So the headline today is that the Dow is having its best month in 20 years. It sounds like a statistical outlier, some extremely rare event ... something you shouldn't weigh too heavily in your speculative analysis. Hopefully you're detecting my sarcasm. You can look at it a different way, I started testing my new system this month and wouldn't you know it, we have some statistical improbability on the very first month! If you're a trading system developer, surely you feel that the moment your new system goes live that the market is out to prove that your system doesn't work any more. heh.

Good thing I decided to cap my risk with a bear call spread. It's tempting to go with naked options to keep more premium, but if the indexes have thier "best month in 20 years" you're screwed. With the spreads, my risk is always 100% defined. I also opened way out of the money, so while the indexes have run straight up, my 56/57 spread is still out of the money (although not by much). The only time I ever consider running naked (sorry for the bad visual) is when I don't mind the pure directional bet that assignment might put me in. In the case of IWM, I put on a put credit spread to the downside because I didn't want to own more IWM. The bear call spread to upside is because I don't want to be short IWM. If either of those statements were inverse, I would consider going naked.

So the plan at this point is to wait. August is typically a slow month thanks to summer vacations. I expect a bit of mean reversion. It's a weird feeling when you don't really care which way the market heads. My only real care is if the market heads down sharply. But then again, if that happens, I buy more long term holdings. I think a wise man once said, trade what's there, not what you think is there. So I stress, once again, to have a plan for all cases.

The last 12 months have been particularly brutal for investors. The very fundamentals of the markets and investing were challenged. Asset allocation was declared dead, talks of shotgun shells and gold being the new world currency, calls for S&P to go to 350 and all other sorts of mayhem. People were scared, they sold indisciminately and without a plan. It was the topic of many discussions with friends and family when normally the topics were kept to things much lighter such as sports or the newest restaurant around town. Everything was different this time, the banks were going to collapse, real estate and home prices permanently changed, expected returns from the markets forever altered.

Deja vu all over again. Today, the Dow is flirting with 10,000, the S&P 1,000. This isn't back to the good ol' days by any stretch, but its hardly collapse. The question I asked over and over again to the sellers is 'when do you get back in?'.  No one ever really had an answer to that question. It was all about running for your life.

I write this to hopefully have something to draw back on when the next "this time it's different" bear market rolls around. I'm not signaling an all clear, but we're substantially off of our lows, numbers are stabilizing and the VIX is at 25. The world to this point did not quit spinning. There's still a lot of recovering to do, but my long term portfolio is in the black (speculative is not) and I suspect a lot of other people are starting to feel relief instead of fear. In fact, I heard one of the morning radio jockeys tell people that it was now OK to open their 401K statement. Talk about random.

A rare political rant, but while reading the weekend IBD, the chart below really struck me. During previous recessions, it was usually mentioned that "ya, we're bad, but the unemployment rate is much higher in Europe". Somehow that statement was comforting. Perhaps that's why the chart below is disturbing. We're now at the same unemployment rate as our friends in Europe. Yet somehow the president can declare that jobs have been saved and the stimulus is working.

What's very remarkable is not just the number, but the steepness of the line.  Europe shot up as did most developed nations, but we still managed to catch up. Housing and market prices have stabilized in the short term, so maybe there is hope of the unemployment stabilizing as well. I'm skeptical if not downright pessimistic that we're going to see unemployment below 7% any time soon. Unemployment, arguably, is a lagging indicator. Even so, I'd be very hesitatnt to say that the stimulus is working and much more inclined to say that it's too early to tell.

In the previous article, I shared my 56/57 bear call spread on IWM.  Yesterday's close was 55.09, putting my short calls at risk. Even though it is statistically unlikely for the short calls to finish in the money, it wasn't impossible by any stretch. The impressive winning streak over the last couple of weeks has really made for interesting times on the speculative positions which are nearly all statistical. When things deviate outside of their probabilities, my speculative positions usually hurt. It's not always the case though. I do have some speculative positions (just plain stock) that have ratcheted some nice wins in the last couple of weeks. They were sold at their respective profit targets. It's also interesting because my long term portfolio (which holds some long IWM) is now down $103 total. I consider this a full recovery. So when the market moves up, I'm happy. When the market moves down, it hurts, but not quite as much.

For some reason I like to spend more time on creative positions and analyze those that are losing. The key here is that I don't want surprises. If the position is behaving differently than I anticipated with whatever the market delivered, I obviously don't understand what I'm doing and need to close the position. Thankfully, that's not the case here. In fact, I've been so happy with the way things are acting, I've decided to double down a bit. I opened another spread at 59/60. This is another 5+% away from my original bear spread. Again, I'll be elated if we run to 59 or 60 by August expiration. But if we don't, I have a little locked in cushion. I'm also interested in watching this one behave in the wild as well. And for those keeping score, it was another 0.12 credit.

A week ago yesterday, I completed the Iron Condor trade I mentioned in that morning's article.  At the time I wrote, IWM was at 50.50 but steadily rose throughout the day.  With the IWM at ~51.40, I felt compelled to take a stab at the 56/57 bear call spread and was filled at 0.12 (same price as my put credit spread).  This is also ~10% out of the money on a position that was already about 7% ahead.  This allows me to eliminate most run-up's.  For the IWM to run 17% and hold it for one month would be unusual, but certainly not impossible, hell, it happened this year. I just consider highly unlikely.

So the numbers to watch are IWM 42 and IWM 56.  These are where my short options strikes are.  A close between 42 and 56 equals full profit ($12 credit for each side = $24 per Iron Condor spread).  A close above 56.24 or below 41.66 would mean a loss.  My maximum loss now is $66 per spread and my maximum profit is $24 per spread.  It really helps up the reward side on credit spreads when you do Iron Condors.  This is why most folks put them on immediately instead of "legging into" them as I did.  Since only one side can expire in the money, you hedge your maximum loss.  But instead of 1 way to lose, now you have 2 ways to lose.  There's always a trade off.

I may or may not convert into Iron Condors in the future.  The idea is to continue with the put credit spreads whenever my trading system flags a hit.  That's going to be automatic.  Whether or not I convert that into an Iron Condor is going to be at my discretion. I say its not likely in most cases unless there's a significant run up.

Right now my IC is in the red as the market has continued to move up day after day. It would still take a pretty extraordinary move (5+% to breach my short options), but it's certainly within the realm of possibility. I've not wagered much, so this is going to be a fun one to watch.

If you trade Iron Condors, I'd love to hear your thoughts on this trade.

OK, I don't know whether laugh or be disgusted, but I'm going to go ahead and laugh and file this under 'humor'.  I think picking on Lenny Dykstra and Cramer is shooting fish in a barrel, but at one point these guys had serious 'cred'. Cramer may in the eyes of many still yet, and that's scary. I've resisted the urge to needle Nails, but I thought I'd pass along a funny clip from The Daily Show with Jon Stewart.

Click (opens new window) (might need to disable pop up blocker)

Draw your own conclusion as to whether or not this is funny or scary, but know that no one is looking out for you. 

So my new system flagged a trade on Monday.  The market took a brief dip and then went higher on Monday and a bit more on Tuesday.  The put credit spread is firmly in the black for now. The next thought might be to complete this position as an iron condor. Briefly, an iron condor is an option position which really is comprised of two vertical spreads. Usually a put credit spread and a call credit spread. This is a market neutral strategy where you expect the underlying to stay fairly put so that both of your credit spreads expire worthless and you obtain maximum profit. Of course, markets don't always stay put and iron condors have pretty bad risk/rewards with extremely high success probabilities. I've read several cases where folks have been making consistent profits month after month for a year or two only to have one bad month wipe out all of the profit and then some. Iron condors are quite dangerous like that. You are short a ton of gamma.

My initial trading system is bullish only because I've never had any success being short of the indexes and being consistently profitable. So why would I entertain the idea of putting on a bear call spread now? Two things, one, if the underlying (in this case, IWM) moves much higher, the distance between my bull and bear spreads are substantial making the probability of both expiring worthless much greater. Second, I have a pretty good idea what the profit distribution looks on my existing trading system to hopefully discern a good spot to be relatively 'safe'.

(click to enlarge)

This profit distribution shows that most of my positions expire profitable and they're between 0-5%. A few make it as far as 10-15%. The 30-35% outliers concern me slightly because I think I might have a data error somewhere. But let's assume I don't and that 8 of the positions out of 100 or so make it to 20% or better. It would be relatively safe to put on a bear call spread when the underlying hits over 5% profitable. Most of my trades are ~10% out of the money, so that takes care of about 90+% of the cases of my bear call spread being a loser. And of course, this is offset by the fact that my bull put spread will certainly expire out of the money which adds to my bear call 'padding' should the short call get breached.

As of right this minute, my put credit spread was put on with IWM trading around $48. It's currently trading at $50.50 which represents about a 5% gain at this point. I haven't figured out my plan on this yet, so I may miss the boat to try it, but if it continues upward, I may give it a go and see what happens.

I'll keep you posted (after the fact).   Do not follow me. I could lose you lots of money.

Finally got a bite on the new trading system. I used RightEdge to develop the system. The goal of the system is low frequency / high probability. There are two reasons for this. One, I like winners more than losers, even if the R/R is skewed, it's better to win more psychologically. Let's say that you have a system that is 50% winners and 50% losers. The average winning profit is 5% and the average losing profit is 4%. This has a positive expectancy. Let's say you could take the same system and adjust it to be 60% winners and 40% loser with a winning and losing profit of 5%, which would you prefer (numbers aside). I like option B. Now, I'm completely making those numbers up, but hopefully you see my point.

Now the second reason for low frequency is that I can use options. Options require additional time for two reasons. One, once a trade is flagged, there are a number of strategies to pick from. Second, options are pretty illiquid so if you need to be in and out of a trade, options will let you down time and time again. My plan is to let the trade run until expiration (about 1 month per trade). Oh, and the options use far less capital, so I can let them go longer and give myself exposure to the same symbol a few times over without worrying about risk too much.

So on to the trade, my first entry was IWM. I went with an AUG 42/41 put credit spread. I was filled for 0.12 credit. The 42 strike is just over one standard deviation from the current price of $48. My backtesting shows that combined with my filters and indicators and a one standard deviation out of the money credit position that I should expect around a 95% success rate. Here again we have a high probability / dismal risk/reward type setup. Selling out of the money put credit spreads isn't a bad strategy by itself. You win some, you lose some. My idea is to couple this OK strategy with a pretty good trading system and see if the two make sparks.

I'll keep you posted. And as always, never, ever follow my advice or trades. These are works in progress designed to invoke thought and constructive conversation. Your ideas are welcome. 

Sing it with me ...

Tom Petty said it best for sure.  I've got my new trading system up and ready for testing.  As I mentioned before, it's an infrequent trader.  To reveal some more details, it's a mean reversion type system. At least it will expect that the current price when a position is opened will hold less than one standard deviation. My trading system has a filter in place that results in less trades, but from all of my tests so far, roughly the same profitability as a higher frequency system, because it has a higher winning percentage. Naturally, this produces a higher Sharpe Ratio and more restful nights.

So there is my empty "Scan" tab in RightEdge.  Nothing doing when it seems like so much is going on.  This is another bit of psychology that a trading system developer must overcome. It was a lesson that I learned the hard way in my earlier years. It's easy to try and outguess the system, but once you do so, you've invalidated all of your work as its no longer based on something systematic, but discretionary. Reward yourself by following your system as closely as possible. The testing phase should turn up differences between reality and backtesting. If there is a sharp contrast, the system must be chucked. But don't try and compensate, anticipate or outsmart your system. Make it a point to follow closely and change the system if necessary, not your behavior.

A front page story, for whatever reason, on marketwatch.com is the gasoline ETF (symbol: UGA). It is touted as an ETF that does not invest in oil, but rather, refined gasoline itself. This ETF has the same problems as an oil ETF, most notably, tracking error. I'm not sure how tracking refined gasoline futures contracts is any better than tracking crude oil futures contracts, but if you think so, there's ETF for that.  Recently, there has been a bit of an outrage about the leveraged and short ETFs that also suffer from tracking error. This ETF is structured to suffer from exactly the same problems. You see, these ETFs do not buy the commodity itself, but rather, they invest in futures contracts that allegedly track the spot price of the underlying commodity. This is probably good for short term trading, and I mean a couple of weeks at the most, but like the leveraged and short ETFs, this ETF will suffer from contango and backwardation of the underlying futures contracts.

This probably sounds like a silly statement, but I love to understand what I'm investing in.  Leveraged, short and futures investing ETFs, I just don't get.  Stocks and bonds are straightforward, options are fuzzy to most and are quite complicated, but once you understand them, there are models that can pretty much tell you exactly how they're going to behave as the variables change.  Those variables are time, price and volatility. Leveraged, short and futures investing ETFs move to the beat of their own drum. I don't understand the price moves (and please enlighten me if you do).  They vaguely represent the move of the underlying.

Let's talk about tracking problems.  The current price for spot crude oil is 69.31.  This is represents a large price of what you pay at the pump. The price of crude on December 23rd 2008 was 30.28, which was the 'bottom' of the price range during the last fuel price run up during 2006-2008. This represents a price increase of about 120% during December until today. Assuming you had the wherewithal to purchase some USO, which is the oil tracking ETF by the same company, on December 23rd, 2008, would your gain be 120%.  Well, nope.  The opening day price of USO on 12/23/2008 was 31.06.  USO trades today at 36.05. This is a paltry gain of 16%. This is approximately 1/5 of the gain of the actual spot price. Is this a sufficient hedge? I would say absolutely not.

So given the numbers I've put forth, would you 'hedge' your price at the pump using UGA? I wouldn't. Would you hedge your price at the pump with USO, again, I can say unequivocally, I would not. If the S&P 500 ran up 120% and the investing public who bought a fund that tracked the S&P 500 gained 16%, I would expect blood in the streets, or at the minimum, I would expect this fund to be hung out to dry. While the tracking error for leveraged and short funds on equities may not be as significant, you get the point. I strongly believe that if the S&P 500 was as volatile as the price of a barrel of oil, we would see similar behavior.

My point, as its been in the past, is to understand what you're investing in. I do NOT invest in a fund, stock, ETF, etc that doesn't have a track record of at least 2 years (unless I'm just gambling) and I hope you'll consider the same. I hope you'll consider following a similar mindset.

Have a great Independence Day. 

I wrote a review about Zecco here about two years ago.  I liked what I saw and opened a small account with them for speculative trades.  I've been with Interactive Brokers since 2001, so it would take a long, long track record to get me to switch.  Plus, IB options commissions could not be beat.  No mind.  Free stock trades isn't something to let go by.  I was also interested to see if 'free' cost money in the way of poor execution.  Much to my surprise, the execution was pretty good, even on odd lots.  There was no shenanigans with the free trades either, they were free.  No account minimums, inactivity fees, etc.  Well, that changed in October 2007 when I wrote this article about Zecco bait and switch.  The fall out to me was pretty spectacular (they were verbally whipped and beaten for weeks after the announcement). To me, this was a sign that their business model of giving things away for free wasn't working (I guess they thought they would make money on volume?).  They raised the zero commission minimum balance to $2,500.  I had more than that in the account, so I actually wasn't affected, but I saw the writing on the wall.  I sold what I wanted to sell and moved all cash back to my IB account where the rules weren't changing so quickly.  I could no longer trust this company.

I don't know when it was enacted, but I signed into Zecco today to take a look at my few remaining open positions and noticed that the new account minimum for zero commission is $25,000.  Quite a leap and I'm certainly not keeping that kind of money with a company like this.  So what have the new commission schedules gotten us little guys? Nothing that I can tell.  It's still a subpar platform with no bells and whistles.  I think the little guys $4.50 funded the forex operations which is a profit machine for most brokers at this point.

So as I suspected, the zero commissions was nothing more than an elaborate marketing scheme.  Hope nobody closed their IB accounts.