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Tradecraft – Watch Out for the Herd

On September 21, 2009, In Good Articles, by ElfLord

I HAVE TO LAUGH when any of the online brokerages — whether full-service or deep-discount — offer research reports as an incentive to open an account. The frenzied tracking of price/earnings ratios, analyst upgrades or earnings announcements is equally amusing. From a trader’s perspective, this type of widely disseminated information is useless. As soon as research is released, it becomes old news. With few exceptions, research, fundamentals and other well-publicized information offers little edge in the market: Most of it is already factored into a stock’s current price.

Cisco Systems (CSCO) offers us an excellent and timely example. Last August, Cisco reported glowing financial results, with fiscal fourth-quarter revenue up 61% and net income exploding 69%. Chris Stix, an analyst with Morgan Stanley, enthusiastically reaffirmed the stock as a Strong Buy. But for those people following the fundamentals or analysts’ research, it proved an inopportune moment to get in. Cisco is down about 70% from that date (although surprisingly, Stix’s Street cred remains as high as ever).

To understand why generally available information is all but worthless, consider the way in which popular investing strategies lose their luster. For example, buying companies that were being added to the S&P 500 or whose stocks were being split both used to be excellent tactics — until word got out and everybody started playing these angles. The effectiveness of both techniques has all but evaporated in recent years. It’s simple: The more people squeezing an orange, the less juice for each to drink. (more…)

Tradecraft – The Diversification Delusion

On September 18, 2009, In Good Articles, by ElfLord

LIKE A WARM BATH or high thread-count sheets, nothing feels quite as comfortable as money in the bank. And with the major equity indexes down year-to-date, I’m surely not the only one who finds a sweet satisfaction in watching interest payments tumble in each month to a plain old money-market account. Cash (and cash equivalents like money-market accounts, certificates of deposit or Treasury bills) are often referred to as earning the “risk-free” rate for obvious reasons. Cash provides a predictable, but paltry, return. And while cash deserves a place in everyone’s portfolio, you can’t just hide in a money market all your life. There are other ways of dealing with risk besides hiding your money under the mattress. The name of the game is wealth creation: In order to make some money, you’ve got to make some moves.

And while it took a 68% drop in the Nasdaq to finally sink in, most investors are now realizing that the most effective way of reducing risk in their portfolio is by diversifying among various types of assets. Diversification lowers a portfolio’s volatility and can even enhance returns. And while index funds that track the S&P 500 give the illusion of diversification, because they are weighted by market capitalization they are essentially focused on large-cap stocks. Owning Cisco Systems (CSCO), Intel (INTC), General Electric (GE) and an index fund exposes you to as much diversity as a potluck dinner at David Duke’s house. (more…)

Tradecraft – Building Pyramids

On September 16, 2009, In Good Articles, by ElfLord

LET’S SAY YOU want to buy XYZ. Maybe it announced better-than-expected earnings or crossed a key moving average. Perhaps you are watching a similar company or index move and expect XYZ to follow along. Maybe you used the company’s products or read some compelling research. As Rod Stewart sang, we all need a reason to believe. Whatever your reason, you believe. Fine. Two sides make a market, and nobody knows the future. If you are bullish on XYZ, then it’s time to buy XYZ.

What messes most people up isn’t what to buy, but how. Having a good investment idea is a start, but putting it into practice is another thing altogether. And while a sound trading technique won’t prevent you from losing money, it will keep your losses small and the majority of your capital focused on the most profitable ideas. No trade is without risk, but the difference between risk and recklessness is proper procedure. Trading is like any fine art: There is such thing as objectively good form.

The oldest — and the only surviving — of the ancient Seven Wonders of the World are the Egyptian Pyramids. Their longevity is due, in part, to inherently strong design. The majority of a pyramid’s mass rests at its base, closest to the ground. A much smaller portion of the material is used near the top. The setup creates a uniquely stable architectural footprint. (more…)

Tradecraft – Hedge Funds for the Masses!

On September 14, 2009, In Good Articles, by ElfLord

IN A FREE COUNTRY with free markets, we must each make our own decisions about how to invest our assets. From real estate to Research In Motion (RIMM), Home Depot (HD) to hedge funds, there are many choices for those of us with an open mind and a penchant for profit. The ultimate arbiter isn’t research reports, but the bottom line. So whether you watch the market minute by minute or never check your statement, make no mistake: We are all portfolio managers.

As has been widely noted, the biggest long-term determinant of a portfolio’s performance isn’t security selection or market timing, but asset allocation. And while hedge funds like mine have been regulated out of reach for most investors, a hedge-fund-style philosophy of asset allocation is an option I think you should investigate.

First, let’s define some terms. Like mutual funds, hedge funds are simply investment pools managed by a portfolio manager. While most people assume that hedge funds trade frequently and take big bets on financial esoterica like derivatives, the main difference is that hedge funds have tremendous flexibility in how they can allocate their assets. Hedge funds can invest in almost anything. They can sell short, use options and futures, and even take positions in illiquid securities like real estate and collectables. (more…)

Tradecraft – Liquidity Is for Losers

On September 11, 2009, In Good Articles, by ElfLord

NO MATTER AT what level you play the trading game, you’ve got to understand what business you’re really in. And when you buy XYZ Widgets at 90, you aren’t getting into the widget business. You’re getting into the business of providing liquidity to a company’s float — in this case, XYZ above 90.

What moves stocks, bonds or anything else is the relationship between demand and supply. By definition, traders and speculators profit by adding liquidity to illiquid markets. Doesn’t matter if it’s Cisco Systems (CSCO) or soybeans, traders narrow the spreads between the price at which someone’s willing to sell and the price at which someone else is willing to buy, bringing down the cost of execution. Trading isn’t about predicting the future, but about gaming the liquidity demands for a particular security. Generally speaking, I want to be long illiquid markets and short liquid markets.

First, a little background. You can’t imagine how drastically the liquidity picture has changed in just a few short years. Back in the early 1990s, when most market pros still referred to the Nasdaq as the “over-the-counter” market, stocks traded in eighths. That meant there were only eight “price points” within a particular dollar increment in which you could own Nasdaq stocks. And while 12.5 cents — one-eighth of a dollar — was the minimum spread between every price fluctuation, many stocks traded with half-point spreads or more. With mutual funds exploding in popularity and a huge influx of Internet-driven retail trade, this made making markets a very profitable business. In a sense, you had a big “edge” on every trade. (more…)

Tradecraft – Spring Training for Traders

On September 9, 2009, In Good Articles, by ElfLord

FROM PHONE SERVICES to floor cleaners, my office gets 10 calls a day from people selling something. But just because it’s offered doesn’t mean you should bid. There are a lot of companies I like and a lot of stocks I think look promising. That doesn’t mean I buy them. To paraphrase Gordon Gekko, I look at 50 deals a week. I choose one, and then watch it like a hawk.

In trading, as in most games, the best advice is usually the simplest. Not just because it’s the easiest to remember, but because it works. And I never got a hit at bat or made a dollar in the market before I started adhering to one simple principle: Keep your eye on the ball. What most people don’t realize is that 90% of “trading” is watching. I’m a trader, but there are many days I don’t make a single transaction. And when it seems the whole world is kibitzing about Greenspan or the gross domestic product, I do what I always do: watch the market and watch my stocks. In my experience, the best indicator of the market is the market — not the pundits, not the analysts, not the media, not the Fed, not hemlines or the stars.

That’s why it’s vitally important you follow your portfolio’s prices. The occasional earnings-inspired blow-up aside, the big moves don’t happen overnight, but develop over time. Meaningful trends take weeks or months to unfold — they don’t simply materialize out of nowhere. The Nasdaq didn’t drop 60% overnight, but over the course of a full calendar year. Nobody can say they didn’t have ample warning. If you’ve been long the major liquid names, you’ve had plenty of opportunity to get out. But you had to be watching your holdings — and you had to have the guts to get out. (more…)

Tradecraft – Your First Loss Is Your Best Loss

On September 7, 2009, In Good Articles, by ElfLord

THE REASON THAT pain hurts is because it should. Pain is nature’s way of telling you to get out of harm’s way. And when the market moves and I’m losing money, it hurts. That kind of pain is the market’s way of saying, “You were wrong.” And now that so many people are hearing that message from the market, it’s time to think about trading losses, what they mean and what to do about them.

While I do the requisite research, and I try hard to be right all the time, I also give myself permission to make mistakes. I’m never surprised when things don’t turn out as I expect. Contrary to popular belief, trading isn’t about always being right, but about dealing with the inevitable experience of being wrong. The trick isn’t to never be wrong about a company, but to recognize when you’re wrong and do something about it. As my mom says, “Life is the story of Plan B.” This starts with a very basic part of the game: admitting defeat and taking a loss. That’s tough for many people to do, because it means putting ego aside. Say you buy stock in SuperDuperTech at 50. When it falls to 40, most people begin the blame game. From election uncertainty to earnings jitters, interest rates to inflation, people will attribute a loss to everything under the sun — everything, that is, except their own analysis, which somehow remains infallible. (more…)

ZF Capital

Tradecraft – Watch Out for the Herd

Tradecraft – The Diversification Delusion

Tradecraft – Building Pyramids

Tradecraft – Hedge Funds for the Masses!

Tradecraft – Liquidity Is for Losers

Tradecraft – Spring Training for Traders

Tradecraft – Your First Loss Is Your Best Loss

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