discount brokers and technical analysis

The stock market can be considered as the place where the financial characteristics of publicly traded companies meet the hopes and fears of potential equity investors.  Fundamental analysis addresses the former issue, technical analysis the latter.

In the US of the Roaring Twenties, technical analysis served both functions.  Depression era reforms that forced companies to release accurate and readily understandable financial statements had not yet been enacted.  So the trading activity of “insiders,” detected by carefully watching price and volume movements, was the best gauge one could get of how firms were actually doing.

Since that’s no longer the case, why do online brokers (Merrill Edge is the only exception I know of) provide such lame information on company fundamentals?

Several reasons, I think:

–brokers earn their revenue from trading, not from investment results.  (For what it’s worth, there’s a strong belief in the professional investment community that there’s an inverse correlation between the amount of trading a portfolio manager does and investment performance.)  So it makes some business sense that they should provide tools that make trades easy to do, with an old-style video game-like interface that makes it seem important and fun.

–a fundamental research effort is a headache.  It’s difficult to create and sustain.   It’s expensive, as well.  Arguably, offering proprietary research also exposes the broker to liability if the recommendations don’t pan out.  The user needs some accounting/economic background to understand what’s being said.  The broker who provides fundamental research has an obligation to consider whether a recommendation is suitable for a given client–opening another can of worms.  And, of course, an emphasis on fundamentals runs the risk of refocusing clients away from frequent trading, to the detriment of profits.

–discount brokers do offer a kind of fundamentals-based product through actively-managed mutual funds and ETFs, as well as through their sponsorship of networks of financial planners for whom they provide back office services.  Offering fundamental research might put brokers into competition with those planners.  And the fundamentally-based fund offerings carry a much higher price tag than DIY trading.


trading (ii)

have a game plan

In the beginning, when you’re feeling your way, a plan will likely be relatively simple.  Still, it should contain at least three elements:

–what you intend to do

–why what you’re doing will enable you to make money, and

–how you are going to measure your performance.

the process

In all likelihood, a trading process will include a healthy dose of technical analysis, which in its saner elements is an effort to read the short-term emotional mood of the market.

Take the case of Tesla (TSLA), where investors seem to alternate between bouts of severe depression and wild enthusiasm.  The plan may consist simply of buying TSLA at, say, $200-, when spirits are flagging, and selling at $250+, when owners are dancing in the streets.

Or it could be that you’ve held Amazon (AMZN) for years.  You observe that the stock is travelling in an upward-sloping channel that’s now bounded on the low side at, say, $750 and on the high side at $850.  You might decide you can trade around a core position by selling some of what you own above $850 and buying below $750.

the source of profits

Ultimately you have to believe that something you do gives you an edge over the average investor. Maybe you are very familiar with the price action of a certain stock because you’ve owned it for a long time.  Maybe your work gives you insight into the publicly traded companies in a given industry or geographical area.  Maybe you think that rising trading volume always precedes rising/falling price and you use screens to identify stocks where this is happening.

measuring performance

There’s a very strong tendency among even professional investors to remember successes vividly but brush losses under the rug.  Because of this, it’s essential to measure how you’re doing, both in absolute terms and relative to the performance of a benchmark index on at least a monthly basis.

This is also the best way to identify your strengths and, more importantly, the mistakes you are prone to.  Everyone has something in this second category.  Simply no longer doing stuff that you always lose money on can give a big boost to performance.  I know this sounds silly, but I can’t think of a single professional I’ve known over the years who hasn’t had to deal with eliminating a chronic bad investment habit.

More on Monday.


so you want to be a day trader

why trading?

As human beings, we’re all very complex.  Sometimes(often, in my case) we do things for reasons we don’t clearly understand.  We can be influenced in ways we’re not fully conscious of by our families, our friends, our neighbors, our heritage   …as well as by daily bombardment by media of all types.

Sounds silly, but:

–Early in my career as an analyst, I remember calling the CFO of an oil and gas exploration firm to ask him, in polite terms, why anyone would buy the tax shelter programs he was selling through investment advisers, since my reading of the prospectuses seemed to show that virtually all the benefits went to the promoter.  His reply was that buyers were not particularly sophisticated financially.  They typically bought the programs as a way to signal to others that they were wealthy enough to have a “tax problem.”

–Some people are attracted to the riskiest stocks simply because they’re risky rather than because they might offer superior returns.  Buying them is in effect a substitute for going on a thrill ride at the amusement park.

In my experience, successful investors and successful traders have one thing in common.  They are clear about their purpose   …which is to make money.  They’re not working to feed their egos, make friends, or enhance their standing in the minds of others, although these positive things might be nice as side effects.  It’s all about making a return.

This is not to say one shouldn’t have scruples.  As an active manager, I avoided tobacco stocks, for example, because I believe this is a morally bankrupt business.

There’s also no way to know whether you can make money buy buying and selling financial instruments–whatever your holding period–unless you try.

Nevertheless, if you are going to be successful, the bottom line must be that you intend to make a profit.


More tomorrow.
























trading: buying in thirds

coming late to the party

I’ve found that the situation arises more often than one might think where I find a stock I think it interesting but where I’m very clearly not the first one at the party.  In other words, the company has potentially attractive long-term prospects but the stock is not cheap enough that I can justify buying a full position right away–and I don’t have a practical feel for how it trades.  My instinct is that the price is a bit too high, but I’m not sure.

how to get involved?

What I’ll typically do is buy a third of the position I ultimately want to have.

I’ll then continue to find out more about the company and watch the stock’s trading carefully (my experience is that people, myself included, never look hard enough if the name is only in a paper portfolio–a kind of portfolio I find psychologically pretty useless, anyway).

My intention will be to buy another third on a decline of, say, 5% – 10%, assuming I don;t turn up new information, positive or negative, that overturns my whole thesis.

If I I buy the second third, I’ll wait for a further decline to buy the final portion.

What does this method get me?  I have immediate exposure, in case I’m correct on the stock but too pessimistic on valuation.  At the same time, I still have a chance to lower my average cost by buying the bulk of the position at a lower price.

an example

My California son and I have been talking about the Elon Musk empire for a long time.  Following its weak  4Q14 results, our conversation turned to Tesla (TSLA).  It’s a stock I’ve owned off and on, but my son hasn’t.  (My view, (too) simply put, is that TSLA is a lot like a gold mining issue whose assets consist solely/predominantly in ownership of a reportedly fabulous orebody now under development.  Such stocks typically peak the day the mine opens–when investors have to deal with facts, not dreams.  Before then, the dreams are more important. )

My reading of the TSLA chart–hopefully more useful than parsing nocturnal visions with a dream book–made me think the stock continues to trade in a range between $180 and $260-ish.  I was also willing to believe that TSLA’s 4Q14 failure to sell enough cars was mostly due to bad weather and port difficulties.

Anyway, I decided to buy my first third at $200.  My son said he would wait for $190.

I bought his first third at around $191, where I bought my second third.

I bought his second third at $186? …and another (less than) one-third for myself there. as well.

Then the stock began to move up quickly and we haven’t bought any more.

The result:  my son has a somewhat smaller position, relative to his total portfolio size, with an average cost of $188?.  I have a larger relative position, with a higher relative cost, $194?.  So we both have exposure, and at a lower cost than if we’d bought all at once.

Another point: We’re dealing with a discount broker where our total commission costs are around $20.  Paying for two or three trades instead of one makes little difference.  For a traditional “full service” broker, this probably won’t be the case.





Blackrock’s new trading platform as attack on traditional money managers (l): background

I’m going to write two posts about the internal trade order-matching network that Blackrock intends to have up and running next year.  This one will provide background, some of which I’ve written about before.  Tomorrow’s will deal with how the Blackrock network fits as a strategic weapon in the money manager’s arsenal.

three types of commission

For a conventional money manager, commissions paid for trades–or bid-asked spreads, which amount to the same thing–break out into three types, from most expensive to least:

–research commissions, aka “soft dollar” commissions.  These commissions consist of a payment to a broker for executing and recording a trade plus an amount to compensate for research services.  Ten years ago the research service payment was predominantly in return for information from the broker’s own in-house research.  Today, most brokerage house analysts have been laid off and work in independent research boutiques that their former employers act as middlemen for.

The amount paid per trade will depend on the size and trading habits of a given institutional client, by may amount to, say, $.05 per share.

–commissions for execution.  These are paid strictly in accord with the SEC mandate for registered money managers to obtain “best price” and “best execution” when they trade for clients. They might amount to $.03 per share, of which $.015 might be the broker’s cost and the remainder a profit element.

–trades through electronic crossing networks, aka “dark pools” (for fantasy or vampire fans, I guess).  These have become increasingly popular.  One advantage of such networks is their low cost–maybe $.001 over the expense of executing a trade.  The second is their anonymity–you don’t run the risk that your intentions are not only broadcast to your broker’s proprietary trading desk, as they surely are, but also to all the broker’s best customers as well.

attacks on the conventional model

Blackrock’s new trading platform is the latest one.  That’s tomorrow’s story.

A second attack, blunted for a while by the financial crisis, is coming from Fidelity and concerns soft dollars.

When I entered the industry, conventional money management firms typically had large cadres of in-house research analysts who serviced the firm’s portfolio managers and reported to a research director.  This was expensive.  Also, in many cases the firms didn’t have strong enough general management to ensure the in-house research was any good.

As time went on, firms gradually shrank their in-house research efforts.  Instead, they began to increasingly depend on analysis generated by the brokerage houses they traded with–paid for with higher-than-normal commissions.  This “solved” the management problem.  And it had the added benefit of increasing profits by shifting the cost of research away from salaries paid out of the money manager’s fee income to commission expense paid by the client!

How do you justify this, either to the SEC (assuming the agency weren’t clueless) or to clients?  The standard response was that this was normal industry practice.  How so?  …because that’s what the industry giant, Fidelity, does.  The mantra has been that if Fidelity allocates 15% of its commission volume to pay for research, it’s ok for everyone else to do that, too.

Just before the onset of the financial crisis, however, Fidelity, which has a large in-house research staff, decided to change its practice.  It proposed to the major brokers that it pay them a set cash fee for research each year, say, $8 million.

Brokers balked, for two reasons.  The money was been less than they were getting paid before.  It would have forced an internal reallocation of compensation away from the traders who run the firms to the researchers who were specifically identified with the fee income.

For other money managers–to my mind, the true target of the Fidelity initiative–this was a nightmare.  They could no longer use Fidelity as justification for their soft dollar spending.  In addition, their profits would plunge as they either paid out large portions of their management fee income to newly rehired research analysts or to brokers for their research output.  Smaller managers might be forced to close up shop.

The soft dollar issue hasn’t gone away.  Brokers, however, have “solved” their internal profit allocation problem in the short term by firing most of their veteran researchers during the downturn.  And Fidelity seems to have lost interest for the moment in pushing the issue.  …or at least publicizing it.  It may well be striking cash deals with small research boutiques.

I think Blackrock’s trading platform idea has similar elements of using large market size to damage smaller competitors while at the same time making a profit for itself.

Should you “buy when there’s blood in the streets”? … or “not try to catch a falling knife”?

Wall Street has spawned millions of clichés.  They run from capturing the essence of stock investing, “Buy low; sell high” to not-so-useful chatter (for investors) from traders, like “Wait for a pullback,” to the inane natterings of cable TV show personalities.

Market truisms are often mutually contradictory.  But, excepting the ones from TV, they often outline possible approaches to important investment issues.   That’s certainly the case with the two I’ve cited in the title for this post, which talk about how to deal with sharp drops in the market in general, and how to play a possible upturn in the business cycle (and therefore in the market cycle as well) in particular.

the big middle

In the old days–meaning pre-Eighties, professional investors in the US customarily talked about working the “big middle.”   The idea was to avoid undue risk at potential cyclical turning points in the market.  A manager would do this by becoming more defensive as he saw three signs:  the economy beginning to expand at an unsustainably high rate, the market becoming fully valued and the Fed about to shift money policy from expansive to restrictive.

He might miss the actual market peak by months.  But he was prepared to profit from the subsequent downturn.  As he sensed the opposite signs, however–the economy flagging, the market cheap and the Fed about to reverse course–he would do nothing.  He would wait for the market to clearly turn upward again before becoming more aggressive.  Again, he might miss the absolute bottom by months, but he would avoid coming out of his defensive position too soon and he would gain performance for a year or more after he turned his portfolio more positive.

No one talks about this overall strategy anymore.  Why not?

–For one thing, as a result of deliberate policy decisions by the major governments of the world over at least the past quarter-century, individual country economies are much more closely linked in a global network than they were.  The closed economy model is a thing of the past.  Markets are affected, sometimes profoundly, by events that take place elsewhere and over which the local government has only limited control.

–The investment business is much more competitive today than it was then.  Underperforming for six months or a year may be enough to get a manager fired before the “big middle” strategy allows him to catch up.  His clients may say they’re ok with the risk mitigation his approach provides, but when the numbers fall behind the peer group, memories can be very short.  And it’s always the customer’s right to take his business elsewhere if e chooses.

–For thirty years, we’ve been seeing the creation of ever newer derivatives tools that allow the manager to change portfolio composition much more quickly than before.  In addition, volumes in the physical market have been steadily increasing as well, allowing managers whose contracts with customers bar the use of derivatives to act swiftly, too.  Maybe we’re now seeing the limits to this speed, even large market participants have the flexibility to alter their portfolio structure in a matter of a few weeks if they choose to.

To sum up, linkages with the rest of the globe mean more chances for sharp short-term market movements, which new tools and increased competition have professionals increasingly focused on.  Also, as the recent “Crash of 2:45” shows, the new tools themselves may be another source of temporary market instability.

the falling knife

Opinion is divided on how to approach sharp market declines.  “Don’t try to catch a falling knife” expresses one technique.  I’m not sure what the origin is.  I’ve only begun recently to hear it in the US, although it was already very common among British investors when I began to look carefully at foreign markets in the mid-Eighties.

The “falling knife” idea is a variation on the “big middle” theme.   The thought is that when investors are selling aggressively and stocks are dropping sharply, it’s better to wait until this energy has exhausted itself before going in to pick up the pieces.  See the bottom and watch the turn happening before entering the market.

blood in the streets

The “blood in the streets” approach is to some degree the opposite idea.  Buy when everyone else is selling, when the predominant emotion in the market is fear, and when stocks are cheap.  Don’t wait for the turn.  By the time you’ve convinced yourself that the worst is over, the best buying opportunity is long gone.

more professionals are embracing the “blood” idea…

…in my opinion, anyway, for two reasons.  The opportunity to profit from market disruptions, and by doing so to perform better than one’s peers, is too great to ignore.  Increasingly, the time period over which clients are judging professionals’ performance is shrinking.  Hedge funds, where returns may be scrutinized and evaluated on a month by month basis, are the limiting case.  But this performance pressure is also being felt by long-only managers.

What should individuals do?

The most important thing is to ask yourself two related questions:

–Are you willing to accept the extra risk of trying to trade a downdraft in the market?

–Is your financial situation strong enough that you can absorb possible losses if you turn out to be wrong?

Assuming the answer to both questions is “yes,”  these are my thoughts:

1.  Ask yourself what the primary trend in the market is.  Are stocks generally going up or generally doing down?  Are we in a bull market or a bear market?

In my opinion, you should only be interested in counter-trend movements.  Only think about buying, or about replacing defensive stocks with more aggressive ones, during a decline that happens in a bull market.  Conversely, only use a sharp upturn to become more defensive during a bear market.  Otherwise, do nothing.  During the past twenty years, the lows have typically been much lower, and the highs higher, than anyone would have predicted.  Welcome to a world with derivatives trading.

2.  Calculate probabilities as best you can.  The point is that you don’t need to find the absolute bottom in order to act.  For me, if I can satisfy myself that a stock might go down 10% but has an equal chance of going up 30%, I’m happy to buy.  Your own risk tolerances will determine what the appropriate ratio is for you.

3.  Separate market events from stock-specific ones.  In a temporary downturn, more economically sensitive stocks will typically decline more than defensive ones.  Similar stocks in the same industry should show roughly similar volume and percentage change patterns.   These patterns should also be similar to the stocks’ behavior during past declines.  An individual stock decline that is, say, twice what one should expect and that happens on much higher than expected volume can be a warning sign that sellers are acting on newly developed negative information that you may not be aware of.  In such a case, discretion is the better part of valor.  Choose a different stock to buy, or don’t transact at all.

4.  Don’t force yourself to do anything you don’t feel comfortable with.  I think it’s a characteristic of today’s market environment that if you miss an opportunity today, another one will likely occur in a month or two.

Trading: how valuable is it to do?

For professionals, very…

The short answer:  my experience is that competent professional trading supporting an equity portfolio manager can add one percentage point to annual returns.  Conversely, poor trading can subtract about the same amount.  Good trading, then, can take a third-quartile manager and put him in the second quartile; bad trading can do the opposite.

…for us, not so much

What about for you and me, though?

I think the key question for any individual investor is how much time is he willing to devote to investing.  A typical professional spends fifty hard–that is, not counting chatting in the coffee room with colleagues–at-the-desk working hours a week on his craft.  Even so, that’s not enough to keep pace with professional competition.  So the job of investing is usually split into three parts, one of which each professional in a firm will concentrate on.  The three are:  research, trading and portfolio management.

Realistically, we’re not going to work as hard as that, no matter what we tell ourselves.  So it’s essential for us to simplify and prioritize our activity so that we can do one or two things well, rather than do a half-baked job on several.

Committing our time to investing

As far as time commitment goes, I think the three parts break out as follows:

1.  portfolio management. Learning how to formulate a strategy takes the most time initially.  Once you actually create one, you’re thinking of it in odd moments most of the time, but your real work of testing, evaluating, trying to figure out what will come up next, is only done for short periods once or twice a month.  In terms of everyday effort, this most important part of managing your money takes the least time.

2.  securities analysis. Selecting the individual stocks, if any, for your portfolio requires a considerable initial effort to learn about he companies, their histories and their prospects.  Monitoring company developments and the stock’s price action takes daily attention if you want to do things right.

3.  trading. Trading can absorb your entire day, if you want it to.  After all, investment managers pay their traders hundreds of thousands of dollars yearly to do just that–to watch the markets, from overseas and pre-market activity to after-hours trading.    The question for us is whether, if we’re going to devote, say, 15 hours a week to our investments, becoming expert in this area is the most valuable use of our time.

(I probably should mention that I do have a  trading experience.  For about five years I ran a global fund where I was the manager and also did all the trading.  I won’t claim to be a really proficient trader, but I’m not that bad.)

Trading takes up a lot of time

An example:  one of my sons, a twenty-something, asked me recently to sell the (small amount of) PALM that he owned and put the proceeds into ATVI.  He had bought PALM, which I consider a really speculative stock (too much so for me), after a Bono-related investment vehicle had given the company an infusion of cash that would allow it to complete and launch the Pre. My son later became convinced that the Pre was going to be upstaged by the raft of Android phones now being released–which is why he wanted to sell.

Anyway, my son gave me a limit of $12 for PALM and none for ATVI.  I placed two limit orders online, one for PALM at $12 and another for ATVI about 2% below the previous close.  I thought the market was going sideways and both stocks were volatile enough intraday that the limits would likely hit.  I then did other things.

On day one, nothing happened.  On day two, prior to the open an analyst released a buy recommendation on PALM that pushed the stock up to $12.27 in early trade.  The stock faded as the day went on and closed at about $11.65.  Of course, I had sold at $12.  on day three, ATVI fell about $.05 below my limit intraday, before closing slightly above it.

Could I have done better?  Yes.  Speaking strictly about trading PALM, I could have spent all of day one and the first couple of hours of day two watching the market.  When I saw the new buy report on day two, I hopefully would have let the stock run and sold at, maybe, $12.20.

For us, it’s too much

But that would have meant spending eight or nine hours monitoring trading in PALM to get another 2%.  As one of my first bosses told me when I was talking about making a trade that might get me 10%–our job is to look for the 30%s and the 50%;  105 is too little to waste time and energy on.

To that, I’d add that if we’re going to allocate ten hours a week to investing, it’s better to spend that time trying to find the next AAPL rather than blowing a week’s worth of time looking for a 2% that may or may not be there for the taking.

Why do all the discount broker ads talk about trading, then?

Three reasons:

1.  The obvious one.  Trading is the service a discount broker offers.  The more you trade, the more money the broker makes from your account.  (See my posts on how your broker gets paid.)  The broker will also benefit if your account grows, but he will gain more from high turnover in an underperforming portfolio than from a low turnover one that outperforms.

2.  Trading tools are easy to provide.  You can even get them for free from Yahoo or Google.

3.  Offering trading advice is much simpler than offering investment advice.  Giving investment advice to a broad range of customers isn’t cheap or easy.  The broker opens himself to the risk of litigation if the investment advice proves unsound or if it is unsuitable for the economic circumstances of a given client.  So the discount broker has to have a research staff (which will end up costing the firm a lot of money) and representatives who will do risk tolerance and other suitability analysis.  Suddenly, the firm that does this not a discount broker any more.  It’s an old-fashioned “full service” broker.

Besides, discount brokers already offer back office services to independent financial planners.  So they would be competing against their own customers.