Buy the Strength Well the Weakness

The first half or this decade has witnessed some of the toughest and most frustrating financial markets in recent memory. Good trading strategy holds that you should be able to profit equally in both up and down markets. But, during many campaigns, markets have appeared to be moving both up and down nearly simultaneously. Many solid uptrends have been punctuated with violent downside reactions. These price slides briefly halt the uptrend by stopping out speculative long positions and after the stops have been 'cleaned out,' the market resumes its northerly course. Conversely, quite a few bear trends have experienced equally violent tallies. The rally cleans out the speculative protective buy stops, knocking the so called weak holders out of their profitable short positions; then the bear market resumes. 

The attention of the margin department is being noticed more frequently than ever before due to the erratic and violent nature of counter trend swings. What should you do when confronted with the ever familiar call for additional margin? Over the many years, I have had countless conversations with traders, both in stocks and futures, concerning the strategy of dealing with margin calls. In general, most investors are ambivalent and inconsistent in their response to margin calls and require guidance in terms of a viable, strategic response. There are two types of calls: new business and maintenance. Exchange regulations generally require that new business calls be met with the deposit of new funds, not by liquidation. Maintenance calls, however, can be met with either deposit of new funds or by reducing positions. 

Maintenance calls are the most common type of margin call and it is unfortunate that most investors invariably make the wrong decision when confronted with the request for additional margin. There are two options: putting up new money, or reducing positions. If reducing positions, a decision on which one(s) should be liquidated to meet the call should be made. In most circumstances I do not recommend depositing new funds to meet a maintenance call. The call is a clear sign that the account is underperforming, or at least some of the positions are underperforming, and there is no logic in trying to defend bad positions with fresh money. The appropriate strategy is to liquidate some positions to eliminate the margin call and to reduce your risk exposure. But, if you close positions to reduce risk, aren't you also reducing your profit potential and your ability to regain a profitable footing? Reducing positions, yet maintaining and even enhancing your profit potential sounds like a worthwhile although hypothetical goal; but how can you actually achieve it? It can be done with a simple and basic strategy that is well known to successful professional traders but unfortunately, not to public speculators. Those positions Which show the biggest paper losses when marked to the market, should be closed out especially if they are moving anti trend. This clearly reduces risk exposure. Yet, by maintaining the most profitable positions, which are trending in the direction of the dominant market trend and possibly even adding to those positions (pyramiding), you are maintaining your potential for profit. The odds clearly favour ultimate investment success on profitable with the-trend positions over losing anti trend positions. 

Regrettably, most speculators choose to close out their profitable positions while holding on to the losing ones. How many times have we heard the statement, 'I can't afford to take the loss.' The likely outcome of this attitude is that, when the position is ultimately liquidated, the loss is greater than it would have been earlier in the game. The strategy of closing profitable positions while holding on to losing ones is costly and is typical of unsuccessful traders. Conversely, one of the traits of successful operators is to close out losing positions and stay with, and even add to, the winning ones. And, while it may be more gratifying to take profits rather than losses, we should not be concerned with satisfying the ego here. We should be playing for big profits coupled with limited risks and, in that context, you should be more concerned with an overall profitable operation than in trying to prove yourself right and the market wrong. 

There is another corollary here that professional operators use. In any given market, or in two related markets, you should buy the strongest acting one and sell the weakest acting one. This tends to hedge your bet in a constructive fashion, because-«if the market advances, your long leg should outperform your short leg; while, if the market declines, your short leg, being the weaker acting of the two, should go down faster and further. And, in some markets, futures for example, you may get an accompanying bonus, with reduced straddle (spread) margins. 

The strategy of buying the strength; selling the weakness can be exemplified by the Chicago com market which was in a broad downtrend from late 1983 to early 1987. The wheat market, on the other hand, was trending generally higher, providing technical, or systems traders, with a succession of highly reliable and straightforward trading signals. Let us assume you received a sell signal in com during June 1986 and put on a short position. Your margin in each 5,000 bushels com contract would have been US$400. Then you received a buy signal in wheat in October of the same year and bought a contract. The margin on each wheat contract would have been US$600, so for your combined short com and long wheat position you would expect to have to post US$ 1,000 in margin. You may be surprised to learn that you wouldn't have to post this amount or even US$600, the higher of the two legs. It is possible to put on the entire two sided position (short com and long wheat) for a total margin of just US$500. Generally however, it is not advisable to trade on such a thin margin and in this example, at least the US$600 required on the higher side (wheat) should be deposited, but it's still very high gearing. Refer to Figures 12. l , 12.2 and 12.5 to see how the position worked out. Note the high profit, due to the extreme gearing involved, that was earned during this period in the com versus wheat spread position a result of buying the strength and selling the weakness. 

Figure 12.1 July 1987 Com. You buy the strength (wheat) and sell the weakness (com). This is the type of situation that many professional operators seek; it has good profit potential, reasonable risk, and low margin. Opportunities like this appear every yeat-and the trader should be alert to the chance to buy the strength and sell the weakness. For entry timing, you can take signals from whichever technical or trading system you have confidence in and time each leg on the basis of these signals. 

Another aspect to this buy strength and sell weakness strategy is a tendency of many futures bull markets to experience a so called price inversion, also called an inverted market, in which nearby futures gain in price relative to the distant months of the same commodity, and ultimately sell at premiums to the distant markets. This could be due to a tightness, or to a perceived tightness, in spot (nearby) supplies. Traders should watch these spread differences carefully, because an inversion of the normal relationship between nearby and distant futures (on a closing price basis) could help confirm a bull market. In fact. I generally add an additional 25% to 50% to any long position I am carrying following such a price inversion. 

Figure 12.2 july 1987 Wheat. You buy the strength (wheat) and sell the weakness (com). This is the type of situation that many professional operators seek; it has good profit potential, reasonable risk, and low margin. Opportunities like this appear every year-and the trader should be alert to the chance to buy the strength and sell the weakness. For entry timing, you can take signals from whichever technical or trading system you have confidence in and time each leg on the basis of these signals. 

  should be deposited, but it's still very high gearing. Refer to Figures 12.1, 12.2 and 12.3 to see how the position worked out. Note the high profit, due to the extreme gearing involved, that was earned during this period in the com versus wheat spread position a result of buying the strength and selling the weakness  

Figure 12.3 july 1987 Wheat versus Com Spread Chart. As an alternative method of timing spread (buy strength versus sell weakness) trades, you ran use spread charts, These charts are available for a broad selection of related markets or two different futures in the same market. You can enter and liquidate positions on the basis of price differences. As an example, let's assume you put on long wheat versus short com at wheat 70 cents over com, and the current difference has widened to 1.00 over (you have a 30 cent profit on the position). If you want to stop out if the difference narrowed to, say 90 cents, you would enter the following order. "Buy (quantity) com and sell (quantity) wheat at 90 cents stop, premium on the wheat." With this order, you would be locking in your profit at 20 Cents, less breakage and commissions. 

One other aspect of these so called spreads, particularly iti'._currency or futures markets, is a tendency among some traders to straddle up to avoid taking a loss.'Assume for example, you ate long silver with a big loss on the position, and the market is trending down. Rather than take the loss by selling the May silver, some traders would sell July silver instead, effectively locking in the loss at that point. This is not a good idea. This act doesn't prevent the loss; it merely postpones it and the losing position still has to be dealt with in unwinding one of the 'legs' of the spread. A more logical strategy is to take the loss, by closing out the original position; then watch the market from an unbiased, sidelines position and re enter either long or short when the trading indicators provide an objective entry signal. 

In summary, it doesn't much matter how you label the basic strategy: hold the profitable position and close out the losing position, or buy the strength and sell the weakness. What is important is that you are aware of it, identify the strong versus weak markets and apply this strategy consistent and disciplined manner. 

13 Larry Hite: The Billion Dollar Fund Manager 

It was mid-summer in 1992. I was driving through New York's Lincoln Tunnel. which connects New York City to New Jersey. passing underneath the venerable Hudson River. The fact that I was driving to New Jcrsey wasn't very surprising. but the fact that I was doing it in midday. during market hours. was. People who know me. know that it is almost impossible to pry me away from my desk and trading monitor during market hours. So. why the exception? 

I was on my way to have lunch with someone whom I've known for some 20 years. since the first time he called on me in my office at 25 Broad Street. in the heart of the Wall Street district. A former stage magician and rock star promoter and a most likable person. he had a simple proposition for me. He wanted to set up a computerized commodity trading system and then establish a series of futures funds which he would manage and market throughout the world. He wanted to know if I would be willing to join him in this venture? 

I briefly took stock in my situation. At the time. I had been in Wall Street for 16 years and for the past eight years. had owned and operated my own commodity brokerage. Not a very large firm. but it had a good reputation. was profitable and. most important. it was mine. I was a member of five commodity exchanges and my firm was a clearing member of the New York Mercantile Exchange. So far. his proposition sounded fine. I had plenty of room in my office and could easily set him and his colleagues up in private offices with whatever equipment they might require. But. there was one problem. and it concerned the 'timing' of this situation. 

I had just closed out huge long positions in copper and wheat which I had been nurturing and suffering through for the previous eight months. and on which my clients and I had realized a profit of several million dollars. Perhaps not huge by today's standards. but quite respectable for the early 1970s. I had already determined that. having been in the front line 'trenches' of high stakes speculation for so many years. the time was right for me to close my firm and retire. I was about to relocate to a large four-storrey villa at Evian. France. on the shores of the Lake Geneva. which I had purchased the previous year. In fact. I had already informed my clients of the closure. had been sending them back their substantial profits from our trading activities and had informed my staff of the situation. RegtetSJlly. I concluded that it just wasn't possible to turn back and that I ould have to inform Larry Hite. of my decision. He went on to become one of the largest commodity fund managers in the world. 

There I was. on the way to spend quiet afternoon with an old friend. looking forward to a nice lunch. plenty of reminiscing and discussion of future plans. People like Larry Hite always seem to have one eye on the present and one on the future. They're generally too busy to dwell on the past for very long. So. what about this Larry Hite; the billion dollar fund manager? 

First of all. he admitted that he doesn't consider himself a very good commodity trader. to which I replied that he could have fooled a lot of people. myself included. His surprising response: he isn't primarily in the commodity business; he considers himself in the "good bets' business. He said that. when he looks at trading opportunities. he doesn't really see markets and positions. Instead. he sees probabilities. risks and rewards. He notes that the strategy of investing. which includes money management and risk control. is as important. if not more so. than the actual technical aspeCts of trading. In fact. this is the thesis which underlies much of this book and it's good to see a world class fund manager in complete agreement. 

This is what Hite had to say about his development as a fund manager: 

'I began to devote my resources to developing an unemotional. risk averse quantitative approach to the markets. Price data was subjected to rigorous computer testing to determine if they were recurrent statistical events. If so. then the events were subjected to further testing using strict risk parameters to determine if such a disciplined methodology could be consistently profitable. 

I discovered that. yes. I could risk a very small part of the farm. and make above-average returns with reasonable consistency. Yes. I could totally avoid any interpretations of chart patterns or underlying supply and demand factors that impact a particular market. and my positions would not suffer. And yes. I could diversify into many markets. remain extremely disciplined. and I considered my strategy to be a real accomplishment because it has a trading plan that suited my personality and my wallet; disciplined, quantitative and profitable. In short, with the assistance of a statistician and a programmer, I have'developed a set of mathematically proven rules that have worked for me.' Here is what Hite had to say about the 'good bets business': 

'I consider myself to be in the good bets business. That is, through the use of a computer, we search for good bets and try to play only good bets. If the bet does not meet our standards, we throw it out, even if it is something that someone else might jump at. This is analogous to actuarial work. Essentially, what I did was to take a highly charged, exhilarating profession and turn it into an actuarial process something that would appeal to anyone who finds accounting too exciting. I deemotionalized markets and trading and reduced them to a probability study.' On trading being 'Zen like': 

'For me, this is a very Zen like business, and your most valuable tool is yourself. There is a Japanese book about sword fighting whose premise is this: when you get into a sword fight, immediately assume that you're dead so you won't have to worry about being killed. Then, all you have to worry about is making the appropriate moves. 

Once you figure out the right action, assemble the means to implement it correctly and then proceed. That is what a good trader does. He or she sets out a programme either through the use of a computer or through some other method to achieve a designated objective. In my case, I thought that de emotionalizing the markets was the right way to approach the idea of consistent returns. If that is not exciting enough for some people in the business, then so be it. I don't trade for excitement; I trade for profits.' ' And on limiting risk: 

'It boils down to a de emotionalized, risk management game for both the big trader and the small speculator. Although we are sometimes involved in as many as 50 markets at any given time, we have a set risk parameter, or stop level, in every one of these 50 markets. Beyond that, we use a maximum percentage draw down, which relates risk on each position to total equity. That is, we limit the risk on each position in our portfolio to one percent of the account's total equity, based on closing prices. And time that the loss on any position, as of the close, equals one percent (or more) of total equity, we liquidate that position the following morning.' 

In our conversation, I discussed with Larry Hite his strategy for implementing a maximum risk of one percent of the account's equity on each position. I pointed out that, while it was easy to limit losses to within one percent when dealing with accounts in the multi million dollar category, it would be more difficult for the smaller investor for whom the one percent limitation would obviously be too close. For instance, a one percent limit on an account with US$30,000 would only be US$300, and this would be so close as to stop the trader out tecuttently just on the 'noise' from the floor traders' scalping activities. 

Hite acknowledged that the one percent limitation would be too restrictive for smaller accounts. Nevertheless, he felt that the general strategy of this approach to risk control was valid. He would, on a smaller account, bump up the risk limitation to approximately two percent of capital. This would still adhere to the general strategy of risk control, but would allow the smaller trader additional leeway. Obviously though, risking more than the recommended one percent limit does make the overall operation more risky, and behaves each trader to exercise even more vigilance to avoid over trading and other inappropriate tactics. 

System trading: Kroll's Method

(from Dragons and Bulls, Stanley Kroll)

As discussed earner, out or all the diverse technical methods utilized in trading systems, I have opted for the KIS approach, primarily using moving averages crossover methods. As trading systems go, the moving averages approach is the oldest and most basic of all analysis methods. In its simplest form, a moving average (MA) is the sum of ‘x‘ consecutive closes divided by ‘x'. For example, you would obtain a ten day simple moving averages (SMA) by adding the closing prices for the previous ten days and dividing the sum by ten. Perhaps the most popular SMA combinations are the 5 versus 20 day, and the 4 versus 9 versus 18 day. The ‘versus’ comes into the picture because systems traders have discovered through years of trial and error and testing, that a ‘ctossover' technique captures the maximum advantage of a MA trading system. 

There are, essentially, two ways to play MA systems, and they can amaze traders by frequently outperforming much more complicated and elaborate systems. In a simple, basic system, where you use, for example, a 12 day SMA, you would buy when the closing price goes above the 12 day SMA, and would sell when the closing price goes below the 12 day SMA. This simple system, however, offers less flexibility and probably inferior performance than the second approach, which uses a dual (or even a triple) crossover, for instance a 5 versus 20 day crossover system. You would buy when the short term line (the 5 day SMA) crosses above the long term line (the 20 day SMA), and liquidate long and possibly go short as well, when the opposite occurs. 

Serious systems traders tend to get considerably more involved with moving averages. Some use so called weighted moving averages which give greater weight to recent than to older price action, while other operators use exponentially smoothed moving averages, which may incorporate a potentially infinitely smoothed time span via more complex calculations Such approaches clearly require the use of a personal computer with customized software, where all calculations can be done at lightning speed. 

For any moving averages strategy, regardless of its complexity, the critical question concerns the number of days of the analysis and Whether it should be optimized (tailored) for each distinct commodity. In this regard, some of the best technical research has been by American analysts Frank Hochheimer and Dave Barker. I should point out that, notwithstanding their excellent research, these studies were done many years ago and should not be depended on today, as markets and overall volatility have changed. Nevertheless, I include this research to indicate how the studies can be done, and as a starting point for modern research. 

Hochheimer tested a broad array of moving averages, from 3 to 70 days, on each of 13 different futures for the 1970 1976 period. His results showed that there was not one ‘best' universal combination. His best combinations (closing price going through a SMA) Which projected best overall profits were: If 

           Best       Cumulative                                                                           Ratio
           average  Profit Loss     Number of      Number of      Number of      profits/
           (days)     (US$)             trades               profits            losses             Totalt trades/

Silver      19         42,920 +       1,393                429                 964                 .308 

Pork        19         97,925 +        774                  281                 493                  .363 

bellies
Com        43         24,646 +        565                  126                 439                  .223 

Cocoa      54         87,957 +        600                  157                 443                  .262 

Soybeans 55         222,195 +      728                  151                 577                  .207 

Copper     59        165.143 +       432                  158                 274                  .366 

Sugar        60        270,402 +       492                  99                  393                   .201 

Figure 15.1 Frank Hochheimer's testing of "best combination" moving average calculations. 

It should be noted that these are purely hypothetical trades done on the basis of an after the fact calculation. Clearly, real time results are unlikely to show such profxts. Also, note the low ratio of profits to total trades, from .201 to .366; quite typical of systems and formula trading. 

For those traders interested in going beyond the simple closing price versus a single moving average, the dual moving average crossover would be the next step. With this technique, you calculate both a short term and a long term moving average, for example an 8 versus 35 day average. You buy when the 8 day crosses above the 35 day, 

and you sell when the reverse occurs. Here again, Hochheimer did some excellent research in the testing of optimum crossover periods, using 20 different combinations for the years 1970 1979. Some of his optimum combinations are: 

C Silver 13 versus 26 days

Pork bellies 25 versus 46 days

Com 12 versus 48 days

Cocoa 14 versus 47 days

Soybeans 20 versus 45 days

Coppper 17 versus 32 days

Sugar 6 versus 50 days 

Dave Barker also did some fine work in systems testing. He tested the 5 versus 20 day dual MA crossover system (without optimization) versus an optimized dual MA crossover system for the 1975 1980 period. Not surprisingly, the optimized version consistently outper formed the straight 5 versus 20 day version. Here is a partial list of Barker's best combinations: 

0 Silver 16 versus 25 days

Pork bellies 13 versus 55 days

Com 14 versus 67 days

Cocoa 14 versus 38 days

Soybeans 23 versus 41 days

Copper 4 versus 20 days

Sugar 14 versus 64 days 

It is particularly interesting to note the close correlation between some of Hochheimer’s and Barker’s optimized crossover combinations. 

For those operators who wish to pursue moving averages crossover trading further, here is a description of two trading systems, one long term and the other short term, that have been shown to work well in 1992 and 1993. 

Long term system Either of the following combinations: 

0 Close versus 5 day EMA versus 8 day EMA. 0 Close versus 7 days SMA versus 50 day SMA. 

Where: SMA Simple Moving Averages and EMA Exponential Moving Average 

0 Buy signal: the first time that the close plus both MA's line up positive, Buy tomorrow on stop at high of today plus 3 ticks. 

0 Sell signal: the first time that the close plus both MA's line up negative, Sell tomorrow on stop at low of today minus 3 ticks. O Exiting a market: use money management stop of US$1,500. 

It should be noted that this is a long term system which utilizes loose stops. 

Short term System 

Use 60 minute (hourly) bat charts. (For this analysis, you will require an on line inttaday technical analysis system.) Trades are made on the close or next day's opening. Avoid taking trades based on intraday signals. Watch the following indicators: close price, 7 day SMA and 50 day SMA. 

0 Long entry: if you get a bullish close versus 7 SMA versus 50 SMA line up on 60 minute chart, buy tomorrow on stop at high of today plus 3 ticks. 

0 Short entry: if (you get a bearish close versus 7 SMA versus 50 SMA line-up on 60 minute chart, sell tomorrow on stop at low of today minus 3 ticks. 

0 Exiting a market: initial stop: US$600.00. Advance stop by US$300 when you have a US$400 profit. Move stop to break even after US$800 profit. Do not change this stop. 

As you can readily see, one of the virtues of a computerized trading system is that it is quite specific and exact. Another significant feature is that it suffers no bias for the long side of each market, as the majority of speculators do. All signals are derived from the mathematics within the system. 

In essence, it boils down to this. A trading system is a tool, and like most tools, there are quality ones and mediocre ones. No system can be the ‘ultimate answer' to consistent profits and at best must be combined with good market strategy, money management and viable risk control. There are still plenty of successful traders who wouldn't know the difference between a data disk and a slipped disk. However, in the hands of an objective and distiplined operator, the ‘right’ system can be a significant aid for successful trading. But, and here comes the big ‘but' again, its benefit will be proportional to the patience and discipline with which the operator applies the system. 

Chapters 14 and 15 should have provided you with a realistic, understandable introduction to systems trading. For a more detailed study, which is outside the scope of this book, refer to other works completely devoted to computer systems trading. 

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