One subject that has received widespread publicity in recent years is program trading. Perhaps, never in the history of financial markets has there been more criticism about a trading approach that was less understood. I would venture a guess that less than one out of ten people opposed to program trading even know the definition of the term. One source of confusion is that program trading is used interchangeably to describe both the original activity and as a more general term encompassing various computer-supported trading strategies. (for example, portfolio insurance).

Program trading represents a classic abitrage activity in which one market is bought against an equal short sale in a closely related market in order to realise small, near risk-free profits, resulting from short-lived distortions in the price relationship between such markets.

Program traders buy or sell an actual basket of stocks against an equal dollar value position in stock index futures when they perceive the actual stocks to be underpriced or overpriced relative to futures. In effect, program trading tends to keep actual stock and stock index futures prices in line.

Insofar as every program-related sale of actual stocks is offset by a purchase at another time and most program trades are first initiated as long stock/short futures positions, arguments that program trading is responsible for stock market declines are highly tenuous.

Moreover, since the bulk of economic evidence indicates that arbitrage between related markets tends to reduce volatility, the relationship between increased volatility and program trading is questionable at best.

Portfolio Insurance

Portfolio insurance refers to the systematic sale of stock index futures as the value of a a stock portfolio declines in order to reduce risk exposure. Once reduced, the net long exposure is increased back towards a full position as the representation stock index price increases.

The theory underlying portfolio insurance presumes that market pries move smoothly. When prices witness an abrupt, huge move, the results of the strategy may differ substantially from the theory. This occurred on October 19, 1987, United States of America, when prices gapped beyond threshold portfolio insurance sell levels, triggering an avalanche of sell orders which were executed far below the theoretical levels.

Although portfolio insurance may have accelerated the decline on October 19, it could be reasonably be argued that the underlying forces would have resulted in a similar price decline over a greater span of days, in the absence of portfolio insurance. This is a question that can never be answered. (It is doubtful that program trading, as defined above, played much of a role in the crash of the week of October 19, since the severely delayed openings of individual stocks, tremendous confusion related to prevailing price levels, and exchange restrictions regarding the use of the automated order entry systems severely impeded this activity.)

Professional gamblers have long claimed that there are two basic position-sizing strategies - martingale and anti-martingale. Martingale strategies increase one’s bet size when equity decreases (during a losing streak). Anti-martingale strategies, on the other hand, increase one’s bet size during winning streaks or when one’s equity increases.

If you’ve ever played roulette or craps, the purest form of martingale strategy might have occurred to you. It simply amounts to doubling your bet size when you lose. For example, if you lose $1, you bet $2. If you lose $2 then you bet $4. If you lose $4, you bet $8. When you finally win, which you will eventually do, you will be ahead by your original bet size.

Casinos love people who play such martingale strategies. First, any game of chance will have losing streaks. And when the probability of winning is less than 50 percent, the losing streaks could be quite significant. Let’s assume that you have a streak of 10 consecutive losses. If you had started betting $1, then you will have lost $2,047 over the streak. You will now be betting $2048 to get your original dollar back. Thus, your win-loss ratio at this point - for less than a 50:50 bet - is 1 to 4,095. You will be risking over $4,000 to get $1 in profits. And to make matters worst, since some people might have unlimited bankrolls, the casinos have betting limits. At a table that allows a minimum bet of $1, you probably couldn’t risk more than $100. As a result, martingale betting strategies generally do not work - in the casinos or in the market.

If your risk continues to increase during a losing streak, you will eventually have abig enough streak to cause you to go bankrupt. And even if your bankroll was unlimited, you would be commiting yourself to risk-to-reward strategies that no human being could tolerate psychologically.

Anti-martingale strategies, which call for larger risk during a winning streak, do work - both in gambling arena and in the investment arena. Smart gamblers know to increase their bets, within certain limits, when they are winning. And the same is true for trading or investing. Position-sizing systems that work call for you to increase your position size when you make money. That holds for gambling, for trading, and for investing.

The purpose of postion-sizing is to tell you how many units (shares or contracts) you going to put on, given the size of your account. For example, a position-sizing decision might be that you don’t have enough money to put on any positions because the risk is too big. It allows you to determine your reward and risk characteristics by determining how many units you will risk on a given trade and in each trade in a portfolio. It also helps you equalize you trade exposure in the elements in your portfolio.

Some people believe they are “doing an adequate job of position sizing” by having a “money management stop.” Such a stop would be one in which you get out of your position when you lose a predetermined amount of money - say $1,000. However, this kind of stop does not tell you “how much” or “how many,” so it really as nothing to do with position sizing. Controlling risk by determining the amount of loss if you are stopped out is not the same as controlling risk through a position-sizing model that determines “how many” or if you can even afford to hold one position at all.

1. Develop Consistency - You can create a mindset of consistency by developing beliefs that support you in obtaining this result. In order to develop consistency, there are a number of things, which you must do, including identifying your edges, defining the risk in each trade in advance, and accepting the risk to be able to exit a position when a defined loss level is realized. These and key mindsets help traders work through the issues they face in taking a trade, making the trade and executing their exit from the trade

2. Trading is a Probability Game - You can’t be a perfectionist and expect to be a great trader. Your losses (that you hope will return to breakeven) will kill you

3. Jumping In Too Soon or Getting In Too Late - These mistakes come from traders not having a well-defined plan of how they will enter the market. This positions the trader as a reactive trader instead of a proactive trader, which increase the level of emotion the trader will feel in reacting to market movements. A written plan helps make a trader more systematic and objective, and reduces the risk that emotions will cause the trader to deviate from his plan.

4. Not taking profits on winners and Letting winners turn to losers - Again this is a function of not having a properly thought-out plan. Entries are easy but exits are hard. You must have a plan for how you will exit the market, both on your winners and your losers. Then your job as a trader becomes to execute your plan precisely.

5. Great traders don’t place their own expectations on to the market’s behaviour, whereas poor traders expect the market to give them something. The market does not know who you are and owes you nothing. Period. When conditions change, a smart trader will recognize that, and take what the market gives.

6. Emotional pain comes from expectations not being realized - When you expect something, and it doesn’t deliver as expected, what occurs? Disappointment. By not having expectations of the market, you are not setting yourself up for this inner turmoil. The market doesn’t generate pain or pleasure inherently; the market only generates upticks and downticks. It is how you perceive and respond to these upticks and downticks that determine how you feel. This perception and feeling is a function of your beliefs. If you’re still feeling pain when taking a loss according to your plan, you are still experiencing a belief that your loss is somehow a negative reflection on you personally.

7. The Four Major Fears

• Fear of Losing Money
• Being Wrong
• Missing Out
• Leaving Money on the Table

All of these fears result from thinking you know what will happen next. Your trading plan must approach trading as a probabilities game, where you know in advance you will win some and lose some, but that the odds will be in your favor over time. If you approach trading thinking that you can’t take a loss, then take three losses in a row (which is to be expected in most trading methods), you will be emotionally devastated and will give up on your plan.

People want maximum performance, so there is always a temptation to override your trading system. The few times you do something to override your system and improve your performance that work really stands out in your mind. However, you tend to forget the times that don’t work and the day-in, day-out slippage (i.e. the cost of trading) that affects your bottom line.

If you don’t have a trading system at all, then numerous biases affect your trading. However, several key biases come into play even when you have the best of systems. Let’s take a look at these biases that tend to cause people to override or not follow their systems.

Gambler’s fallacy bias

The gambler’s fallacy is the belief that when a trend established in a random sequence (or in the market, for that matter), the trend will change at any time. Thus, after four consecutive up days in the market we expect a down day. Even people who are well-respected researchers of the market suffer from this bias.

People assume that the probability goes up for a win after a losing streak or up for a loss after a winning streak.

When you understand what’s involved in winning, as do professional gamblers, you’ll tend to bet more during a winning streak and less during a losing streak. However, the average person tends to do exactly the opposite: to bet more after a series of losses and less after a series of wins.

Conservative with Profits and Risky with Losses Bias

Perhaps the number one rule of trading is to cut your losses short and let your profits run. Those who can follow this simple rule tend to make large fortunes in the market. However, most people have a bias that keeps them from following either part of this rule.

People, once they have a profit in hand, are so afraid of letting it get away that they tend to take the sure profit at any sign of a turnaround of the market. Even if their system gives no exit signal, it is tempting to avoid letting a profit get away that many investors and traders continue to lament over the large profits they miss as they take sure small profits.

People want to take profits quickly and give their losses some room. This gives them the illusion of being right, but what they are really doing is “cutting their profits short and letting their losses run.”

These two common biases are well stated in the old saying: “Seize opportunities, but hold your ground in adversity.” The good trader had better use the adage: “Watch profit-taking opportunities carefully, but run like a deer at the first sign of adversity.”

Bias that “My Current Trade or Investment Must Be a Winner”

What makes all these problems come to the forefront is the overwhelming desire of human beings to make current positions (those you have right now) work out. What happens? First, when you have a losing position, you’ll do anything to nurse it along, hoping it to turnaround. As a result, losing trades tend to become even bigger. Second, profits are taken prematurely in order to make sure they remain profits.

Why? People have an overwhelming desire to be right. Over and over again, I hear traders and investors telling how important it is for them to be right when they make a market prediction or, even worst, when they invest their money in the market.

Once a person makes a prediction, the ego becomes involved in it, making it difficult to accept anything that happens in the process of trading that seems to differ from your prediction.

This bias may be at the root of all other biases. Yet being right has nothing to do with making money.

Think about it for a moment. How can many people look at the same situation, same material, same market, same indicators, same analysis and come up with so many different interpretations and conclusions? One of our readers got upset about short selling and called it “promoting destruction, stealing and theft”. While some make eight digit profits through the falling markets others see it as bad and immoral. I wonder what different thoughts create each one of those vastly different approaches and outcomes.

If someone told you there are unlimited amounts of money to be made in the markets today, what would be your first reaction? Not the opinion you take five minutes to form, the very first reaction. Would you say:

• No way.
• Of course
• Not in this market
• It is easy for some
• Where?
• How may I get my hands on it?
• Only immoral people make that much money.
• I know. I already have my hands on it.
• They are just lying to trick me into

Call it self talk, conditioning, brainwashing, subliminal training, cybernetic imprinting and judge it immoral, wrong or unfair: you have thoughts patterns deep in your mind that shape your outcomes. So what do you do? As Carl Jung said, you make the unconscious conscious. Then modify it to suit.

Here is a simple exercise. Get ready to write (pen and paper is better, but keyboard will do if you must). Start repeating to yourself: “I will be the world’s first trillionaire through my trading”. Then write down every objection you think of. Do it quickly like a brainstorming session. Write every objection and every obstacle you think of. Do this long enough until you feel you got out every objection and covered every aspect. The next step is to turn each objection into a positive sentence (avoiding double negatives). For example:

That is absolute nonsense.
Ineffective double negative: That is not nonsense.
Effective positives: That makes sense. That is so sensible. That is the absolute truth.

Do this for every sentence you wrote. Then read your new list at least once a day.

In trading we talk about minimizing risks and maximising rewards. This is a risk free exercise with unlimited rewards. Do you believe it?

Imagine if you will, that the time had come to replace your car and that you had the opportunity to ask Michael Schumacher for his opinion as to the best car you could get. What might his possible answers be?

• A Ferrari
• Something with maximum power to weight ratio
• Anything red with superb traction in corners

Or he might say “It depends. What do you want it for, how much do you want to spend, what trade-off can you accept between performance and running costs, do you want spare parts and servicing available promptly, anywhere?

Back to trading again, there are specific characteristics of different markets be they stocks, currencies, index futures or commodity futures that can work better or worse with different trading plans but unfortunately there is not a brochure that neatly tabulates the features for comparison.

Finally, there is the unfortunate fact that the markets are greatly affected by human emotion and mass psychology so they can be capricious and change their character for no obvious reason. For example on the 11th July Oil touched 147 USD and yet on the 5th August reached as low as 120 USD, an 18% decline in 16 trading days. Does it seem likely that the world’s energy demand fundamentals have changed this quickly? No of course not, but as traders we don’t particularly care so long as we know how to capture some of that short but highly profitable move.

Closely related to our first question, is “How do I get more consistent results from my ABC Trading Plan as taught in the Smarter Starter Pack?” Often, this is a question arising from having expectations which exceed our current level of study and experience. Would we give our children the keys to a car, point out the steering wheel, the “go” pedal, the “stop” pedal, and tell them to read the RTA book of road signs and expect them to drive safely in the city and the country, in day and night, in sun fog or snow and to watch out for drivers who break the rules?

It is common sense that we would not do this, but every week people excitedly rush into their first trade having not completed the reading, watching or practicing aspects of their education, having not spent enough time understanding the powerful software tools they own, and having not tested their plan on their chosen market.

Yet the excitement and desire to be successful dulls our perception of danger. We have all been there but as independent, self-directed traders and investors we owe it to ourselves to note W.D. Gann’s words in “Speculation, A Profitable Profession” – “Remember that the harder you work, the more knowledge you will get, and the more profits you will make.”

Rather than being a “One Size Fits All” proposition, the “ABC Trading Plan” is in fact a framework of trading plan options that can be shaped to specific goals. It is essential that we each make it our own so in future articles I will further explore some of those choices.

The game of speculation is one of the most popular and pervasive of all games known to humans. It took its name from the speculare, who stood at the back of a Roman ship during sea voyages. His job was to find good fishing areas. The game as we play it is as old as history. Joseph, in the Old Testament, noticed a seven-year cycle of good and bad harvests in ancient Egypt. He convinced the Pharoah to buy or tax away the excess on good years and warehouse it for lean years. He became immensely wealthy and influential because of his shrewd speculations.

Speculation combines chance and skill and includes elements of hunting, deception, cooperation, competition, creativity, rhythm, and physical strength - in short, all elements of games we played as children. Here is a brief outline of the game:

Object of Game: To make a profit by buying something at a low price and selling it at a high price.

Equipment: A phone or internet and money. For advanced players, a rented quote screen or quote.

The Board: An organised stock or commodity exchange such as the Singapore Stock Exchange (SGX) or the New York Stock Exchange (NYSE). The Play: Arrange with a member of the Board to buy and sell while the Board is open. You can do this on credit. Unless you are a member, you lose when you owe a member more than you have available to pay during the required time frame.

Strategy: Be careful to balance potential reward with risk. Most players lose, so if you find yourself part of the herd, chances are you should change your plan. Combine cooperation with colleagues and competition with opponents to gain the limited chips.

Purpose of Play: A popular 19th-century proverb says: “A child doesn’t play because he’s young. He’s young so he can play.” Infants are born helpless, but they learn for themselves how to survive in a world of competition and cooperative play. Nature gives us the rudiments for success but relies on play to focus, sharpen, and strengthen them for the vicissitudes we will meet within the game of life.

Indeed, play is so fundamental that the very language we use to describe it has its own syntax. As Huizinga points out:

Does this mean that the act of playing is of such a peculiar and independent nature as to lie outside the ordinary categories of action? Playing is not doing in the ordinary sense; you do not “do” a game as you “do” or “go” fishing, or hunting, or Morris-dancing, or woodwork - you “play” it.

Play is so basic, so fundamental to human nature, that the roots of culture grow in it: language, myth, ritual. “Now in myth and ritual,” Huizinga says, “the great instinctive forces of civilized life have their origin: law and order, commerce and profit, craft and art, poetry, wisdom and science. All are rooted in the primeval soil of play.”

The game is never easy. The people you play with and against have their own agendas. Sometimes, the only way you can achieve your agenda is by beating theirs. Their goal is to beat you. At other times, cooperation is the key to joint success.

Play is fundamental. It connects us to our humanity, to our culture and history, to the cycles of nature, where everything has its season, and every season returns in due course.

Are You an Investor, a Speculator or a Gambler?

What exactly is an Investor, a Speculator or a Gambler in the context of the Stock Exchange Market or for that matter, any markets?

The Public as well as the Media have often loosely and interchangeably used these three terms. Comparisons are often made between their activities, but the terms are never explicitly defined.

You might ask if there is a need to be distinct on these terms. Well, there is definitely such a need simply because, if you want to profit from the market consistently, it is crucial to first, know who you are and how you are going to participate in the market. In fact, the mindset and methods employed by an investor, speculator or gambler differs extensively and greatly affect the profitability of participating in the market. How perilous it is to venture into the markets blindly!

The Public often called themselves Investors, perhaps, influenced by the Media. But how many of them are really Investors or even Speculators. Think about it, many of the self- acclaim Investors are actually habitual Gamblers, betting on the market on the slightest rumours, insider news, company news or fluctuations, hoping to get rich quick by chance. This is not a debate on whether gambling is good or bad, but if you’re going to gamble; don’t you think you have a better chance at the Casino, which is there for this purpose?

So, what are the differences between an Investor, Speculator and Gambler? In order to differentiate between them, we should start by defining them. If you’re sufficiently motivated, I encourage you to try to define the terms ’speculating’, ‘gambling’ and ‘investing’ before you continue reading this article… you may surprise yourself.

Consider the following.

Investor

An investor is an individual whose primary concerns in the purchase of a security are regular dividend income, safety of the original investment, and if possible, capital appreciation.

A person whose principal concern in the purchase of a security is the minimizing of risk, compared to the speculator who is prepared to accept calculated risk in the hope of making better-than-average profits, or the “gambler” who is prepared to take even greater risks.

In 1934, Graham and David Dodd addressed the issue and offered a definition of “investment” in their classic text book Security Analysis

“An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return.
Operations not meeting these requirements are speculative.”
- Graham and Dodd’s Security Analysis (original 1934 edition)

Speculator

Speculation is the buying, holding, and selling of stocks, commodities, futures, currencies, collectibles, real estate, or any valuable thing to profit from fluctuations in its price as opposed to buying it for use or for income - dividends, rent etc.

A speculator is one who is prepared to accept calculated risks in the marketplace for attractive potential returns.

Speculation: The activity of forecasting the psychology of the market.
Speculative motive: The object of securing profit from knowing better than the market what the future will bring forth.
John Maynard Keynes in The General Theory of Employment, Interest, and Money

Gambler

Gambling (or betting) is any behaviour involving the risk of money or valuables on the outcome of a game, contest, or other event in which the outcome of that activity is partially or totally dependent upon chance or on one’s ability to do something.

“A gamble is the assumption of risk for no purpose but enjoyment of the risk itself, whereas speculation is undertaken in spite of the risk involved because one perceives a favorable risk-return trade-off. To turn a gamble into a speculative prospect requires an adequate risk premium for compensation to risk-averse investors for the risks that they bear.”
- Investments by Zvi Bodie, Alex Kane, and Alan J. Marcus

Regardless of how you define the terms, it is likely to be a worthwhile activity to estimate your expected returns on both an absolute basis as well as relative to an appropriate benchmark. And if you find yourself enjoying the activity of investing or if you find yourself addicted to the speed and excitement of the trading game, perhaps you should seriously consider whether you’ve crossed the line between investing and speculation, or worse yet, maybe you are really gambling with your money.