In part 1 of the series, I'll discuss the simplest of all option plays, going long a put or a call.  I'll outline the advantages and disadvantages of this simple strategy.

One of the "theories" you've probably come across in the stock market is that when something becomes front page news in your local paper that the trend is about to change.  When the Dow or Nasdaq is above the fold, it might be time to consider going against the news.  Likewise, when the topic of discussion at family gatherings or with your cab driver is the market, it's time to do the opposite of what they say.  I recently went out of town to visit family.  The thing that really grew tiring was the moaning about the gas prices.  Prices have been rising steadily for years, but this time the first question out of everyone's mouth was "how are the gas prices down by you".  I was caught off guard and didn't have the figure down to the penny.  What's more, the front page of the local newspaper had the now commonplace photos of the gas sign on Any Street USA with proverbial "Gas Pains" or "Crude Reality" type headline.  Certainly they've written software to churn out these articles about soaring commodities because they all have the same flow.

A comprehensive article on the ETFs and ETNs being offered to date.  It also explains the difference between ETFs and ETNs.  I mention them quite frequently, so if you do not know the difference, I highly recommend you take the crash course.

http://seekingalpha.com/article/30369-commodity-etfs-and-etns

Detroit Rock City

Going out of town for a little holiday over the next few days.  I will be mostly incommunicado.  This is a trip to visit family up in Detroit, so there will be no rest and relaxation and little time to write.

I would like to leave this week with a few thoughts about where the market is.  The few hundred point shaving over the last couple of days isn't really all that surprising.  The major averages have been hovering towards the top end of their ranges for weeks now.  It was going to be time for a blast off to the upside or some mean reversion.  Being a mean reversion kind of guy, I expected (but did NOT predict) the latter.

Losing 400+ points puts us at the lower end of the short term range and close to the middle of the medium term range.  If she goes much lower, I'll be looking to add to the long side.

The selling over the last couple of days has not been accompanied by volume.  This can be sliced both ways (and you'll probably see it done).  Without volume, it means the move is lacking committment.  This means that the bulls are still in control.  Obviously, the bull argument.  While the bears may say that the relatively low volume sell means that the sellers are not done selling.  You'll need to see some "capitulation".  Also, I think many bulls are seeing this little run up to 13K as a feel good rally in a bear market.  As long as that's the prevailing attitude, I expect us to stay around 12-13K for a little while.

But hey, what do I know?  You should plan accordingly regardless of where the market is and be positioned according to your plan either way it heads.

Enjoy your holiday weekend!

One of the most successful ETF products to date is the gold ETF by streetTracks (GLD).  What makes this ETF fairly popular is direct access to the underlying.  Gold bars are held in vaults, not futures contracts.  This has proven that the price of the ETF tracks the underlying pretty well.

As the popularity of this ETF grew and grew fast, the question asked by option traders, is why we don't have options on GLD.  The reasons have varied from not enough volume (clearly wrong) to that the level of derivation was too much (again, wrong).  Apparently the market has spoken and the options are on their way.  If all of the hurdles are properly cleared the CBOE could list these options as early as the end of this month.

I'm not a gold lover.  An asset that seems to create nothing but volatility or at best, counterbalances volatility in your portfolio without actually creating real returns over time is not really for me.  However, I really like the idea of being able to play gold speculatively.  If the volume on the options is anything like the volume on the ETF, we could find ourselves with another liquid option set and that's always good news!

If you've invested or traded for any length of time, you have probably picked up an Investor's Business Daily once or twice.  It's a good paper and I find the news and articles very interesting.  The news of the day is really only half of the paper though.  The other half is dedicated to finding and analyzing stocks that match what is referred to as CANSLIM.  CANSLIM is an acronym for the criteria used to analyze stocks in the IBD.  Each week, IBD publishes a proprietary ranking known as the IBD 100 where the 100 best CANSLIM candidates are printed with charts and a brief analysis.  The thing that has always bothered me about CANSLIM is the subjective buying.  Apparently if something breaks out of a cup and handle, it's a buy.  Identifying this pattern has always been troublesome to me.  I've never traded CANSLIM for that reason.

But hey, you shouldn't have to worry too much about picking the precise entry point because the rest of CANSLIM has really identified a quality company that's going to be great for your long term holdings, right?  Not exactly.  As in previous comparisons, I truly enjoy taking on conventional wisdom with reality.  The reality piece being the price of the mutual fund or ETF that employs the conventional wisdom du jour.  In this case, we analyze the price action for CSSGX for the past two years.  We compare it against the S&P 500 benchmark.

(Click to enlarge)

In this timeframe, the underperformance has been pretty dramatic.  Did I also mention that for this performance you can expect to pay a hefty 1.7% fee?

According to this weekend's IBD, the IBD 100 performance since inception is +239.3%.  So what's the difference between a 5% return and a 239% return?  There could be a number of things at play.  Maybe the cup and handle yields impressive power.  If this is true, it holds more power and an more of an edge than any other chart pattern.  I'm skeptical.  Some more likely candidates are CSSGX doesn't necessarily invest in the same securities as those printed in the IBD 100, but the criteria should be similar, right?  Transaction costs may also be to blame.  Imagine if you had to buy and sell 100 securities a week.  Hard to make money with the commissions.

Whatever the case may be, if you're struggling with CANSLIM, you can plainly see that you're not alone.  Even the pros can't seem to get it quite right.

I will conclude by saying that I feel IBD is a great paper that is chock full of ideas.  It also preaches discipline and risk management which are extremely important concepts.  I would not follow the advice of the publication to the letter, but the concepts are dead on.

The headline from marketwatch.com reads Proposed funds up the ante to magnify stock market returns threefold.  So now it's party time because we're now going to average a return of about 30% per year given the conservative estimated 10% return per year on the S&P 500.  Before we go dancing in the streets, let's splash a cold dose of reality on this.  The fine print reads that they're attempting to mimic the move of the tracking index day to day, but returns over time may suffer tracking error.  Folks, tracking error is code for things won't add up and it certainly won't be in your favor.  When tracking error is discussed this is always referred to as returns less than that of the tracked index or basket.  Another misleading piece of the article is the reference to magnifying returns threefold.  Although returns are generally referred to in a positive context and risk is generally referred to in a negative context, let's focus on returns as both negative and positive.  So 3x returns also means 3x the losses.  Is this something you can deal with in your portfolio?

Let's have a look at how a simple 2x leverage fund stacks up against 1x ETFs.  This simple chart plots the QQQQ against its 2x leveraged product the QLD.

(click to enlarge)

Over the last two years, the leveraged ETF when simply held has created nothing but stomach churning.  And when the going got tough, the leveraged product got rough.  This product may be great for day trading and maybe swing trading, but buy and hold is clearly another story.  Based on this chart, you can probably devise a system for when the leveraged product deviates from the non-leveraged product to do a little pair trading or long one and/or short the other.  But that's also wild and speculative.  My point is that for a buy and hold investor, this doesn't make any sense.

Based on my post from Friday and Pete's suggestion to Google (which I had done already at least 10 times), I decided to give it one more go.  It took about 30 minutes, but I finally found what I was looking in an obscure link from one of the exchange's web site.  The OCC provides volume data across all exchanges.  I wish it was aggregated, but either way, this will definitely save me some time!

Oh, and here's the link.  http://www.theocc.com/market/volume/volbyproduct_form.jsp

My interest in trading systems grew in tandem with my interest for options.  At various points throughout the years, I've focused on one more than another, but I've always kept the two in my mind.  While developing trading systems, I'd keep in mind how options could be applied.  And the same goes for looking at option strategies and how they might be applied to trading systems.  Allow for two quick examples.  If one were developing a trading system for thinly traded stocks or penny stocks, there is likely no possibility that this could be used with options.  If one is studying 4+ leg option strategies, there is likely no possibility that this could be used within a trading system since fills and spreads would probably kill a lot of your trading system's edge.  The good news is, trading systems like options typically do better in a high liquidity environment.  If you're getting bad fills in either options or within your trading system, it's very likely that your backtested results are not going to be anywhere near your trading account results.

Another lesson learned over the years is the effect bad data has on your testing results.  This can be somewhat mitigated by statements made in my previous post regarding mixing up your watchlist.  However, when reviewing your results you may notice some wildly profitable positions.  A clear signature of this is a windfall profit after a hold time of only one bar.  This is further established when you have a profit target and the position closes far above that target.  Typically in a trading system with profit targets based on daily data, your PT order will be submitted the next bar (day) after the system gets confirmation that the order was filled.  Of course, you can get a finer granularity of data and make this happen much quicker, but let's keep it simple because it can apply across the board.  Typically what happens is a rogue tick or just a plain wrong low/high print will trigger the backtesting engine to open a trade.  This will cause your position, when analyzed at the close, to show a massive, but erroneous profit.

Most modern backtesting tools (RightEdge included, of course), have the ability to specify how many open positions you'll allow per symbol.  While testing my systems, I typically like to allow a single open position per symbol.  The reason for this is that multiple open positions per symbol can skew your results and exacerbate survivorship bias.  Most are familiar with the term survivorship bias, but if you're not, I'll explain very briefly.  A trading system is already "cheating" because it's taking symbols of companies that currently exist.  In other words, merely surviving as a company is a big assumption you've made in your system.  You add to that risk by allowing open orders to pile on top of open orders.  With survivorship bias, we already know that today the company is alive and (hopefully) doing well.  However, in your backtesting, more than likely you've bought more and more as the company shares were plummetting and then at some point the whole thing was rescued and you were rewarded handsomely for the risk assumed.  This is represented in your phenomenal backtesting results.  Your backtest does not understand this risk, but you should.

Note: I've tried to get the bank accept my backtesting profits as deposits and they won't.

Platinum lovers in the United States will finally get what they've been asking for.  Tomorrow, a brand new (probably shiny) ETN will launch along with its short counterpart on the NYSE.  The ticker symbols are PTM for the long platinum and PTD for the short platinum.  These will be brought to you by UBS E-TRACS.  Non-U.S. traders have had a platinum ETF on the market for over a year.  All U.S. traders who wanted platinum exposure could only do so through futures contracts, until tomorrow.

No information has been posted to their site at the time of this writing.

I've been working on a new trading system.  Since we're hard at work on RightEdge during the day, day trading is not really an option with a real account.  I've always enjoyed trading on daily data because of the pace.  I can always go back and analyze the trade in progress.  My goals for this system are:

• Relatively frequent trades.
• Manageable drawdown
• 1 position per symbol
• Low exposure per symbol

A few things I've learned over the years is how deadly curve fitting can be.  I've discussed this in the past but would like to reiterate some of my ways for getting around this.  Naturally, trading systems are curve fitted to a certain degree, otherwise they would be random.  However, what I'm trying to avoid is tailoring the curve to my particular watch list and/or time period.  To avoid that, I change watchlists frequently while developing, testing and optimizing the system.  As you tweak parameters, you should begin to notice some normal distribution of results.  For example, let's take a profit target.  Let's say you set a profit target as an optimization parameter and the value is 1% to 10% with a step of 1.  You'll likely notice that your winning percentage will go down as your profit parameter goes up and your net profit will likely form a bell curve of sorts if plotted where the profit target is X and the net profit is Y.  Hopefully, this type of pattern repeats itself to a certain degree as you change your watchlist.  Oh yes, and don't just change your watchlist, change your timeframe as well!  If your system has 70% winners, for example, it should hang pretty close to that for any time period you test.  If it's a long only system, it will likely do better in bulls and worse in bears.  This is an inevitability.

One of the traps I fell into years ago was developing a system (usually an extreme system) and then finding a watchlist that looked good with my system.  This was a great way to lose money, and I did!

Testing Your Trading System

It probably sounds obvious, but backtesting your system is just the beginning of your testing process.  The second phase of testing is executing it in real time market conditions.  If you're relatively new to executing systems live, I highly recommend you sign up for an account that has simulated trading.  Enter your orders (or have RightEdge do it) to your broker and let them get filled in real time.  Follow your account with simulation for some time and see if the simulation picks up trades or fills that didn't really happen.  This will hopefully identify the degree of error in data.  If you see one of these, be concerned, if you see several, abandon ship.  The last phase of testing is running it in a live account with real money, however, use about 1/10th the size that you will when you go into production.  Let's say you are going to allocate $10,000 for a trading system and you'll allocate no more than 10% per trade in production, or $1,000.  For testing, I highly recommend doing 10% of that, so each trade would be $100.  You'll likely lose small money on the commission, but that's a small price to pay for validating your system with real money.

Back to my trading system, I'm in the second phase of testing at this point.  I'll be testing over the next couple of weeks or more in a simulated account and then moving over to real money if everything pans out.  I'll keep you posted.