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A Few Notes on Trading Realities

| | Posted in: Equity Options, Volatility Effects

Author Jeff Augen describes his 2010 book Trading Realities: The Truth, the Lies, and the Hype In-Between as “designed to help investors understand the economic and political forces that drive financial markets and to invest alongside those forces instead of against them. It also provides a blunt assessment of the limitations that most private investors face. Understanding these limitations and being able to manage risk are as important as choosing the right investments.” Some notable points from the book are:

From Chapter 1, “Global Economic Forces and the Average Investor”:

Pages 19-20: “…global economic forces affect individual investments. The effect is especially relevant to stock investors who are often surprised when seemingly solid investments lose money as they fail to keep pace with currency devaluation.”

From Chapter 2, “The Harsh Realities of the Marketplace”:

Page 34: “‘Long-term investing’ is a relic from a previous era when constant, steady growth was common at all levels in the economy. …Those days are gone forever…”

From Chapter 3, “Betting with the House”:

Pages 60-61: “When the government takes aggressive action to prop up the markets, bet with the government…because they have massive amounts of money, a powerful public relations machine, and control over all the most important financial reports.”

From Chapter 4, “Identifying Trends”:

Pages 63-64, 69: “One of the most important changes has been the explosive growth in algorithmic trading that has been driven by the availability of cost-effective supercomputing and very high-speed communication links between systems. …large investment houses are able to identify and exploit market inefficiencies in very brief time frames. …The combined insights of millions of traders built on an endless stream of instantly available news, coupled with supercomputers that trade in the millisecond time frame, remove any possible advantage that can be gained from looking at a chart. Investors should, therefore, assume that the price of a stock constantly reflects every relevant piece of information and that the next price change will reflect the impact of the next piece of news.”

Page 115: “Learning to identify uncertainty is one of the most important skills an investor can acquire. …Option traders earn a living quantifying uncertainty in the form of volatility, the most important factor in the price of an option contract.”

From Chapter 5, “A New Era”:

Pages 120, 122: “…the new era is fundamentally different from those of the past, yesterday’s approaches to investing are unlikely to work again for a very long time—if ever. Two characteristics dominate today’s markets: leverage and instability. …leverage is a result of explosive growth in both the size and complexity of the world’s financial markets. …instability, is directly related to the complexity of the financial world. A major source of this complexity is the tight relationship between markets and the speed with which billions of dollars can move from one location to another.”

Page 136-137,140, 152: “High-frequency trading…has emerged as a new theme that dominates today’s electronic marketplace. …One of the most important characteristics of the new era is the speed with which a trend disappears. …activities that occur at the tick level cannot be analyzed using minute, hour, or daily charts. Trends that appear on these charts are either the result of large-scale economic forces or artifacts with no predictive value. The overall effect of high-frequency trading has been to place private investors looking at stock charts completely out of sync with the underlying forces driving the market. …In many ways these dynamics represent the death of technical charting as it was once known.”

From Chapter 6, “The Importance of Volatility”:

Page 163: “Price change distribution is the key to understanding the behavior of any financial instrument.”

Page 168: “The VIX sometimes provides signals that can be used to predict the direction of the market. Especially relevant are differences between the value of the VIX and the actual volatility of the S&P 500.”

Page 173: “An investor who pursues the covered call strategy can reasonably expect to own VXX for almost nothing within one year.”

From Chapter 7, “Strategies for a New Market”:

Page 215, 217: “Most stock investors would be surprised to learn that they can achieve the goals of stock ownership using options, and that most option structures are both safer and more profitable. Simple stock ownership is always inferior and should be avoided unless options are not available. …Often the best candidates are stocks that have experienced large price declines. In such situations, uncertainty can cause high option prices to persist for extended periods of time after the stock has stabilized.”

Page 198, 201, 205, 210: “Collars top the list of conservative trades and, in most cases, they outperform simple long stock positions. …a vertical bull spread is many times less expensive, considerably safer, and almost always more profitable than an ordinary long stock position. …covered call strategies almost always outperform simple stock ownership. …Investors who consistently sell calls against their stock positions have more stable portfolios that deliver more constant returns. …An investor who purchases a stock for long-term ownership would do much better to simply sell an at-the-money put. …[Deep in-the-money options] trades are simple to execute, less expensive, and have properties that make them superior to simple stock ownership.”

Page 221: “Because the market is a zero sum game, individuals who limit themselves to using traditional off-the-shelf indicators will always lose money to sophisticated traders armed with more powerful tools. The days of buying and selling stocks when moving averages cross or an oscillator reaches one side of a channel are over. Moreover, investors who fool themselves into believing that they can exploit some combination of these indicators are making a huge mistake.”

Some themes in this book are similar to those covered in Jeff Augen’s 2009 book Day Trading Options: Profiting from Price Distortions in Very Brief Time Frames, as summarized in “A Few Notes on Day Trading Options”.

Some reservations regarding the trading strategies recommended in the book are:

  • The author does not cite formal research or conduct rigorous empirical analyses of large numbers of observations to support assertions in Chapter 3 on betting with the government or Chapter 6 on the predictive value of implied-realized volatility divergences or the profitability of selling covered calls on VXX options.
  • The author uses examples rather than cited formal research or rigorous empirical analyses of large numbers of observations to support assertions in Chapter 7 on the net outperformance of several options strategies relative to buying and holding the underlying stocks. The discussions do not crisply quantify levels of expected outperformance on either a per-trade or sustained portfolio level.
  • The author does not address why sophisticated institutional counterparties do not extinguish the potentials for profit identified in Chapters 3, 6 and 7.
  • The author sometimes relies on mean and standard deviation statistics to describe expected return and risk. To the extent that asset returns do not have normal distributions (are susceptible to black swan disruption), “normal” interpretations of these statistics may mislead.

In summary, investors and traders may find Trading Realities an interesting discussion of the competitive challenges that face individuals (especially technicians) in a market environment dominated by automated, high-frequency trading. However, the author does not establish confidence in recommended trading strategies with empirical research.

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