Such was my experience with spreads - specifically, Treasury Bill futures spreads.

After my initial experiences with futures trading in the early 1980’s, I decided to take a deep breath and do more research before heading back into the battle. I read about futures spreads, and took out a subscription to a publication called Spread Scope. It was an unassuming booklet, rather colorless  and plain, and contained a  collection of spread graphs of all of the major futures contracts.

First, a few lines about spreads. I found out that trading “raw” futures contracts can be dangerous - very dangerous. Even if you have a system with stops in place, once in a while some bit of news hits the tape, and your  position can go into either the stratosphere or the tank. And, as I found out with Orange Juice futures, your position can go limit up or down for several days in a row. If you happen to be on the correct side of the move, you couldn’t be happier. But, if you’re on the wrong side, you can be in for a rough ride to financial oblivion.

With a spread, you are both long and short the same commodity. So, if a limit move occurs you at least have  a chance of surviving.

Now, spreads do have volatility, but they aren’t nearly as volatile as the underlying contracts, so many traders of futures, or options, have figured out that spreads can be not only safer, but more profitable, than trading the underlying instruments. And because spreads are safer and less volatile than their “raw” contracts, the margin to trade them is substantially less. Instead of $1000-3000 , margin might be as low as $150.

As I flipped through the pages of Spread Scope one thing jumped out at me. The spread lines of the financials - Treasury Bills and Treasury Bonds, looked a lot smoother than other spreads. Another light going off in head.

The way to make money trading is to find a trend and just ride it. The less volatile the trend, the better. In other words, the smoother the trendline, the more likely it is that you can make money trading it, because the pullbacks and whipsaws are minimized. I call charts with smooth lines “smoothcharts”.

I was so interested in these smooth financial spread lines, that I sent for all the back issues of Spread Scope that were available. I collected several years of issues, and each one showed the same thing - smooth upsloping spread graphs of the financials. And, the smoothest lines belonged to the Treasury Bills.

The reason for this is that bills are sold at a “discount”. Over time the value of the bill rises at a rate that can be mathematically described as a log.  If interest rates remain steady or fall, treasury bills and their underlying futures rise at a steady rate until they expire, and more bills are issued. Treasury Bill, and later Eurodollar, futures were available for trading in various strikes - the shortest being three month bills. The three month TB spreads had the least volatility and the smoothest trendlines. As an example, if the month is August, you bought the September bill and sold the December bill. You were then long a three month Treasury Bill spread. The margin cost was $150 and you made $25 for every 1 cent of price movement, which was almost always up.

My Spread Scope research indicated that trading these spreads was the closest thing to a “sure thing” that I had ever found, so I decided to start trading them.

I called my broker at Lind Waldock and  bought one spread. I made some money. I bought another. I made money. My account balance at the time was under $5,000. As the account gained value, I had more money to buy more spreads.

Let’s step back for a minute and look at the larger picture. In the late 1970’s and early 1980’s there had been a terrible period of inflation and interest rates had skyrocketed. Thanks to a recession and Paul Volcker’s tight- fisted monetary policy, rates began to fall, and this was the perfect environment for rising bill and bond prices, and, as it turns out, this was the reason why the spreads were doing nothing but going up.

My account value began to increase at a fast pace - first to $10,000, then to 20, then to $50,000. By the time it hit $83,000 I was trading about 50 spreads. Each time TB futures increased by .01 I made another $1,250.

Then, one day, the Feds made an announcement and decided to change policy, and interest rates reversed course with a vengeance.  

At the moment of their statement  rates spiked in a move that hadn’t been seen in years, and my spreads began to plunge.

I had been plotting them on my point and figure charts, and at the end of the day the charts signaled a “sell”. However, I had never seen a sell like this before and it looked like an anomaly. So, the next morning I decided to watch the market to see if the spreads would rebound. They didn’t and my 50 spreads plunged, so I sold some. Now, with all trading there is something called “commissions and slippage”. This can hurt, especially on market orders of large numbers of spreads. You have to pay a commission on each side of the spread, and there is slippage on each side. Bottom line - money goes away very fast.

After I sold off some spreads, I was forced to sell more. Then, the market rebounded, and I got a buy signal on my charts, so I stepped back in and bought more spreads. Of course, this was a “whipsaw” and the market plunged again, so I got a sell signal, and sold more spreads. This back and forth continued. Not only was the smooth uptrend of the previous several years broken, but my trading system stopped working, and my account value continued to fall.

The next few weeks didn’t go well, and to make a long and painful story very short, by the time I stopped trading ,my $83,000 had plunged to $3,000. Now, this seems hard to believe if you haven’t traded futures before. However, I can assure you that my story is being repeated over and over again all over the world as you read this.

When my account was going up daily, I was euphoric. When it all came to a crashing halt, I was just stunned. Welcome to the wonderful world of fear and greed, or is it greed and fear.

I told myself that it had been better to experience this with “only” $83,000 than millions. My losses were “tuition” paid to the school of hard knocks and experience. And, after all was closed out, I had only lost, really, about $2,000.

And what did I learn from all of this? Well, I did learn that markets go down a lot faster than they go up. I learned that bubbles do burst, and when they deflate the air goes out of them very fast. I learned that the same over-leverage that can propel you into the financial thermosphere can just as quickly smash you into the dust. Reward IS proportional to risk.

I learned that it’s extremely difficult, and likely impossible, to come up with a trading system that works in all types of markets. A trend following system will get smashed in a choppy market. And, a system that tries to pick tops and bottoms in a channeling market will get blown out in a trending market, and you never know when a market will change from trending to choppy and back again.

I found out about commission and slippage costs and gap openings. But, the real lesson learned was about myself and how I reacted to wild market swings. I found that I just couldn’t resist the temptation to buy as many spreads as my margin would allow, and how that level of greed and over-confidence would play out in real time. And, when I hear about traders who blow billions of dollars, I understand how it happened, except on a much different scale.

Eventually, Treasury Bill futures became unpopular, and Eurodollar futures took off, and many years after my spread experience, I got on board the Eurodollar express on an even larger scale, a story I will tell in another post.

However, most traders then, and  now, used both  fundamental analysis and what I call “personal analysis” to decide what and when to trade stocks. Before the PC era you could subscribe to newsletters and charting services that mailed you weekly or monthly books of stock charts. The idea was that once a week, or month, you would look through the charts and decide what you were going to trade. I subscribed to a number of these services and had piles of their soft cover booklets stored for reference in my home office. Any buy or sell ideas had to be tested by writing down the trade prices then computing the numbers by hand. Starting in the late 70’s a  few brave soles used the Apple II, and eventually the first IBM PC, to do this, using the primitive spreadsheet programs that became available over time. 

The bottom line was that “system traders” were out there, but coming up with any meaningful backtesting was not easy to accomplish with the tools available. 

I though it might be of interest to look at how far we have come in this roaring number-crunching era, by looking at how I started my quest for calculating help.

As a child my favorite Sci-Fi movie was The Day The Earth Stood Still (1951). The inside of the alien flying saucer contained a computer with twinkling lights and no paper. In the 1960’s my favorite TV program became Star Trek - again, with a computer that Captain Kirk spoke to, and of course, the Enterprise had no paper, and the ship’s computers had twinkling lights and beeping sounds. 

Now, that was a vision of the future!  However, the reality of the mid-1960’s was that the electronic calculator hadn’t been invented yet. Computers were huge and extremely expensive machines that were locked in back rooms of large companies. And, if you wanted to calculate anything you had to do it by hand, or use a slide rule, or a calculating machine of some sort. 

I had a number of slide rules - long ones, and circular ones. One day I decided to search for a calculating machine. I loved crunching numbers, and at the time my hobby was weather forecasting, and I wanted to calculate averages and moving averages. So, I found a used mechanical calculating machine, that looked like, and felt like a small cash register, with a pull handle to activate the gears. This was a heavy, clunky and fantastic addition to my life. I believe I paid about $100 for it, and it really worked. I later found an electronic version and retired the pull-handle clunker. 

Those machines used mechanical parts inside to spin number wheels and come up with answers. Huge progress. 

One day, in the late 60’s,  I heard about a company that was selling an electronic calculator, with lights to display the numbers, and no moving parts! I bought one for $50. It was a Bowmar, about the size of a hardbound book, plugged into the wall, and could add, subtract, divide and multiply, and was the beginning of something incredible. 

By the middle 70’s I was back at the University of California, and one day picked up a magazine that had an article about something new - a personal computer kit. I wanted one, but couldn’t figure out what I would do with it if I actually built the thing. Also, the electronic calculator era was in full swing, and Hewlett Packard had a nice collection of them for sale, so I decided to pass on the PC and I spent $300 for a calculator from HP. I put my slide rules away, and moved into a new age of calculating bliss. 

Then, around 1980, Casio, also a maker of calculators, came out with one that included the BASIC programming language. It stored programs on a cassette tape recorder with a special attachment. While in college I had learned FORTRAN and had run programs at the university computer center, typing in the data on punch cards. After graduation, I worked for a company in Berkeley in its computer department. They used a PDP-11/45 computer to calculate numbers that were fed into it with punch cards, so the leap to a hand-held programmable calculator was something I couldn’t pass up. I bought two Casios, and still have them, and I believe one still works. 

I wrote a number of programs to calculated gains and losses from my trading systems, and the Casio carried me forward until my first PC purchase. 

When the first IBM PC came out, it was very expensive. A simple setup could run from $2500-$5000. Fortunately, IBM later offered a PC Junior. It turned out that the Junior was, like the Edsel, a bad business idea. IBM put one CPU chip into it’s flagship PC and another one into the Junior. So, programs that would run on the PC wouldn’t run on the Junior. At least Junior was a lot cheaper than the PC, so I bought one for $1250. 

I converted my Casio programs to the Junior and was able to test my systems, until I eventually sold the Junior and bought a used IBM PC with the “real” Intel chip. The Junior used an Intel 8088 chip running at 4.77 MHz while the “real” PC used the 8086 chip. Today’s CPU chips run at 2-3Ghz - as in Giga, rather than Mega. 

Other personal computers were available at the time, including offerings from Atari, Tandy (Radio Shack) and Commodore. I just felt better going with the IBM as the name seemed to have a more serious business intent than the other offerings. 

And what about Apple? It was the name. How could a computer named Apple be a serious tool for business? For artsy purposes, an Apple seemed fine, but for stock market number crunching, I, and most other technical traders, had to have the IBM PC. 

Of course, there were still no programs that could backtest stock market trading systems. In order to do any testing or charting in the 1980’s you still had to get data into the PC. Various data services appeared and I bought a program from Metastock called The Downloader, that allowed me to log into  a stock data service, and download, via dialup phone line, stock prices at the end of the day. This was a huge leap forward from writing down the prices by hand on 4×4 to the inch graph paper, or entering the data by hand into a spreadsheet. I still miss the little tweets and log-in tones from those dialup years. 

Then, in 1989, I read about a new software product called System Writer. The advertising said that it used a new language called Easy Language, that was similar to BASIC, and that anyone could easily write and back test trading systems. Or, the program came with pre-canned systems. 

At first I stubbornly avoided the program. I felt I was doing fine writing programs on my own, and System Writer was quite expensive - over $1000. 

Eventually, Omega Research cut the price in half, and I purchased a copy of SW. It evolved into TradeStation. TradeStation later purchased an existing brokerage, thus making it possible for the software platform to place trades automatically, with no human intervention. 

I once remarked that I could become rich if only I could plug in one of my trading systems into a computer, and it would trade the system for me automatically, and I didn’t have to make the buy and sell decisions myself, and then have to call them in every day. Well, that era finally arrived and is with us today and is being offered by an expanding list of brokerages. Of course, I learned that getting rich isn’t easy, no matter what trading system or platform is used. 

Is it possible that market trading will eventually be dominated by computers making automated trade decisions - essentially a battle of the algorithms. To what extent is trading being computer driven today?

After the huge stock market crash of October 19, 1987, an article appeared in Barron’s saying that in 1929 brokers jumped out of windows, but during the 1987 crash it was the computers that jumped out of the windows. 

And, as I look back on my decades of using technology to make trading decisions, that image never leaves my mind.

And while today’s computers make it easier than even to follow, chart and analyze stocks price patters, they don’t guarantee trading success. A bad system, traded by a fast computer, will still lead to a bad result. And a great trading idea can still lead to a great result. And, all it takes is one great idea.

I loved receiving their letter. It contained a summary of other newsletters and introduced me to the concept of sentiment and “point and figure” charting.

If you have never seen or thought about “point and figure” charts, they are curious and interesting collections of X’s and O’s, and they look completely different than bar charts. PF are only concerned with vertical movement in a stock, and time (or horizontal movement) is disregarded. This can have certain advantages over conventional charts.

They don’t contain any points or figures at all. A brief history can be seen here: Wikipedia - Point and Figure Charts

What I liked about them was that they filtered out the smaller fluctuations in price movement and they  generated numerical buy and sell signals. I hand plotted numerous PF charts of the various stocks and futures I was trading and I was able to make profitable buy and sell decisions using them. Unfortunately, I didn’t always follow the signals generated by the charts - a common weakness of all traders, and often a financially fatal weakness.

The Apple  computer was around in those days and IBM came out with its PC and PC Junior in the early 1980’s, but stock market charting programs were not available. So, hand plotting was my only option. And, I read some years later that doing the work by hand  was preferred by many traders since it gave a more “intimate feel” for each stock or commodity. And, while that may or may not be true, it is true that hand plotting does take a lot of time and is prone to mistakes. And, when you are trading you don’t want to make mistakes.

The longer I worked with PF charts the more I thought the “normal” method of plotting them needed improving. First of all, the box sizes were fixed, then at some predetermined and arbitrary level they changed. Well, I thought that this was ridiculous, so I began plotting the price scale as a log scale, so that every box became an equal percentage of the previous box. When I did this the buy and sell signals that the charts generated improved.

A few years into my charting, and after I had a computer, I wrote a little utility program that allowed anyone to print a Log Point and Figure chart on any dot matrix printer, and I uploaded it to Compuserve for anyone to use.

I also began to pen the up columns in green and the down columns in red. I added little green and red flag symbols at the buy and sell points, and eventually I got totally sick of drawing all the X’s and O’s so I just put a dot at the top and bottom of each column and drew a quick vertical line to fill it in. When you’re hand plotting charts the last thing you need is more aggravation. Later I used colored pencils to shade the columns either green or red. I was having fun, but this was very time consuming.

Eventually stock market charting programs became common, yet there was no way to computer backtest a PF chart system. So, I started writing one, but never finished it.

I eventually came to the conclusion that any system is better than “seat of your pants” trading, and that a PF chart system was just another way of filtering price and bringing me to a rational buy or sell signal. From that point on, it was up to me. Without an automated trading method, a “hand’s off” method of placing my trades, it still came down to me. Should I take the signal or not? The chart says sell, but what do I think? Should I think? What do “the experts” think?

I found out that this sort of questioning leads to losses, and while a system seldom produces more winning than losing trades, that system, in the long run, is going to make more money than “do I really want to do this” trading. I found out that I needed a system, and I needed to know if the system worked over time, and on which stocks.

And this is still my preferred method of trading.

Here is a link to one my early hand drawn P&F charts of PWJ (Paine Webber). It shows PWJ moving up strongly from the summer of 1982 at the start of the five year bull market that began on August 13th. There was only one sell signal generated.

PWJ Point and Figure Chart

Why intra-day trading? My testing, and the testing of others, has shown that it can be more profitable to trade intra-day bars than daily bars. There are many important market moves that happen intra-day that can’t be captured with daily bars.

So, I call this type of trading “micro-trading”. A similar term is “day trading”.  However, this implies closing out one’s positions at the end of the trading day, and carrying no positions into the after market hours.

I used TradeStation to backtest AAPL (Apple Computer) over the period 10/27/2008 through the close of today (2/13/2009). In my previous post (”Is This Market Tradeable?”) I noted that there had been little price change  in the SPY over this period of time, while there had been much volatility, with the market moving violently up and down within a loosely defined “trading range”.

The system I applied to this test  I named Simple_LS_01. It’s a simple buy and go long, then sell and go short system using a moving average, that can be optimized.

The logic is: if price (close) goes above the moving average the system buys (goes long) and covers any short positions. If the close goes below the average, the system sells, and goes short. The trades are made at the market on the next bar open. It’s probably the simplest system one could create, but it’s a good test of bar length optimization.

Because the trading day consists of 390 minutes, these minutes are evenly divisible into a number of bar lengths. For example: 195 min bars, 130 min, 78 min, 65 min, 39 min, 30 min, 26 min, 15 min, 13 min, 10 min, 6 min, 5 min, 3 min, 2 min, 1 min, and of course tick by tick data. All of these numbers divide evenly into 390.

I set my beginning date to 10/27/2008 - the beginning of the current trading range market.

I assumed a $5,000 position in AAPL on each trade.

Let’s first look at a simple “buy and hold” strategy. A buy of AAPL on the morning of 10/27/2008 would have resulted in the purchase of 52 shares at 95.20.  AAPL  hit 112.19 on 10/30. The maximum intraday drawdown occurred when AAPL printed a low of 78.20 on 1/20. This was a drop of  -33.99 points from the high, times 52 shares for a total of $-1,767.48 or -35.3% on the initial $5,000 investment. 

The ratio between the maximum gain and maximum drawdown (ignoring negative sign) is 16.99/33.99 or .50, or 50%. I would consider this a poor reward/risk ratio. AAPL closed today at 99.12. So, that position gained +4.1% to date.

For each intra-day bar period I optimized for the moving average that produced the best gain and lowest drawdown.

I adjusted each test so that the first trade occurred on 10/27/2008. If you are using TradeStation to test and you want to make sure all the tests are comparable, you have to adjust the “maximum number of bars study will reference” and the date range, so that the first trade occurs on 10/27/2008, or whichever date you want to begin with. This post is a revision of one I published earlier today, and now includes this adjustment.

The best results were obtained with bar lengths that varied between 39 minutes and 5 minutes. The 39 minute bars made $2615 profit with a $-1003 drawdown, for a Net Profit/MaxDrawdown ratio of 260.7%. 40 trades occurred and 35% of them were profitable.

The 10 minute bars made $2674 profit with a $-640 drawdown, for a Net Profit/MaxDrawdown ratio of 418.1%. However, this system generated 70 trades and only 23% of them were profitable.

Profits were below $2000 on bar lengths above 39 minutes and below 5 minutes.

If one is thinking of “micro-trading” and using short duration bars, such as 1 ,2 3 min or tick bars, a very common practice, make sure to test this bar length first. Don’t assume a short bar length will be more profitable than a longer bar length!

Also, the shorter the bar length the more bars in a day, and the more one’s computer resources are taxed. Short bar lengths take longer to optimize and generate a huge number of trades, particularly if one is trading a number of stocks. This generates a lot of accounting aggravation at tax time.

Of course, this test was only on one stock and over a choppy market environment. Any system should be tested over different market time periods on a basket of stocks, and a simple system like this one is just a starting point for any serious system trader.

However, it does demonstrate a basic idea of system testing: start with an idea, in this case “micro-trading”, then find out what does and doesn’t work, and begin to eliminate the failed strategies, and keep the successful strategies. It’s similar to “natural selection” although this is “tested selection”.

If you keep testing ideas, you’ll gradually develop better and better systems, and hopefully, will improve your profits, and minimize your losses.

One additional note: I don’t just optimize systems for the highest profit - I look for the max profit as a percentage of the max drawdown, because I want to maximize profits and minimize losses. Remember, controlling drawdown and losses is critical if you want to become a successful trader.

SPY 10/27/08 to 2/12/09

Let’s go back to October 27 (2008). On that day the SPY closed at 83.95. Today, it closed at 83.66. Net change in three  and a half months has been -.3%. The range, from high to low, over that period of time has been 25.81 points, or 30.9% based on today’s close. So, we have a wide range, with little or no change. The market is “range trading”. It is choppy and flailing wildly depending on the news of the moment. Every statement by a public official, every economic report, every speculation is driving the market into a frenzy. However, after all is said and done, little has changed.

This is the perfect market to drive system traders crazy. And how have you been faring over these recent months?

Basically, most trading systems require trending - either up or down, and when a market isn’t trending, and individual stocks or stock groups aren’t trending, it’s extremely difficult to make money.

All systems have some sort of filter, some way of preventing relentless whipsaws. A simple system that buys when price moves above a moving average and sells when price drops below that moving average, allows prices to move up and down as long as the moving average isn’t crossed. Once the average is crossed, an action is taken - either buy, or sell.

So, systems such as the above will always catch a trend, but never buy at the exact low, nor sell at the exact high. There is always a period of lag. These systems catch the middle portion of the trend. This is the basis of almost all trend following systems.

Now, what happens if the trend is short, if price turns down soon after a buy signal is generated? Well, the answer is that losses will occur.

In a basically trendless market, a trend following system won’t - can’t make money. One must look for those few stocks, or futures, that have some sort of trend, then attempt to trade them, either long or short, depending on trend direction.

When a profitable system breaks down, and stops making money, it is usually because the market is no longer trending, no longer behaving in a manner that the system is designed to handle. These periods are when drawdown occurs.

Today’s market was all too typical of recent market action. The market closed with an uptrend yesterday, then opened to the downside with a gap - so if you were long anything going into the open you had immediate losses. Depending on the type of system, stops were hit and long positions were closed out. Short positions were opened. Then, the market rallied strongly into the middle of the day, then crashed to new lows, then rallied almost vertically on yet another news announcement.

Is this type of market tradeable? Are you fast enough to react to the minute by minute movement? What do you do if you have to leave your computer screen? Can your system handle the volatility?

And, what can you do with months like this?

You can use this period of time to improve your system with additional rules - do this, or don’t do this based on the open, the last hour etc. You can backtest your stocks, one by one, to see which ones are working in this environment, and then you can delete the stocks that have been losers. You can get out entirely. You can get “small” - that is, keep trading, but reduce your position size, or you can just trade a couple of stocks.

In times like this I have learned to stay in the market but to get “small”. I prune my stock list to just the ones that have been making money in recent months. I reduce my position size. But, I keep trading. Why? Because it’s how learning happens. It’s how systems are improved.

To repeat my subtitle, “It all seems easy when you’re making money”. However, when times get tough, when you’re losing money, that’s when the learning takes place. That’s when you look at your system and the market, and test new rules and new strategies. If you can survive the tough times, you’ll be stronger and better when the good times return.

And, there will always be tough times, and there will always be good times.

SPY 2_12_09 30min Bars

I have also mentiioned here that I had a background in forecasting - weather forecasting to be specific. I have always been very intense about my forecasting, and have used many unconventional techniques to arrive at an accurate result. My perception has been that forecasting the weather and the stock market represent  similar challenges, and can benefit from a similar approach, although I have found that weather forecasting is a LOT easier. Storms don’t turn around in a microsecond due to some unexpected statement by the Fed Chairman, or Treasury Secretary.

Back to 1983. Every year I received a call from a man who asked me about my Florida seasonal forecast, and once in a while he would call about particular weather patterns that might bring freezing temperatures to the citrus growing regions of Central Florida.

Fortunately, I had worked in Florida as a meteorologist and had been the only one in my area to call for snowfall in Northern Florida in 1977.

So, I was familiar with the situation there and when the big freeze of December, 1983 arrived I was ready for it, and knew it was coming quite far in advance.

When my caller asked me about the freeze forecast, I asked him about the reason for his call. He told me that I had made a great deal of money for him in the past by alerting him to upcoming freezes, as he had been trading orange juice futures.

Light bulb going off in head…why had I not thought of that before? In those days, the science of long range forecasting was not as developed as it is today. With the Internet, we can click on a number of websites and get a 10 to 15 day forecast, and these long range projections are often correct. In the “old days” of the 1980’s a five day forecast was all that most people were going to get from their local newspaper or TV newscast, and many of these sources only gave a three day forecast. The Weather Channel was only a few years old.

I was stretching things and trying to forecast out to 10 or more days in advance using upper-air analysis patterns and any experimental techniques that I thought might work.

After I told him about the upcoming freeze, I decided to try my hand at the orange juice futures game. So, I opened my own account at Lind Waldock, sent them $5,000 and I was ready.

As I recall I purchased the  January contract in the upper 120’s, and after the freeze hit it shot limit up for three days, where I sold. So, I made 22 cents profit for a grand total of $3300, or 67% on my $5,000.

Well, I was certainly happy about that. However, I was not using any sort of technical analysis or quantifiable strategy to get into or out of the trade, so when the contract continued up to the 150-160 range I felt foolish. I believe the high for that contract was over 170.

After the contract expired I plotted a chart of it by hand and concluded that if I had traded off that chart, and sold after a break of a simple moving average, I could have made  almost 20 cents more.

Well, to repeat an old saying, “you can’t go broke taking a profit”. But, you can feel bad.

Since I felt I had learned something valuable about applying forecasting knowledge to the futures markets, I decided to try my hand at heating oil futures. Another cold wave was coming and my analysis indicated that heating oil would go up as a result. It didn’t, and I couldn’t believe it, and not only did I lose my orange juice profits, but I found myself sitting on a $1,000 loss overall, so I got scared, sold my heating oil position, and the contract immediately shot up, and I felt even worse. Does this remind you of any trading you have done?

Welcome to the real world of  “the markets” , where common sense isn’t common, and what is supposed to happen doesn’t, and where smarts don’t make for profits, and where crazy things do happen every minute of every day.

I later spoke with a friend, who had some insight into futures trading, about the unexpected heating oil contract drop, and he suggested that when the traders walked outside and it wasn’t cold, they went back inside to the exchange and sold the contracts. Timing is everything.

I began to learn that stocks and futures can go up or down for various and mysterious reasons, and these reasons may or may not be known in advance, and may or may not be rational. And the more I thought about my adventures with the freezes I realized that I had been lucky with the orange juice and unlucky with the heating oil and that I needed to go back to my charts and my systems, and that in the real world the major forces that drive the markets may not be visible to any of us.

I didn’t close my futures account, but I did figure out another way to make a lot of money trading the “commodities” markets. I will go into that in my next post.

At the time I had never traded futures. Back then everyone referred to them as “commodities”, with  corn and hogs and soybeans and gold coming to mind.

I was still trading stocks through Charles Schwab, and unlike today commission costs were a large percentage of the total trade cost. There were a few discount brokers offering $29 to $39 commissions, but Schwab was higher. it wasn’t easy to make money trading actively with costs like that.

In my previous post I talked about The Schwab Mob, a group of mostly retired men who spent many hours every day in the Schwab waiting area, watching the tape and talking about stocks. I was the junior member.

It was there that I met Porter. He was in his 60’s, at least, was retired from the Air Force, seemed to always have a smile on his face and something interesting to say, and of course loved trading stocks, and seemed to like me a lot. And I liked him a lot. He was more interested in trading than the others, who were more inclined to buy and hold for some unspecified longer term period.

Porter and I were only interested in holding on as long as we were making money. We were both trying to figure out ways to time the shorter waves that lasted from several days to several weeks in length.

My background was in statistics, computers, and forecasting, and Porter figured out that we would make great trading partners.

He had a wealth of practical stock trading experience and I gained knowledge from our association.

One evening I went over to his house and discovered he was a paper packrat like me. He had piles and piles of papers, all about stocks and the market, piled up, it seemed like,  from one end of the house to the other. I have met other traders like Porter, and all with the same fascination with paper. Today, we are moving into a paperless world, where articles can be bookmarked from the Internet, but then, there was no Internet, so every scrap of paper, every article, every newsletter, every magazine, every copy of  Barron’s or the Wall Street Journal contained some tiny bits of wisdom that just might make us rich someday, so throwing anything away was just not a good idea. And making money would only take that one great idea.

One day Porter came up with one of those ideas - we could trade these new stock index futures for others and take a small percentage of the gains. Essentially, we could become mini-hedge fund managers.

When Porter mentioned this to me he had already approached some of the Schwab Mob members with his idea, and they were interested in diversifying. At the time the market was in a very bad mood, and traders were looking for something new.

So, Porter convinced several Mob members to open futures accounts with Lind Waldock, and we signed on as the traders of those accounts. Each account was opened with $10,000.

Well, we had been working out some profitable trading strategies over several months, getting the NYSE data from the newspaper, Schwab, and the nightly TV business reports.

We began to subscribe to the NYSE bulletin, and of course we had copies of Barron’s and the Wall Street Journal. We were able to put together a complete data history of the NYSE contracts.

However, once we actually began trading the contracts, we ran into drawdown. Of course, we were in uncharted territory.

I know now that every system, from buy and hold, to discretionary trading, to seat-of-your-pants trading, to mathematical system trading, runs into periods of drawdown. I now know that one must have some idea of how large that drawdown might be, and make sure that this number is acceptable relative to the size of the trading account.

I have found that I can take a 20% drawdown without feeling uncomfortable. So, whenever I trade anything I adjust my position size so that, if I get the worst drawdown I can find historically, it will only take my position down 20%.

When Porter and I traded the NYSE futures contracts we only had three months of data to work with, so we really didn’t know what sort of drawdown to expect. We were primarily focused on the potential gains.

All of our systems were worked out by hand. We gathered the data and I plotted it on hand drawn charts. Again, this was before the IBM PC. I used a hand-held calculator to compute gains and losses.

Our systems were profitable on paper, but when we started trading in the real market in real time, we ran into unexpected turbulence.

Well, things weren’t all that bad. Most of the accounts were going up and down around the 10k mark. After many weeks, Porter and I had a meeting at my house, and after hours and hours of work on the systems, we just looked at each other and I said, “Nothing Works”! And the realization of this was really funny at the time, and we both broke out into uncontrollable laughter, and we never forgot the moment.

Well, we were actually trading real money for other people, so this wasn’t so funny. I’m sure that this sort of thing goes on all over the world every day as people who are supposed to be making money for their clients actually come to realize that trading the markets is a lot more difficult than it appears on the surface.

Not long after that I noticed that a few of the accounts took a big “hit” - an equity drop of several thousand dollars. I called Porter and asked what might have happened. Up to that point all of our trades had been agreed upon in advance, and he called them in. He told me that he had made an “off system” trade, and that things hadn’t gone well.

That was it for me. I decided that since “nothing works” and Porter couldn’t control the urge to trade, we would have to shut down the operation and give control of the accounts back to their owners.

It was another series of lessons learned. I learned that when one is looking at a stock chart, or working out a trading strategy,  it seems fairly simple and straightforward to make money trading. However, the reality is that it’s very difficult to do this in real time, in the real market, with real money - and especially with other people’s money.

I found out that it’s also very difficult to stay “on system” and not pick up the phone and call in an “off system” trade on a hunch, or feeling. I have found myself picking up the phone and making trades, as if my brain and hand were disconnected - my hand belonging to another person living inside me, who just wanted to do something bold.

Some people just have to trade. Perhaps, they are like gamblers who just have to gamble. Perhaps they like the action. Perhaps they can’t control themselves. Perhaps the greed or fear takes them over and they lose rational control.

I found out that the only way I can make money in the market is with a carefully conceived and tested trading strategy, an automated trading platform, and strict money management.

I have found that I don’t so much mind losing my own money, but I hate losing other peoples money. I especially hate losing money for friends and family.

After Porter’s “off system” adventure, we broke up our partnership, and I lost contact with him. I also stopped going down to the Schwab office, and began to intensify my system research.

As you may or may not recall, it was in August of 1982, the 13th to be exact, that the market began a huge bull run. I will talk about that in a later post.

I was confident that I possessed the skills to “beat the market” and, for that matter, beat the fund managers who had  previously been handling my money. Confidence, like faith, can be based on wishful thinking as well as fact. To this day I remain confident, proved by years of trading experience, but also tempered by experiences that give me caution, experiences that remind me that over-confidence can lead to recklessness and large losses. Am I talking about you, too?

When I first opened the Schwab accounts at my local branch, there was no Internet, Jimmy Carter was The President, and interest rates were in a Bull Market, along with precious metals prices. It was an interesting time to jump into the market, but upon reflection, when is it NOT been an interesting time to be in the market?

The plush Schwab office contained a number of comfortable chairs, counters for writing up orders, and monitors with the market scrolling by, trade by trade. I learned that this was the ticker tape, now become electronic, and it was not only fascinating, but almost riveting.

I wasn’t the only one who thought so. Seated in the chairs and milling around were a group of mostly retired men, I fondly call them The Schwab Mob. There was a core group who seemed to live there, and others, such as myself, who floated in from time to time.

But, we all had one thing in common - a fascination and love, or hate, for the market.

I learned to sit with the Mob, and read the tape -” tape reading”, as it is called. I learned the stock symbols and the volume shortcut symbols, and I began to get a “feeling” for the tape. I read up on how to “tape read” and began to make simulated mental trades. One quickly learns that these patterns of price and volume movement can and do have a “mind of their own” .

I found out that I was much more interested in this numerical challenge than reading lengthy and boring financial statements. And I came to the bizarre conclusion that I would rather own a stock that was going up than a stock whose product I understood. Many years later a book by the guru Peter Lynch proposed an opposite strategy, that one ought to first understand the company then buy the stock. I became somewhat skeptical of this approach, used by 99% of all stock investors as the basis of their buying and selling decisions, when I found that the companies that I loved the most had stocks that seemed to go down, and ones I had never heard of, were the ones going up.

There was one “Mob” member, whose name I have forgotten, who, so “they” told me, only bought stocks, but never sold them. He appeared to be in his 70’s, and seldom spoke. It was said of him that he was very rich, precisely because he never sold any stocks, that this strategy was the secret to his wealth, and that we could all learn something from him. Apparently, he had the patience of a mighty tree, still standing after years of big storms.

The more I thought about this “no sell” strategy, the more I realized that one would have to make a very careful buy decision, knowing that the stock to be purchased would be one’s companion for life. In later years, Warren Buffett embraced a similar philosophy.

For me, however, I just didn’t have the patience, and couldn’t take the dips and drops that any stock inevitably takes. I found out that the higher a stock soared, the more inclined I and almost everyone else was, to buy more of it, and at the very peak of the price wave, the news about the stock was always great, the financial reports a beautiful thing to behold, the volume strong, the price action a joy to watch, and it was at this precise moment in time that the stock began to drop, along with the wealth of everyone who bought it, and the drop picked up steam until almost everyone who had any sense sold it, except for a few brave or clueless soles, who may or may not have done the right thing.

My afternoons at Schwab taught me many lessons. It was the beginning of a long road of learning and discovery. And, it lead me to the conclusion, included in the header of this site, that “It all seems easy when you’re making money.” I learned that real lessons, real knowledge and real progress come, not when things are going well, but when a large trap door opens under you and you fall head, or tail first into it, and you never saw it coming.

I began to study all about Mutual Funds. There were so very many to choose from. I decided that the best ones to invest in were probably those that had been doing well over the years. I found out that there were numerous Mutual Fund  newsletters that ranked and reviewed the various funds and fund families.

This was all new and very interesting to me, and I ended up subscribing to several newsletters, and sent my money off to a few funds including Fidelity, and my favorite at the time, the United Services Fund, a gold fund, then riding the wave of increasing precious metals prices. Eventually gold hit $800 per ounce and plunged, and that was the beginning of the end of United Services Fund.

I found out very quickly that, at least for me, Mutual Funds were just too boring. True, some moved up and down with certain market sectors, like today’s ETFs, and the United Services Fund, in particular, really moved quickly.

However, one could not trade them during the day. Money either had to be mailed or wired into the fund, and switches between funds within a family had to be made overnight. I discovered that this process was too slow and frustrating for me, and I learned that I didn’t like having someone else manage my money. If I was going to go through all the trouble of studying thousands of funds, I could just as well study the stocks that made up the funds.

I came to the conclusion that Mutual Funds were just not for me.

We all discover who we are and what we are made of when we enter the investing/trading arena. We all have a certain tolerance for risk, and an emotional “speed” that drives us. We all have a need to either be in control, or give up that control to someone or something else.

I discovered that I needed to make my own trading decisions. I needed to buy and sell individual stocks at any time during the trading day, and I needed to be in control of every aspect of that process.

There is a wide range of investing styles - as wide as there are people in the world. Some people go to a bank, and an investment advisor puts their entire life savings into some load fund, and these folks don’t have any idea what they are invested in. Every quarter a statement arrives, and when times are tough they don’t even look at it. Several decades later they have either made money or lost money, but this passive process suits them.

Others are frantic traders. The more volatile the instrument, the more they like the process.

We all have to discover who we are and what we can handle in the world of trading and investing. I discovered I was a trader.

What I needed to learn from that point forward, was just what kind of a trader I was, how much risk I could take, how much of my time I would devote to the process, how much loss I could take, how greedy or fearful I was and what I would learn from this wild ride through the blind curves of Wall Street.

As you may have discovered already, the ride never stops, the curves are sharp and bumps can be devastating, and you learn things about yourself that you would never have discovered had you not jumped into the fray and held on for dear life.

The year was 1960. I was in my teens. I had never purchased a stock before, but along came this incredible company (or so I thought) that was going to revolutionize the way we watched TV. The company was called Subscription TV and the symbol was STV. I read about it in the paper.

The whole idea of STV was that this company was going to transmit certain live events, particularly sports and concerts, for a fee, directly to one’s home TV with some sort of electronic interface - a converter box. Wow! Now that was a GREAT idea.

In retrospect, this was the idea behind HBO and Pay Per View.

So, I went to a local stock brokerage company and opened an account with money I should have saved for college. I purchased $100 worth of stock, and of course paid some sort of commission, that was certainly a large percentage of the transaction.

Along came the election of 1960. There was great excitement over the battle between John Kennedy and Richard Nixon. There was also a proposition on the ballet to stop STV. This was California and anything can be put on the ballot with enough signatures. And the rallying cry against STV was that it would kill free TV, and that scared a lot of folks.

For most people, TV was something new, and mostly in black and white. Fortunately, it was free, and the thought of having to pay for TV was not acceptable.

Of course, STV wasn’t going to kill free TV, but who cares about the truth - this was politics. Backing this initiative were the theatre owners, who were naturally concerned that people would stop going to the movies and stay at home watching all the good stuff on TV.

So, on theatre screens across California there splashed a commercial to Save Free TV.

And, of course, the proposition passed, and STV filed law suits, and the stock plunged, and I lost almost all of my money.

Hindsight is always clear sight. As the election neared the stock began to sink. I didn’t have an exit plan. I should have sold STV on the way down. If the proposition failed, STV would have been on the cutting edge of the future and I would have been riding the crest of the wave, or so I dreamed.

Years later STV won their law suits, but by then it was too late. The last I heard they had all of their equipment stored in a warehouse in Santa Monica. I can’t recall another proposition that put a private company out of business.

I didn’t buy another stock for 20 years, but I never forgot the lesson learned - a company can have the greatest product in the world, and circumstances can send that company and its stock into a large pit, and along with the stock, your money can disappear.

Some lessons learned:
1) don’t put all your money into one stock - diversify
2) have an exit plan, a stop, an options hedge
3) don’t fall in love with any stock or any company story
4) don’t “chase” a stock unless you have a very tight stop
5) calculate your total commission or fee costs as a percentage of the trade

Many years later I bought another stock that seemed like a great idea, and that trade worked. It was my best stock trade ever, and I’ll write about that at another time.