A Discounted View

Bubbles are a naturally occurring phenomenon in financial markets. However, while academics and subscribers to the Efficient Market Hypothesis will argue that a market inefficiency, such as a bubble, could not exist, practitioners  see differently. After all, anyone with money at risk  in their own account or for clients will say that the market did not behave rationally during the recent credit bubble in 2007-2008 or the Dot-com bubble in 1999-2000. Bubbles have existed for centuries with the most infamous dating back to Tulipmania in the 1600’s in Holland. Human nature and our inherent behavioral biases  fuel the rapid rise in asset prices that accompanies a bubble’s expansion phase. This unsustainable growth in investment leads to an eventual dramatic decline that happens nearly as fast the popping of a balloon. While the peak and end of a bubble are easily identifiable in hindsight, the stages of a bubble can be further classified into five chronologi...

No matter how hard you try to fight it, trading will test your emotional stability. It simply cannot be avoided. We as human beings are wired with an emotional, reptilian brain that will over-rule our rational and probabilistic thinking especially when dealing with money. Moreover, Alexander Elder  states “Thinking about money interferes with decision making” (The New Trading for a Living). New traders look at open profits and think about the ways they can spend the money they just made in the market. Elder continues by saying “ Professionals focus on managing trades ; they count money only after trades are closed.” In other words, professionals focus on process not outcome .  Additionally, when a novice trader is experiencing a large drawdown or a series of losses he or she is more inclined to hold losing positions below initial stops with the hope that the prices will recover. The inability to sell a losing position stems from our emotional brain. For example, emoti...

In his book, Trading Systems and Methods, Perry Kaufman provides some simple, non-mathematical rules that all traders should employ when running a trading program. While there is a purpose and time for using statistics and more advanced mathematical concepts to manage risk, these guidelines will help keep your trading on the path to profitability.   Only risk a small amount of total capital on any one trade . This suggestion echoes the teaching of Dr. Alexander Elder who popularized the 2% Rule . Simply put, when trading you should never exceed a particular amount of risk in any one position that could compromise your performance. In the futures industry, risk-based position sizing algorithms  are commonly used to determine the ideal position size or Optimal f. Know your exit conditions in advance . Kaufman states that “There should be a clear exit criterion for every trade, even if the exact loss cannot be known in advance.” I...

The art of professional portfolio management  experienced a revolution after the concepts in Harry Markowitz’s seminal paper explained how investors view risk and return. In his work, he derived formulas used to calculate volatility and expected return of a diversified portfolio with the ultimate goal of his to find the best portfolio allocation to maximize return for a given level of risk. His work is based on three assumptions: 1) Investors are generally risk-averse, 2) investors base their portfolio decisions on risk and expected return only, and 3) investors measure risk as the variance (or standard deviation) of expected returns. The third assumption led Markowitz to conceive the idea of a portfolio being “mean-variance” efficient when no other portfolio offers a higher expected return at a given level of risk, or lower level of risk for a given expected return. Creating portfolios that have higher mean-variance efficiency depends on certain statistical characteristic...

Harry Markowitz, the founder of Modern Portfolio Theory, once said that “diversification is the only free lunch.” Decades since his seminal work in developing mean-variance efficient portfolios that maximize return for a given level of risk, this adage still holds true in most market environments. It is common practice for fund managers to diversify among asset classes based on Markowitz’s findings. However, diversification with his methods can be taken one step further .  While diversifying your account in all suitable asset classes is worthwhile, a trader can also diversify an account with different trading styles which will create uncorrelated return streams. For example, Perry Kaufman suggests that a well-diversified trader has an ideal mix of three, maybe four, unique strategies. Generally speaking, these three trading styles can be categorized as Trend Following , Mean Reversion , or  Pattern Recognition . Furthermore, styles can be differentiated by time horizon....