Trading Is Not A Zero-Sum Game, It Is -EV

Trading and Poker as a zero-sum game is the new efficient market theory. I can't count the number of times I've heard that trading is a zero-sum game repeated without any fact based evidence what-so-ever. Let's look at the definition of a zero-sum game first:

a zero-sum game is a mathematical representation of a situation in which a participant's gain (or loss) of utility is exactly balanced by the losses (or gains) of the utility of the other participant(s). If the total gains of the participants are added up, and the total losses are subtracted, they will sum to zero.

So first let's disprove poker.

Buy into a 2/4 limit hold 'em with a $100 rack and post on the big blind. For sake of argument let's assume this is a 2-1-1 blind situation. If the first three hands are discarded, 4% of the rack is gone. If this is a full game of ~8 players and a hand count per hour of 35 you should be blinded 4 times. Without playing a single hand approximately 16% of equity will be lost in an hour.

Now to disprove trading.

I have a $1500 account. I buy 100 shares of XYZ at $10 for a total of $1000 and a commission of $7. I now have $1000 of stock and $493 in cash. I sell $XYZ the next day for $10 and a commission of $7 to you who has a $1500 account but with $1 commission. After this trade I have $1486 and you have $1000 in stock and $499 in cash. Let's repeat. I now have $1000 in stock and $479 in cash and you have $1498 in cash. If this repetition continued further, even though I bought and sold the same number of shares for the same price, soon enough I won't even be able to buy the same number of shares.

As long as there is a rake in poker and commissions in trading the game will always be -EV. The typical claim that trading is a zero-sum game is concluded briefly with, “For every winner there is a loser.” However, even this is not completely true as shown in the trading example. Further there is plenty of evidence that the game of trading is really a wealth transfer from the many to the few. A number of account studies have shown unequivocally that 90% of them are net negative and the owners of these accounts have a strong tendency towards the disposition effect: cutting winners short, letting losers run, and adding to losers but not to winners.

This is just one of many market maxims that when not vetted and taken at face value can lead to erroneous conclusions and outcomes, poor habits and thinking. One that I've recently thought about is “Trade what you see, not what you think.” The problem with this is that we now know through behavioral sciences that both are faulty and can not be relied upon unquestioned. When looking at a chart our eyes are subject to optical illusions and blind spots, and our thinking is subject to misidentify a trend based upon a sequence of 2 in a row among other behavioral biases.  Not only are they problematic individually, they can become more so when used in tandem. The moral of this story is: question first, verify second, believe third.  Reality based, evident backed trading trumps assumptions and maxims.

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Weekend Review October 11, 2013

By Friday, Tuesday did not happen; and so it goes during highly volatile and emotionally driven news cycles such as the debt ceiling and shutdown of the American government. On Tuesday it appeared that big money was stepping aside as well watched and highly liquid stocks sold off hard on heavy volume but by Friday the indexes bounced back just as swiftly with gains of more than 2% on Thursday alone. With a looming deadline this upcoming week, less is definitely going to be more.

I don't know if the market is pricing in a default or pricing in a resolution. Even when either of these events occurs there is still no telling which direction the market will react as it could be a sell the news event regardless. We don't have to look much further back then the 2008 Lehman collapse to know that the market is not always prepared and is willing to suspend disbelief of the improbable because it just can't phantom it actually happening, and this is where the real danger lays.

This is not the week to make assumptions on how the Clowns of Capitol Hill are going to behave. There is a core group of ideologues who clearly have little understanding of anything at all and are acting in an irrational manner with little concern for the potential effects of their decision making. As push comes to shove I do not underestimate the reptilian part of their brain kicking into high gear as the stress and tension mounts resulting in dangerous consequences and precedence.

I know that I trade my beliefs and I also know that there is a fringe group in the US that governs by theirs. This is an important point because when there is a belief system that is subscribed to 100%, one only has to look at the patterns and events that have happened before to be aware of what people are capable of doing. It is misguided to think that it can never happen here even though it happens everywhere else on the globe. It is misguided to think that it can never happen here even though historically some of these things we believe we are above have happened here already.

My preparation for this week is worse case scenario. I'd rather prepare myself for the most negative outcome possible than be optimistic that just like the movies the powers that be are going to wait until 00:00:01 to cut the red wire. Even then it still might blow depending upon market reaction.

Wax On, Risk Off

One of the luxuries of being a blip is the ability to go from 0 to 60 to stopping on a dime with minimal energy spent and impact felt. Those who trade with size and move markets can not do so with nonchalance. They can try to slowly liquidate and pass off from strong to weak hands, but when they want out of a room that's well over capacity and there's only one exit it becomes completely evident what they're up to. This is why it's important to pay attention to the stocks that trade with the highest dollar volume and/or are often spoken of and about as leaders.

Today the market moved from risk on to bum rush the exit as many of these stocks have been taken to the woodshed. The preponderance of evidence now indicates there is a change of character in the market and attention must be paid to it. In my weekend review I noted to pay particular attention to the bigger monied stocks as breadth indicators were sending me a mixed message and I felt it prudent under the circumstances to defer to the behavior of individual stocks. Early in the morning many of these spoke, or rather shouted. that the minefield was live and heightened caution warranted.  

AMZN

FB

PCLN

SPLK

YELP

The preceding are just some of the momentum stocks that took it on the chin today.  In total 361 stocks in my universe were down 4%+ today on higher volume.  Coupled with this, the well known fear index $VIX has been spiking too suggesting that concern about the general market has heightened over the past couple of weeks.

$VIX

These are the moments when gains can evaporate, or worse, become loses.  It's of utmost importance to have a game plan of action as to what to do when the calm water becomes a furious whirl pool. A week back I penned (figuratively) a post about mistakes and moving forward. I still have the two open positions I mentioned --AMBA and RKUS --with strict guidelines as to how I will trade them, so in this regards today's action is just noise and does not effect me in the least. My swing trades however, have been abandoned with profits and losses booked as they are on a completely different trading plan and time horizon, and are cut without hesitation when it's clear large distribution is hitting the tape in an extended market.

Moving forward I expect the continued noise of the debt ceiling to be in play so capital preservation until this resolves is the number one priority.  Earnings season will be in play so rebuilding watch list during this period will be where I'll put some of my energy.  Going over previous trades and noting where I've improved and what still needs to be worked on will be my focus.  From every pullback and correction comes renewed opportunity and a robust playing field to take advantage of.

Weekend Review 10/04/2013

If there is one concept this week exemplified it is simply this, read the market... don't interpret the news effect upon it. Yes, the government shutdown is a significant news event and one that hit home to me personally as it has effected friends and family, but the market did not confirm this as a back breaking situation. If anything the market continues to look healthy and robust even with the debt ceiling as catalyst looming.

Breadth Checklist

Going through my checklist this weekend, on a short term basis the market does not look extended here as the number of NYSE stocks above their 10 and 20 period moving average is 45 and 55 respectively. On the other hand, the number of stocks in my universe down 25% in a quarter is 188 and the number of stocks above 50% for a month is 20 which are both signs of caution, so there is a mixed message happening. When there are crossing signals it's best to go to the source and look at what the market leading stocks by dollar volume and most discussed are doing. This gives a clue as to what the big money is doing in terms of potential liquidation as well as what the most highly mentioned stocks that have captured the social/retail attention. Do any of these look problematic?

FB

PCLN

YELP

Additionally looking at the index relationships it's evident that the SPX has been relatively weak while the RUT and COMPQ have been showing strength. This is a sign of a risk on environment as small caps and tech continue to perform and lead the way.

RUT:SPX

COMPQ:SPX

RUT:COMPQ

Looking at the week ahead the Clowns of Capitol Hill will still be the most watched event in the world with ramifications for the market but it's best to keep an open mind as to how the market will gauge the conclusion or lack there of. With Alcoa announcing on Tuesday after the close attention will once again be focused on earnings and individual catalyst. Observe and react to the market, don't consume and presume the news' influence.

RVLT Model Book

Today I'm adding RVLT to my model book and have already drawn up the tentative plan of action on how to trade this.  RVLT shot up nearly 51% today on an earnings related catalyst, trading nearly 10 million shares --approximately 30% of it's float.  After such a large sized move I have no doubt that price may very well continue north without me but from a risk/reward situation I can't justify entering this yet so will wait patiently for price to either flag or pullback and hug the 10 period moving average.

RVLT Model Book

Stepping up in time frame, RVLT has exhibited strong volume bars, nearly turning over its float for 4 consecutive months.  Widening out the horizon it is clear that this volume is the highest in it's trading history.  Around the time this spike occurred there was news release relating to a new product --an energy efficient LED light. (source)  So there is a new product launch and earnings catalyst at play here along with massive volume with increasing prices suggesting accumulation.  If there is any substance to this, price confirmation and increasing momentum will be the clues I will pay attention to in the near term and make a decision as to whether or not this will just become a swing candidate or one I will look to trade on a longer term basis.

RVLT Monthly

Month High Volume Revisited

Is it volume which causes price changes, or do price changes cause volume –the hen or the egg, which came first? -H.M. Gartley, Profits in the Stock Market

To use a homely analogy, volume is to the price movement of stocks as gasoline is to the automobile. If you step on the accelerator of your car, giving the motor more gas, the car will start to travel faster. The more gas you feed it, the greater will be its momentum. Now, when your car has acquired considerable momentum, if you throw the clutch out and coast, your car will travel a considerable distance on the acquired momentum. -Richard D. Wyckoff

The current consensus is that high frequency trading accounts for 70% of the daily market volume on the surface and below the surface it is estimated that dark pools accounted for 32% of the trades in 2012 and this has most likely increased in 2013. As retail traders it is important to understand the implications of this, particularly in smaller caps and stocks that trade a few hundred thousand shares a day and assess who is on the other side of our trades and how this effects our price potential. If there is an average of 200K shares traded and 70% of that is HFT, this leaves a pool of 60K shares for day, swing, and positions traders, both professional and retail.

There are both positives and negatives to this. One major positive is that when these algos run amok and in our direction they can rapidly push price in our favor. This works best if one is already positioned in the stock. A counter point negative is that on entry day this can cause price to move beyond a proper risk/reward price point and also has the effect of deeper sell offs into the close or lack of follow through the next day because the demand is mostly manufactured and the absorption of supply is temporal and mainly intraday. Another negative is that the supply remaining can be easily moved by a small group of day traders taking a position then blasting it out to their 10,000 twitter followers.

We can bemoan this effect or we can realize from historical study that there always has been and always will be disadvantages presented to the average retail trader along with the standard risk of trading that applies if the game were fair. Although this is the case, the underlying fundamentals of market mechanics remain the same to this day and the same edges, anomalies, and patterns of 100 years ago work today. One significant change that has occurred, however, is the underlying internal market structure. Darvas spoke of abnormal weekly volume when shares traded exceeded 50 thousand, but the market has become much larger and the vast majority of the stocks in my universe trade more than this on a daily basis. Another fundamental shift is that during Darvas' time the majority of trades were transparent and there was not an informational edge when it came to price/volume relationships, unlike today where the order flow is algo driven or often hidden resulting in a lack of complete information and therefor a disconnect between price/volume.

When I started my studies of volume a year ago I was well aware of the perspective that “Only price pays.” and that volume was not particularly relevant or useful any more due to distortions and off market exchanges taking place. Hell, I even had a hard to reconciling the value of volume and its importance to myself. But, what is often left unreflected is that while price may pay what is the price being paid in the first place and is it an honest price, for not only does a significant amount of volume go unregistered, the prices being paid does as well. And even though I was aware of the statistics and effect of HFT and dark pools I continued to move forward with my line of thinking because volume has to matter after all because along with the open, high, low, close, it is the only other piece of information available.

As a result of these studies and realization of the effect of HFT and DP I've made the decision to move up to higher time frames, particularly the monthly when it comes to my volume studies. I started doing this 6 months ago and now have a model book of the best performing stocks during this time based upon this metric and have been able to improve my criteria for vehicle selection based upon the greater clarity this time frame gives when it comes to quantifying the absorption of supply. Once strong hands accumulate the float the expectation is that the clutch can be thrown into neutral and price will continue its acceleration as the shares that remain come at a premium.

March Momentum/MHV Watch List: 19% of list increased 50%+

Another change I've made to my trading over the past year is to my entry and time stop. Unless there is a compelling reason to enter a trade off the open I will wait until the last hour before making my decisions. There is a trade off as mentioned previously in which I will forgo some of the algo driven potential, however I also get to see if my signal completely forms and price is not faded and sold off hard into the bell. A second modification I made is extending my holding period from 3-5 days to 10 days to account for the lack of immediate follow through I've witnessed on my trades. This has allowed time for price continuation on its terms and has reduced the amount of churning trades by exiting trades that were not above entry price after 3 days.

The current underlying and dominant theme to this market is the FED induced liquidity, HFT, and DP. These are subject to change and hence the market structure as well. This is the flux markets will be under, but unless and until all shares traded are cloaked, there will always be a reason to be studious of both price and volume, thinking in terms of who is on the other side of the trade and what is their time frame, as well as studying chart patterns to identify better risk/reward set-ups.

It takes time for positions to be built by large players and I've found that by moving up to a higher time frame and following  momentum stocks with large monthly volume I'm better able to track rapid price increase with underlying supply absorption.  A periodic review of this list to prune those with waning momentum or decreasing price is sufficient to keep my watch list actionable with the greater confidence that I am on the correct side of the order flow for my time frame. The debate of which is more valuable or important or came first I'll leave to others as long as I have a hen that lays eggs I can eat.