about his success on the current winning trade.

After a few winning and losing trades later, a clear pattern of behavior began to emerge. The Coke bottle trader was ridiculed unmercifully on his losing trades but was able to get his revenge and the last laugh during the winning trades. This trader might have been a little bit crazy, but he wasn’t stupid. He soon learned that his only defense against ridicule was to hold on to winning trades as long as possible and to quickly get out of his losses.

As long as he was sitting on his sofa with a winning trade, no one could tell him he was crazy and make cruel jokes about his messages from Mars. In fact, while he was winning he was quick to wander around the room and ridicule the methods of the other traders who were not making as much money as he was. He displayed the profits in his trading account as hard evidence of the validity of his methods and offered copies of his statements as irrefutable proof that he was getting valuable advice from his alien contacts. Who could argue when his advice from other planets was obviously working?

For a young broker, this experience and the firsthand observation of the Coke bottle trader who suddenly became profitable gave me my first important lesson about the importance of exits. I knew the entry signals had nothing at all to do with his success. His batting average was not any better than that of any other trader. However, this crazy old trader seemed to be able to make money consistently, while other traders with more “sanity” and more valid entry methods were losing.

Before long I was able to recognize that this man had become a successful trader simply by his efforts to avoid ridicule. He knew he was vulnerable during his losing trades, so he closed them out very promptly. His winning trades became his shield against the ridicule of the other traders, and he kept his winners much longer than before his unorthodox methods were revealed.

In the many years since this experience, I have encountered many claims of success for entry methods that probably have even less validity than the Coke bottle messages. I have learned to look only briefly at the entries of winning traders and to examine their exit strategies very carefully. I am very fortunate that more than 30 years ago I learned from the Coke bottle trader that success in trading depends on our exits and not our entries.

Source: http://www.traderclub.com

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