Archive for June, 2008

Investor Bias

Understanding Biases can not only help an investor refine his investment strategy but also help time markets.

The current short bias in the market gives us cues whether NIFTY BANK will collapse, or will push up in Q3.

Predisposition and anticipation. The last time we mentioned Matthew McConaughey was when we borrowed FOOL’s GOLD from him. We happened to see the talented artist’s work again (Al is a legend). Between the Euro Cup group matches, we sneaked in some time for TWO for the MONEY, a UNIVERSAL movie based on Sports betting. It all seemed like a familiar scene just that it was the super bowl match results which McConaughey (Brandon) was anticipating while Al Pacino (Walter) was predisposed to gambling. Two characters of the same story, one anticipates and the other predisposes. One had intuition, rules, reasons, knowledge and skills while the other was reckless, betting everything on a game.

The other guy. One of the first things our guru told us was that market is not a casino. But little did we know then that the probability skill we were learning had a high chance compulsive gambler, as the counterparty. Things became clearer, as time passed that it’s not just about learning to drive the forecasting and calculated bet car, but also to take care of the reckless drivers on the capital market highway. Peter Bernstein, economic historian says that for most of history, in terms of business decisions, the world was agricultural and risk was in weather. And we can’t do anything about the weather. But when we got into capitalism in the 17th and 18th centuries and markets began to function, the risk moved from weather to what will the other guy do? That’s what the whole stock market is about. It’s the other guy that not only brings risk to the system but also changes how markets work and function. Understanding his biases hence becomes key to success.

Bias. What are biases? Biases are false judgment, which lack objectivity. And biases increase or enhance after real money is involved. These emotional fixations are driven by crowd emotions and are different from independent thinking. It has also to do with personal experiences. A failure or winning colors our investment approach to market. A failure makes us more risk averse, while a win makes us take more risk. One best way to do is to get out of the market and reassess. Markets do not tolerate inflexibility. It trashes it. Removing a bias is difficult, because we are influenced by events and news around us. A study of history is a good technique. Frederick II, Holy Roman emperor and king of two Sicilies was a confirmed skeptic, refusing to accept data that he could not verify. It was in Frederick’s court that Leonardo (Fibonacci) was interviewed on mathematical problems in 1220′s when Europe was struggling with mathematical rationality and objectivity. An objective man in such times was an exception.

The expert bias. Oil will go to $ 200, CITI and GM are negative, Crisis is coming are some recent expert calls. First and foremost the experts appear late on the scene. Second, experts have bias too. But the problem is not just the experts, but our inability to really judge accuracy. In time, all calls and forecasts are forgotten. And we don’t really look for an expert to tell us something we don’t know, we are more interested in him (her) telling things we know. It’s like if you are an OIL bull, the OIL expert comments about $ 200 per barrel will be more credible. Or for example financial sector meltdown is all over the place, the reason why the Goldman Sachs call on Citibank’s negativity might sound sharp and objective. It’s more about our preconceived positive or negative bias that we want to enhance, not even once challenging or questioning why these same experts did not tell us at $ 40 where Oil was heading or telling us a year back that CITI or GM stocks might crash. Now that we are at 10 year and 30 year lows for CITI and GM respectively, talking about crashes is easy.

The permanent bias. Making money on trading is tough, or trading both sides of the markets are tough. As we humans suffer from certainty, linearity, straight line, extrapolation and positive bias. That is why brokerages are in business when markets go up and out of business when markets stagnate or go down. Their profile is linked with market upside not downside. A majority of us suffer from permanent bull bias. Nature has no straight line, but if the stocks are going up today, they will go up tomorrow. If stocks are falling today, they will fall tomorrow. These are biases we don’t challenge. It can also be called as the order bias. If there is order, things are correct and when there is chaos, it’s the global economy, the interest rates, the food, oil, currency or politics. A majority of us suffer from a permanent bull bias. There are a few who thrive in falling markets and suffer from a permanent negative bias.

Event and cause bias. A cause is linked with an event, is a bias. If you have the right information, you can profit. The information arbitrage days are over. Knowledge creates a bias linked with overestimation of skills. Before and after we started the markets, the unknown was always greater than the known. And information and cause can never explain the event. The bias creates an illusion. Hamilton Bolton, market thinker always said that it is not the news but the construction placed on the news by the market that confirms the trend.

Risk Bias. How financial markets understand risk is a bias too. Peter Bernstein and Frank J Fabozzi, Streetwise redefines risk. The rational model or shared belief (bias) that portfolio risk is strictly a function of volatility of portfolio returns is flawed. The priority objective in investment management is to control risk not maximize returns, which itself behavioral finance proved, does not happen. It’s paradoxical fact that most investment managers devote most of their time, energy and ability in an apparently futile effort to maximize return. Living within one’s income is one such risk controlling measure that could have avoided the current subprime crisis causing so many job losses and wealth destruction. The cash requirement or future payment obligations are more important in portfolio risk than the volatility of returns. Giving the need to purchase a stock or asset more weightage than the ability to purchase is what really defines risk. Being fashionable in investment decisions typically leads to mediocre results, or worse.

Success Bias. Though success can bias, consistent success needs an unbiased foundation. Dr. K Van Tharp has spent considerable time studying psychology of high achievers and apart from psychology make up, a well rounded personal life, a positive attitude, a motivation to make money, a lack of internal conflict, a willingness to take responsibility for results, risk control, patience and discipline. Tharp found that ability to make unbiased independent choices was also key. Success also comes with writing the trading plan down, as a trading plan and rules in the head is a success bias that leads to failure.

The stupidity bias. If I don’t understand it and not even my neighbor, it got to be inane. How can religion tell us anything about markets? How can a psychologist, poet, artist, and physicist do a better job in forecasting and profiting from markets than a qualified economist or an experienced broker? Both religion and science affirm the unity of nature. This implicit unity of all things found in nature is called the Tao. A J Frost, Market Guru, illustrated readings from Christianity, Tao Te Ching and Upanishads. How the basic philosophy of changes in man and nature runs through every economic concept? How God has been defined as a ratio? It is like asking, how can understanding Indian spirituality detachment guidelines help one profit from Futures?

Biased over unbiased. Predisposition and anticipation are two sides of the same coin. There is a very thin line, when bias (predisposition) creeps in and spoils a clearly laid out strategy. It happens many times, impulses take over and rules are broken like Al did, again and again, every rule. The battle for emotional control goes on. Something like we are doing now, learning to look at opportunities when tide is against us and masses are looking at a crisis. Markets top predispose us to sector leaders, like BANKING did, Banks were the favorite. 50 per cent down, the predisposition is telling us to trash all the banks. But anticipation tells us that 50 percent retracements, more than 6 months of one sided fall, clear five wave structures down, previous fourth wave supports and experts coming out now and warning of a coming crash after the chips are half in value is creating a strong negative affinity. We are again in minority, like we were on 22 Oct when we wrote “Crash and Cash Cycles” where we highlighted the need to be in cash before the crash. “We see a lot of unsustainable greed”, we said.

NIFTY BANK BIAS. Now the question to ask is that are we predisposed to a banking collapse or will the impending panic low create the best time to buy BANKS for Q3? Three months of rise in a year, can give the key edge between a performing and losing portfolio. For us at Orpheus the Banking collapse started in Jan 2008 (India Outlook 2008) and the coming perceived collapse of NIFTY BANK, should give us a panic culmination. We don’t see the NIFTY BANK pushing below psychological 5000. Let’s see how good our anticipation pans out, predisposition, we have none. And “Am I biased?” is a million dollar question we ask ourself every trading day of our life.

The Taleb conundrum

I first read Nassim Taleb’s story on virtue of buying cheap options in 2000. It was a tough time for an option believer in those days in India. Out of my basement stint for an e broker, which was struggling under startup pressures with “nobody seems to be interested in futures” statement mailed to me, Taleb inspired me at a critical time. Eight years, I still believe his cheap option strategy is virtuous, but there is lot about Taleb’s random strategy that troubles me to the extent of challenging it. I have mentioned some of my disagreements prior, but the guru’s work deserves a serious debate.

First and foremost, Taleb makes no claims of being able to beat markets. What this means is that Taleb is not in the predictive business. His hedge fund Empirica was into hedging solutions and not into predictive forecasts. We at Orpheus are into the predictive business, but we also make no claims of beating the market. But there is a difference. There are many ways you can beat a market. You can either give more returns than DOW Jones or Sensex over a year. Or you catch every multi week move that the DOW or Sensex might make over the year.

For example 2007 Sensex saw 6 major turns starting 07 Jan 2007 at 13,860, followed by a upmove to 14,538 on 11 Feb 2007, after which we saw a dip till 18 Mar 2007 till 12,430, from the week ending 18 Mar 2007 till 22 Jul 2007 Sensex pushed up till 15,565, a small dip followed till 19 Aug 2007 at 14,141 and then one way upmove above 20,000 till 13 Jan 2008. On a net basis though the Sensex moved up 50%, but on a gross basis markets move up 77% and down 23% in total six moves averaging 20% each.

A derivatives trader is not concerned about net yearly moves, but all tradable moves whether up or down. So beating the market would mean capturing the entire 101% gross move in Sensex for the year, a tall benchmark and a near impossible task to achieve. But capturing 50% of the net return of 2007 was easy for a buy and hold investor invested from 07 Jan 2007 till 13 Jan 2008. But this passive investor may have beaten the market in 2007, but the market is beating him in 2008 now that it’s down 28% for the year.

Beating the market hence is a misnomer, a jargon which does not mean anything. Any hedge fund that operated from 1975 till 2000 and caught the 1987 meltdown can claim to have beaten the market. It’s more about double digit or tripple digit returns that suggest predictive knowledge and trading expertise. Like what Robert Prechter did when he made 444% in a three month monitored options trading account. Just like many traders do, day in and day out, some survive and some shine. But then trading itself is a hard task, you can actively trade from the age of 26 to 45, like what Taleb did, but then market cycle overtakes the human cycle, the very reason we continue to live the illusion of beating the yearly return of a market and not some supernormal or triple digit returns. Taleb’s philosophy is not for the traders who want to beat the markets and want to make triple digit returns. Taleb’s 1987 jackpot was the one off event that he admits hit him from out of the blue and it had nothing to do with predictive value.

Second. His idea of Randomness is flawed. There is not one man who saw the 1987 crash (I know three of them), or one trader who saw the 2000 tech bubble bust, or one Goldman Sachs, which saw the subprime mess shorting opportunity, there were many who saw the real estate crash in US. Randomness is for the masses. As they don’t understand how markets work. Markets are clock work and not random as Taleb claims. Forecasters have proved it again and again giving not only great calls but also timing them. There are technicians who timed a short call two days before Sep 11, and there are technicians who said after Sep 11 that markets should bottom anytime soon. In 21 trading days DOW hit base and in 40 trading days markets were back above SEP 11 levels. Bill Sarubbi timed Gold for 2007. How can you time markets, if they are random.

Taleb’s hypothesis is weak and does not comprehend random events like earthquake and disasters that don’t affect the markets. Recent Chinese earthquake was all over the news, and the SSEC (Shanghai Index) went up for three days after the earthquake. Even the deadliest Tsunami, which killed more than 225,000 people in eleven countries, was followed by rise in stock market valuations around the globe. Assassination of presidents and prime ministers are random events with poor correlation with market crashes. Market randomness is predictable and has nothing to do with event randomness, which may or may not affect the market. All that does influence the market is non random in nature and is non linear mathematics, pure in its structure. Power law, Fractals, Cycles and sentiment measuring tools have high predictive power. And Black Swans have nothing to do why DOW goes up or down.

Third. Though recent broker inventiveness and rush for trading volumes have lead to the mushrooming of a zillion leveraged products (example 1 to 100 leverage), classically options offered a protected leverage compared to Futures. No wonder the upside was unlimited compared to the downside. The only catch was that 85% of the Options generally expired worthless. And if you are just buying cheap options, volatility or chance will definitely make you rich on that black day like 1987. Volatility is cyclical and starting 2007 is moving up in a 25 year cycle which should top somewhere in mid 2015. This means that chances for buying cheap options are going to be few, but profitable.

Good forecasts cannot be subdued with randomness talk. And there are living legends like Richard Russell forecasting markets day after day starting 1958. Options are versatile instruments that can do better than wait for that 1987 crash again. Being on the long side helps as option writing has unlimited risk that can implode and cause more than a Barings’ failure.
What we have been doing is for you reader’s to judge. But early 02 Jun we gave you a JUN strangle strategy. Markets were at inflexion points, with no clear supports and downward momentum pushed us to run with our negative broad market view. Barring CNXIT (Tech Index)

WAVES.IND.020608 was negative for every other market sector. The Strangle resulted in an 81 percent return without transaction costs. The illustrated chart highlights the decay in OTM call options, the fall of NIFTY over the last two trading weeks, the rise in OTM PUT option premiums and the resulting STRANGLE payoff premiums.

We still remain negative on the market. But considering prices have hit the previous iv wave supports for many of our covered indices, the early next week prices could attempt a sub minor bounce. Markets might get choppy for a few days before turning down again, pushing lower. We will review any new strategies on Wednesday in our mid week WAVES.IND issue. Till then we hope we clarified a part of The Taleb conundrum.