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...

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....

In trading, controlling the risk in a portfolio is determined by position sizing.  Most trading firms employ a fixed fractional contract position sizing method.  Under this methodology, positions are determined using the following formula: Fixed fractional bet sizing: Amount risked per trade = closing equity * fixed percentage risked per trade (e.g. 25bps) Once the Fixed-Fractional Contract Position Sizing Formula has been used to calculate the amount of risk to put on with a trade (in dollar terms), the Risk-Basis Position Sizing method is employed to determine how many shares or contracts of an instrument to buy or sell.  The Risk-Basis Position Sizing method considers the risk for each security, where risk per share is the entry price minus the stop-loss point.  It divides the total risk allowance (e.g. 25bps in dollar terms) by the risk per share to determine the number of shares to trade.  Legendary systems and Trend Following trader Ed Seykota o...

Alexander Elder lays out the background and blueprint for the Triple Screen Trading System (Triple Screen) in his book The New Trading for a Living. Elder has been using this system since 1985 with a few minor adjustments along the way. However, the basic premise remains. He states that the Triple Screen makes “trading decisions using a sequence of timeframes and indicators” (The New Trading for a Living, pg. 154). Specifically, there are three screens applied to each trade and only the best trading opportunities pass these tests. In practice, Triple Screen uses trend-following indicators on longer term charts while the intermediate and short-term charts use oscillators for analysis. Trend-following indicators work well for identifying the existence of a trend, but fall short during a range bound market. Conversely, oscillators demarcate overbought and oversold levels which are useful in a trendless market, but will be consistently overbought or oversold when a trend is emerging. As s...

In Mebane Faber’s paper, “Quantitative Approach to Tactical Asset Allocation,” he builds a quantitative market-timing model that employs a trend-following strategy with built-in risk management. Specifically, he utilizes a moving-average-based trading system which is the most commonly used trend-following method. The system rules are simple and are as follows: Buy Rule: Buy when monthly closing price > 10-month Simple Moving Average (SMA) Sell Rule: Sell and move to cash when monthly closing price is < 10-month SMA At most, this system will rebalance monthly if a market is range-bound. However, when using the 10-month SMA (near equivalent to the 200-day SMA) as a trading signal, systems generally have a propensity for less turnover than other actively managed strategies. The converse, and one basis for comparison, of an actively managed strategy is a passively managed system. Faber’s research compares the model against a buy-and-hold (i.e. long) allocation to the S...

After the August 2015 sell-off the broad-based indexes found support and pivoted higher before month-end. However, by the latter half of September 2015 more selling pressure came into the market pushing the price of the S&P 500 Index (SPX) down to a near retest of its August 2015 lows while moving the value of the Russell 2000 Index (RUT) to new lows.  Even though the price action of these two indexes differed, the behavior of each respective Moving Average Convergence Divergence (MACD) Indicator was the same. Specifically, both MACD’s formed a higher low in late September 2015 after the August 2015 low was formed. Given the aforementioned similarities, MACD conveyed a powerful underlying message. In the case of RUT we observe that divergence formed between the lows of the price and the lows of the MACD lines. That is, as RUT formed a lower-low by the end of September 2015 its MACD was making a higher-low which is indicative of future price strength. MACD is categorized as a ...