Option FanaticOptions, stock, futures, and system trading, backtesting, money management, and much more!

Incremental Value (Part 1)

In contemplating transition from personal trading to wealth management as an investment advisor (IA) representative, I have struggled with fee structure. Thankfully the incremental value I bring to client accounts may buffer my cut as an intermediary.

What can I charge that is fair to the client and worthwhile to both myself and an IA that I represent?

In my opinion, “fair to the client” implies fees proportional to performance.* Consider this: if average annual hedge fund returns since 1970 are 12% while US equities have averaged 10% (approximations based on data from Bloomberg and Barclay Hedge) then does it make sense for the former to charge 2/20 (management/performance percentage fees) when the latter usually incurs a 1% management fee or less? I believe standard deviation is a second essential performance component and I would therefore be interested in comparing risk-adjusted returns. However, starting out with such a narrow edge in absolute return makes me skeptical that hedge funds will be able to justify a fee structure so extreme in comparison.

“Worthwhile to me” means my benefit must at least equal the cost. Working as an IA representative would require me to meet and speak with clients and with the IA, to be accountable to the IA, and perhaps to regularly commute to an office outside the home. These are big sacrifices to make especially when family is involved; much flexibility in my life would be lost. On the flip side, I would be associating [and hopefully collaborating] with co-workers and clients rather than operating in solitary confinement all day long. I would also be paid wages.

“Worthwhile to the IA” means the incremental value I provide is sufficient because a portion of IA revenue (management fee) would be redirected to me.

My initial thinking about the last two paragraphs was somewhat disappointing. I recently read about an IA charging 0.80% annually on the first $1M of assets under management. Thinking minimally, if I wanted to be paid anything more than 0.80% then the IA would be losing money to have me around!

Hope springs eternal when I consider the possibility of outperformance. Wouldn’t 11% annually be the same historical equity return mentioned above plus my 1% management fee or am I blinded by confirmation bias?

I will break out the spreadsheets next time.

* Per SEC rules, only qualified investors can be charged performance fees.

Tasty Statistics

In December 2015, I posted on statistics and trading. In March 2017, I critiqued Tasty Trade’s (TT) “Market Measures” (MM) segment for omitting critical information. Today I present an August 2015 e-mail correspondence I had with the TT research team about a failure to include statistics when presenting backtesting results.

My initial e-mail was as follows:

     > I’m a numbers guy, which is one reason I love the
     > MM segment. One thing I would like to see are tests
     > of statistical significance.
     > For example, in a screenshot from 8/12/14, the
     > takeaway is printed on the slide (16% and 3%). My
     > training suggests if these numbers aren’t statistically
     > significant then they aren’t very meaningful. I’d like
     > to see how significant they are (e.g. p-value).

They responded the next day:

     > I completely understand what you mean about adding
     > statistical significance to studies… this is something
     > we are trying to work into future studies. We have
     > several members of our team who are very capable and
     > have a strong history with… statistical analysis. I believe
     > the major positive to including these numbers would be…
     > more validity to our methodologies and studies… As for
     > a potential negative, our main concern… would be
     > barriers to entry. We want our MM and other segments
     > to be accessible and, while complex, understandable to
     > new and seasoned traders…
     > Thank you so much for the feedback!

I responded a few days later:

     > [With regard to the potential negative, you have] a
     > very legitimate point. Statistics is difficult for many.
     > I believe it provides essential information for those who
     > understand, though. When a study compares two
     > results, one is almost always going to be greater
     > than the other… without the p-value, it’s impossible
     > to know whether the difference is meaningful. Small
     > mean differences and large standard deviations are not
     > significant and only statistics can show us that.
     > I totally get what you’re saying about being audience
     > friendly… it doesn’t take much statistical discussion
     > to get many people to gloss over and tune out.
     > At the same time though, consider Tom Preston’s
     > recent praise of work done by the research team:
         > When they put results out there, we can
         > stand by them both from a data accuracy
         > and conceptual point of view.
     > Can you without providing the statistics? Omitting
     > statistics misrepresents the reality, in some cases,
     > by suggesting meaningful differences exist when in
     > fact they may not.
     > Scientific analysis can always be scrutinized. I
     > believe statistics should at least be presented.
     > Omitting them may substantially undermine the Tasty
     > Trade mission (to combat misinformation and lack of
     > information provided by the financial industry), which
     > Tom Sosnoff literally pounds the table to support.

Their final response:

     > Thanks again for the feedback.
     > Once again, I 100% agree with you that adding hard-
     > hitting statistical numbers will add to studies for those
     > who understand them. We are trying to implement this
     > going forward… I have passed your ideas onto the team
     > and emphasized that there are viewers… that want to
     > see this kind of analysis.

I felt that was a promising e-mail exchange.

Nearly 30 months have now passed and I have yet to see a p-value reported on MM, though. I have seen every single episode.

I had one other controversial idea not shared in the e-mail:

     > Maybe people who don’t or can’t understand statistics
     > should not be trading. Or perhaps part-time trading in
     > in small/hobby size is okay as opposed to trading full-
     > time as a business.

I did mention critical thinking and statistical background in my post on prerequisites for trading as a business.

Hindsight Bias

By the way, Happy New Year, everyone! Today I will discuss a cognitive fallacy capable of ensnaring us all: hindsight bias.

Here is a forum post from July 2015:

      > Why would anyone have their portfolio weighted with long puts in
      > a major downtrend preceding 9/11? It makes no sense. Karen said,
      > “stick with the trend.” A proper portfolio preceding 9/11 would
      > have been selling calls on each rally and EXTREMELY LIGHT on the
      > put side, if at all. Just look at the monthly chart; look at the
      > size of the candles each selling month. Anyone selling naked puts
      > in this scenario needs to look at the bigger picture first and
      > understand the context of the current market they are in.

I responded as follows:

      > I mean no personal insult but I think this is a very ignorant post.
      > I claim ignorance because hindsight makes it easy to determine
      > trend. How likely is your approach likely to work in the future?
      > I don’t know what rules you suggest for use on a monthly chart
      > but simply using a monthly chart means the number of occurrences
      > is limited from the outset. If you don’t have a sufficiently
      > large sample size then your approach may fall prey to curve-
      > fitting: works in the past but not in the future.
      > Discretionary guidelines can always be bent to fit pre-existing
      > biases. What you have described (e.g. “monthly charts,” “size of
      > candles”) is very nonspecific.
      > Being specific means objective definition of rules. Only then
      > can you backtest and begin validation. Author Kevin Davey
      > suggests a good system may be found for every 100-200 tested.
      > Do not believe it so easy to come up with a set of technical
      > criteria capable of predicting the next big fall.
      > You may say, “I can be wrong an extra time or two as long as
      > I’m out before the fall.” I think this is a good point but
      > realize that whipsaw losses can be significant and this may
      > render adherence to your system very difficult. When it
      > comes to losses, traders can be a fickle lot.

Hindsight bias [which also reminds me of future leak] is a common logical fallacy that must be recognized in trading and investing discussion/literature. The fallacy underlies artificially inflated performance claims. To stay on the path of consistent profitability, our challenge is to debunk such fiction and to minimize its consumption of our precious time and resources.

60 Seconds or Less

I have found composition of an elevator pitch to be one of the more difficult things ever!

On multiple levels, describing what I do is tremendously difficult. I recently met with a résumé writing specialist. She said she had written 3,000 résumés in over three decades of business. After talking with me for 90 minutes she said “you still haven’t told me what it is that you do, exactly.”

But when it gets right down to it, I use my money to make money and I have done this successfully for the last 10 years!

THERE. I said it.

And I hate saying it because to some degree I feel it sounds arrogant. To me it carries undertones like “you have to endure a tough commute, work long hours and deal with the day-to-day stresses of a corporate job while I just sit at home in my sweats working a few minutes per day to pay the bills.”

Except that it is not arrogant since I have put in a great deal of hard work to create the business I now operate on a daily basis. A lot of outside-the-box thinking has also been implemented, which may be why it’s called “alternative investing.” For all this, for believing in myself, and for the risk I have taken in leaving an esteemed job as a pharmacist, I am to be commended.

And I am not threatening karma because every business day I take some time to remind myself of where I am, of the gratitude I possess, and of the challenges that lie ahead.

I strongly believe my experience qualifies me to manage client accounts; can I put together a brief 60-second pitch to present this opportunity?

Here’s my first attempt:

      > After several years working as a retail staff pharmacist and pharmacy manager, I
      > retired at the age of 36 to start my own securities trading business. This has been
      > a journey without clients or co-workers that has required extensive self-study,
      > strategy development, and outside-the-box thinking. Over the last 10 years I have
      > learned a great deal about the mechanics of trading and investing. I have
      > succeeded at replacing a six-figure pharmacist salary by posting average annual
      > returns in excess of 15% since 2008. Having risked my own hard-earned money
      > to learn, I now seek a broader application: wealth management for others.

Recycling of Market Participants (Part 2)

Today I continue with a July 2015 thread about relative quiet in the forum.

On Jul 14, 2015, at 12:51 am (PDT) . Posted by CM:

I went back to the States for a couple of months for our annual fishing trip and to help my brother-in-law put up hay for his horses for the winter… When I return to a normal life in a few weeks I will be able to start posting again. My portfolio is currently flat, because of depressed stock prices, but the option trades are positive. Yes, trading plan is working…

I felt inspired to refresh the thread over two years later.

On Sep 26, 2017, at 4:08 am (PDT) . Posted by Mark:

I’m here with one follow-up post because I think many of you are missing the point. Please feel free to disagree; my words are hardly set in stone.

Over the years, I have found traders to be a very fickle lot. The oft-quoted statistic that 90% fail within five [1-2?] years supports this. I don’t know who [if?] did the original study but it is consistent with what I’ve seen of human nature from attending trading groups. Ego fulfillment means bragging when correct and/or making money. And Mr. Market lets us do that—sometimes with gradual profits over a long period of time. At some point he gets crabby and catastrophic losses await for many who have become smug and started to trade position sizes that are too large.

These washouts are when the fickle traders disappear. First they feel stress and lose sleep. Then they are forced out at big losses feeling lucky [hopefully] to have escaped with something. After a period of reflection, they finally walk away—head down and tail between their legs—possibly never to talk about or discuss this with anybody. After the grieving is complete they pull themselves up by the bootstraps and move onto the next big thing.

On multiple occasions I have seen people present impressive performance records punctuated by pauses during sudden market pullbacks/corrections. How lucky they were to have been vacationing at the worst times! I wouldn’t call any particular individual a blatant liar but they certainly are out there.

I think a good strategy meets profit goals within risk tolerance levels net losses—and there will always be losses! Anyone presenting a large sample size of trades without losses is a liar and someone to avoid because that is not reality.

The takeaway here is nothing new: THERE WILL ALWAYS BE LOSSES! As a trader I need to accept this before I begin the journey and strive to always size my positions accordingly. Failure to do this can potentially end my trading career, which on a larger scale, results in the recycling of market participants.

Recycling of Market Participants (Part 1)

On the heels of this post, I recently stumbled upon the following July 2015 thread from a covered calls forum that I saved.

Sun Jul 12, 2015 12:22 pm (PDT) . Posted by AS:

Where is everyone???

Sun Jul 12, 2015 12:55 pm (PDT) . Posted by SP:

Probably vacationing.

Sun Jul 12, 2015 3:21 pm (PDT) . Posted by SB:

People like talking when they make money, remain silent when they lose it. How have covered calls in general done over the last few weeks?

Sun Jul 12, 2015 9:48 pm (PDT) . Posted by JW:

I am thinking SP has if correct, a lot of folks are away for the summer break. This is traditionally a very slow time of year. One member states on the bottom of his posts that “boring is better.” That is certainly the case with myself. There are periods when I feel like I am on a perpetual vacation here… My “job” truly is like watching paint dry. Most of this group will not want to read about each time I pull the trigger on my boring income trades.

Mon Jul 13, 2015 5:03 am (PDT) . Posted by Mark:

On this point I very much disagree with you. Yes, “boring is better” but people are usually losing money when these type of trades are not boring.

I think SB is right on: “people like talking when they make money, remain silent when they lose it.”

This is just my opinion because it’s not something we can ever know for certain.

On Jul 13, 2015, at 3:10 pm (PDT) . Posted by MM:

Or some people aren’t participating.

I’ve been in cash for some months with only a few selective trades which aren’t in options. It’s been a time to be very, very selective in my opinion.

On Jul 13, 2015, at 4:37 pm (PDT) . Posted by MA:

I, for one, have been very busy at work and haven’t had the time it takes to do this right, so I’ve been on the sidelines for the past few months, which appears to be a good place to be with all the turmoil going on with Greece and the market’s reaction.

On Jul 13, 2015, at 4:44 pm (PDT) . Posted by JW:

Many new traders think they are not trading when they are in cash. I think those who have been in the battle for a while know well that cash is a position you chose and there are times that it is the best position.

One thing I have grown very cautious about is posting our bragging rights trades. For example, we did a series of trades on JRJC… [and] nailed returns as high as 13% per monthly cycle selling put options…

I dislike posting these positions for two reasons. I have had a few folks call me a liar when they could not replicate the trade a few days later because the stock took off and they did not have the patience to wait for the right entry opportunity. The other reason is I do not like encouraging newbies to work with volatile issues like JRJC until they have experience and a good plan of how to handle the trade if the tide turns against them.

To be continued next time.

Back to the Future

Over the last few years, the ambitious side of me as been asking “what next?”

I have done a solid job managing my decent-sized portfolio since leaving pharmacy in 2007. I have learned enough to become an option trading “expert.” I have developed a trading business that I continue to operate daily. I have posted annual returns approaching 15%. I have begun to take on “friends and family” accounts.

My next step could involve finding other full-time retail traders with whom to collaborate and develop new strategies. In doing so, I would grow as a trader and develop additional streams of income. Unfortunately, collaboration is hard to find as I have found few other “equals” interested in my work.

Another possibility could involve taking definitive steps to enter the wealth management business. I hesitate to launch an investment advisory because I don’t see a clear path to the assets deemed necessary to make this pursuit worthwhile. My ideal situation would be a [handful of] qualified investors[s] each willing to invest seven figures with me. A small number of clients would allow me sufficient time to trade daily in separately managed accounts. Tens to hundreds of [smaller net-worth] clients would require me to take custody in order to trade all assets at once in a hedge fund. This would require a higher level of trust for someone with no industry experience.

Finding high net-worth clients is probably a necessary hurdle to clear because hedge funds with non-accredited investors face additional challenges (blog topic for another day).

Getting institutional money would be perfect but I suspect this would require an officially audited track record that I do not have. My accountant can testify to my performance but he doesn’t get paid to audit.

To this end, I have considered starting an incubator fund but this would leave me with nothing to offer at the time of presentation. The incubator could be officially audited but no outside investors are permitted.

On the way to a career in wealth management, I suspect the journey must involve putting my performance on display for others. In general and clear terms, I need to something to pitch what I do and how well I do it. I then just need someone to give me a chance—maybe someone willing to start off with a relatively small sum of money that we can [hopefully] watch grow together!

Money for Nothing?

Dire Straits! While I love the song, no longer do I think it characterizes premium trading groups that charge for attendance.

In June 2015, I was irked to see a new trading group for $15/meeting. I e-mailed the organizer to verify: “as in $780/year?”

“It costs $100 for a day of golf,” he replied. “This is a good value.”

Although I enjoy watching on TV, I have never been a golfer.

Charging for a group like this was something I truly despised about the financial industry. I viewed the category of self-directed traders as bifurcated between the traders themselves and the set of companies looking to profit off them. The latter sells mentoring, trader education, market software, coaching, etc.

I could accept raising funds to cover group expenses but I could not accept raising funds simply to pad pockets. I considered myself to be in the business of trading—not a business of the just mentioned that would involve marketing, sales, or advertising. As a group of equals, I figured what a trading group had to offer me was what it had to offer every member: new ideas to bolster trading income. Why should the organizer alone, then, profit from its formation and attendance?

One reason I have since had a change of heart is because this is not a group of equals. I have unsuccessfully searched for others with a full-time trading business (see here, here, and here). I have found many who say they want to learn. I have found some who describe themselves as [inconsistent and] “part-time.” I have found more stock traders who know nothing about options. If the group I form will not be a group of equals and they have more to gain from an informational exchange than I do, a per-session charge is justified as an investment for their future.

My second objection to free trading groups involves accountability. I blogged about this here but the seeds for this belief were planted much earlier. On July 19, 2015, I wrote:

     > I’ve said this recently but I strongly believe it takes a
     > lot of time and effort to make substantial money trading.
     > It takes constant, continuous commitment. I almost believe
     > one must approach trading as a business whether it actually
     > is or not. I think the time dedicated to learning and
     > practicing will ebb and flow and without a maximal
     > level of devotion, when that time ebbs much of what
     > was gained during the flow will be lost.

We hope that with experience comes wisdom. I have changed my tune with regard to investment advisers. I have changed my [Dire Straits’] tune with regard to premium trading groups as well.

Standard Deviation of Returns (Part 2)

I left off by illustrating how standard deviation (SD) of returns is greater for my new friends-and-family account than for the underlying index.

I think of naked puts (NP) as having a significantly lower SD of returns so this was puzzling. Is it a bona fide finding?

Applying the rolling-returns rationale, we can observe SD to be lower for NPs (red line) most of the time. When the market pulled back, SD moved higher for the NPs and has remained higher to date.

Max drawdown (MDD), also discussed in the previous post, would produce a similar result. MDD was roughly 4.8% and 6.6% for the NPs and underlying index, respectively. Despite the small sample size, this is a significant difference in favor of NPs.

I calculated risk-adjusted return (RAR) by dividing total return by SD of returns. This improved NP return from 6.41% to 6.66% and benchmark return from 0.12% to 0.17%. On a percentage basis this represents a much greater improvement for the benchmark but the magnitude of numbers is so disparate that the NP return is still far greater.

Weighing all the evidence, even if the finding is real it certainly may not be relevant.

But then I stumbled upon a solution.

The finding is real and a function of the leverage ratio. Leverage ratio is notional risk of the account divided by net liquidation value. It makes sense to say the more NP positions I hold, the wider account value swings I will see. The underlying index has no position size so its SD will remain constant. Studying SD of the daily account value changes is probably not very meaningful for this reason.

If I wanted to compare SD between NPs and the underlying index then looking at a large sample size of matched trades would probably be best. As one example, suppose I shorted a 700 put. The notional risk is 700 * $100/contract = $70,000. I would therefore use $70,000 as the initial account value and calculate the SD of daily % changes in account value until position close. For the underlying index, I would start out by purchasing a number of shares equal to $70,000 / index price. Daily index account value then equals number of shares multiplied by the index value on each day. From that I could calculate SD of the daily % changes. These two SDs could be compared.

So there you have it: leverage ratio is the culprit making my SD of returns larger than the benchmark! As long as the total returns are significantly better, though, I don’t expect much client pushback.

Standard Deviation of Returns (Part 1)

I have recently begun to trade a small friends-and-family account. In running the early numbers, I was surprised to see standard deviation (SD) of returns tracking higher for the portfolio than for the benchmark.

Based on my trading/research experience, naked puts (NP) generate comparable returns to the benchmark with a significantly lower SD of returns.

The best analysis I have between long shares and NPs may be the second graph shown here. In that analysis I did not calculate the total but using my naked eye and this online calculator, the NP portfolio returns 8.69% per year vs. 11.17% per year for the benchmark. That is not “comparable” returns—it’s a smackdown by the benchmark.

The graph does show this return comparison to be date sensitive. Just three months earlier (1.65% of the entire backtesting horizon), the NPs had a higher ROI than long shares. Across the whole graph, the NP line (red) beats long shares (blue) ~2/3 of the time. Statistically speaking, I worry about this inconsistency. Perhaps a rolling analysis should be done to get a larger sample size than just a single-point comparison, which may not be representative.

In the previous study I used maximum drawdown (MDD)—not SD of returns—as a measure of risk. When I looked at risk-adjusted return (RAR), the NP portfolio significantly outperformed despite the smackdown mentioned above.

Now let’s move forward and study the NP portfolio I have been trading for 1/6 year. I track the cumulative return for the portfolio and for the underlying index:

Cumulative % Return NP vs. RUT index (6-21-17 to 9-5-17)

This is consistent with what I have come to expect from NPs. The equity curves are similarly shaped. The underlying index or NPs can outperform when the market is higher or lower, respectively.

I calculate daily % returns so I can monitor the SD of both:

SD comparison between NP and RUT index daily % change (6-21-17 to 9-5-17)

The NP portfolio shows a larger SD of returns than the benchmark! How can that be?