Archive for May, 2009

Observing the markets: Bumblebee is born

May 19, 2009

I am developing a trading system from the ground up. It’s called Bumblebee. We’re gonna start with the first phase, which includes three parts. Observe market behavior, Code a plan that exploits market behavior, Test the code’s integrity. For acronym fans, this is the OCT phase. Below we will deal with Observation.

The beginning is important because it involves the logic behind the system. Repeatable patterns can be found in markets, but to trade these patterns, I hold the view that there needs to be an identifiable reason for why the pattern develops. It centers around market behavior and the fact that market participants are human and usually act as humans do. This is in contradiction to Efficient Market theory that suggests that market participants always make rational decisions based on their own self-interest and that information is instantaneously absorbed and priced in. When we observe market behavior, we realize how irrational markets really are. But irrational behavior does not mean unpredictable. An alcoholic acts irrationally when he gets lit up and decides to drive to the liquor store to get more booze. But its a pretty good bet (and predictable) that if an alcoholic has a drink, number two through six is not far behind.

Oftentimes, market behavior is exhibited in technical indicators and price chart patterns. Certain candlestick patterns are visual representations of markets revealing themselves. Moving averages represent a group consensus of value. These are all valid hooks to hang your trading hat on. But you can overdo it and end up in a Poisson Distribution before you know it.

For example, consider the following trade system. When the 14-period RSI crosses above 50 and the Ulcer Index reaches 23, and the (insert fibonacci number here) period moving average is (insert another fibonacci number here) percent of price (insert a third fibonacci number here) bars ago, then enter long. That’s not explaining or exploiting market behavior. That looking for patterns. And you can always find patterns in nature that are completely unrelated.

The bottom line is that there needs to be a logical explanation for why a pattern has developed and how it reveals market behavior.

The Bumblebee System is going to trade off the observations that trends, once they develop, continue in their direction until their momentum has become exhausted. Market participants follow market leaders and as the market leaders gather more followers, the trend continues until there is nobody left to follow. The market then sits around twiddling its thumbs until another leader either takes them higher or lower. The trend is your friend until the end, or something like that.

We are going to use two moving averages to document market consensus of fair value. A fast one will demonstrate a short term notion of value and a slow average will reveal the longer term notion of value. The fast one leads the way, the slow one follows. It’s your plain vanilla dual moving crossover system. Long when fast is above slow, short when fast is below slow. But to make it more interesting, we’re going to add a Bollinger band around the slow average. Why? To avoid whipsaws and to give market participants enough time to make up their minds. We ask the market, ‘Which way are you going?’. And then (by inserting Bollinger bands) we ask it “Are you sure?”. If it answers up and yes I’m sure, we go long.

A Bollinger band consists of two lines wrapped around a moving average. The lines are equidistant on the top and bottom, and their distance is defined by a factor of standard deviations. For example, we can select a 2 standard deviation width to the band and capture much of price action. Not 95% of price action as the standard deviation number suggests, but a lot. We are selecting a much smaller factor, something less than 1. We’re trying to keep our question simple in saying “Are you sure?” and we’re not trying to be annoying and ask “Are you absolutely, positively sure?”.

If you draw a moving average and wrap two lines around it, you essentially have four lanes. Two lanes inside the bands on either side of the moving average, and two lanes outside the bands, one over the top line and one below the bottom line. Usually a dual moving average system triggers when the fast crosses the slow. We’re going to require it to not only cross the slow, but its upper or lower band. Once the fast average crosses the slow average and its upper band, it now resides in the top lane and the signal is triggered to enter long. We have a higher threshold for entry. To exit the long, we wait for the fast average to dip below the slow average and enter into the third lane. Short trades will be taken with the same logic in the opposite direction.

It’s a race – FAS, FAZ covered calls

May 15, 2009

With the price-decay nature of FAS and FAZ, being long both is a double whammy. The expectation that one will blast off and make a winner out of the pair is becoming pure fantasy. But the volatility in the options enables one to write covered calls, which deteriorate at a faster rate than the underlying is decaying. At least for now.

The trade is to sell a decaying asset (out-of-the-money calls) against a decaying asset (long stock in triple-leveraged ETFs). Because these ETFs are leveraged like they are, implied volatility in the 200% range is about normal. That equates to a lot of premium for covered call writers. Now the question is which asset is decaying faster – the stock or the OTM calls.

I’m betting the OTM calls. And that’s why I’m still owner of these pathetic investment vehicles. I look at it as stock rental, rather than ownership. I could just write naked calls, but what if I’m wrong about neither of these ever being able to blast off? Naked calls are scarier than naked puts because your risk is truly unlimited, whereas the naked put is limited to zero.

I got $1.71 credit for the MAY cycle, and paid a nickel apiece to take off the risk. So my MAY credits netted $1.61 per 200 shares (100 shares FAS, 100 shares FAZ). I sold the JUN 10 calls for $1.70 total and expect a rerun of MAY. If I’m right, my cost basis for the long FAS, long FAZ pair will continue to go lower. Hopefully my cost basis goes lower at a faster rate than the inherent price decay.

XEO JUL/AUG 360 put calendar

May 15, 2009

Yes, putting on a long put calendar is a directional trade that profits if the stock goes down, but it’s more than that. On Thursday, I put on the XEO JUL/AUG 360 put calendar for a debit of $3.45.

We’ve had quite a rally over the past several weeks. And just when you think the bulls have exhausted their ammunition, along comes another fusillade of buying. When will this rally end already? The long put calendar is a way to play the market short AND play the current volatility long. You basically have a couple of factors that contribute to your success. First is price action. Obviously, as price action declines a short delta position will be in position to benefit.

Next is volatility. When markets sell off, the volatility normally increases as every worried mouse runs out to buy protective puts, bidding it higher. When you have a long put calendar, you are long vega, which means that you win when the thing you’re long (ie, volatility) goes up in value.

And let’s not forget positive theta. You’re long put calendar will accumulate theoretical monies each day that goes by, because your short put in the front month will decay at a faster rate than your long put in the back month.

So, this is a directional play in both the price and volatility arenas. I think the rally is a little overbought and due for a correction. And I also believe that the current volatility is oversold and also due for a correction. The VIX-style volatility index that tracks the OEX is the VXO, and it settled at a low-of-the-year yesterday in the $32 range.

The XEO is a European-style, cash-settled index. It’s twin is OEX, which is the American-style version. Both track the S&P 100. I’ve chosen the XEO because of some chicanery that happens with early exercise in the OEX product.

FAS and FAZ next meeting

May 12, 2009

Like a couple ensnared in a tumultuous relationship, FAS and FAZ are about to get back together again. You can tell they both regret how it’s been lately. They both want to give it another chance, hoping that this time it’s going to be different.

I’m guessing the next meeting pivot is around $7.20. That’s where my regression-like line is pointing. The correlation is currently around -0.86, which is pretty close to being perfectly negatively correlated. I’d like them both to remain below $10 on Friday, as that is options expiry and I’m short both FAS and FAZ calls at the 10 strike in MAY. Readers will recall I collected $1.71 credit for both short calls.

Where is this pair going? Quite frankly, I’m not sure. It’s shaping up as a mean-reverting play, but with a price decay component.

I went long equal shares when FAZ traded at $12.00 and FAS traded at $6.20. I’m becoming convinced that this strategy is mathematically guaranteed to lose. The income from selling covered calls against both longs is reducing the pain just enough for me to keep it alive. How’s that for a trading strategy. Hey, it’s discretionary.

These two little magnets draw each other closer before one switches its polarity and they diverge. All the energy expended on the ritual is wearing both of them out. They have some serious co-dependent issues. It’s like the drunk spouse abusing the enabling spouse. They break up, they get back together. And they’re both worth a little less in the end.