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My Journey through Losing Marbles and Position Sizing Strategies: Part 1 by D. Witkin
The VIX: When It Works and When It Doesn't by D.R. Barton, Jr.
On the Lookout for a Major Structural Shift
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My Journey through Losing Marbles and Position Sizing Strategies: Part 1
This week begins a three-part series from an excerpt of a new book that Dr. Tharp is working on due out in late 2012. This book will be a compilation of Dr. Tharp's insights as well as personal stories of transformation from traders.
“That’s another 1R loser,” Van announced to the class as he drew the final marble from the bag. There was an audible groan from most students, but not from me. “OK,” I thought, “Maintain your composure. No matter what, DO NOT smile. Smiling would be bad. Just think about dead cats or something.”
The twenty-five-or-so guys in the class were just like me: reasonably smart, decent people trying to transform themselves into world-class traders, and each was sacrificing the Saturday before Super Bowl Sunday as proof of dedication to the craft. I certainly didn’t want to alienate any of them, but Van’s announcement meant I’d just won the pot in a game designed to show a critical trading concept. The pot was only $80, but the win proved I had made a major change in how I thought about trading. To me, the win meant that, in a class of smart, driven traders and in front of one of the top trading coaches in the world; I was top dog that day.
It was February 2011 and I was attending a Tharp Think workshop at the Van Tharp Institute. For me, the workshop was an opportunity to celebrate the end of my best trading year ever—over a 130% gain—and reinforce the concepts most responsible for getting me there.
Learning to Trade
My path to trading was anything but direct. After working for a while in Information Technology (IT) after high school, I went to college and graduated with a liberal arts degree. After graduation, I worked a couple of IT jobs until I found a home as an IT and management consultant at a “Big 5” accounting and consulting firm.
By this time it was 1998, and I had become fascinated with making money in the markets. It seemed incredible to me that millions of people could come together to find the “right” price for a company, and the people who were great at it could become as rich as Warren Buffet. The company I worked for gave me an opportunity to spend seven months in Germany, which I viewed as a great opportunity to lock myself in my small apartment and read everything I could get my hands on about trading, and maybe trade a little, as well.
Germany was a perfect place for me to focus on learning to trade. I didn’t speak the language, and I didn’t know anyone except the people I worked with, so I read. First, I focused on fundamental analysis. I read books about how Buffet, William O’Neil, James O'Shaughnessy, and David Dreman invested and how to identify companies worth buying. Next, I learned about technical analysis from Martin Pring, Stan Weinstein, and Trader Vic. Then, I found options, reading the entire, 800-page McMillian on Options, as well as books by George Fontanills and others. I became fascinated with limited risk, and the incredible complexity of trades I could create using options. “Holy crap,” I thought, “these things are amazing. There is an option strategy for every possible situation. And look at the leverage! Woo-hoo!”
I liked saving money and had managed to put away $15,000 to $20,000, so I started to trade. Sometimes I’d screen based on fundamentals and then decide to buy a few stocks. Other times I’d find momentum stocks and buy options expiring in a few months. I also subscribed to some newsletters and would pick and choose investments that sounded good to me, primarily looking for those I thought had the best chance of a significant return despite the risk. In hindsight, I really didn’t have much of a trading strategy. There were no real entry criteria, other than the caveman approach: me see, me like, me buy. There was no pre-defined exit point where I’d admit I was wrong and get out, and I would decide how much money to allocate to each position by gut feeling.
Unfortunately, I lost on more trades than I won, which confused me. After all, I had done my homework and learned about trading. I had good reasons for entering every trade. I should have been winning much more money. In talking to people at work, it sounded like THEY were making money—a lot of it. But why? I knew I’d studied more than they had—when I talked to them, they didn’t know anything about the fundamentals, Warren Buffet, technical analysis or cool option terms like delta, theta, and gamma. I understood gamma, for heaven’s sake! How cool was that?! I thought I was destined to make money.
“Danger Will Robinson, Danger!”
In late 2000, I read something on the Internet suggesting that to win in trading you needed to have the right psychology. This was a new angle I hadn’t thought of. You needed the right psychology to be a good trader? Could this be true? I was skeptical. The guys at the office didn’t seem to give a hoot about psychology, and they were making money. Even so, I decided I would explore it before ruling it out.
My introduction to trading psychology would come in the form of a book called Trade Your Way by Dr. Van K. Tharp. I didn’t know it at the time, but the date I ordered Dr. Tharp’s book, September 27, 2000, was within weeks of the end of one of the longest, most profitable bull markets in US history. I was 30 years old and about to lose most of my net worth. But, of course, I didn’t know this at the time, so I put the book on a shelf. I wanted to focus on making money now, not after I dealt with intangibles like psychology.
When the bear market began, I continued trading as I had the prior few years—I didn’t follow any real strategy, but I’d read a ton and thought I understood enough to continue to be profitable. I traded some on the short side, but my primary focus was long. The market had been going up for most of the last 20 years and the downturn in late 2000 seemed like just the “blood in the streets” buying opportunity I’d read about. Really great stocks like Worldcom, Global Crossing, Earthlink, and Puma Technologies were now real bargains. I bought them all.
I would soon discover the importance of applying the appropriate metaphor for the current market situation. Yes, there was “blood in the streets,” but the right metaphor for the moment was “don’t try to catch a falling knife,” or “low stocks can always go lower” or “don't fight the tape.” Funny thing about trading metaphors: most of the “market experts” who quote them don’t give you any truly helpful advice on when to apply one versus another. The metaphors always sound wise when someone says them, though, don’t they?
Over the next two years, the S&P 500 plunged more than 40% and, in a show of solidarity, the vast majority of my money went down the drain with it. I was angry and disgusted with my failure and determined not to lose all my marbles again.
Clearly I needed to change what I was doing, but what was the best way to do that? And who could I trust to help me? My trust in the traditional “experts” had diminished in lockstep with my account value. Maybe that book by Dr. Tharp was worth a read after all.
To be continued next week...
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The VIX: When It Works and When It Doesn't
When I coached Little League baseball, the process of trying to figure out the strengths and challenges of the individual players always fascinated me.
One year, we had this tiny guy with a great big throwing arm. This kid could really hum the ball, and on top of his throwing skills, he was very good at fielding ground balls. This made him a great candidate for playing the most important position in the infield—shortstop.
In baseball, the shortstop plays between second and third base. Most batters are right handed so they hit more balls to the shortstop than to any other position. In addition to getting a lot of balls hit their way, shortstops have to make a long throw to first base in order to get the hitter out.
So our strong-armed, little guy seemed ideal for shortstop. Until I hit a ground ball to his right. He missed it. And another. Then another. If I hit a ball directly to him or to his left, he gobbled it up. But hit one to his right and there was little chance he would make the play.
Fortunately, we had an ideal solution for this player. We put him at third base where the foul line protected his right side. His strong arm was still a great asset at this position, since it’s a long throw from third base to first.
Once we assessed this player’s abilities, we could put him in a position where he could excel. And he thrived at third base all season.
The VIX volatility index indicator is much like our little ball player. It has some amazing strengths (as we’ve discussed in recent articles), but it also has a glaring weakness. Let’s investigate where it is useful and where it’s not.
The VIX: Gold for Oversold, Not So Hot for Overbought
Several weeks ago, I wrote about VIX as a tool that works. We looked at a chart that showed how well VIX has described market fear points—basically times when VIX has traveled above 30. As way of review, here’s that monthly chart of the S&P 500 on top and the VIX below.
The traditional level of concern is 30 (shown by the horizontal blue line). Every trip the VIX takes above that blue line tells a story.
In short, VIX does a great job of alerting us to an oversold market. A move above 30 indicates the options writers require a greater premium to sell options, especially puts. VIX “just works” when used to indicate short-term, oversold markets because it describes a relative level of fear or skittishness in the markets.
However, like our little baseball player who didn’t do so well with ground balls hit to his right, VIX does a lousy job alerting us to overbought periods. In fact, if we use the traditional level of 18 for an overbought reading on the VIX, it really is fairly useless for any market in an uptrend. Let’s take a look.
We could argue that there are a few useful signals, but the vast majority of time that the VIX has been less than 18 has not signaled overbought conditions or a valid reason to sell. The VIX overbought “signals” have been early or just false.
So here’s the bottom line: the VIX does a great job of telling there is short term fear / oversold situation in the market (spikes above 30) and longer term fear/downtrend (stays above the 30), but a poor job of predicting overbought markets.
About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".
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This course is not dependent on your experience level. It is not system, time-frame or market specific. It is just as helpful to a seasoned trader that has been managing millions for over a decade as it is for the new investor with a small personal account, or to the person who has yet to place a single trade. This is because the focus of this program is YOU.
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On the Lookout for a Major Structural Shift
Q: A comment regarding D.R. Barton's recent article.
An interesting article you penned, with an equally interesting chart. Seeing a 20-year view like that, it surprises me that the VIX was not higher during the tech crash (i.e., it hit about the same level as the peak of the last 2 months). Your explanation of Internet/trading technology vs. cycle times is certainly correct. The rate at which (far more) market participants can act is much higher than 10 years ago.
The other factor that explains this, to my point of view, are currencies and interest rates. The bailouts of both private and public sector has led to monetary madness, with a lot more US$, Eur and others in existence. And all at ridiculously low interest rates. This has many implications but the main one is a hunt for a store of value. That store is no longer currencies or high-interest deposit accounts. It has become anything considered to have value, e.g., gold, wine, property (at least in Europe), etc. The problem is that the supply and demand of these alternative stores of value is opaque, which leads to swings in perception of what is risky and what is safe.
Therefore my conclusion is that we are going to see volatile market conditions till there are changes to one/some of the major currencies, e.g.,
gold-backing or other measure that lends more credibility than a government's promise. That is the structural shift I will be looking for to know the rules have changed again.
A: With cash having nowhere to find yields that beat inflation, much is being driven to the asset classes you mention. And the Fed has committed to this low-yield environment for the next couple of years! So I believe you are right about that being a major structural shift to look for.
—D.R. Barton, Jr.
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