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Credits: Mark McDowell, Robert Tharp, Van Tharp, Ken Long, Frank Eaves
Bear Market Strategies
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Credits – Evolution of the Bear Workshop
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▪ Mark McDowell – this is dedicated to him – Creator and instructor for Bear Workshop v2.0. RSI(2) trader. Bear market phases
▪ Robert Tharp – Original Bear Market Strategies creator, RSI(2) & Rocks & Rockets originator/trader
▪ Van Tharp – Author and presenter of v1.0, NCAV system, Tharp Think, market type etc.
Other Contributors: ▪ Ken Long
– Market type methodology, day trading methods, learning journal, Brown’s permanent results, volatility monitoring etc.
▪ Frank Eaves – NCAV research & back testing
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My Professional Background
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▪ 1989-1991: Equity & Derivative Research, London Life Insurance Co.
▪ 1991-1993: Equity & Commodity Derivatives, Citibank Canada
▪ 1992-1996: Cooper Panko & Partners, Investment Management
▪ 1993-1996: Head of Equity Derivative Trading, Citibank Canada
▪ 1996-1999: Equity Proprietary Trading, Deutsche Bank Canada
▪ 1999-2007: Equity, Fixed Income, and Alternative Investing, Self-Employed
▪ 2007-2013: Managing Partner, Portfolio Manager, GMPIM LP
▪ 2013-2015: Senior Portfolio Manager, Fiera Quantum LP
▪ Present: Trading, VTI Instructor, ST2 Candidate, Self-Employed
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My Education & Certifications
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▪ Commodity Trading Manager (2010)
▪ Investment Counsel & Portfolio Manager (2007)
▪ Masters of Transpersonal Psychology (2005)
▪ Chartered Financial Analyst (1996)
▪ Bachelor of Mathematics (1993)
▪ Canadian Investment Finance (1992)
▪ Canadian Securities Course (1989)
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My Psychological Profile
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▪ Myers Briggs: I-N-T-J - The Architect
▪ Enneagram: Type 3 - Achiever
▪ VTI Trader Test: Strategic Trader
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My Passions
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Self-Development
Spirituality
Trading
Making money Role model
Who AM I?
Challenge My potential
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Dream Life: Experience life to its Full Potential being happy, healthy, wealthy and wise
Life’s Purpose: To Inspire (in-Spirit) by fully embracing Who I Am, creating Abundance in All-Ways
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Bear Market Experiences – S&P500
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Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec YTD
2006 6.04 6.16 1.38 14.23 -0.42 29.82
2007 3.15 1.51 -0.46 4.25 4.78 -1.28 -3.06 0.60 3.65 3.33 0.02 n/a 17.41
2008 n/a n/a n/a -1.21 6.41 3.20 1.74 -0.90 0.41 5.45 2.56 1.67 20.76
2009 1.46 -0.76 -0.73 3.67 -0.67 1.79 0.22 4.03 3.59 -2.40 5.45 2.33 19.17
▪ 1987
▪ 1998 – proprietary trading
▪ 2001 – ‘sabbatical’ & research
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Objectives
“…the future belongs to those who prepare for it today.” - Malcolm X
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Beliefs Disclaimer
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▪ “…you trade your beliefs about the markets…” – Van Tharp
▪ This workshop reflects my beliefs and/or the beliefs of those that have presented the material prior.
– They MUST fit you – They MUST be useful to you – create your map
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Workshop Primary Objective
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▪ Assist with your bear market preparation:
– Provide you with tools to trade a bear market with confidence
– Allow you to begin (or continue) to develop a bear market trading plan that fits you – there will be homework to do to integrate material!!
– Be in a position to profit from bear markets (or at a minimum get more out of bull markets)
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Workshop Objectives
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▪ Learn methods to identify and define bear markets ▪ Understand what causes market cycles and what to monitor in terms of
the big picture ▪ The importance of market psychology in bear markets ▪ Provide an introduction to options - consider if using them suits you ▪ Provide an introduction to hedging techniques and strategies ▪ Learn several strategies & systems for bear markets (for the beginning,
middle and ending phases) ▪ Applying Tharp Think to bear markets trading including:
– Learn about the psychology (self) of trading in bear markets – The importance of setting objectives – System development plan/process
▪ Outline your next steps to develop your plan for trading bear markets ▪ Network with other traders during and after the workshop
– Set up personal accountability / inspiration
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Outline
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Overview of Workshop – Outline
Self
SystemMarket
Big Picture
▪ Psychology ▪ Objectives ▪ Business / Trading Plan ▪ Networking
▪ Options ▪ Hedging ▪ Strategies ▪ Systems ▪ Development ▪ Position Sizing
▪ Identification ▪ Characteristics ▪ Market Psychology
▪ Monitoring
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Workshop Outline
14
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Part One = Day 1 ▪ Introductions = people here are resources ▪ Overview of bear markets ▪ Big picture view – what to look for? ▪ Identification – bear market type ▪ Market Psychology ▪ Introduction to options ▪ Introduction to hedging
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Workshop Outline
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“Pre” Examples Beginning During End
All Weather Cash / stop loss RSI(2) NCAV
Brown’s Permanent Hedging: futures, ETFs, Shorting
Rocks & Rockets Sell puts on quality
Volatility targeting Fake Out Sell options –delta hedge
Hedging: puts Option Spreads Option spreads
Hedging: puts & covered calls
Prepare for bull market…
Defensive portfolios Faber10SMA
Option spreads Buy Dips
Part Two: Strategies and systems
Part Three: Trading Bear Markets
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Big Picture Frameworks
“To eliminate emotional risk, neutralize your expectations of what the market will do.” - Mark Douglas
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The A HA! Moment What I think about it/ How it connects
What I will DO about it ResultsTrader’s Learning Journal Date:
Learning Journal reprinted courtesy of Ken LongBear Market Strategies © 2020 Van Tharp Institute, Inc. All Rights Reserved.
The reproduction or transfer of this material is prohibited by the Van Tharp Institute student agreement.
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The A HA! Moment What I think about it/ How it connects
What I will DO about it Results
What got my attention? How does it relate to what I already know?
What actions will I take based on the insight?
What were the results of my actions?
What did I notice that’s new information?
What material is new to me?
What can I do that will help me implement this idea?
Did the results meet my expectations?
What did I just learn / realize / see / hear that seems useful ?
How does this connect with or relate to my beliefs?
Who do I need to talk with to get more information?
Are there additional steps or action items I should consider?
What insight do I have about the material being presented?
What other aspects of my trading might be affected by this insight?
What additional questions do I have?
Did the implementation generate new insights or ideas that were new “A HA!” moments?
Trader’s Learning Journal Date:
Learning Journal reprinted courtesy of Ken LongBear Market Strategies © 2020 Van Tharp Institute, Inc. All Rights Reserved.
The reproduction or transfer of this material is prohibited by the Van Tharp Institute student agreement.
The headings above are the 4 columns of the Trader’s Learning Journal
The questions below are intended to help you fill out the Learning Journal. Be creative. Keep notes on anything that may be useful or needs more explanation.
The Learning Journal will help you get the most value out of this workshop. It will help you remember what you found most valuable and what you intended to do
about it.
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The Big Picture: Economy
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▪ How will you monitor it?
▪ Example: How the Economic Machine Works – Take notes, get ideas – build your plan – Ray Dalio, Bridgewater
▪ http://www.economicprinciples.org/
http://www.economicprinciples.org/http://www.economicprinciples.org/http://www.economicprinciples.org/
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The Big Picture Beliefs – Dalio Discussion
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Government ▪ Central Government – collects taxes and spends money ▪ Central Bank – controls the amount of money and credit by influencing interest rates and printing $ Credit ▪ The most important part of the economy – biggest and most volatile ▪ Spending drives the economy - ones persons spending is another person’s income ▪ Short term debt cycle
– 5-8 years – Credit not available = recession – Credit available = expansion
▪ Long term debt cycle – 75-100 years – Credit bubble caused
▪ Inflation: when amount of spending and incomes grow faster than the production of goods, prices rise – central banks raise interest rates and fewer people can afford to borrow $ and cost of servicing debt rises. Spending slows and incomes drop.
▪ Deflation: when less spending causes prices to fall ▪ Recession: when economic activity decreases. Then central bank will lower interest rates, etc.
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The Big Picture – Reducing Debt Burdens
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1. Cut spending – austerity – But causes incomes to fall faster than debts do – Higher unemployment – Deflationary
2. Reduce debt - through defaults and restructuring – Banks squeezed – Deflationary
3. Redistribute wealth – From wealthy to unemployed – Deflationary
4. Print money – Inflationary and stimulates – Buying assets – only helps those who own financial assets – Central bank must work with central government
Beautiful Deleveraging – Balance of spending cuts; reducing debts; transferring wealth and printing money – debts
decline relative to income; real economic growth is positive; inflation not a problem – Economic and social stability maintained – Incomes must rise faster than debt
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The Big Picture – Monitoring Plan Example
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▪ {R + I – B} > {S – T} ▪ Note: 1 million seconds = 12 days; 1 billion seconds = 31 years; 1 trillion seconds = 31,000 years
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The Big Picture – Monitoring Plan Example
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▪ US GDP$ ~ 18.5 trillion ▪ R = 2.6% GDP ▪ I = 1.5% ▪ B = 2.5% 10 Year Yield ▪ S = 3.9T / 18.5T = 21.1% ▪ T = 3.3T / 18.5T = 17.8%
▪ {R + I – B} = 2.6% + 1.5% - 2.5% = 1.6%
▪ {S – T} = 21.1% - 17.8% = 3.3%
▪ {R + I – B} ⬄ {S – T} ???
1.6% < 3.3%
▪ {Real Output + Inflation – Borrowing Costs} > {Spending – Taxes}
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The Big Picture: Governments
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▪ Decisions that impact the trading game ▪ Geo-political issues ▪ Elections / Referendums ▪ Wars / Conflicts ▪ Sanctions / Trade wars ▪ Trade pacts / Treaties ▪ Protectionism – Tariffs ▪ Taxation ▪ UN / NATO etc.
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The Big Picture: Elections & the Euro Zone
▪ Netherlands March 15, 2017 ▪ France April 23, 2017 ▪ Germany September 24, 2017? (between August 27 – October 22)
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The Big Picture: Governments
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▪ Ray Dalio & Timothy Geithner ▪ Full Interview At Delivering Alpha (Sept 2016)
▪ What are some things that make you think about your monitoring of the big picture?
(Revised Link)
https://www.cnbc.com/video/2016/09/19/ray-dalio-and-timothy-geithner-delivering-alpha-unfiltered.html Ray & Tim 33min
https://www.cnbc.com/video/2016/09/19/ray-dalio-and-timothy-geithner-delivering-alpha-unfiltered.htmlhttps://www.cnbc.com/video/2016/09/19/ray-dalio-and-timothy-geithner-delivering-alpha-unfiltered.html
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The Big Picture – Government
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▪ US Economic Policy Uncertainty Index
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Big Picture example - Presidential Cycle?
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▪ Does the Presidential cycle matter?
▪ Average = 1.87 years into
presidential term
▪ 2008: Mar’09 ▪ 2012: n/a or ~ Nov’12 ▪ 2017: ?
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The Big Picture: Monitoring Trading Firms
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▪ Stock Price (if available) ▪ Quarterly Earnings Releases ▪ CMBX – debt insurance (if available) ▪ Market Share Analysis ▪ Personal Contacts – Brokers etc. ▪ Your experience ▪ Depositor Insurance in your country
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The Big Picture: Trends - Example
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▪ Eastman Kodak: – In 1998, Kodak had 170,000 employees and sold 85% of all photo
paper worldwide
– 3 years later you would never take pictures on paper film again
– Market capitalization peaked around $25 Billion
– Digital cameras were invented in 1975 - the first ones only had 10,000 pixels, but they followed Moore's law…
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The Big Picture: Markets
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▪ Equities (Indices, ETFs, Stocks) – Developed & Emerging
▪ Debt / Rates – Government (federal, state, muni) – Corporate (investment, high yield) – Developed & Emerging
▪ Commodities (Energy, Currency, Metals, Agriculture, Livestock, etc.) ▪ Spot Currencies ▪ Real Estate (liquidity and transaction cost considerations) ▪ Collectables (liquidity and transaction cost considerations)
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The Big Picture: Markets
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The Big Picture: Markets
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The Big Picture: Markets
34
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▪ VIX traded close to lows as Donald Trump entered the office. But the cost for hedging tail risk spiked
up to highs! CBOE SKEW Index ("SKEW") is an index derived from the price of S&P 500 tail risk.
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The Big Picture: Markets
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The Big Picture: Markets Example
36
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▪ What is important to monitor for the markets you are trading?
▪ Are there opportunities that can be monitored for trades?
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The Big Picture: Markets - Sentiment Indicators
37
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Definition: ▪ A Sentiment Indicator is a graphical or numerical indicator designed to show how a group
feels about the market, business environment or other factor.
Examples: ▪ Put-Call Ratio: is calculated by dividing the number of traded put options by the number of
traded call options. As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to hedge their portfolios in case of a sell-off.
▪ AAII Sentiment Survey ▪ U of Michigan US Consumer Sentiment ▪ The Commitments of Traders (COT) reports provide a breakdown of each Tuesday’s
open interest for markets in which 20 or more traders hold positions equal to or above the reporting levels established by the CFTC. Reports are available in both a short and long format. The short report shows open interest separately by reportable and non-reportable positions.
http://www.investopedia.com/terms/i/indicator.asphttp://www.investopedia.com/terms/p/putoption.asphttp://www.investopedia.com/terms/c/calloption.asphttp://www.investopedia.com/terms/h/hedge.asphttp://www.investopedia.com/terms/s/sell-off.asp
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The Big Picture: Markets - TED Spread ▪ 3 month Eurodollar minus 3 month US T-Bills ▪ Indicator of credit risk
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Correlation – Single Stocks vs. S&P500
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▪ Using SPX options prices, together with the prices of options on the 50 largest stocks in the S&P 500 Index, the CBOE S&P 500 Implied Correlation Indexes offers insight into the relative cost of SPX options compared to the price of options on individual stocks that comprise the S&P 500.
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The Big Picture: Self
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▪ Ongoing Training & Education ▪ Physical Fitness ▪ Personal Psychology ▪ Business Planning ▪ Vacations / Down Time / Recharging ▪ Goals / Objectives ▪ Mistakes Analysis
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The Big Picture: Base Currency
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▪ How will your base currency fair during a bear market? ▪ What are your exposures?
– In what currency is your trading account denominated? • Profits / Losses
– In what currency do you make money? – In what currency do you have liabilities/expenses? – What is the impact to the goods and services you consume?
▪ Other considerations?
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The Big Picture – Monitoring Plan Example
42
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▪ Bloomberg Markets [email protected] ▪ 5 things to start your day February 9, 2017
mailto:[email protected]
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The Big Picture: Monitoring sources
43
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▪ https://tradingeconomics.com/
https://tradingeconomics.com/
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The Big Picture – Monitoring Sources
44
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Source Source
www.forexfactory.com www.cnnmoney.com
alerts.google.com www.bigcharts.comfinance.yahoo.com www.cboe.comwww.quicken.com www.nyse.com
www.Bloomberg.com www.nasdaq.comwww.stockcharts.com Bloomberg TV
www.cbsmarketwatch.com CNBC TVhttp://www.tradingeconomics.com [email protected]▪ What are some other good sources to consider?
Van’s monthly SQN report
http://www.tradingeconomics.com/mailto:[email protected]
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The Big Picture
46
Bear Market Strategies S1703B © 2020 Van Tharp Institute, Inc. All Rights Reserved.
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▪ Must be useful to you ▪ Can involve very little effort or a great deal of analysis
Max: Comprehensive overview & Analysis
NOTE: see example from Robert van Paridon in appendix
Select Specific Opportunity &
Research
Min: Self, Broker & System(s)
DANGER
:
BALANC
E
REQUIRE
D
NOTE: See example from Robert Van Paridon in appendix.
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Markets and Market Type
“The most intelligent way to trade is to confess you don’t have a clue where the markets are going.” - Hugh Johnson
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What is the Purpose of Market Type?▪ Market type answers the question:
– Has the market has been going up, down or sideways?
– Has it shown the same, more, or less volatility compared to the past?
▪ Market type is NOT predictive. It does not predict what the next period (day, week, month) will be like.
▪ We use market type to tell us which trading systems to use, because trading systems work best in the market type for which they were designed.
48
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Determining Market Type▪ The simplest way – look back at chart
– Is the market going up, down or sideways for that timeframe? – Is it more or less volatile than it was before?
▪ But - how to make it more objective / useful?
49
Up, normal volatility
Sideways, normal volatility
Down, high(er) volatility
Down, normal volatility
Sideways, high(er) volatility
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Determining Market Type
Why knowing the market type is important: • Trading systems do not work in all market types • Determine which trading systems will work in each market type • Use trading systems based on when they are most effective • When the trading system isn’t aligned with the market type, stop using it
When to look for bear markets: • When market moves from bull to sideways • When volatility begins trending up • Market begins to make lower highs and lower lows
50
Side-ways
Bear
Bull Normal
Volatile
Quiet
Market Classification Volatility
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Calculating Market Type
51
While observation can
be useful, we can use data to
calculate market type
Use historical price data to calculate the
direction price has been moving
Use historical price data to
calculate volatility
compared to volatility in the
past
Examples of categories: For direction: 1) up - down - sideways 2) strong bull – bull – neutral – bear – strong bear
For volatility: 1) low – normal – high –
very high
Examples: Timeframe: intraday, daily, weekly Stats used: SQN, MA, RL? Price data: close? high? mid-point?
Choose lookback period: 1) 5 to 10 days for intraday system 2) 30 to 100 days for swing system 3) 100 to 200 days - trend following
Examples: Average true range (ATR)
Standard deviation (SD)
Historical volatility (HV)
Implied volatility (IV)
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Determining Market Type
52
▪ Linear Regression Line – Linear Regression Line finds the “best fit” for a set of data points – Select a look back period consistent with trading system – Slope indicates market type (up – sideways – down) – Add a calculation to measure volatility (e.g., ATR compared to historical ATR) – Use multiple timeframes to show potential turning points
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Market Type – Van Tharp▪ Dr. Van Tharp’s methodology
– Updated every month in the VTI newsletter – Calculated using System Quality Number (SQN)
53
Measure daily percent changes of SPY for 100 days and then calculate the SQN • SQN > 1.47 is Very BULLISH • SQN between 0.75 and 1.46 is
Bullish • SQN between 0 and 0.74 is
neutral • SQN between 0 and -0.7 is
Bearish • And SQN below -0.7 is very
Bearish
Measure volatility • Calculate daily average true range
(ATR(20)) as percentage of daily close and determine the mean and standard deviation for all 20 day windows
• ATR% > 3 standard deviation above mean is Very Volatile
• ATR% between 0.5 and 3.0 standard deviation above mean is Volatile
• ATR% between -0.5 and 0.5 standard deviation from mean is Normal
• ATR% < -0.5 standard deviation from mean is Quiet
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Dr. Van Tharp Market Type – from IITM newsletter
54
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Market Type – Ken Long
▪ Market Type – from Ken Long’s market type (chart on next page) • Bull market: SPY price >= 2% above 200 day moving average • Bear market: SPY price +1 SD from
average • Ken’s market type is also available
from his Daily Reports (Tortoise Capital Management)
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Example of Market Type - Ken Long
56
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Comparison of Market Type: Tharp vs. Long Tharp’s Market Type (same period as previous slide)
57
Strong Bull Bull Neutral Bear
Quiet Normal Volatile
Direction based on Market SQN for 100 day period
Volatility based on ATR% for 20 day period
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Comparing Market Types – Tharp vs. Long
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• For this time period: • Bull, neutral/sideways and bear types are similar, with
Van’s market type highlighting the bear earlier than Ken’s market type
• Volatility types are sometimes different between the two approaches
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How to Determine Market Type
▪ Other methods for market type: – Moving average crossovers
• Example: SPY’s 100 day moving average crosses below 200 day moving average
– Price closes below moving average • Monthly moving average: 4, 6, 8, 10 months
– ADX (Average Directional Index)
59
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Another Version of Market Type
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▪ Direction: Regression Slope(100) – Is the slope positive, negative or close to flat?
▪ Volatility: Historic Volatility(20) – Is the historic (close to close) volatility over 20 days greater than +1 standard deviation, below -1 or
within -1 to +1?
-
Another Version of Market Type
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▪ Direction: Regression Slope(100) = slope of line of best fit over 100 days RS(100) = [Value RS(100)n – Value RS(100)n-100] / 100
– Up more than 2% – Sideways within 2% of flat – Down more than 2%
▪ Volatility: Historic Volatility(20) = standard deviation of price returns H.Vol(20) = StdDev [ln(Closen/Closen-1)] x Sqrt(252)
– High when greater than 1 standard deviation (16% of the time) – Normal when within 1 standard deviation (68% of the time) – Low when less than 1 standard deviation (16% of the time)
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Psychology of Bear Markets
https://www.youtube.com/watch?v=hashPaU7Dpk eTrade
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https://www.youtube.com/watch?v=hashPaU7Dpkhttps://www.youtube.com/watch?v=hashPaU7Dpk
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Psychology in Bear Markets
63
Graphic: http://wdongli.wordpress.com/
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Cognitive Biases – Drive Market Behavior
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Cognitive Biases – Drive Market Behavior
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Cognitive Biases – Drive Market Behavior
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▪ See article in Appendix on Behavioral Finance
-
Loss Aversion / Prospect Theory
▪ Loss aversion is encapsulated in the expression “losses loom larger than gains” (Kahneman & Tversky, 1979)
▪ Pain of losing is psychologically about twice as powerful as the pleasure of gaining ▪ People are more willing to take risks to avoid a loss ▪ Loss aversion can explain differences in risk-seeking versus aversion ▪ It is associated with prospect theory ▪ Loss aversion has been used to explain the endowment effect and sunk cost fallacy, and it may also
play a role in the status quo bias
▪ Know this exists within market psychology – don’t allow it in your psychology
Sources: ▪ Gächter, S., Orzen, H., Renner, E., & Starmer, C. (2009). Are experimental economists prone to framing effects? A natural field experiment. Journal of Economic
Behavior & Organization, 70, 443-446. ▪ Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-291.
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http://www.behavioraleconomics.com/endowment-effect/http://www.behavioraleconomics.com/sunk-cost-fallacy/http://www.behavioraleconomics.com/status-quo-bias/http://www.behavioraleconomics.com/status-quo-bias/
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Beliefs about bear markets – any useful?
Quiet Bear: ▪ Rare to non-existent ▪ Pessimism ▪ Lack of interest ▪ Low volume ▪ Early – inst. quietly selling ▪ End – inst. quietly buying ▪ Little news ▪ At end of bear ▪ After sideways? ▪ Time to buy options?
70
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Volatile Bear: ▪ Violent ▪ Crashing ▪ Oversold? ▪ Fear ▪ Stops ▪ Gaps ▪ Liquidity ▪ Regulation changes ▪ Policy changes ▪ Margin calls ▪ Bankruptcies ▪ Underwritings down ▪ Safe havens sought ▪ Money tight - scared
Other: ▪ Stops get hit causing more downward
pressure ▪ Lack of stops or rule-based systems
causes panic selling ▪ Fear is the driving market force ▪ The safest place for money is cash ▪ I just want to get out! ▪ Stocks are on sale ▪ Best time to buy stocks ▪ Volatility increases ▪ Odds of prices going down are higher ▪ Irrational behavior ▪ Gaps occur – SL not filled ▪ Liquidity at risk ▪ Illiquid securities more risky ▪ Margin calls ▪ Financial system at risk ▪ Guns and gold ▪ I’m not going through this again
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“Everything” goes down
Volatility goes up
“Average” investors take a long time to recover
and re-enter the market
Traders just want to get out
at any price
Fear and panic are common emotions
Most people have a “long”
bias – we prefer to be buyers of
stocks
Psychology in Bear Markets
71
Photo: http://livinglifewithchemobrain.blogspot.com/
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Options and Hedging
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Option Terminology - Test
▪ Strike: _____________________________________________________________________________________ ▪ Expiration or Maturity: _________________________________________________________________________ ▪ Call: _______________________________________________________________________________________ ▪ Put: _______________________________________________________________________________________ ▪ Write: ______________________________________________________________________________________ ▪ Open: ______________________________________________________________________________________ ▪ Close: ______________________________________________________________________________________ ▪ Premium: ___________________________________________________________________________________ ▪ Money-ness: ________________________________________________________________________________ ▪ Intrinsic Value: ______________________________________________________________________________ ▪ Time Value: _________________________________________________________________________________ ▪ American: __________________________________________________________________________________ ▪ European: __________________________________________________________________________________ ▪ Historic Volatility: ____________________________________________________________________________ ▪ Implied Volatility:_____________________________________________________________________________ ▪ Contract Size: _______________________________________________________________________________ ▪ Delivery: ___________________________________________________________________________________ ▪ Style: ______________________________________________________________________________________ ▪ LEAP: ______________________________________________________________________________________ ▪ Time decay: _________________________________________________________________________________ ▪ Margin: ____________________________________________________________________________________ ▪ Delta Hedging: _______________________________________________________________________________ ▪ Underlying: _________________________________________________________________________________ ▪ Exercise: ___________________________________________________________________________________ ▪ Delta: ______________________________________________________________________________________ ▪ Gamma: ____________________________________________________________________________________ ▪ Rho: _______________________________________________________________________________________ ▪ Theta: _____________________________________________________________________________________ ▪ Vega: ___________________________________________________________________________________________________________
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Options - Introduction ▪ An option is a contract to buy or sell a specific product (underlying) at a specified price (strike) at (or
over) a predetermined time (expiry or maturity)
▪ A call option gives the buyer the right (but not the obligation) to buy (i.e. call the product away from the seller)
▪ A put option gives the buyer the right (but not the obligation) to sell (i.e. put the product to the seller)
▪ A seller is giving the buyer these rights for a price (premium)
▪ Uses: – Hedging – Generating Income – Speculating
74
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Call Payoff Diagram ▪ A call option gives the buyer the right to purchase the underlying at the strike ▪ Long = a bullish view ▪ Short = generally a bearish view, or used to generate income Note: Max loss on short is theoretically unlimited
75
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Put Payoff Diagram ▪ A put option gives the buyer the right to sell the underlying at the strike ▪ Long = a bearish view ▪ Short = generally a bullish view, or used to generate income Note: Max loss on short = strike price – 0
76
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Options and the Assumption of Normality
▪ It is assumed that asset prices (stocks etc.) follow a normal distribution ▪ This makes the math easier in option pricing and in virtually all areas of
quantitative finance
IT IS AN OVER-SIMPLIFICATION AND IS INCORRECT
77
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Normal Distribution
▪ A process that is normally distributed says that a 6 sigma event has a 1 in 500 million chance of occurring…
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Normal Distribution
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Kurtosis: Measure of tails. - Normal = 3. Greater 3 => more outliers than normal.
Skewness: Measure of symmetry. - Zero = balanced. Positive = tail is on the right.
-
Historic Volatility
Genesis Trade Navigator Example of 20 day Historic Volatility: ▪ MovingStdDev (Log (Close / Close.1) , 20) * SqrRoot (252)
80
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Excel Example:
Hist.Vol = StdDev [ ln( Closen / Closen-1 )] x Sqrt(252)
-
Options - Volatility
▪ Volatility – A measure of asset price movement - how
much a asset price moves up and down – Larger up-and-down movement of the asset
increases the volatility and affects the price of the options, because it increases the uncertainty as to whether the option will expire “in-the-money”
▪ Volatility of the underlying asset is a key factor in determining the value of an option. – As the volatility of a asset increases, an
option's premium will increase (all else equal) – The difficulty of predicting the behavior of a
volatile asset allows the option seller to command a higher price for the additional risk assumed.
81
Graphic: http://www.optionsplaybook.com/
Historical volatility for 2 stocks
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Volatility – Implied vs. Historic
▪ Historical volatility is a measure of price movement based on how the security has behaved in the past - it is a function of historic price movement
▪ Implied volatility is the volatility implied by the option price – i.e. the level sellers are willing to sell and buyers are willing to pay – It also reflects what is expected to occur in the future
▪ Although related - implied does NOT necessarily equal historic ▪ If they vary too drastically arbitragers will intervene
– Buying options and delta hedging when implied vols are too low relative to historic – Selling options and delta hedging when implied vols are too high relative to historic
82
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The Option Greeks
▪ Delta = rate of change of option price for a unit change in the underlying
▪ Gamma = rate of change of delta for a unit change in the underlying
▪ Rho = rate of change of price for a unit change in interest rates
▪ Theta = rate of change in price for a unit change in maturity
▪ Vega = rate of change of price for a unit change in implied volatility
Note: the units of change can vary depending on convention.
83
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Option Pricing Basics - Quiz
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Impact Call Value Put Value
Underlying Price Up
Underlying Price Down
Longer Expiry
Shorter Expiry
Volatility Increases
Volatility Decreases
Interest Rates Increase
Interest Rates Decrease
Other (dividends, storage etc.)
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Option Strategies
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Strategy Objective View Risk Return
Call BuyingProfit from
appreciation Lock in good
purchase price
Neutral to Bullish
Limited to premium Unlimited
Call WritingIncome
Lower cost of purchasing
Neutral to Bearish (covered call
writing may be bullish)
Unlimited if naked
Limited if covered
Only premium received
Put BuyingProfit from down
moves Protect against
losses
Neutral to Bearish
Limited to premium Substantial (i.e. to 0 price)
Put WritingIncome
Lower purchase price
Neutral to Bullish (cash secured
puts may be bearish)
Substantial (i.e. to 0 price)
Only premium received
SpreadsProfit from
differences in value of options
Any Limited Limited
Collars Protect unrealized profits Any Limited Limited
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Option Diagrams
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Option Spreads
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▪ Bull Put: Credit trade. LP + SP. ▪ Bull Call: Debit trade. LC + SC. ▪ Bear Put: Debit trade. SP + LP. ▪ Bear Call: Credit trade. SC + LC.
▪ Calendar: X = X. Different Expiries. ▪ Diagonal: X ≠ X. Different Expiries. ▪ Butterfly: 3 X’s. ▪ Condor: 4 X’s. ▪ Iron Condor: Both Puts & Calls. ▪ Double Diagonal: Short and Long Straddles. Different Expiries. ▪ Ratio Back Spread: Slight credit. Add OTM LP / LC.
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Trading Options – One Methodology
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▪ Source: Options Animal
-
LEAPS – Long Dated Options
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▪ LEAPS = Long-term Equity Antici-Pation Security
▪ Options with a longer time to maturity
▪ Options were originally created with expiry cycles of 3, 6, and 9 months, with no option term lasting more than a year. Options of this form, for such terms, still constitute the vast majority of options activity
▪ Equity LEAPS always expire in January
and…
▪ There are now options that expire weekly
-
Ex: Put Option Chain for SPY as of 09/24/2014
90
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Ex: Put Option Chain for SPY as of 09/24/2014
91
Graphic: optionsXpress.com
Underlying stock
Option chain
Strike prices
Expiration months
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Ex: Put Option Chain for SPY as of 09/24/2014
92
Graphic: optionsXpress.com
Calls expiring Dec 2016
Puts expiring Dec 2016
In the money
Out of the money
At the money
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Ex: Put Option Chain for SPY as of 09/24/2014
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Graphic: optionsXpress.com
In the money
Out of the money
At the money
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Ex: Put Option Chain for SPY as of 09/24/2014
94
Graphic: optionsXpress.com
Implied volatility Delta
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Option Chain Example – with Greeks
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Option Chain Example
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▪ CQG Trader ▪ DOM (depth of market) view ▪ Notice bid / offer spread
-
OptDriver – Option Pricing http://www.fis-group.com
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OptDriver – Option Pricing http://www.fis-group.com
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OptDriver – Option Pricing - example http://www.fis-group.com
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Option Terminology - Test ▪ Strike: Price at which an option can be exercised – price to purchase if a call, price to sell if a put ▪ Expiration or Maturity: when an option contract ceases to exist - expires ▪ Call: provides the buyer the right to buy the asset at the strike price ▪ Put: provides the buyer the right (but not obligation) to sell or “put” the asset at the strike price at/before expiration date ▪ Write: to sell an option ▪ Open: when a new contact is formed ▪ Close: when an existing option contract is reversed ▪ Premium: intrinsic value + time value, price of the option ▪ Money-ness: the intrinsic value. Relating the strike price to the price of the underlying asset ▪ Intrinsic Value: the amount the option is in-the-money (ITM) ▪ Time Value: price of an option less the intrinsic value - the part of the option price that is based on its time to expiration ▪ American: option can be exercised anytime during the options life ▪ European: option can only be exercised at maturity (expiry) ▪ Historic Volatility: the realized volatility of an asset’s price over a given period of time ▪ Implied Volatility: the market’s “forecast” of volatility for the underlying stock – the volatility “implied” by the price of an option ▪ Contract Size: the deliverable quantity underlying an option contract ▪ Delivery: the method of payout of an option generally physical or cash settled ▪ Style: the exercise convention i.e. American, European ▪ LEAP: long term equity appreciation securities – long dated call option ▪ Time decay: the amount of price depreciation that occurs due to the passage of time ▪ Margin: Equity that must contributed by a customer to enter into an option transaction ▪ Delta Hedging: an options strategy that aims to reduce (hedge) the risk associated with price movements in the underlying by
offsetting long and short positions ▪ Underlying: the asset for which the option contract is written ▪ Exercise: buyer invokes the right to sell the stock to writer (seller) ▪ Delta: the amount an option will change in price, based on a dollar change in the underlying stock ▪ Gamma: rate of change of delta for a unit change in the underlying ▪ Rho: rate of change of price for a unit change in interest rates ▪ Theta: rate of change in price for a unit change in maturity ▪ Vega: rate of change of price for a unit change in implied volatility
100
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Hedge Funds
101
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Hedging – “Hedge” Fund Strategies
▪ Equity Hedge – Market Neutral – Fundamental (growth, value) – Quantitative – Sector (technology, healthcare etc.) – Short Bias
▪ Macro – Active Trading (systematic,
discretionary) – Commodity (CTA – commodity trading
advisor) – Currency
102
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▪ Event Driven – Activist – Credit Arbitrage – Distressed – Merger Arbitrage (aka Risk Arb) – Private Issue – Special Situations
▪ Relative Value – Asset Backed – Convertible Arbitrage – Corporate or Sovereign Debt – Volatility Arbitrage – Yield
▪ Multi-Strategy – These funds provide a combination of the above
A hedge fund is an investment fund that pools capital from a limited number of accredited individual or institutional investors and invests in a variety of assets, often with complex portfolio construction and risk management techniques. It is administered by a professional management firm, and often structured as a limited partnership, limited liability company, or similar vehicle. Hedge funds are generally distinct from mutual funds as their use of leverage is not capped by regulators and distinct from private equity funds as the majority of hedge funds invest in relatively liquid assets.
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Hedge Fund Gains
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Hedging – 3 Infamous Failures
Long-Term Capital Management ▪ Had an arbitrage strategy that could take advantage of temporary changes in
market behavior and, “theoretically”, reduce the risk level to zero ▪ A $3.65-billion emergency loan fund was created – enabling LTCM to survive the
market volatility and liquidate in an orderly manner in early 2000.
Amaranth Advisors ▪ The hedge fund's energy trading strategy suffered a loss over $6 billion on
natural gas futures in 2006 in part due to faulty risk models ▪ Amaranth was charged with the attempted manipulation of natural gas futures
prices
Tiger Funds ▪ The value investing strategy (buying stocks with earnings vs. those with none)
hit a brick wall during the 2000 bull market in technology ▪ The greater fool theory prevailed and tech stocks continued to soar and as a
result, Tiger Management suffered massive losses
104
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PART I What are Bear Markets?
"Study the past, if you would like to divine the future.“ - Confucius
https://youtu.be/4GX4W5PBESg eTrade
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https://youtu.be/4GX4W5PBESghttps://youtu.be/4GX4W5PBESghttps://youtu.be/4GX4W5PBESg
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Global Boom and Bust Examples
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U.S. Boom and Bust Cycles 1775 – 1943
107Source: Tension Envelope Corporation
▪ Red = Federal Debt ▪ Green = National Income ▪ Shaded = Business Activity ▪ ▪ - ▪ - ▪ = Stocks ▪ - - - - = Bonds ▪ - - - - = Commodities
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U.S. Boom and Bust Cycles
108
Source: https://www.thebalance.com/boom-and-bust-cycle-causes-and-history-3305803
▪ The National Bureau of Economic Research (NBER) provides the history of boom and bust cycles.
▪ Since 1854, there have been 33 cycles.
▪ On average; – the booms last 38.7 months – The busts last 17.5
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http://www.nber.org/cycles/recessions_faq.html
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U.S. Boom and Bust Cycles Since 1929
109Source: https://www.thebalance.com/boom-and-bust-cycle-causes-and-history-3305803
Cycle Time Comments Cycle Time Comments
Bust Aug 1929 - Mar 1933Stock market crash, higher taxes, Dust Bowl. Bust
Dec 1969 - Nov 1970
Fedraisedrateto9.19%.
Boom Apr 1933 - Apr 1937 FDRpassedNewDeal. BoomDec 1970 - Oct 1973 Fedloweredrateto3.5%.
Bust May 1937 - Jun 1938 FDRtriedtobalancebudget. BustNov 1973 - Mar 1975
Nixonaddedwage-pricecontrols.Endedgoldstandard.OPECoilembargo.Stagflation.
Boom Jul 1938 - Jan 1945 WorldWarIImobilization. BoomApr 1975 - Dec 1979
Fedloweredrateto4.75%
Bust Feb 1945 - Oct 1945 Peacetimedemobilization. BustJan 1980 - Jul 1980
Fedraisedrateto20%toendinflation.
Boom Nov 1945 - Oct 1948 EmploymentAct.MarshallPlan. BoomAug 1980 - Jun 1981
Fedloweredrates.Formore,seeHistoricalFedFundsRates.
Bust Nov 1948 - Oct 1949 Postwaradjustment BustJul 1981 - Nov 1982 Resumptionof1980recession.
Boom Nov 1949 - Jun 1953 KoreanWarmobilization. BoomDec 1982 - Jun 1990
Reaganloweredtaxrateandboosteddefensebudget.
Bust Jul 1953 - May 1954 Peacetimedemobilization. BustJul 1990 - Mar 1991
Causedby1989SavingsandLoanCrisis.
Boom Jun 1954 - Jul 1957 Fedreducedrateto1.0%. BoomApr 1991 - Feb 2001
Endedwithbubbleininternetinvestments
Bust Aug 1957 - Apr 1958 Fedraisedrateto3.0%. BustMar 2001 - Nov 2001
2001Recessioncausedbystockmarketcrash,high-interestrates
Boom May 1958 - Mar 1960 Fedloweredrateto0.63%. BoomDec 2001 - Nov 2007 Derivativescreatedhousingbubblein2006
Bust Apr 1960 - Feb 1961 Fedraisedrateto4.0%. BustDec 2007 - Jun 2009
SubprimeMortgageCrisis,2008FinancialCrisis,theGreatRecession
Boom Mar 1961 - Nov 1969JFKstimulusspending.Fedloweredrateto1.17%. Boom
Jul 2009 - Now
AmericanRecoveryandReinvestmentActandQuantitativeEasing
https://www.thebalance.com/stock-market-crash-of-1929-causes-effects-and-facts-3305891https://www.thebalance.com/what-was-the-dust-bowl-causes-and-effects-3305689https://www.thebalance.com/fdr-economic-policies-and-accomplishments-3305557https://www.thebalance.com/fdr-and-the-new-deal-programs-timeline-did-it-work-3305598https://www.thebalance.com/president-richard-m-nixon-s-economic-policies-3305562https://www.thebalance.com/what-is-the-gold-standard-3306137https://www.thebalance.com/opec-oil-embargo-causes-and-effects-of-the-crisis-3305806https://www.thebalance.com/what-is-stagflation-3305964https://www.thebalance.com/fed-funds-rate-history-highs-lows-3306135https://www.thebalance.com/president-ronald-reagan-s-economic-policies-3305568https://www.thebalance.com/savings-and-loans-crisis-causes-cost-3306035https://www.thebalance.com/role-of-derivatives-in-creating-mortgage-crisis-3970477https://www.thebalance.com/subprime-mortgage-crisis-effect-and-timeline-3305745https://www.thebalance.com/2008-financial-crisis-3305679https://www.thebalance.com/arra-details-3306299https://www.thebalance.com/what-is-quantitative-easing-definition-and-explanation-3305881
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Bear Markets – Depression to GFC
110Source: http://www.nbcnews.com/id/37740147/#.UvwLCvldWSp
▪ Losses of more than 20% from peak
-
Robert FREY - 180 years of Market Drawdowns
111
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▪ How often are we in a state of regret? ▪ Creates trading / investing stress
▪ https://youtu.be/27x632vOjXk?t=181
▪ https://www.youtube.com/watch?v=27x632vOjXk 3 MIN FOR 20
https://youtu.be/27x632vOjXk?t=181https://www.youtube.com/watch?v=27x632vOjXkhttps://www.youtube.com/watch?v=27x632vOjXk
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Robert FREY - 180 years of Market Drawdowns
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▪ You are usually in a drawdown state about 75% for S&P500
▪ 60% of the time it is ‘extreme’ (>20%)
▪ Value of long term perspective => danger of bears preventing long term focus
Thoughts?
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Many Predicting Doom and Gloom? (or have) …
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Many Predicting Doom and Gloom? (or have) …
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Bear Market Overview
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▪ Outline of a bear market
Bull
Bull
1 - Side
3 - Side
2 - BEAR
When does the bear start for your system?
Bull “corrected”
Note: Sideways can be short / non-existent
Bull
?
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Bear Market Overview
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▪ SPX weekly bars
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Bear Market Overview - Volatility
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▪ SPX weekly bars
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Bear Market Overview - Volatility
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▪ Volatility future (VX) daily bars
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Bear Market Overview
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▪ Nikkei 225 weekly bars
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Bear Market Overview
120
▪ Characteristics of bear markets – Extended downtrend (as compared to correction or dip)
• It is important to know the difference – Lower highs and lower lows
• Rather obvious definition of a trend – High volatility - large moves, both down and up
▪ Volatility increases as bear market deepens ▪ Both down days and up days will be wide range days ▪ Gaps at open can be large for assets that are not traded overnight ▪ Consider the impact on a trader’s psychology of large intraday moves ▪ Swing systems are not a good fit for a bear market (MM,KL)
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Bear Market Overview – Sector example
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▪ Oil ETF vs. SPX daily bars
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Bear Market Overview Inter-market RelationshipsWatch the money flows during bear markets. Money flows from stocks into other “safe haven” markets to weather the storm
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Government debt is seen as being “nearly risk-free”, i.e., capital will be repaid Money flows to the US Dollar - the world’s reserve currency. Commodities are priced around the world in USD, so they go up in price.
- US Bonds - Gold/Silver - Swiss Franc
Stocks
One trader’s bear market (stocks) may be another trader’s bull market (bonds)
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Bear Market Overview – Inter-market Relationship
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▪ SPX weekly bars vs. TLT (iShares 20+ Treasury Bond) ETF
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Sovereign Bonds / US Treasuries
30+ Year Bull Market in Bonds and the Deflationary Dilemma
▪ At zero (negative?) or very low interest rates – will bonds provide the same immunization for “risk” portfolios?
▪ Are US treasuries risk free?
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Bear Market Stocks vs. Bonds
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SPY: ETF for S&P500
TLT: ETF for 20+ Year US Treasury Bonds
• Stocks, represented by SPY, drop > 50+% • Bonds, represented by TLT, rise > 33%
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Bear Market Impact – Ratings & Capital Structure
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Countries: ▪ Ratings
– Developed vs. Emerging ▪ Sovereign Debt (Currency) ▪ Government Agencies Companies: ▪ Ratings
– Investment Grade vs. non ▪ Large/Small Capitalization
“Risk on” / “Risk off”
-
Restrict/ ban short
selling Restore uptick rule for shorting
Change/ raise margin
requirements
Manipulate interest rates
Impose taxes/fees
on speculators
Change holding periods for long
term capital gains
Impose currency controls
Peg one currency to
another
Confiscate assets
(e.g., gold)
Bear Market Overview Other Considerations
“They” (government, exchanges, “big money”, your broker…) will change the rules
during bear markets
127
Be prepared with contingency plans:
Blueprint for Trading Success Workshop
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Margin - The Brexit example
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The Brexit example
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The Brexit example
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▪ Post referendum outcome – June 24, 2016 late AM eastern time…
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The 2016 US Election example
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Defensive Stategies
“Holy grail trading is finding a strategy [system] where you manage the inevitable losses while maximizing profits.” - Mark Shipman
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Part Two: Strategies and systems
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“Pre” Examples Beginning During End
All Weather Cash / stop loss RSI(2) NCAV
Brown’s Permanent Hedging: futures, ETFs, Shorting
Rocks & Rockets Sell puts on quality
Trend Following Volatility targeting Fake Out Sell options –delta hedge
Hedging: puts Oops Sell Option spreads
Hedging: puts & covered calls
Option Spreads Prepare for bull market…
Defensive portfolios Faber10SMA
Option spreads Buy Dips
Day 2:
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Development Overview – Building Blocks
Systems
Strategies
Rules & Indicators
▪ More mechanical methods with rule set
▪ Collection of rules grouped together (aka techniques)
▪ Useful based on history
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Some Back Testing Beliefs“Study the past, if you would divine the future.” - Confucius
▪ Good to help determine what does ‘not’ work – Shapes direction of research
▪ Useful to frame what is (may be) “possible” ▪ Mechanical => how to improve with TQN
– Provides a foundation ▪ Helps with refinements
▪ Exists are a good example ▪ Still require market intelligence and learning ▪ Fully mechanical systems typically have had a lengthy
development process – Some argue continual…
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Bear Market Overview
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▪ Outline of a bear market
Bull
Bull
1 - Side
3 - Side
2 - BEAR
When does the bear start for your system?
Bull “corrected”
Note: Sideways can be short / non-existent
Bull
?
-
137
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Bridgewater’s All Weather Fund
▪ “The principles behind All Weather relate to answering a deceptively straight-forward question explored by Ray Dalio with co-Chief Investment Officer Bob Prince and other early colleagues at Bridgewater:”
‘What kind of investment portfolio would you hold that would perform well across all environments, be it a devaluation or something completely different?’
▪ http://www.bwater.com/home/research--press/the-all-weather-strategy.aspx
▪ In the appendix:
http://www.bwater.com/home/research--press/the-all-weather-strategy.aspx
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▪ http://www.bwater.com/home/research--press/the-all-weather-strategy.aspx
Bridgewater’s All Weather Fund
▪ Note: 25% of RISK
http://www.bwater.com/home/research--press/the-all-weather-strategy.aspxhttp://www.bwater.com/home/research--press/the-all-weather-strategy.aspx
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Harry Brown’s Permanent Portfolio
▪ 25% in U.S. stocks, to provide a strong return during times of prosperity. For this portion of the portfolio, Browne recommends a basic S&P 500 index fund such as VFINX (Vanguard 500 Index) or FSMKX (Fidelity Spartan 500 Index).
▪ 25% in long-term U.S. Treasury bonds, which do well during prosperity and during deflation (but which do poorly during other economic cycles).
▪ 25% in cash (money market funds) in order to hedge against periods of “tight money” or recession.
▪ 25% in precious metals (gold) in order to provide protection during periods of inflation. Browne recommends gold bullion coins.
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Harry Brown’s Permanent Portfolio - Performance
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Harry Brown’s Permanent Portfolio - Performance
▪ Assumption: rebalance each year to get back 25% allocation split among all four asset classes
▪ TSM = total stock market ▪ ST = short term i.e. cash proxy ▪ Green; the asset that did the best. ▪ Red: the asset that did the worst in a
particular year Note that “worst” does not mean the asset was necessarily negative, just that it was the lowest performer for that particular year.
▪ Orange any year with a loss for the portfolio
▪ Results graciously provided by Ken Long
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Sovereign Bonds / US Treasuries
30+ Year Bull Market in Bonds and the Deflationary Dilemma
▪ At zero or negative interest rates – will bonds provide the same immunization for “risk” portfolios?
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Systems & Strategies: Divergent Strategy Example
Trend Following
143
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144
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Trend Following – Divergent Strategy
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Trend Following
▪ Performance of Trend Following versus 60% Equity & 40% Bond during large drawdown periods.
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Trend Following
▪ Monthly results from 9 active Trend Following firms.
-
System: 5 day Highest High & Lowest Low
147
Beliefs: ▪ Trend following works – lots of research
Edges: ▪ Let winners run, cut losers ▪ Divergent strategy = like being long volatility ▪ Simple and systematic
Data: Daily bars on liquid futures (see Appendix)
Filters/Conditions: ▪ None OR; ▪ Use Regression Slope for Bull and Bear = market type
Entry: buy if trades above 5 day highest high or sell if trades below 5 day lowest low ▪ iStop: none
Target: none
Stop & Reverse: at 5 day highest high or 5 day lowest low
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148
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Trend Following – 5 Day Results; no Market Type SeeAppendixforFuturesList
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Trend Following – 5 Day Results with R.Slope=75 SeeAppendixforFuturesList
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