JS Global Macro Notes

Interesting commentary. And while I generally agree with what you have written in Part I, I’d like to play the devil’s advocate for a moment if I may. I have read a few of Soros’s books, and Reminiscences 4 times, the first time being in the mid-90s. I have only respect for both Soros and Livermore. The logic behind a top down approach is generally sound and valid in my view. However, I am reminded of Reminiscences, where Livermore reluctantly teams up with the leading cotton expert and buys into the man’s fundamental analysis because he found it to be logically unassailable. Except, of course, for the price action. As we know, it cost Livermore his fortune at the time.

Here is my point. When Livermore was trading only price action to the exclusion of all else he always made money on balance with no meaningful upset. The same applied after he transitioned to a real brokerage firm following a painful learning experience with delayed data. I acknowledge his assertion that his large profits were derived from his assessment of general conditions: “to study general conditions, to take a position and stick with it.” But, aside from allusions to not having followed his plan, I am inclined to believe it was his sticking to a position because of perceived general conditions that also cost him his greatest losses. Although less spectacular, when he played a tight game, his results were more consistent.

In Chapter 5 of Reminiscences, he notes that “In big bull markets the plain unadulterated sucker, utterly ignorant of rules and precedents, buys blindly because he hopes blindly. He makes most of the money – until one of the healthy reactions takes it away from him in one fell swoop.” I wonder if there is a point of intersection between the “unadulterated sucker” and the seasoned trader who takes a position and “sticks with it” because of his assessment of general conditions. It is for this reason that I sometimes question whether a fundamental viewpoint is genuinely a need-to-have or perhaps something more of a nice-to-have.

And so, the question remains. To what extent should an assessment of fundamentals affect actual trading? Should it perhaps limit the direction in which trades are taken? (Perhaps in the direction of the long-term trend or its point of inflection, or some such?) Is it reflected in the size of trades or their protective stops? And so on. The principal question that interests me is this: If price gives a strong entry signal that is not supported by an assessment of general conditions, do you take it or do you ignore it?

As you can see, I’m not a very sophisticated trader. Presently, I trade only price. I suppose we all move along, and hopefully forward, at our own pace. Regardless, I look forward to your Part II.

 

Here is a question for you in return -- how does one go about trading only price?

I ask the question because I have a hard time conceiving how fundamental bias is successfully left out.

Here's what I mean. Let's say I go through my screens and see attractive breakout patterns in twenty different stocks spread out across five different industries. Using price alone, how would I choose among all these? Or would I be obligated to trade them all?

One semi-solution would be to restrict the universe of acceptable vehicles in advance. This is what many CTA trend following funds do -- they apply price paramaters to a limited number of futures contracts.

But even then, is this really trading price alone? What about the unacknowledged reality that trading commodities only implies an accidental macro bet on the outlook for commodities? (Many mechanical trend following programs are known to have a rougher time in commodity bear markets.)

And for the price-only trader who trades stocks... again, which stocks? It seems to me one winds up with a fundamental overlay embedded in the selection criteria whether intended or not.

At any rate, many paths up the mountain as we know... will expand more in part II...

 

Also, re, Livermore...

The Livermore saga of wipeouts and comebacks seemed to be an expression of Ed Seykota's comment, "Everybody gets what they want out of the market."

For some reason Livermore seemed to desire, on some deep psychological level, the roller coaster ride of going bust and coming back again. Vic Niederhoffer seemed to exhibit a similar trait; on my first reading of Niederhoffer's Education of a Speculator, my immediate thought was "Here is a man who wants to go broke." And so he did. Repeatedly.

I would dispute that Livermore ever really traded price action exclusively except for his time in the bucket shops, and even then the stocks he chose to follow still had to have something of a haphazard fundamental selection criteria to them.

I would further argue that, to the extent that price alone can be traded in bucket shop style or floor trader style, such a strategy is vulnerable to being conquered by a supercomputer. (Hence the slow extinction of floor traders.) One of the reasons I much prefer swing and position trading is because I know the bots and liquid-cooled supercomputers deployed by Goldman Sachs have no chance of drinking my milkshake.

Re, Livermore going bust from Percy whispering in his ear etc., that failing was simple. He didn't manage the risk, and he ignored his own sound principles. As Livermore directly notes, "staying wrong is what does damage to the pocketbook and the soul." Price action is of course critical as a timing filter, an entry and exit guide, and a risk management tool.

 

In my own case, I only trade a couple of futures markets intraday, and rather short term at that. It keeps me sufficiently occupied. However, I suppose that in the future I may also trade a larger but limited number of futures for more than one day. I have not put a lot of thought into it, but I imagine I would use fairly blunt directional criteria on a longer time frame, and my existing entry timing criteria in a much shorter time frame, which is the only time frame I presently use for my intraday work.

I don't know how price-only stock traders or those with larger portfolios make their selections, but I imagine they use various screens and filters. Since we have both already referred to Livermore, you will recall he believed in choosing the best performing stocks in the best performing sectors. On the face of it, I imagine one need not necessarily focus on the fundamentals to arrive at such selections. Must the fundamentals necessarily be studied with care beyond their impact on price and its character? I expect that the debate will continue long after we're gone.

As an aside, I had a very quick look at your site. It's quite interesting and I will be reading more of it as time permits. However, I note that you are rather critical of Keynesian economics. I think this branch of economics has been given a bad rap. I am not much of an economic thinker, but I believe that the other half of the equation gets overlooked, by both its critics and it supposed practitioners. Specifically, while politicians are typically quick to spend and cut taxes during economic contractions, they are not nearly as inclined to raise taxes and at least moderate spending when the economy is bustling. Therefore, I think that any criticism towards Keynesian economics is valid to the extent that this criticism is directed at the unbalanced employment of the theory rather than the theory itself. Just my opinion. And while on the topic, what are your general views on the Obama Administration thus far? Just curious.

 

I think it's interesting that you should refer to Seykota, who didn't seem to have much time for fundamentals from what I gathered in Market Wizards.

Regarding Livermore, I read in Smitten's biography that he was prone to depression for a good deal of his life. Perhaps that may have contributed to his roller coaster rides in the market. However, I am not prepared to discount the possibility that the kinds of swings he took which made him spectacular profits were also the kinds of swings he took that caused him to go bust or near bust on a number of occasions. I don't think the two disparate outcomes are necessarily entirely independent of one another. Yes, he admitted that he lost big when he ignored his own sound principles. However, one of those principles was “to study general conditions, to take a position and stick with it.” And while "staying wrong is what does damage to the pocketbook and the soul," I wonder to what extent a fundamental bias contributes to someone overstaying a position. If memory serves, he was more consistent when he was nimble, and the roller coaster rides began in both directions when he started taking positions and sticking with them.

Please don't misunderstand me. I don't wish to criticize Livermore. Rather, these are my observations in an attempt to better understand the man and his trading.

 

I don't know that floor traders are necessarily becoming extinct specifically because of supercomputer trading algorithms. I would have thought it was more a matter of exchanges going electronic, and thankfully so. The fewer hands between me and the guy ultimately on the other side of my trade, the better for both of us.

As for using a longer time frame (swing and position trading) to stay outside of the reach of those evil liquid-cooled supercomputers, it is arguably a valid way to hold on to your milkshake. We will agree that these bots generally increase our risk in the market. You have chosen to play from more of a distance by staying outside of their reach for the most part, so to speak. But in so doing you are increasing the ticks or points at risk on any given trade. It is a reasonable tradeoff. But in the face of increased risk, I prefer to minimize my financial risk per trade and draw comfort from being able to make more of them. That is the tradeoff I have chosen. Besides, my milkshake is undoubtedly much smaller than yours.

 

I would argue yes, if only because this method -- combining fundamentals and price action in trading vehicle selection -- has been exceptionally successful as implemented by a wide array of practitioners: Druckenmiller, Sperandeo, Cohen, PTJ, Bacon, Marcus, Kovner, Livermore himself, and others. Those who have crushed the market for staggering absolute dollar sums have done so with the use of both fundamental and technical inputs, melded together in a full blend.

In contrast, I have never come across a truly successful broad-based, multiple asset stock trading methodology that does not incorporate fundamentals into the equation in some removed way, other than extremely rapid-fire quant algorithms, and even those make use of fundamental inputs as number-crunching fodder.

So again, from a purely empirical perspective, the one place where "price alone" truly seems to reign is in the restricted universe of futures markets w/ CTA style trend following programs -- and those programs are known to have their own achilles heel issues with reward to risk and drawdown profiles.

Basically, I consider the proof to be in the pudding of extraordinary real world success, and while Livermore's record was marred somewhat by extreme ups and downs, others have applied his essential process with far more smoothness and consistency over time. (PTJ, for example, has gone a quarter century without a losing year in his own trading.)

Well, that's the rub. The Keynesian approach may be perfectly good in theory, but it falls on its face in the real world.

What good would, say, a revolutionary weight loss diet be if it required impossible assumptions of self discipline on the part of the people who were supposed to use it?

In practical terms, economic policies are like laws -- a benchmark of pragmatic and practical result, rather than theoretical elegance, should be the ultimate yardstick. By that measure Keynesian thinking fails. It runs aground on greedy and short-sighted human nature, the folly of central planning -- note how hard if not impossible it is for the Fed to get liquidity where it actually needs to go -- and the corrupt nature of the system, which is perfectly logical from a Darwinian evolutionary standpoint (those who have an insider's edge will press it).

So again, quite elegant in the classroom. But too many "if / thens" and "if onlys" for the real world.

One of my favorite articles of the past year or two is The Quiet Coup by Simon Johnson. That piece fairly well describes what has happened in Washington.

As for Obama himself, perhaps the most surprising thing has been the man's lack of spine. He needs to take his balls out of Michelle's purse. One could argue that Larry Summers and Goldman Sachs are to BHO as Dick Cheney and Halliburton were to W.

 

Seykota also does not have much time for commodity bear markets, admitting that he has a very hard time making money in them. (I have spent time with Seykota and been to his house on more than one occasion.)

A respectable theory, but not really an indictment of the essential Livermore method, given the manner in which it has been employed by others with a far greater degree of consistency (i.e. excellent long term results, no flaming wipeouts).

No misunderstanding at all. I quite enjoy the feedback, and have no intention of putting Livermore (or anyone else) on a pedestal.

I would add one more bit of food for thought. You seem to be suggesting a danger of the fundamental / technical combination method is that, based on the Livermore experience, it is possible for a trader to blow up using it.

I would argue in response that an undisciplined trader runs the risk of blowup using ANY sufficiently powerful method, and furthermore that the ability to intelligently and consistently handle risk properly is a long-term source of alpha.

Just consider what would happen if method X was devised as such that one could make large sums of money from the market with no risk of ruin. A great enough population of traders would flock to method X so as to diminish the profitability of the strategy to near zero, or otherwise increase the risk as such that making X work without mortal danger became a matter of competitive edge once again. There is no free lunch in trading because one is always competing against other market participants. As a result, factors like skill, talent, and steely self discipline will always be critical inputs to any successful method, and the requirement of such to make a method work should be more of a concept validifier than disqualifier imho.

 

As the exchanges go electronic, the trading that floor traders used to do is replaced by computers.

Now this is an interesting comment, because I would argue that extremely short duration traders actually take on MORE risk than swing traders like me, not less, as a function of the extreme leverage that is employed.

The theory is that shorter time in the market equates to less risk taken overall. But this theory is challenged by the risk of getting nailed in a repeat "flash crash" event with extremely concentrated exposure going in.

There is also the matter of volatility expansion. Consider the debate of tight stops versus wide stops.

On one level it could be argued that "the wider the stop, the bigger the risk." But this is not necessarily true, because risk is a function of total market exposure, not the stop itself.

To see what I mean, consider that Trader A could have twice as wide a stop on the exact same trade as Trader B, and yet both traders could be sizing their trades so as to represent 50 basis points of planned risk.

Also, the tighter the stop, the greater the chance of surprise volatility expansion resulting in a bigger loss than intended. Again a hypothetical example: Trader A buys a volatile stock (say BIDU) with a $4 stop for a swing trade. Trader B takes the same position on an intraday basis, but sizes his trade off a very tight (for BIDU) 50 cent stop. That same afternoon, while both traders are still in, the Chinese government comes out with a content crackdown announcement that is very bad news for BIDU. Which trader is more likely to see his planned risk assumptions blown out of the water?

Then, too, there are the offsetting characteristics of a balanced long / short book, the ability to adjust the portfolio on a holistic basis to account for different market scenarios and profiles, the ability to dial leverage up or down in terms of initial position sizing across the board, the ability to vary position size dramatically based on situational equity curve and conviction factors, and so on.

Point being, it's not necessarily the case that swing and position trading is more risky. It certainly can be, but nothing is set in stone...

 

Well, it's hard to argue with you there. You will note, however, that I prefaced my "argument" with playing the devil's advocate. Even so, I limit my own trading to price action. I cannot compete with better minds at their own game, be it in the area of fundamentals and their opportune access and interpretation, or in the area of math and the pricing of options and such. However, I can look at price and create my own game with my own rules, even though it may not be isolated from the above. As the saying goes:

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