At 0311

BUY HIGH, SELL HIGHER: RELATIVE STRENGTH SYSTEM p.
48
March 2011 Volume 12, No. 3
Capturing alpha with momentum and contrarian strategies p. 30 International ETF trading system p. 24
TRADING STRATEGIES FOR THE FINANCIAL MARKETS
Tale of a hedge fund p. 58 Prepping for tax season p. 62
Intraday stock-index futures setup p. 18
Oil back in the spotlight p. 16
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CONTENTS
March 2011 Volume 12, No. 3 Trading Strategies for the Financial Markets
Trading Strategies Time ltering scalp trades Analyzing hour-by-hour performance of an intraday
18
setup highlights optimal trading times. By Active Trader Staff
24 Trading international stock-index
ETFs with relative strength Rotating into the strongest exchange-traded funds
representing different countries stock markets shows the potential to boost returns and reduce volatility. By Jay Kaeppel
BYLINE
30 Active alpha investing for
the markets new normal

In a market environment with potentially little to offer, a simple ETF sector rotation approach shows the ability to outperform. By Prof. Davide Accomazzo and Rosario Rivadeneyra
38
Execution and management of iron condors Timing the component spreads of this four-option
position can help avoid its drawbacks and maximize its potential. By Geoffry Wong
In Every Issue
8 Contributors 10 Opening Trades
Trends and events moving the markets.
69 ETF Snapshot
Volume, volatility, and momentum statistics for ETFs.
71 Key Concepts 72 Traders Bookshelf 73 Upcoming Events 73 Advertising Index 74 Traders Marketplace 76 Trading Calendar
70 Futures Snapshot
Volume, volatility, and momentum statistics for futures.
68 Stocks Snapshot

Volume, volatility, and momentum statistics for stocks.
71 New Products & Services
www.activetradermag.com March 2011 ACTIVE TRADER
Contents Contact Active Trader:

Editorial inquiries: editorial@activetradermag.com
42
Advanced Concepts Base metals and Chinese monetary policy

currency trade in disguise?
Comments, suggestions: suggestions@activetradermag.com For advertising or subscription information, visit: www.activetradermag.com
Are sliding prices for base metals a By Howard L. Simons
48

Trading System Lab Buy high, sell higher

A relative strength stock system beats the market by a wide margin in testing. By Robert Sucher Jr.
62

The Business of Trading Handling IRS notices and exams

If you find yourself confronted with an IRS notice, learn how to proceed to avoid tax trouble. By Robert A. Green, CPA
54

Trading Basics Order up: 2011

Dont get your OCOs, SCOs, and MOCs mixed up. This primer on order types will make sense of the alphabet soup.
The Economy U.S. economic brieng

the markets reaction to them.
66
Updates on economic numbers and
By Active Trader Staff
57

The Face of Trading Nurturing patience

Learning to wait for the trades that matter. By Active Trader Staff
80
Trade Diary Going long after a bearish week

in the crude oil market.
58

Active Trader Interview A new hedge-fund world

In part 2 of our interview with Lars Kroijer, the former hedge fund manager discusses the future of hedge funds and the alternative to alternative investments for individual traders looking for an edge.
By Active Trader Staff
CONTRIBUTORS
For all subscriber services: Active Trader Magazine P .O. Box 17015 N. Hollywood, CA 91615 (800) 341-9384 www.activetradermag.com
Editor-in-chief: Mark Etzkorn metzkorn@activetradermag.com Managing editor: Molly Goad mgoad@activetradermag.com
Howard Simons is president of Rosewood Trading Inc. and a strategist for Bianco Research. He writes and speaks frequently on a wide range of economic and nancial market issues. Geoffry Wong is a private trader using the technical analysis tools and strategies he has developed over many years. Previously, he was a propriety options and derivative trader for Goldman Sachs, where he was involved in all aspects of trading in options on futures, equities, and derivative products. Wong also assisted in research for the rm and used in-house technical and fundamental analysis to select various option strategies. At Goldman Sachs, he developed option-pricing models to nd anomalies in mispriced options, and developed trading practices to prot from those anomalies. He can be contacted at options.inabigway@gmail.com or (917) 951-0364. Davide Accomazzo has been trading professionally since 1996. From 1996-1997 he was a Euro-convertible bond/international equities sales trader with Jefferies Group, where he covered many international funds. In 1998 he left to trade his own capital, and in 1999 he started Kensington Offshore Limited, a speculative hedge fund that outperformed the S&P 500 during the 1999-2002 boom and bust economic cycles. In 2001 he launched Kensington Capital Management LLC, a commodity trading advisor that focused on trading options on futures and currency futures. In 2004 Accomazzo was recruited by UBS Wealth Management USA to manage the portfolios of high net worth investors. In 2005, Accomazzo co-founded Cervino Capital Management LLC as managing director, head of trading and is the sole principal trader for the companys managed futures programs. Rosario Rivadeneyra is co-founder and managing partner at Quant Investments, an investment advisory rm based in Monterrey, Mexico. She holds a Masters in nance from EGADE, a leading business school in Mexico, and studied at the Graziadio School of Business and Management of Pepperdine University. She is a contemporary dancer and performing arts supporter. Jay Kaeppel is the author of Seasonal Stock Market Trends (Wiley, 2009) which was selected as one of the Top 10 Trading Books for 2009 in the Hirsch Organizations 2010 Stock Traders Almanac. A former commodity trading advisor, Kaeppel is an independent trader and trading strategist with Optionetics. He writes a syndicated weekly column called Kaeppels Corner for Optionetics.com. His previous books include The Four Biggest Mistakes in Option Trading (Traders Library 1998), The Four Biggest Mistakes in Futures Trading (Traders Library 2000), and The Option Traders Guide to Probability, Volatility and Timing (Wiley 2002). Robert A. Green, CPA, is CEO of Green & Company (GreenTraderTax. com), a CPA rm focused on traders and investment-management businesses. Green is also founder and CEO of the GreenTraderTax Traders Association. He is the author of The Tax Guide for Traders (McGraw-Hill, 2004) and Greens 2010 Trader Tax Guide. GreenTrader provides tax preparation, accounting, consulting, entity, and retirement-plan formation services; IRS/state tax exam representation; and trade-accounting software. For more information or to participate in free conference calls, visit www.greencompany.com. Robert Sucher holds a M.S.E.E. in signal processing from C.S.U. Northridge (1992). After working 12 years in the military aircraft industry, he moved to the Canary Islands (Spain) where he began actively trading stocks and futures in 1999. In 2002, he started an ongoing journey with WealthLab.com, assisting customers with trading tools.
BYLINE
Associate editor: Rakesh Sharma rsharma@activetradermag.com Contributing editor: Howard L. Simons Contributing writers: Marc Chandler, Keith Schap, Robert A. Green, Chris Peters
Editorial assistant and webmaster: Kesha Green President: Phil Dorman pdorman@activetradermag.com Publisher, ad sales: Bob Dorman bdorman@activetradermag.com Classied ad sales: Mark Seger seger@activetradermag.com
Volume 12, Issue 3 Active Trader is published monthly by TechInfo, Inc., PO Box 487, Lake Zurich, IL 60047-0487. Copyright 2011 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. Annual subscription rate is $59.40. The information in Active Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Trading and investing carry a high level of risk. Past performance does not guarantee future results.
TRADING OpeningStrategies TRADES
U.S. stocks follow through into new year

2009-2010 in the top 10 percent of two-year gains since 1960.
classic holiday rally closed 2010 near the years high, capping one of the strongest two-year runs for stocks in the past 50 years. Although it was a double-digit year for equities overall, small-cap and technology stocks led the broad market by a wide margin: The S&P 500 (SPX) gained 12.79 percent in 2010, but the marketleading Russell 2000 (RUT) doubled that return, rallying 25.41 percent. The Nasdaq 100 (NDX) wasnt too far behind with a 19.24-percent gain. But despite the S&Ps more modest 2010 gain, its 39.23-percent return for 20092010 was the ninth largest two-year rally since 1960. And that gain pales in comparison to the indexs 84-percent gain from the March 2009 nancial-panic low to the end of 2010. The bullishness carried into the rst full week of trading in 2011: All U.S. indices were in the black through Jan. 7, with the Nasdaq 100 (+2.65 percent) leading the pack by a relatively wide margin, while the Russell 2000 eked out a marginal gain (+0.51 percent). The rally dampened market volatility in December nearly to its lowest levels of the year. The CBOE volatility index (VIX) fell below 15.50, the lowest it has been since April 2010, which was the last time the market sold off sharply. The declining volume trend evident since the fourth quarter of 2009 remained intact through the end of 2010, with the rst week of January 2011 producing a not-uncommon spike in trading activity.
U.S. INDICES ON THE YEAR, 2010
S&P 500 LARGEST TWO-YEAR GAINS, 1960-2010

Years 1997-98 1995-96 1996-97 1975-76 1998-99 1985-86 1988-89 1979-80 2009-10 2003-04 Open 1163.62 757.02 955.4 102.49 1388.91 249.05 350.62 137.21 1186.6 1173.83 High 1244.92 761.75 986.25 107.46 1473.1 254.86 354.1 140.66 1262.58 1217.33 Low 1136.88 716.69 924.92 102.12 1387.38 241.27 339.62 125.32 1186.6 1173.76 Close 1229.23 740.74 970.43 107.46 1469.25 242.16 353.39 135.75 1257.64 1211.92 One-year 26.67% 20.26% 31.01% 19.15% 19.53% 14.62% 27.25% 25.76% 12.78% 8.99% Two-year 65.95% 61.29% 57.56% 56.81% 51.40% 44.80% 43.03% 41.24% 39.23% 37.75%
U.S. INDICES, FIRST WEEK OF 2011
12/31/09 Russell 2000 Nasdaq 100 S&P 500 Dow

625 1,860 1,115 10,428
12/31/10
784 2,218 1,258 11,578
+/25.41% 19.24% 12.79% 11.02%
12/31/10 Nasdaq 100 S&P 500 Dow Russell 2000

2,218 1,258 11,578 784
1/7/11
2,277 1,272 11,675 788
+/2.65% 1.10% 0.84% 0.51%
10
Opening Trades
Industry adjusts to Dodd-Frank

A more transparent, stable marketplace? Higher fees and fewer choices? Brokerage firms and analysts discuss the implications of Dodd-Frank for individual traders and investors.
BY RAKeSH SHArMA
he nancial crisis of 2008 ravaged markets and rattled the nancial system to its core. The Dow Jones Industrial Average (DJIA) fell 33.84 percent that year, its worst showing since 1932, early in the Great Depression, and trillions of dollars of shareholder wealth evaporated. The crisis also exposed long-ignored loopholes in nancial regulations that enabled Wall Street to run amok, resulting in widespread outcry for regulatory reform. Congress passed the Dodd-Frank Act into law in June 2010 in an attempt to address U.S. regulatory shortcomings, especially the lack of accountability in over-the-counter (OTC) derivatives
FiGUre 1: NEW REGULATIONS, NEW WATCHDOGS

CONSUMER FINANCIAL PROTECTION BUREAU Independent head and budget Autonomous rule-writing Creates Regulates Contributes
trading, such as the now-infamous credit default swap transactions that helped destroy Lehman Brothers and other investment banks. Although specic applications are still being drafted, the new rules from proposed restrictions on proprietary trading to increased margin requirements and suitability standards are likely to impact institutional rms and banks more than individual investors. However, there is some concern the changes will result in higher operating costs that rms will ultimately pass on to end customers that is, average investors and traders. Overall, there is still a big gap between what the law mandates and how regulatory agencies and nancial rms will satisfy the new requirements. You dont have the playbook as yet, says Ken Grant, risk professional and president of Risk Resources LLC. I would say 20 to 25 percent of the laws impact is known while 70 to 75 percent of its impact is unknown.
Educating the individual investor

In addition to Wall Street chicanery with OTC derivatives, a widely held view is that widespread nancial illiteracy also contributed to the nancial crisis. In response, Dodd-Frank approved the creation of two new agencies (the Financial Stability Oversight Council and the Consumer Financial Protection Bureau) to protect retail investors, along with an Ofce of Financial Literacy to educate investors (see Figure 1). It has also mandated increased communication between brokerages and their customers. For example, brokers are now required to disclose short-sale activities once a month to customers, including information relating to compensation or nancial incentives for each sale. In addition, brokers must provide customers with the option to not have their securities used in short sales. The biggest area of impact for individual investors is that they will now have access to a constant stream of continued communication from companies, says Charles Rotblut, vice president of the American Association of Individual Investors (AAII) in Chicago. It is important for [investors] to know that they are active business owners if they invest in a companys stock and active lenders if they invest in bonds. However, Rotblut sounds a note of caution regarding the practical effect of the new information that will be available to investors. As we have seen in the case of dieting, reinforcing a message or increased communication does not always work, he
National consumer complaint hot line; Office of Financial Literacy
Banks and credit unions with assets over $10 billion
To the regulationmaking process
FINANCIAL STABILITY OVERSIGHT COUNCIL Chaired by the Treasury secretary Consists of 10 federal nancial regulators, an independent member, and ve nonvoting members Identies Recommends Regulates
Emerging risks in the financial system
Rules for capital, leverage, liquidity, and risk management
Nonbank financial companies
Dodd-Frank mandated new government agencies intended to protect and educate public investors.
12
says. Similarly, increased communication might not always result in an educated investor.
Brokers must give customers the option to withhold their securities from short-sale lending.
Broker obligations: A question of standards
Dodd-Frank also calls for uniform duciary standards for brokers and investment advisors, which represent the obligation to act in a clients best interests. Although it has not dened the standards, the law empowers the SEC to do so. Brokers are currently governed by the so-called suitability obligation to advise their clients. This obligation contrasts with the duciary duty that governs investment advisors, because the former incorporates factors such as client age, net worth, and time horizon into investment advice. Imposition of a more rigorous standard could impact a large cross section of traders and investors, according to some industry participants. We have an awful lot of clients who know what they want to do in terms of trade, Christopher Nagy, managing director at TD Ameritrade, says. Depending on how duciary duty is dened, it might affect client actions. For example, in the case of a completely self-directed investor, he says the rm would have to check his or her liquidity and other information, which might result in delays and other problems for the investor. According to Heinzman, introduction of a uniform standard might also affect asset classes available to investors; certain products may be deemed too risky or complex for certain market participants. Whole classes of less sophisticated and less afuent investors may no longer have access to the products and services offered by large global investment banks, he says. The result will be less investment opportunities available to retail investors. The key to making the new standards work, Heinzman says, is to harmonize the rules between investment advisors and brokers.
Proprietary trading
Section 619 of Dodd-Frank has special implications for investment rms. The section, also known as the Volcker rule, named after former Fed Chairman Paul Volcker, deals with proprietary trading (in-house trading with rm, rather than customer, funds). Proprietary trading desks have become huge sources of prots for large banks and trading rms, an increasing number of which have turned to high-frequency trading strategies that now drive as much as three-quarters of the volume in the U.S. stock market. According to its advocates, the upside of proprietary trading is that it adds liquidity to the market. The downside, according to detractors, is that it increases leverage and risk at these rms, thus endangering the nancial system as a whole. According to the Roosevelt Institute, a New York-based policy research institute, Wall Street rms suffered an estimated $230 billion in proprietary trading losses by April 2008. The Volcker rule prohibits banks from engaging in proprietary trading. But, the new law provides regulators with a 15-month observation period before deciding how to enforce it. In the meantime, banks are reportedly exploring ways to reorganize their proprietary trading groups, including spinning them off into hedge funds, to skirt the law. James Heinzman, managing director of securities solutions at Actimize, a New York-based risk and compliance solutions rm, and former managing director of Bear Sterns, says there are two schools of thought on this issue. According to the rst school, the ban on proprietary trading will lead to greater transparency and a more level playing eld. The second school believes the ban could lead to loss of liquidity. There will be a reduction in the pools of liquidity available to investors, especially in the case of retail investors, says Heinzman. Less liquidity will mean greater price volatility and spreads. In the extreme, retail investors could end up paying higher prices and be forced to accept more risk as well, he says. Rotblut, however, thinks limits to proprietary trading are unlikely to affect individual investors. Hedge funds or large investment rms have more exposure to stocks with large market volumes, such as CISCO, he says. A reduction in proprietary trading should not impact their liquidity. Grant says the ban will be positive for individual investors. It takes away access to information and, consequently, the proximity advantage that institutional rms enjoy, he says.
ACTIVE TRADER March 2011 www.activetradermag.com
Increase in brokerage costs?

The new law could end up having a signicant impact on brokerage costs, for two reasons. The rst cause is the Meeks amendment, which approves an increase in the quote fees stock exchanges charge to brokers. According to Nagy, this could have
continued on p. 14
13
Opening Trades
a major impact on TD Ameritrades fee structure. It has the effect of increasing fee structures signicantly and impacts my ability to charge commissions, he says. Second, the new regulations could result in higher IT costs for nancial rms. David Thetford, securities compliance analyst at compliance and technology solutions rm Wolters Kluwer Financial Services, says the duciary duty will place an added burden on brokerages and dealers. Implementation of the duciary standard will result in extra labor and more conversations about regulation, he says. This will likely result in higher costs for the rms. Whether those costs are then passed onto traders remains to be seen.
report of the effectiveness of their internal accounting controls to the SEC) had the unintended consequence of creating a high barrier to entry for some rms. There may be other unforeseen downsides to increased regulation. The risk of companies moving businesses offshore to lessrestrictive regimes is a very real risk, Heinzman says. It might take years to ensure clarity and impact of the new law, according to Risk Resources Grant. That said, he is pretty condent Wall Street will come out of it OK despite complaints of being overburdened with regulation. Ultimately, Wall Street will benet because they have the resources to turn whatever happens to their relative advantage, he says.
The bottom line

Although much about DoddFrank remains uncertain, what is clear is the law heralds a new era of increased market regulation. We let the genie out of the bottle, says Terence Dolan, chief executive ofcer at Benjamin & Jerold, a New York-based boutique nancial services rm. The question before us now is how to get it back into the bottle. For retail investors, industry regulation is the most important part of the act. The key for individual investors is that the SEC has the ability to enforce regulations and continues to adapt as the nancial industry evolves, AAIIs Rotblut says. According to Ameritrades Nagy, a balanced approach to regulation is important. Too much regulation is a bad thing, and too little regulation is also a bad thing, he says. The pieces of regulation that dont work need to be repealed. For example, he says, strict compliance with certain sections of the Sarbanes-Oxley law (which requires all publicly traded companies to submit an annual
BArclAY TrAdinG GroUpS MAnAGed fUtUreS perforMAnce AS of NoV. 30

Top 10 traders managing more than $10 million Trading advisor 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. November return 21.74% 20.70% 9.44% 7.89% 6.53% 5.16% 4.93% 4.89% 4.72% 4.45% 2010 YTD return 11.11% 105.50% 53.09% 60.64% 4.21% 7.74% -17.02% -1.22% -12.54% 24.91% $ under mgmt. (millions) 104.2 16.4 60.0 49.5 10.1 12.0 19.5 14.5 12.1 80.5
Beneficentia (Essentia) Global Invest. Mgmt (High Frequency) Tactical Invest. Mgmt. (Inst'l) 24FX Management Ltd Astmax (AMCI) eStats Funds Mgmt (Delev) Aquila Capital Concepts (Pharos) Interkraft Energy Fund Aquila Capital Concepts (Pharos Evol.) AIS Futures Management (3X-6X) Level III Management eStats Funds Mgmt (Composite) Genuine Trading (USA Index) Brock Cap'l Mgmt (Heartland Ag) Sagacity (HedgeFX100) CenturionFx Ltd (6X) Stein Invest. Mgmt (Trading Edge) GTA Group (FX Trading) Misfit Financial Group (Delta) Vermillion Asset Mgmt (Indigo)
Top 10 Traders managing less than $10 million and at least $1 million 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 10.50% 10.40% 10.36% 10.20% 9.78% 7.26% 6.78% 6.54% 5.63% 5.51% 89.45% 14.64% 88.13% -14.58% 3.85% 66.06% 27.63% 21.80% 7.74% 7.42% 1.9 6.0 6.5 2.6 1.0 3.5 2.1 1.9 2.5 9.7
Based on estimates of the composite of all accounts or the fully funded subset method. Does not reflect the performance of any single account. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE PERFORMANCE. Source: Barclay Hedge (www.barclayhedge.com)
14
Opening Trades
Oil irts with triple digits in new year

Although three years ago the idea of $100 crude bordered on the apocalyptic, few market watchers seem to expect another oil gusher, even as prices again edge toward the century mark.
BY ActiVE TRadER Staff
n early January crude oil (CL) pushed to its highest level since 2008 the highest, in fact, since the market was in the process of collapsing from its stratospheric July 2008 high above $147 per barrel on its way to a February 2009 low below $34 (Figure 1). As of Jan. 3, crude oil had nearly tripled in price from that nadir, reaching $92.58 after staging a choppy 30-percent rally off its August 2010 swing low (Figure 2). Long the most actively traded and widely watched commodity market, crude mostly disappeared from the headlines after its implosion, only gradually recapturing ink from the mainstream press as it sustained prices above $75 in early 2010, and especially after it tested its late-May low and clawed its way back above $90 the nal round-number threshold in the path of the psychologically loaded $100 level. However, the oil market has arguably entered a new paradigm since 2008, and the recent rally has thus far failed to engender the same level of hype that accompanied the markets rst run to $100.
Underlying market dynamics
On the fundamental side, analysts point to several reasons for the recent bump in prices. Dominant among them is positive news about the global economy, according to Chris Lafakis, economist at Moodys Analytics. While economic growth has been slow, especially in the U.S., it has remained positive for many months, and there has been an absence of bad news to reverse the trend. Recent positive macroeconomic data has increased investor expectations that the global economy will recover strength in 2011, he says. As economies recover, of course, oil demand increases. Due to an increase in demand from China and other emerging economies, and the prospects of a U.S. economic recovery, we are returning to a constrained supply environment, says Allen Good, equity analyst at Morningstar. That means demand may outstrip supply. However, few analysts seem to view the market as overheated the way it was two to three years ago, and supply concerns are generally muted. The current situation is fundaFiGuRE 1: 50-PERCENT CRUDE REBOUND mentally different from what happened in 2008, according to Lafakis says, who says tremendous demand from China, which was buying oil and oil products in preparation for the Beijing Olympics, was the main reason for the 2008 surge. The strong demand caught investors off guard, and they panicked, sending oil futures higher, he says. The market is less likely to be squeezed today. For example, Lafakis says OPEC currently has excess capacity of 4 million barrels per day that can be brought online if oil prices increase to $100. Some analysts think oil will hurdle $100 in the coming months, but few see the potential for a extended At the beginning of January, crude oil topped $90 for the first time in more than run beyond that threshold. In an intwo years and recovered more than half of its massive 2008-2009 sell-off. (Prices vestment note released in December shown are weekly estimates and do not reflect daily price extremes.) 2010, Goldman Sachs economists Source: U.S. Energy Information Association (http://tonto.eia.doe.gov) described a structural bull market
16
that would lift oil prices back to $100 per barrel. Although he says oil could hit $100 this year, Lafakis does not believe it is a sustainable level. A price of $100 would trigger an increase in oil production, he notes. Another question is whether the increase in oil prices could derail the still-fragile economic recovery. Lafakis doesnt think so. A $1 per barrel increase results in a $1 billion increase in consumers annual energy costs, he says. He says it would take an approximately $20 increase to appreciably slow GDP growth.
Oil stocks
Rising crude prices have, of course, buoyed the prices of oilrelated stocks. Stocks of oil companies are probably pricing in slightly higher right now, Good says. However, the rise in prices may not result in a bonanza across the board. Oil producers, whether they are [sovereigns] such as OPEC FiGuRE 2: THE RECENT RALLY countries or companies such as Exxon or Shell, stand to benet the most from increased oil prices, says Lafakis. Reneries, on the other hand, are less likely to prot from higherpriced crude. Reners face long-term headwinds, Good says. In the short term, their margins may have peaked. Now, prots depend on further acceleration in growth and demand.
The lack of momentum in the current uptrend also plays against the participation of trend-following commodity trading advisors and hedge funds that played a big part in the 2007-2008 crude bubble (and the hedge-fund universe has been particularly decimated since then). While the initial rebound off the 2009 low was robust, price gains have been more haphazard since mid-2009. Every signicant push past a $10 threshold into the $60s, $70s, then the $80s, has been relatively short-lived and was typically followed by stagnation, and then a $5 to $10 retracement that nipped momentum in the bud just as it seemed the market might mount an extended rally. Nonetheless, there is little way to predict what might happen if the market does manage to stay above $100 for an extended period. Markets, like the people who comprise them, have relatively short memories.
Price action
Although crude oils behavior over the past 18 months bears little resemblance to its 2007-2008 run, the market has regained more than half the ground it lost in the subsequent sell-off. (However, the 50-percent rebound represents a technical hurdle in and of itself, as Fibonacci enthusiasts will likely sell into this anticipated resistance level.)
As of Jan. 3, March crude oil futures had topped $92, having rallied approximately 30-percent from late August 2010.
Source: TradeStation
17
TRADING TRADING Strategies Strategies
Time ltering scalp trades

Analyzing hour-by-hour performance of an intraday setup highlights optimal trading times.
BY ACTIVE TRaDER STaFF

successively lower lows. This pattern can be expressed by two simple rules: 1. T he lows of the ve-minute bars three, four, and ve bars ago are above the lows of their respective preceding bars. 2. T he lows of the current bar and the two preceding bars are below the lows of their respective preceding bars. As formulas, these rules are: 1. Low[5] > Low[6] and 2. Low[4] > Low[5] and 3. Low[3] > Low[4] and 4. Low[2] < Low[3] and 5. Low[1] < Low[2] and 6. Low[0] < Low[1] (Note: A version of the pattern that requires the most recent ve-minute bars low [Low[0]] to be a certain amount below the previous low will be discussed at the end of the article.) Basically, these rules simply identify situations in which there has been upward pressure for at least three ve-minute bars (notice that it can be more than three), followed by three bars of downward price action (lower lows). This representative pattern was unoptimized and was selected only because of its simplicity and relative frequency. It was originally analyzed in ve-minute data in the S&P 500 ETF (SPY),
continued on p. 20
here are several old saws about the best and worst times to put on positions during the trading day: avoid the open and close (because theyre too volatile), avoid the middle of the day (because its not volatile enough), and so on. The intraday volatility of the stock market does follow, on average, a very predictable intraday prole: The beginning and the end of the day are, in fact, the most active periods, as traders react to early news and establish positions at the open (or get out of bad positions held overnight) and then unwind many trades before the closing bell. The middle of the day lunchtime in New York and Chicago, as often noted features much less movement and volume because the early news has been absorbed and most positions have been established; the market often consolidates, or jerks back and forth, until activity picks up again in the last hour or two of the trading session. For intraday traders, the implications are fairly obvious: If youre looking for directional moves and follow-through, avoid the dead-zone in the middle of the day and focus on those periods when the market is most likely to move. (Conversely, traders looking to take contrary positions may choose to sell resistance and buy support during midday ranges.) Lets look at a basic intraday buy setup, applied on the veminute time frame, and see what we can learn from analyzing its behavior during different periods of the day.
The pattern: Three up and three down

We will start with the simplest of patterns: three ve-minute bars with successively higher lows followed by three bars with
18
Trading Strategies
but here it will be tested on ve-minute bars in the E-Mini Dow futures (YM) from Feb. 1, 2010 through July 16, 2010 a total of 9,412 price bars, or the equivalent of more than 37 years of daily price bars. Only regular-session data was used, 8:30 a.m. to 3:15 p.m. CT. Figure 1 shows a few examples of the pattern.
Raw pattern performance

The pattern formed 135 times in the 118 days in the analysis period just a little more than once a day, on average. This is far too infrequently for a genuine scalping pattern, but it nonetheless provides enough samples to do a relatively thorough analysis. Table 1 shows the E-Mini Dows performance in the rst 12 (ve-minute) bars following the pattern, using an entry one point (tick) below the low of the second-to-last bar of the pattern (i.e., entering as soon as the nal bar makes a lower low). Gains and
FIGUrE 1: TRADE SIGNALS
losses were calculated based on exiting at the closes of the following 12 bars. Figure 2 graphs the average and median post-pattern performance along with the markets average and median one- to 12-bar returns for the entire analysis period. While the patterns returns are extremely modest, they do outperform the even more static performance of the market overall. (The analysis period as a whole was at, dominated by an early uptrend, then a volatile sell-off highlighted by the May 2010 ash crash. The E-Mini Dow had 68 up days, 48 down days, and gained a total of 41 points between Feb. 1 and July 16, 2010.) Figure 3 (p. 22) looks beyond the closing gains to compare the patterns median largest up moves (LUMs) to the largest down moves (LDMs). The LUM is the biggest gain from the pattern entry to the highs of each of the following 12 bars, while the LDM is the biggest loss from entry to the lows of each subsequent bar (the chart shows the absolute value of the LDMs to make comparison easier). Its apparent the pattern was followed by notably more up movement than down movement in the rst few bars (along with the highest winning percentages, as shown in Table 1), but this edge quickly eroded until, by bar 12, the LUM/LDM ratio had fallen to 1.00. There was a somewhat stable zone in the middle: Upside movement held a small but steady edge from bar 5 to bar 9, and the median LUM ranged from 17 to 21 points during this window. Now lets see how the pattern behaved at different times of the day.
Time of day: Frequency and winning percentage

Figure 4 (p. 22) shows the distribution of pattern occurrences throughout the trading day. Theres the expected activity early in the session, but after a brief lull, another uptick occurs from around 10:10 to 10:50 CT. The period from 11 a.m. to a little after 1 p.m. is relatively quiet, except for an anomalous high reading at the 12:35 bar. A small surge in activity from 1:15 to 1:30 is followed by a
The pattern, which triggered approximately once a day, consists of three higher lows followed by three lower lows on the five-minute time frame.
TABLE 1: POST-PATTERN PERFORMANCE

Bar Avg Med Min Max Sum Win% 1 2.3 3 -59 33 308 62.96% 2 1.34 2 -61 47 177 54.81% 3 2.63 2 -71 49 331 54.81% 4 1.58 1 -65 58 196 51.85% 5 0.23 1 -66 72 28 54.07% 6 0.77 1 -66 65 93 53.33% 7 1.29 2 -60 64 152 53.33% 8 2.33 2 -63 79 272 53.33% 9 2.45 5 -81 97 284 54.81% 10 1.07 3 -88 98 124 53.33% 11 1.50 5 -85 92 171 51.85% 12 2.67 5 -90 92 302 53.33%
The patterns gains were modest, with the biggest relative (per bar) edge occurring in the first few bars especially bar 1, which was the only bar to have a winning percentage higher than 60 percent.
20
FIGURE 2: PATTERN PERFORMANCE

brief respite before a nal high-activity period from 2:15 to the days end. With the exception of the relatively high frequency mid-morning period (10:10-10:50) period, the prole essentially adheres to the common pattern of activity clustering toward the beginning and end of the trading day, with a lull in the middle. Now look at Figure 5 (p. 23), which shows the winning percentages associated with patterns occurring at different times of the day. One of the most interesting things about the results is that, rather than indicating certain time periods are uniformly better than others, it shows particular time periods are associated with a tendency toward success or failure either in the rst bars after the pattern or in the later bars. For example, patterns that occurred
continued on p. 22
The pattern had modest, somewhat haphazard performance (blue lines), although it was more bullish than the markets overall performance (reddish lines)
21
Trading Strategies
in the 1:05 to 2 p.m. period (red) tended to have lower winning percentages in bars 1 to 4, but from bar 5 forward, the odds of a gain were 60 percent or higher, and in three cases above 70 percent. Patterns that were triggered in the 8:45 to 9 a.m. period (medium blue) had winning percentages near 65 percent for bars 1 and 2, but that probability dropped off sharply at bar 4 and never again climbed above 50 percent. Conversely, the patterns in the 12:05 to 1 p.m. category had low winning percentages
FIGURE 3: UP MOVEMENT VS. DOWN MOVEMENT
(almost all below 50 percent) through bar 6, but these jumped notably (55-60 percent) from bar 7 forward. Overall, the most consistent time periods were the 10:05 to 11 a.m. (light purple) and 2:05 to 3:15 (dark blue) periods. With a few exceptions (e.g., bar 1 for the 2:05-3:15 patterns), trades that were triggered during these periods had win rates at or above 60 percent, with the 2:05-3:15 patterns particularly strong from bar 8 to bar 12. The consistently worst period was, in fact, 11:05 a.m. to 12 p.m. (light blue), which had a winning percent below 50 percent for nine of the 12 bars. If nothing else, it appears that avoiding trades during this period would be benecial to overall performance.
Keeping time on your side

Although intraday volatility patterns are fairly stable, it is worthwhile to research how a specic pattern or strategy performs at different times of the day. The results shown here, while still preliminary, indicate that not only are some times more advantageous than others, but different times of the day may require using different holding periods or trade horizons. In this case, the same entry signal was more profitable with a short holding period (one to four bars) early in the trading session, but late in the trading session a longer holding period (6 to 12 bars) was associated with a higher winning percentage. They also point to the potential for good results and a relatively high trade-signal frequency in a period (roughly 10-11 a.m. CT) that is typically thought of as a uneventful time of the day. One nal bit of analysis: We analyzed a modied version of the pattern on more recent data (Aug. 1, 2010, to Jan. 10, 2011, again in the E-Mini Dow futures) to see how the results compared to the initial test. This iteration of the pattern added the requirement that the low of the nal bar be at least 10 points below the low of the previous bar a criterion designed to capture more-signicant price drops that were thought likely to be followed by quick bounces. The results suggested the modication might be successful in this regard, although trade frequency was quite low. There were only 35 signals, but the median gain at bar 4 was 5 points much higher than the 1-point median gain of the original
There was, on average, more up movement than down movement following the pattern, but that edge was most prominent at bars 1 and 2.
FIGURE 4: TRADE DISTRIBUTION
Aside from a bump in the number of trade signals between 10 and 11 a.m. CT, the pattern was most active toward the beginning and end of the trading session.
22
FIGURE 5: WIN PERCENTAGE BY TIME PERIOD
pattern. However, performance dropped off sharply after bar 4, suggesting these were relatively brief trade opportunities. Nonetheless, incorporating a price-movement parameter into this type of setup could be a rst step in creating a more robust signal. Analysis showed the median low-to-low decline for the nal two bars of the setup was 5 points and the average was 7.3. A more moderate decline requirement (e.g., 2-4 points) for these bars might improve returns without eliminating too many signals.
The pattern had a low probability of success in the 11:05-noon period, but favorable odds in other periods depended on the trades time horizon.
23
Trading international stock-index ETFs with relative strength

Rotating into the strongest exchange-traded funds representing different countries stock markets shows the potential to boost returns and reduce volatility.
BY JAY KAEPPEL
he concept of investing in the strongest areas of the market has been a winning strategy for many stock investors over the years. Like any strategy, a relative-strength approach i.e., buying the stocks that are currently outperforming others is by no means perfect, and can, in fact, result in above-average volatility. Nonetheless, the potential for outsized returns can outweigh this risk. Traditionally, relative-strength investing consists of buying a portfolio of top-performing stocks, and research has shown this approach can greatly outperform a buy-and-hold approach over time. The increased volatility of the approach stems from the reality that any individual stock even a high-yer is susceptible to an adverse event, such as a surprisingly unfavorable earnings report, that can knock it out of the sky. In time, the relative-strength method has been improved by focusing on sectors and industry groups. Although an individual stock can be knocked down by a one-off event, sector trends are less likely to turn on a dime and typically take a longer time to play out. Momentum in a top-performing sector will often taper off resulting in another sector assuming the top spot before it enters a prolonged decline. This fundamental concept can be exported around the globe through trading single country exchange-traded funds (ETFs),
24
which track the performance of different international stock indices. In 1996 the iShares family of ETFs launched several ETFs to track the major stock market averages of a number of various countries around the globe. This universe has expanded over the years to include dozens of international stock-index ETFs. Not surprisingly, there is a high degree of correlation among them. If there is a global stock bull market, most country ETFs will rise in value, while most will decline in the face of a global bear market. Nevertheless, for trading purposes, we can treat each of these instruments as distinct sectors.
Applying a relative-strength strategy to international ETFs

The list of international stock-index ETFs shown in Table 1 (p. 26) is by no means exhaustive it does not, for example, include such important players as China and India. However, those in the list all have data going back to 1996, which gives us the ability to back-test a strategy over a meaningful time period. Figure 1 (p. 27) shows four international ETFs (representing Brazil, UK, Japan, and Malaysia, top to bottom) that have experienced varied results over the years (although all participated in the 2008 market collapse).
continued on p. 26
Trading Strategies
There are many ways to measure the performance of one market relative to another, some of them very complex. However, the simplest approach if based
TAbLE 1: iSHARES COUNTRY ETFS TRADING SINCE 1996

iShares Fund Australia Canada Sweden Germany Hong Kong Italy Japan Belgium Switzerland Malaysia Netherlands Austria Spain France Singapore Taiwan United Kingdom Mexico South Korea Brazil U.S. Total Market Ticker EWA EWC EWD EWG EWH EWI EWJ EWK EWL EWM EWN EWO EWP EWQ EWS EWT EWU EWW EWY EWZ IYY
on a sound concept is often the most useful. The technique used here measures the one-year percentage return for each of the ETFs at the end of each month. The ve ETFs with the best one-year returns are held during the next month. Initially, each of the ve ETFs purchased receive 20 percent of the total portfolio equity. Subsequently, each time an ETF drops from the top ve, it is sold and the proceeds are used to purchase the fund that took its place. If more than one fund drops out of the top ve at the end of a given month, the proceeds from the funds sold are allocated equally to the new funds that take their place. If fewer than ve funds show a gain, then anywhere from 20 percent to 100 percent of the portfolio can be held in cash. For example, if only two of the funds show a gain over the previous 12 months, then those two funds would be held while the remainder of the portfolio
would be held in cash. The strategy purchases only ETFs that have produced a gain over the previous 12 months; it does not buy the smallest losers. If no ETF has a positive 12-month return, then no position is held during the following month, and the entire portfolio is held in cash. The relative-strength strategy rules are: 1. A fter the close of trading each month, measure the one-year change for each of the 21 ETFs in Table 1. 2. I f ve or more of these funds have positive 12-month returns, during the next month hold the ve with the highest returns. When starting out, allocate 20 percent of capital to each ETF .
TAbLE 2: PERFORMANCE COMPARISON

System No. trades % protable trades Avg. annual return Net gain StD of annual returns Average winner Average loser Median winner Median loser Largest winner Largest loser 145 59.3% 12.9% 344.3% 18.9% +17.3% -7.5% +8.2% -5.1% +260.1% -31.4% 9.0% 118.6% 25.6% Buy-and-hold 1
These international stock-index ETFs all have price histories dating back to 1996 and represent equity markets in North America, Europe, Asia, Latin America, and Oceania.
The relative-strength strategy outperformed buy-and-hold, and did so with reduced volatility.
26
FigurE 1: INTERNATIONAL STOCK-INDEX ETFS
3. If a fund drops out of the top ve at the end of a given month, sell this fund and use the proceeds to buy the fund that replaced it in the top ve. 4. If two or more funds drop out of the top ve and are replaced by new funds, the proceeds from the sold funds should be split as close to evenly as possible between the new funds being purchased. (This helps rebalance the portfolio holdings over time.) 5. If a fund drops out of the top ve at the end of a given month and is not replaced by another fund with a positive 12-month return (in other words, if there are fewer than ve funds with positive 12-month returns), then sell that fund and hold the proceeds in cash. 6. If no funds have positive 12-month returns at the end of a given month, sell any existing fund positions and keep the portfolio in cash. 7. If the entire portfolio goes to cash, each new fund position should be allocated 20 percent of the total account equity until ve fund positions are held. These rules were tested on the 21-ETF portfolio from March 31, 1997 through Dec. 28, 2010 using an initial account equity of $10,000.
Measuring the results

Table 2 compares this strategys results to buying and holding equal initial investments in all 21 ETFs from Table 1. During 13 years and nine months of testing, the strategy averaged an annual gain of 12.9 percent vs. 9 percent for buy-and-hold. The strategys ending net prot was 344.3 percent, which was nearly three times the buy-and-hold prot of 118.60 percent. Figure 2
continued on p. 28
These four international ETFs (representing Brazil, UK, Japan, and Malaysia) have experienced varied results over the years. The relative-strength strategy rotates into the strongest ETFs (from a pool of 21) each month.
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Trading Strategies
FIGURE 2: TRADE-BY-TRADE RESULTS
The strategy posted a winning percentage of nearly 60 percent. The largest single winner (+260 percent) occurred in EWO held from October 2002 to December 2005), while the largest loser (-31 percent) occurred in EWH (November 2007 to September 2008).
shows the strategys trade-by-trade percentage returns, while Figure 3 compares the strategys equity curve to buy-and-hold based on a $10,000 initial investment. The system made money in 10 years and lost money in four. It also outperformed the benchmark all funds index, which represents buying and holding all 21 funds, in 10 of the 14 years. Also, the systems volatility (as measured by standard deviation of annual returns) was less than 75 percent that of buyand-hold (18.9 percent vs. 25.6 percent).
FigurE 3: EQUITY CURVES
Diversication and momentum

Using simple relativestrength analysis with international stockindex ETFs allows investors to diversify stock holdings across the globe and achieve an above-average rate of return by focusing on those markets that are outperforming the rest.
The strategys equity curve mirrored buy-and-holds trajectory, but outperformed it by a wide margin.
For information on the author, see p. 8.
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Active alpha investing for the markets new normal

In a market environment with potentially little to offer, a simple ETF sector rotation approach shows the ability to outperform.
BY PROF. DAVIdE ACCOMAZZO ANd ROSARIO RIVAdENEYRA
n trading there are two main approaches: momentum, when a trader bets price will continue in the direction of the previous period; or mean-reversion, when a trader bets prices are in a short-term overbought or oversold situation and are therefore expected to revert to a longer-term mean or fair value. Of course, identifying a trend in a momentum-based strategy or a contrarian overbought-oversold condition also requires determination of a time horizon. A two-week directional move may be considered a trend by one type of trader, while another may require a two-month move to qualify as a trend. Given these general investment parameters, I started researching different momentum-based ideas, testing different time periods to see if trading advantages could be found across the board by implementing simple momentum or contrarian rules to different asset classes. Further, the convergence of two factors the realization that for a few years the passive beta approach of buy-and-hold would have been a loser, and the explosion of exchange-traded funds (ETFs) created the conditions for this type of research.
The rst analysis of this idea was conducted in 2008 immediately before the nancial crisis as an exercise for students at the Graziadio School of Business and Management at Pepperdine University. In this article, the study is updated with two additional rotation studies using forex and commodity ETFs.
Go to p. 71 for more information about: Sharpe ratio Variance and standard deviation
Beyond buy-and-hold: Goodbye beta, hello alpha

For years Wall Street has relentlessly promoted the buy-andhold investment approach. Over time this strategy morphed into a quasi-Holy Grail of investing for two major reasons: rst, its winning streak over a fairly long time period, thanks to one of the most powerful equity market bull runs ever recorded (1982 to 2000); second, its simplicity and cost efciency in terms of execution. The buy-and-hold strategy also ts rather well with the operational needs of the Street. It creates a constant and stable inow of money into equities, and it frees stockbrokers and nancial advisors from the heavy work of actually managing portfolios and allows them to concentrate on asset gathering. The buy-and-hold mantra also helps mutual funds by securing stable ows of capital
Its unlikely economic conditions will favor a passive investment approach in the foreseeable future.
30
FIgURE 1: UNEVEN PERFORMANCE
Since the bursting of the tech bubble in March 2000, equity market performance has been inconsistent, and passive investment strategies have little to show for the past decade. into investment products while minimizing liquidity issues. The success of buy-and-hold also helped validate passive investing and indexing (i.e., beta replication), an investment approach that forgoes market timing, active asset allocation, and stock picking in favor of replicating benchmark performance at low execution and management costs. All investment strategies, including buy-and-hold and indexing, experience market cycles with favorable macro and structural conditions. Inevitably, however, these cycles are followed by unfavorable periods. For example, since the bursting of the tech bubble in March 2000, equity market performance has been inconsistent and stocks have underperformed most other asset classes. As a result, a strictly passive strategy has very little performance to show over the past decade. The S&P 500 index originally peaked on March 24, 2000 with a closing price of 1527.46. It then proceeded to lose about 50 percent over the next two years before rallying to a new closing high on October 11, 2007 at 1554.41. This peak was followed by another crash a 55-percent decline over the next year and half (Figure 1). In early 2011, the S&P had rallied back above 1250, still approximately 20 percent below its 2007 peak. And although on a rolling basis holding U.S. stocks passively for at least 10 years has rarely produced signicantly negative performance in real terms (there are only three general periods of underperformance since 1880), 2000-2009 has left passive investors with large losses. To make things even more depressing for the indexing crowd, it is unlikely economic conditions will favor the passive approach in the foreseeable future. The long-term implications of the credit-deleveraging process, along with the inationary pressures that have been steadily building up because of aggressive global monetary and scal policy, suggest uneven performance for equities for quite some time. For the next few years a new normal is likely to emerge in both the real economy and the nancial markets, as they will probably reect Main Streets uneven performance with low-beta returns. Not so shockingly to the astute investor, active risk management and active asset allocation seem to be back in fashion. Alpha investing, the technique of actively seeking alternative and possibly uncorrelated sources of return beyond the passive
continued on p. 33
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Trading Strategies
TABLE 1: ETF UNIVERSE

Available since May 2003 Available since Dec. 2007
TABLE 1: ETF UNIVERSE

Available since May 2003 Available since Dec. 2007 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Available Dec. 2007 Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Basic Materials
MXI IYM ITB IYR Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes Yes
Transport
IYT Utilities IDU JXI
Construction & Real Estate
International
IEV FXI AIA EEM EWZ
Consumer Goods
KXI RXI
Energy
IEO IEZ IXC
Fixed Income
EMB MBB TLT TIP
Financials
IAI IYF IAK IAT IXG
Commodities
GSG IAU
Health Care
IHF IHI IHE IBB
Commodities
DBA GLD GSG RJI SLV UNG USO
Industrials
ITA IYJ EXI
Natural Resources
IGE
Currencies
FXE FXC FXY FXM FXB FXS
Technology
IGN IGV IXN SOXX Telecom IYZ IXP
The ETFs used in the study covered a wide range of stock sectors, fixed income markets, commodities, and currencies.
32
TAblE 2: ORIGINAL STUDIES

STUDY 1 Period: May 2003 to April 2008 Sample: 18 ETFs Portfolio: 4 ETFs Weight per ETF: 25% Sectors: 4 Period Annualized return 1 month Period avg. return Period max. loss Daily max. loss Annualized return 3 months Period avg. return Period max. loss Daily max. loss Annualized return 12 months Period avg. return Period max. loss Daily max. loss Momentum 8.50% 0.71% -8.97% -3.79% 20.59% 5.15% -12.35% -3.09% 13.03% 13.03% -4.65% -3.83% Value 12.24% 1.02% -7.54% -2.80% 12.29% 3.07% -11.53% -2.64% 17.62% 17.62% SPY 9.33% 0.78% -6.05% -2.60% 9.21% 2.30% -10.71% -2.74% 7.81% 7.81% -4.95% -2.96% STUDY 2 Period: June 2006 to May 2008 Sample: 30 ETFs Portfolio: 7 ETFs Weight per ETF: 14.29% Sectors: 7 Momentum 17.54% 1.46% -6.54% -3.04% 16.29% 4.07% -5.85% -3.09% 7.21% 7.21% Value 3.94% 0.33% -5.07% -2.07% 7.49% 1.87% -7.69% -2.69% -7.74% -7.74% -7.74% -3.27% SPY 7.02% 0.59% -6.05% -2.60% 6.47% 1.62% -9.51% -2.74% -6.68% -6.68% -6.68% -2.96% STUDY 3 Period: October 2006 to May 2008 Sample: 36 ETFs Portfolio: 9 ETFs Weight per ETF: 11.11% Sectors: 5-9 Momentum 17.17% 1.43% -5.03% -3.20% 15.56% 3.89% -3.93% -4.38% Value 3.91% 0.33% -6.13% -2.44% -5.87% -1.47% -10.84% -1.89% SPY 3.13% 0.26% -6.05% -2.60% -3.19% -0.80% -9.29% -2.68%
The original analysis included ETF data through 2008. performance produced by beta exposure, is going to be the central and pivotal element of every successful portfolio. deconstructed as follows: 1. M omentum will overweight the portfolio toward those sectors/asset classes that are showing price outperformance. 2. C ontrarian will overweight the portfolio toward those sectors/asset classes that are suffering price underperformance The exact rules and composition of the portfolio are described in the following section (Trading method). The idea was to create a model that would allow for an active sector, commodity, or forex rotation in the search for market
continued on p. 34
Investment philosophy
The original study looked at a simple and cost-effective way to actively manage a primarily equity-based portfolio. This article adds studies of commodity and forex ETFs as well. We focused on ETFs as low-cost allocation vehicles to help build a diversied portfolio that could be actively managed using simple rules, and applied the aforementioned major investment styles momentum and contrarian. Although there are myriad ways to dene these two approaches, the philosophy behind them can be
33
Trading Strategies
anomalies. Consistent with the premise that economic and equity performance will be signicantly uneven in the future, we looked for an active strategy that would capitalize on such sector discrepancies. We also decided not to run correlation studies, but to build and rebalance portfolios strictly on sectors selected by the general rules. The philosophy supporting this decision was to concentrate on a strategy dedicated to signicantly outperforming the benchmarks, and then analyze the risk of the portfolio by looking at how the largest losses compared to the index and by calculating the strategies standard deviation and Sharpe ratio.
Momentum strategies seem to work better with quicker rebalancing, while contrarian approaches need longer time frames to arbitrage mispricings.
Trading method
For the sector ETF studies (Studies 1 and 2) we rst looked at the available sectors for trading via iShares and chose 42 ETFs representing the following 15 sectors: Basic Materials, Construction & Real Estate, Consumer Goods, Energy, Financials, Health Care, Industrials, Natural Resources, Technology, Telecommunications, Transportation, Utilities, Fixed Income, International, Fixed Income, and Commodities. One drawback inherent in this approach is the relatively short historical period available for analysis. We believed we had to back-test at least ve years of performance for the results to have a solid foundation. Because a large number of ETFs were introduced in 2006, only 19 of the 42 selected ETFs had data going back at least ve years (see Table 1 on p. 32 for the complete universe of ETFs). Therefore, we decided to expand the research into two studies to compare how results would vary when more ETFs were included in the sample. The commodity and forex studies were especially impacted by limited liquidity and short history (three years), as well as a limited number of ETFs from which to choose. Despite these constraints, this was not a signicant problem, as the available ETFs were diversied, liquid, and had enough price history to validate the analysis. (Over time,
interested researchers can conduct additional studies as more data accumulates for these ETFs.) Each study had different test periods, but all were recalibrated using the same rules: rebalancing every month, rebalancing every three months, and rebalancing every 12 months. At the end of each period (monthly, quarterly, or annually) we would rank the percentage performance of the available ETFs for that period. Then, for the momentum portfolio, we would buy the ETFs in the top 25 percent of the ranking for the following period. For the contrarian portfolio, we would buy the ETFs in the bottom 25 percent of the ranking in the next period. We equally weighted the positions of the ETFs forming the portfolio, and only included one lter: no more than 25 percent was to be invested in each of the 15 sectors. Our benchmark was SPY, the ETF that tracks the S&P 500. Study 1 spanned May 2003 to November 2010; 19 ETFs were available for trading and the portfolio consisted of a total of four ETFs. Study 2 spanned December 2007 to November 2010; 42 ETFs were available and the portfolio contained 10 ETFs. The commodity and currency portfolios (Studies 3 and 4) were rebalanced monthly and quarterly, and they consisted of only one ETF . For the momentum portfolio, the best-performing ETF in the current period was allocated 100 percent of capital the following period. For the contrarian portfolio, the worst-performing ETF in the current period would be the only ETF held in the following period. The commodity study included seven ETFs, while the currency study included eight ETFs. The benchmark for the currency study was PowerShares DB US Dollar Bullish Fund (UUP), which tracks the performance of being long U.S. dollar futures against six other currencies. The S&P GSCI Enhanced Commodity Trust (GSC) was used as the benchmark for the commodity portfolio. The strategies were tested on adjusted monthly closing prices (from Yahoo Finance), except for SOXX (data provided by Fidelity). Adjusted daily closing prices were used to determine the maximum daily loss within the worst period. The results do not incorporate commissions or slippage.
Test results
The results in Tables 2 (p. 33), 3, and 4 (p. 37) suggest a cost-effective and simple active alpha strategy is achievable. Momentum strategies have outperformed in most time frames and different
continued on p. 36
34
TAblE 3: UPDATED RESULTS

ETFs Period: May 2003-Nov. 2010 Sample: 19 ETFs Portfolio: 4 ETFs Weight per ETF: 25% Period (months) Annualized avg. return Period avg. returns Average gain Average loss 1 Period max. return Period max. loss Winning periods Losing periods Annualized std. dev. Sharpe Ratio Annualized avg. return Period avg. returns Average gain Average loss 3 Period max. return Period max. loss Winning periods Losing periods Annualized std. dev. Sharpe Ratio Annualized avg. return Period avg. returns Average gain Average loss 12 Period max. return Period max. loss Winning periods Losing periods Annualized std. dev. Sharpe Ratio Sectors: 4 Momentum 11.52% 0.96% 3.78% -4.69% 18.06% -14.67% 66.67% 33.33% 18.12% 0.63 12.95% 3.24% 10.76% -8.05% 24.62% -32.38% 60.00% 40.00% 24.11% 0.53 7.42% 7.42% 17.54% -53.33% 31.79% -53.33% 85.71% 14.29% 27.96% 0.26 Value 0.14% 0.01% 3.56% -4.85% 12.15% -28.14% 57.78% 42.22% 20.23% 0.00 12.14% 3.04% 8.73% -10.26% 19.61% -30.22% 70.00% 30.00% 21.72% 0.55 10.16% 10.16% 21.32% -17.75% 75.66% -34.46% 71.43% 28.57% 32.98% 0.30 SPY 5.65% 0.47% 2.94% -3.92% 9.94% -16.52% 63.33% 35.56% 15.04% 0.37 7.29% 1.82% 6.44% -7.41% 16.29% -21.57% 66.67% 33.33% 17.16% 0.42 4.69% 4.69% 11.61% -36.80% 26.35% -36.80% 85.71% 14.29% 19.77% 0.23 ETFs Period: Dec. 2007-Nov. 2010 Sample: 42 ETFs Portfolio: 10 ETFs Weight per ETF: 10% Sectors: Min. 4, Max. 10 Momentum 3.30% 0.28% 4.99% -5.33% 14.31% -15.24% 54.29% 45.71% 21.51% 0.15 -1.02% -0.25% 10.02% -15.67% 21.35% -27.70% 60.00% 40.00% 30.60% -0.04 10.33% 10.33% 10.33% N/A 12.15% N/A 100.00% 0.00% 2.58% 3.94 Value -4.75% -0.40% 5.04% -6.85% 11.02% -25.05% 54.29% 45.71% 26.74% -0.18 1.42% 0.36% 9.56% -13.45% 20.70% -31.71% 60.00% 40.00% 30.30% 0.04 33.18% 33.18% 33.18% N/A 59.99% N/A 100.00% 0.00% 37.92% 0.87 SPY -2.83% -0.24% 4.76% -5.87% 9.93% -16.51% 51.43% 45.71% 22.00% -0.14 -0.65% -0.16% 10.79% -11.11% 16.29% -21.57% 50.00% 50.00% 25.77% -0.03 16.88% 16.88% 16.88% N/A 26.35% N/A 100.00% 0.00% 13.40% 1.25
The updated analysis included performance results into 2010.

35
Trading Strategies
Related Reading
Nicholas Barberis, Andrei Schleifer. Style Investing. Harvard Institute of Economic Research Discussion Paper 1908, December 2000. Bob Litterman. Active Alpha Investing. Goldman Sachs Asset Management, Open Letter to Investors, 2008. R. Schiller. From Efficient Markets Theory to Behavioral Finance. Journal of Economic Perspectives, 17 (Winter) 2003. E. Dimson, P . Marsh, M. Staunton. The Worldwide Equity Premium: A Smaller Puzzle. London Business School, EFA 2006 Zurich Meetings, April 7, 2006. H. Markowitz. Portfolio Selection. Journal of Finance 7, No. 1, March 1952. H. Hong, J. Stein. A Unified Theory of Underreaction, Momentum Trading, and Overreaction in Asset Markets. The Journal of Finance, Vol. LIV, No. 6, December 1999. K. Geert Rouwenhorst. International Momentum Strategies. Yale School of Management, February 1997. asset classes. Momentum outperformed benchmarks across the board, with a notable exception in the three-year study using annual rebalancing, where the value strategy performed much better (probably because of the 2008 market dislocations). However, value also did better in the longer seven-year study using annual rebalancing, indicating momentum strategies seem to work better with more frequent rebalancing while contrarian approaches need longer time frames to capitalize on mispricings. Particularly noteworthy is momentums outperformance in the commodity sector using one-month rebalancing, where it posted an annualized average rate of return of more than 23 percent, vs. -7.25 percent for the commodity benchmark. In forex, a threemonth rebalancing strategy performed well, both relative to the benchmark and in absolute terms, with an annualized rate of return above 10 percent. One caveat is the larger standard deviations of momentum strategies. However on a risk-adjusted basis the returns remain attractive because their Sharpe ratios are generally higher than
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the benchmarks and in some cases higher than those of the value strategies.
Cheap and simple alpha

As mentioned, the motivation behind this analysis was to test a simple and cost-effective way to produce an active alpha strategy that could replace or at least complement more traditional betadriven portfolios. The ultimate portfolio optimization comes from the ability to identify sources of return produced by active and skilled investment management. The consistent ability to create enhanced performances by superior market timing and security selection or more simply, alpha is today more than ever a central tenet of an optimal portfolio. Over the past decade, indiscriminate exposure to a generalized beta has produced negative returns, and future conditions do not seem to indicate a change in this situation. As a result, the need to actively incorporate alpha-seeking strategies in traditional portfolios is a priority. There is a considerable amount of research to validate the both the momentum and contrarian strategies as solid starting points. Momentum strategies seem to generally work across boundaries for several reasons: under-reaction to the dissemination of news (a practical discovery in clear contrast with the efcient market hypothesis), difculty for large investment funds to deploy their capital quickly, and, ultimately, the simplicity of execution in momentum strategies that may lead to easy replication and selffullling results. Interestingly, studies show momentum strategies seem to be more successful in shorter-term periods, while value strategies seem to outperform over longer time horizons (see International Momentum Strategies by K. Geert Rouwenhorst, Yale School of Management, February 1997). This study seems to validate these conclusions: While momentum outperformed the benchmark and contrarian strategies in most scenarios, it underperformed in the simulation using annual rebalancing, which the longest time frame tested with the least frequent rebalancing. This switching of outperformance between time horizons could be exploited in a core-satellite type of portfolio, in which the core part of the portfolio is dedicated to long-term value beta exposure and the satellite is comprised of alpha-seeking momentum investing. A simple ETF momentum strategy using quarterly or monthly sector, commodity, or FX rotation offers a cost-effective way to capture the critical alpha component every portfolio will need to offset negative conditions for traditional beta investing.
For information on the authors, see p. 8.
TAblE 4: UPDATED RESULTS: COMMODITIES AND CURRENCIES

Commodities Period: Dec. 2007-Nov. 2010 Sample: 7 ETFs Portfolio: 1 ETF Weight per ETF: 100% Period (months) Annualized avg. return Period avg. returns Average gain Average loss 1 Period max. return Period max. loss Winning periods Losing periods Annualized std. dev. Sharpe Ratio Annualized avg. return Period avg. returns Average gain Average loss 3 Period max. return Period max. loss Winning periods Losing periods Annualized std. dev. Sharpe Ratio Annualized avg. return Period avg. returns Average gain Average loss 12 Period max. return Period max. loss Winning periods Losing periods Annualized std. dev. Sharpe Ratio Commodities: 1 Momentum 23.35% 1.95% 8.91% -7.86% 16.94% -23.73% 57.14% 40.00% 34.07% 0.68 -3.21% -0.80% 7.95% -13.94% 29.84% -27.85% 60.00% 40.00% 31.18% -0.11 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Value -29.50% -2.46% 7.01% -9.56% 15.08% -24.28% 42.86% 57.14% 35.97% -0.82 -25.95% -6.49% 18.15% -17.05% 39.70% -31.45% 30.00% 70.00% 20.91% -1.25 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A GSC -7.25% -0.60% 5.71% -7.29% 17.21% -27.54% 51.43% 48.57% 30.80% -0.24 -8.83% -2.21% 16.34% -14.57% 29.72% -43.97% 40.00% 60.00% 42.97% -0.21 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A 3.21% 0.27% 2.78% -3.72% 9.27% -8.35% 61.36% 38.64% 14.22% 0.22 10.11% 2.53% 8.96% -7.76% 17.27% -17.24% 61.54% 38.46% 19.94% 0.50 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A Currencies Period: March 2007-Nov. 2010 Sample: 8 ETFs Portfolio: 1 ETF Weight per ETF: 100% Currencies: 1 Momentum Value -0.98% -0.08% 3.09% -2.49% 9.03% -15.42% 43.18% 56.82% 14.43% -0.08 9.09% 2.27% 6.12% -2.21% 16.03% -8.92% 53.85% 46.15% 6.18% 1.45 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A UUP -0.65% -0.05% 2.25% -2.36% 8.43% -7.01% 50.00% 50.00% 10.90% -0.07 -1.88% -0.47% 3.38% -4.95% 8.67% -8.86% 53.85% 46.15% 5.13% -0.40 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A
The updated analysis added commodity and currency ETFs.
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Execution and management of iron condors

Timing the component spreads of this four-option position can help avoid its drawbacks and maximize its potential.
BY GEOFFRY WONg
lthough option traders are often attracted to strategies that offer limited risk and a relatively high probability of success, these approaches are often more difcult to apply than they appear on paper.
The iron condor is a four-option strategy with limited risk that is designed to prot when the underlying market remains in a relatively low-volatility condition during the life of the trade. It is a credit spread that is, the trader collects premium upon establishing an iron condor, and this net credit is the positions maximum prot. The components of an iron condor are: 1. Short one out-of-the-money (OTM) put; 2. Long one OTM put with a lower strike price; 3. Short one OTM call; 4. Long one OTM call with a higher strike price. The trades maximum prot occurs when the underlyings price is between the strike prices of the short put and short call. Notice options 1 and 2 comprise a bull put spread, while options 3 and 4 represent a bear call spread (see Option terms for denitions of these positions). The long call and long put options essentially protect the position against large up or down moves in the underlying instrument. Although the iron condor seems to represent a fairly straightforward concept collect premium and keep it as long as the
underlying market does not break the short strikes in either direction and implied volatility remains low it is easier to prot from these positions in theory than in practice. The reason goes back to thinking of the iron condor as the combination of a bear call spread and a bull put spread. In short, traders typically collect too little premium on either the bear call spread or the bull put spread portion of the position when entering all legs of the trade simultaneously (and they give away the bid-ask spread, too). This is a result of the differences between call and put options that are equidistant from the underlying price in a given situation. Lets look at the mechanics of properly executing an iron condor.
Before the trade

There are a few basic steps for entering any options trade. The rst is identifying an appropriate underlying stock or commodity. This is more challenging than it might rst seem. Basically, you should be intimately familiar with the underlying market you are interested in trading. It is not in your best interest to apply a strategy unless you have a complete understanding of the underlying stock or futures contracts historical highs and lows, annual and quarterly reporting dates, average daily true range (volatility), and volume, as well as the open interest (the number of open positions) in the specic option contracts you might trade. All these factors play an important role in price movement.
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Option terms
Premium: The price of an option. Bear call spread:A credit spread that consists of a short call and a higher-strike, further out-of-the-money (OTM) long call in the same expiration month. Bull put spread:A credit spread that consists of a short put and a lower-strike, further OTM long put with the same expiration date. The spreads largest potential gain is the premium collected, and its maximum loss is limited to the point difference between the strikes minus that premium. Delta:The ratio of the movement in an options price (premium) for every one-point move in the underlying instrument. An option with a delta of 0.5 (50 percent) would move a half-point for every one-point move in the underlying stock; an option with a delta of 1.00 (100 percent) would move one point for every onepoint move in the underlying stock. Strike (exercise) price:The price at which an underlying instrument is exchanged upon exercise of an option. Time value (time premium):The amount of an options value that is a function of the time remaining until expiration. As expiration approaches, time value decreases at an accelerated rate, a phenomenon known as time decay.
Selecting an underlying instrument with the appropriate characteristics is an important step in capturing the most premium (credit) possible. Stocks such as Apple (AAPL) will have more premium value simply because their interday volatility is greater than that of many other stocks. For example, if you sold a bear call spread on AAPL a few strikes OTM (i.e., selling an OTM call and buying a higher-strike OTM call with the same expiration date), you would expect to receive more money than if you sold a call spread on, say, Microsoft, which has much lower volatility. Larger underlying price moves translate into higher option premiums. Another factor that effects the premium value is market perception, or bias. Using Apple stock again, the market prices the OTM calls higher, which results in higher premiums and call-spread values. For example, the market bias a few months ago was that it was willing to pay more for OTM calls than OTM puts. As a result, calls were more expensive than puts that were equidistant from the current stock price. At times, option deltas may explain this anomaly or relationship.
The signicance of delta

One of the overlooked aspects of delta is that it is synonymous to the probability of exercise that is, the odds the underlying will be at a given (strike) price at options expiration. As a result, you need to be careful when simultaneously selling call spreads and put spreads with the same delta but different premiums. Equal probability of exercise should yield equal premium, all else being equal. If the calls in our example are trading at a premium to the puts but their deltas are the same, there is a value disconnect. If you decide to sell a call spread that is $10 OTM with a delta of 25 percent (.25) and receive a $2 credit, you would expect to receive the same $2 credit when selling a $10 OTM put spread with a 25-percent delta. However, this is often not the case. For example, in the month of January, AAPL was trading around $340.The $360 call expiring in one month was trading for $5 with a .20 delta in other words, reecting a 20-percent chance AAPL would be trading at $360 in one month.By comparison, the $340 put was
continued on p. 40
FIGURE 1: IRON CONDOR PROFILE
The iron condor has limited risk and limited profit potential, and can be broken down into bear call spread and bull put spread components.
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Trading Strategies
True range
True range (TR) is a measure of price movement or volatility that accounts for the gaps that occur between price bars. This provides a more accurate reflection of the size of a price move over a given period than the standard range calculation, which is simply the high of a price bar minus the low of a price bar. The true range calculation was developed by Welles Wilder and discussed in his book New Concepts in Technical Trading Systems (Trend Research, 1978). True range can be calculated on any time frame or price bar five-minute, hourly, daily, weekly, etc. Using daily price bars as an example, true range is the greatest (absolute) distance of the following: 1. Todays high and todays low. 2. Todays high and yesterdays close. 3. Todays low and yesterdays close. Average true range (ATR) is simply a moving average of the true range over a certain time period. For example, the 20-day ATR would be the average of the true range calculations over the past 20 days. trading for $3.50 with a .20 delta, which implies a 20-percent probability AAPL would be trading at $340 at expiration. Why should you sell the OTM put for less than the OTM call if the odds are equal AAPL will be trading at either $340 or $360 at expiration? One of these premiums is too cheap. This may be a good reason to try and leg into the iron condor and receive a higher premium for either the bear call spread, the bull put spread or both. However, because of its risks (described later), this approach is suggested for more seasoned traders.
value. You are taking on some additional risk by selling one leg at a time, and entering the spread in this fashion requires patience. If you sold your call spreads rst, you must understand you are now short the underlying instrument and have risk exposure if it rallies. For example say you sold a $29 Microsoft call and bought a $30 call. The $29 call has a delta of .25 and the $30 call has a delta of .10. This is a bear call spread, so the net difference between the two strikes is 15 percent, which in the case of selling one spread would make your short 15 shares (15 percent of 100 shares). The opposite is true if you sold the put spreads rst: You would be long a certain percentage of shares.
Iron condor management

As with all trading, proting from an iron condor is a matter understanding your risk and knowing how to manage it. With condors the risk is well-dened: the difference between the strike prices and the credit received for selling the spread. For example, lets say AAPL is trading at $340 and you sell a $360 call and buy a $380 call (a $360-$380 bear call spread) for a $2 credit. If AAPL settles at $340 at expiration, the trade prot is $2. If AAPL is trading at $365 at expiration, you would lose $5 on the $360 short call but would keep the original $2 credit, so the total loss would be $3. Determining the optimum time to sell an iron condor is a bit tricky. A good rule of thumb is to determine a consistent percentage to exit any trade for example, a 15-percent decline in the value of the spreads collected premium. Many traders are inclined to let their iron condors ride until expiration to collect the maximum prot. Although this works out sometimes, in the long run it usually leads to traders letting positions move against them and producing losses. Traders should clearly dene their risk level for these trades and be disciplined about exiting when that loss is reached. Finally, the time value factor is very important. The goal is to optimize the decay curve that is, catch it at its peak. Time decay is not linear; most option models show the maximum erosion occurs in the nal two weeks before expiration. Accordingly, these types of strategies are most advantageous when entered with three weeks remaining until expiration.
For information on the author, see p. 8. Geoffry Wong will be a speaker at the Traders Expo in New York on Feb. 22 (www.tradersexpo.com).
Execution: Legging into an iron condor

Entering the call-spread and put-spread components of the iron condor separately makes it possible to collect equal premiums for them. The call spreads and put spreads are sold based on favorable conditions in the underlying. For example, if the stock or commodity is approaching major resistance, you can attempt to sell the call spread rst. You would be selling into strength with the understanding the market is approaching long-term resistance. Here, you are deferring to the chart. If this analysis of the underlying is correct, the stock will hold resistance and will retreat or sell off at some point. When the downside correction occurs, you can then sell the put-spread component because the market will pay more premium when the stock is dropping in
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ADVANcED TRADING Strategies Concepts
Base metals and Chinese monetary policy

Are sliding prices for base metals a currency trade in disguise?
BY HOWARD L. SIMONs
he various creators of the euro may have had certain goals in mind for the common currency, but there is no reason to believe its spread to various funding currencies as part of global carry trades and the use of these spreads as risk barometers were on that list. Yet twelve years into the common currency experiment, this is where we nd ourselves (see A cross rate to bear, Currency Trader, May 2009). As China has pegged its currency to the low-yielding dollar, plus or minus a little revaluation here and there, the excess carry return from the Chinese yuan into the euro can be used as a risk barometer the same way the yen carry has been (see The Robin Hood carry, Currency Trader, July 2010). This carry trade is composed in turn of two parts, the net interest
One of the great surprises of 2009 given Chinas key role in arresting the global recession is interbank credit conditions in China began to tighten in late May 2009.
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rate gain to be made from borrowing three-month yuan and lending into three-month euros and the change in the spot rate. Any increase in short-term Chinese interest rates relative to European rates has the dual effect of tightening domestic credit conditions in China and lowering the interest rate spread. This had been readily observable in the time zones outside of the green rectangle in Figure 1 when we mapped the carry of the yuan (CNY) into the euro against the shape of the Chinese money-market yield curve as measured by the forward rate ratio between six and nine months (FRR6,9) plotted inversely. This is the rate at which we can lock in borrowing for three months starting six months from now divided by the nine-month rate itself; the more this FRR6,9 exceeds 1.00, the steeper the yield curve is. The carry trade index should lead the FRR6,9 by three months given the movement of future interest changes rolling down the curve into the present. This trade had been disrupted during the Eurozones sovereign credit crisis from December 2009 May 2010, the time period noted in the green rectangle. One of the great surprises of 2009 given Chinas key role
FIgURE 1: CNY MONEY MARKEt YIElD CURVE AND CARRY INtO EUR
in arresting the global recession is interbank credit conditions in China began to tighten in late May 2009 (see Viewing the yuan from the grassy knoll, Currency Trader, February 2011); they just did not bother telling anyone. Did this interest rate action and the carry trade into the euro have any impact on global growth prospects in general and on base metals prices in particular?
The carry trade indexs lead was disrupted during the Eurozones sovereign credit crisis ( December 2009 May 2010, green rectangle).
FIgURE 2: ThREE-MONth AhEAD TIN PRIcE ChANgEs As FUNctION Of ChINEsE MONEtARY VARIAblEs
Money and metals

Figures 2-7 depict the three-month ahead percentage price change for an LME three-month forward as a function of the Chinese FRR6,9 led by three months and of the yuan carry into the euro. Positive price changes are depicted in colored bubbles; negative price changes in white. The
continued on p. 44
ACTIVE TRADER March 2011 www.activetradermag.com 43
Advanced Concepts
FIgURE 3: ThREE-MONth-AhEAD AlUMINUM PRIcE ChANgEs As FUNctION Of ChINEsE MONEtARY VARIAblEs
FIgURE 4: ThREE-MONth-AhEAD LEAD PRIcE ChANgEs As FUNctION Of ChINEsE MONEtARY VARIAblEs
diameter of the bubble corresponds to the absolute magnitude of the price change. The current data points are indicated with a bombsight; the last datum involved in calculating a threemonth-ahead return is highlighted separately, and an arrow from there to the present is overlaid on the chart. As it turns out, the high degree of correlation between the six metals involved, copper, aluminum, lead, zinc, tin and nickel, allows us to make some consistent observations. As an aside, while this is good for analytic purposes, it makes no sense economically. With the exception of lead and zinc, which often are extracted from the same ores, these metals are produced in very different areas and under different mining cycles. Moreover, the substitution between them is slight to say the least; while copper and
44
FIgURE 5: ThREE-MONth-AhEAD ZINc PRIcE ChANgEs As FUNctION Of ChINEsE MONEtARY VARIAblEs
aluminum both are used in electrical wiring, we would not suggest substituting copper for aluminum in aircraft manufacture, and the world probably is not ready for beer cans made out of lead. The high correlation of these metals prices is due to the inuence of hedge funds and other investors who insist on trading them together as a group. The net result of tightening trends for Chinese monetary policy is the bombsight had been pushed toward the southern edge of the charts; the rebounding carry into the euro has pushed the bombsight eastward over the past three months of data. None of the six metals examined have a positive price expectation from either this zone or trend in the bombsight. As Chinese demand has been setting the global price for more important metals such as
continued on p. 46
FIgURE 6: ThREE-MONth-AhEAD NIcKEl PRIcE ChANgEs As FUNctION Of ChINEsE MONEtARY VARIAblEs
45
Advanced Concepts
FIgURE 7: ThREE-MONth-AhEAD COppER PRIcE ChANgEs As FUNctION Of ChINEsE MONEtARY VARIAblEs
FIgURE 8: MININg StOcKs ARE A CURRENcY TRADE IN DIsgUIsE
As Chinese demand has set the global price for more important metals such as copper, aluminum, and nickel for several years now, anyone long those metals or long mining-firm equities should run for cover when China decides to tighten. The trade logic also works in reverse.
copper, aluminum and nickel for several years now, anyone who is long those metals as commodities or who is long the equities of mining rms should run for cover each time China decides to tighten. The trade works in reverse, of course. This should indicate global mining stocks relative performance is nothing other than a currency trade in disguise, and had been the case until the weak revaluation began in June 2010 (Figure 8). This development, which promised greater Chinese purchasing power along with various mining industry mergers, pushed the relative valuation of the HSBC Global Mining Index for Diversied Miners against the MSCI World index higher in a quantum fashion. Once this shock has been absorbed, watch for both the base metals and for mining equities valuations to resume being a strong function of Chinese monetary policy.
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TRADING TRADINGSystem Strategies Lab
Buy high, sell higher

A relative-strength stock system beats the market by a wide margin in testing.
BY RObErT SUCHEr Jr. System concept

This system is inspired by techniques Stan Weinstein described in his book Secrets for Proting in Bull and Bear Markets (1988, McGraw-Hill), and includes several of Weinsteins setups, triggers, and lters. Early in the book Weinstein writes that the blueprint to successful trading is less about buying low and selling high than it is about buying high and selling higher. Lets investigate how that would have worked out for the past decade. Setup conditions. Part of the trading approach is to avoid buying or holding a downtrending stock. Weinstein used multiple forms of chart analysis, including trendlines, but he recommended stocks trading below their 30-week simple moving average (SMA) should never be purchased. Therefore, the rst rule ensures the stocks 30-week SMA is above the previous weeks SMA value and that the stock is trading above it. Also, to ensure the broader market is on the trades side, the 30-week SMA of the S&P 500 cannot have declined more than three consecutive weeks at the time of a trade. The next part of a trade setup incorporates the relative strength (RS) of the sector as well as the stocks within that sector. All else being equal, it makes sense to buy the strongest stocks in the strongest sectors. To realize this rule, the strategy identies 10 sector exchange-traded funds (ETFs); all stocks in the test portfolio are segregated according to the sectors represented by
48
these ETFs. The 10 sectors are ranked according to their RS, and candidate stocks are selected from the top-three sectors. Relative strength is calculated relative to a benchmark, such as the S&P 500 index. Weinsteins RS formula (stock or ETF price divided by the benchmark) is used here, but applied somewhat differently. Instead of using the trend on an RS chart, the oneweek RS rate of change (ROC) is used to rank sectors and stocks: the strongest sector ETFs and stocks are those whose RS values are increasing the fastest. Trade triggers. Recalling the buy high theme, Weinstein advises to identify stocks that have consolidated in a range and do not have nearby overhead resistance. A breakout above the top of the range triggers the entry. The system simplies the approach by establishing all-time highs and the most recent 20-percent peak (a top followed by a 20-percent or larger decline) as overhead breakout points. Once a stock breaks above its overhead resistance, any major obstacle (sellers) impeding a stocks advance is practically nullied. Weinstein argues that when a stock pushes into new-high territory, no one is holding it at a loss, and new short sellers represent more eventual buying demand. Position sizing/money management. Weinstein further recommends entering a trade with half the normal position size, but if the breakout volume is at least twice the most recent months
FIGURE 1: SAMPLE TRADE
Go to p. 71 for more information about: Rate of change (ROC)
daily average (the average daily volume over a rolling month, approximately 21 days of trading), the position size is doubled Just as the Profiting with Stock Splits system (Trading System Lab, December 2010) on a dip toward the breakout celebrated TIE, our Buy High system picked it up as well. price. In this system, the posiSource for all figures: Fidelity Wealth-Lab Pro/Developer 6.0 tion is instead doubled following the rst daily lower low FIGURE 2: EQUiTY CUrVE if the price-adjusted volume (volume*close) is more than double its monthly average. Also, instead of using a typical 10 percent (of account equity) position-sizing rule, the system will use 5 percent, which can result in owning up to 20 different stocks. Exit. Weinstein advocates using sell-stop orders for exits instead of percentage targets. To simplify the test, the system uses the stocks 30-week SMA as a primary trailing stop. However, each higher 5-percent low (a non-optimized, arbitrary value) is integrated into the trailing stop. In other words, if the stock pulls back and the daily low advances at least another 5 percent, that pullback low becomes the new The system did a good job of protecting gains, taking the system to all cash (or very close stop price, provided it is above to it) during several rough periods, most notably the 2002 and 2008 bear markets.
continued on p. 50
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Trading System Lab
FIGURE 3: MONTE CARLO DISTRIBUTION OF NET PROFIT
The baseline test results were approximately 15 percent better than the average Monte Carlo simulation.
the SMA. A close below the trailing stop value triggers a sell at the market on the next days open. System rules Setup and lter conditions: 1. Relative strength: Candidate stocks must be in the top-three sectors as determined by RS ranking. 2. Overall market: The 30-week SMA of the S&P 500 has not moved down more than three consecutive weeks. 3. The 30-week SMA of the stock is higher than the previous weeks SMA value and the closing price is above the SMA. Enter long if: 1. The stock closes above a prior 20-percent peak, or 2. The stock closes above the previous all-time high. (In this case, the stock must be in a top sector, but the other setup conditions do not apply.) 3. In the event of a multiple candidates competing for capital on the same day, choose the one(s) with the high RS rate-ofchange.
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Exit rules: Sell at the market when the stock closes below any of the following: 1. A n initial 10-percent stop below the close of the breakout day; 2. The 30-week SMA; 3. T he most recent 5-percent trough low. Figure 1 (p. 49) shows how a trade develops. The light green background indicates that TIEs sector (Materials) qualied as one of the top-three sectors, and the system went long when price climbed to a new all-time high in May 2005. (Note: This was an all-time high within the test data range, beginning June 1, 1999, not an all-time high for the stocks entire history.) The trade occurred on average volume, so only the 5-percent position was maintained, even as the sector lost its top-ranking status. The trade progressed well above the 30-week SMA (blue stair-step line) and was eventually exited by a close below a 5-percent trough low (which actually turned out to be a shake out, as the stock quickly reversed to the upside). Nonetheless, the system
Related reading
Proting with stock splits Active Trader, December 2010 Trading splits can offer a longer-term edge for stock traders. Secrets for Proting in Bull and Bear Markets McGraw-Hill, 1988
re-entered a week later following the second split shown on Figure 1s chart, and that trade turned into a 40-percent winner. Money management/position sizing: Allocate 5 percent of account equity per position on the initial breakout signal. If the price-adjusted volume is more than twice the most recent months average, add another 5 percent on the open after the rst daily lower low. Initial equity: $100,000. Deduct $8 per trade ($16 per round trip) in commissions. Test data: The system was tested on the constituents of the S&P 500 index as of Dec. 10, 2010), as well as the following sector ETFs: IXP, XLB, XLE, XLF , XLI, XLK, XLP, XLU, XLV, and XLY. Dividend data and non-dividend-adjusted price data provided by Fidelity. Test period: June 1, 1999 to Dec. 10, 2010, which includes a 30week seed period during which no trading takes place.
July 2010 (when the system also made a new equity high, Figure 2, p. 49), not in 2008 or 2009. More than 71 percent (1,565) of all trade candidates were rejected during the test because of insufcient purchasing power. (As an aside, one could capture a large number of those trades by using margin. Using 50-percent margin, annualized return
continued on p. 52
FIGURE 4: PROBABILITY OF ACHIEVING PROFIT LEVEL
Test results
From the date of the rst trade on April 18, 2000, the system performed exceptionally well in the U.S. markets lost decade, returning 11.8 percent annually after costs. Although yield did not inuence the entry logic, $23,361, or more than 10 percent of the net prot, is attributable to dividends received, which more than offset the $9,556 in commission costs. The maximum drawdown was moderate at -20.2 percent and interestingly enough, it occurred in
The Monte Carlo simulation also shows the odds are good of achieving the level of profitability found in the baseline test.
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Trading System Lab
increased to more than 15 percent, although the drawdown also increased, to -36 percent.) In back-tests such as this, it is helpful to use a Monte Carlo simulation to get a better perspective on typical performance. After performing a trade scramble of all 2,175 trades in the back-test, Figure 3 (p. 50) shows the baseline tests 230-percent net prot is just above the average and median values of 500 scrambled simulations. The distribution of returns in Figure 4 (p. 51) also indicates the probabilities of achieving a prot comparable to the one in the baseline test are excellent. Figure 5s prot-by-instrument chart shows a few symbols accounted for outsized prots, but to a lesser extent than weve seen in most other Lab tests. Because the system was back-tested using the relatively recent composition of S&P 500 index, the results contain a degree of survivorship bias. However, notice the dark-green cash regions in the systems equity curve, especially during 2002 and 2008
(Figure 2). This shows how the system largely reverted to cash during the most grueling bear-market periods of the past decade. (Note that no interest was earned on free cash in the test.) Furthermore, following Weinsteins method of avoiding stocks below their 30-week SMA should prevent positions from blowing up.
Suggestions
While this systems design often leads to successful re-entries after a stop-out (as occurred in Figure 1), its possible the meat of a move is already in the past. Consequently, limiting entries to stocks that break out to new all-time-high territory following a lengthy consolidation could keep portfolio cash more readily available for other stocks showing that pattern. Also, no effort was made to short stocks with weak relative strength in downtrends a worthy topic of research. Buying low and selling high is more difcult than it sounds.
STraTEgY SUmmarY
Protability Net profit Net profit Profit factor Payoff ratio Recovery factor Exposure Max. DD Longest flat period Commissions Buy-higher system $229,557 229.6% 2.02 2.75 4.08 72.2% -20.2% 588 days $9,556 Buy and hold (SPY) $682 0.7% 0.00 0.00 0.00 98.2% $8 -52% 1,570 days Trade statistics No. trades Win/loss Avg. profit/loss Avg. hold time Avg. win Avg. hold time (winners) Avg. loss Avg. hold time (losers) Max consec. win/loss Buy-higher system 610 42.1% 4.1% 64 days 19.6% 112 days -7.1% 29 days 10 / 13 Buy and hold (SPY) 1 0% -13.9% 2,678 days 0% 0 days -13.8% 2,678 days 0/1
Strategy Summary notes: Portfolio-level results include a 30-week seed period in which no trading occurs (to allow for the initial calculation of the 30-week SMA). This has the effect of calculating slightly lower exposure and annualized returns than those actually generated by the system. Also, because of the 30-week seed period, the buy-and-hold results were calculated from the date of the first trade, April 18, 2000. Finally, although buying and holding SPY resulted in a small net profit of $682, the trade is shown as a loss because the $15,243 in collected dividends were responsible for that gain. Dividends, which add to the equity curve and portfolio measures, are not considered when calculating trade performance statistics.
LEGEND: Net profit profit at end of test period, less commission. Profit factor gross profit divided by gross loss. Payoff ratio average profit of winning trades divided by average loss of losing trades. Recovery factor net profit divided by max. drawdown. Exposure the area of the equity curve exposed to long or short positions, as opposed to cash. Max. DD (percent) largest percentage decline in equity. Longest flat period longest period the system is between two equity highs.
52
FIGURE 5: CONTRIBUTION CHART

Sure, its easy to buy stocks that appear to be at a low level, but these often continue to get even cheaper as traders in 2008 and 2009 can attest. Weinsteins approach of buying high and selling higher appears to have merit more than two decades later.
Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.s testing platform. If you have a system youd like to see tested, please send the trading and money-management rules to editorial@activetradermag.com. Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a systems behavior in real-time trading.
While a few stocks contributed to outsized returns, this characteristic is much less evident than in the majority of Trading System Lab systems. Also interesting is that 144 stocks produced only negative results and 217 others were not traded at all.
PEriOdiC rETUrns
Avg. return Monthly Quarterly Annually 1.0% 2.9% 11.5% Sharpe ratio 0.74 0.72 0.75 Best return 13.9% 24.1% 43.4% Worst return -16.6% -15.1% -8.7% Percentage protable periods 51.1% 59.6% 58.3% Max consec. protable 8 10 5 Max consec. unprotable 9 3 3
LEGEND: Avg. return the average percentage for the period. Sharpe ratio average return divided by standard deviation of returns (annualized). Best return best return for the period. Worst return worst return for the period. Percentage profitable periods the percentage of periods that were profitable. Max. consec. profitable the largest number of consecutive profitable periods. Max. consec. unprofitable the largest number of consecutive unprofitable periods.
53
TRADING TRADING Strategies Basics
Order up: 2011

Dont get your OCOs, SCOs, and MOCs mixed up. This primer on order types will make sense of the alphabet soup.
lthough trading technology continues to grow apace especially at the professional level one thing hasnt changed: knowing what order type to use and when to use it is an important part of successful trading. Since we last updated our primer on order types (Order up, Active Trader, November 2007), the biggest change for retail traders has been the increased availability of advanced conditional orders that allow you to combine two or more trade instructions into a single order, which can be triggered by a wide range of market circumstances. When considering the different types of orders at their disposal, keep a few important points in mind. First, every brokerage is different, and while most of them offer the same basic menu of order-entry options, they will offer different advanced-order types, and/or use slightly different names for them or apply them somewhat differently. Contact your brokerage directly to see what orders they offer and to make sure you understand how they function. Second, keep in mind that complex order types can provide exibility in getting in and out of the market, but they often cost more again, conrm fees with your broker. Finally, just because you have 10 order-entry options at your disposal doesnt mean you necessarily need to use them. Know what works when, and why. You can know the difference between an AON and an FOK order, but if you dont understand the potential benets and risk of each type, and the appropriate situations in which to use them, it wont do you much good.
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While not exhaustive, the following list is representative of the most commonly used orders, along with some advanced order types. Your brokerage may offer order types not on this list, disallow some that are on it, or use different names or acronyms. Some brokerages also have order types that are available for one asset type (e.g., futures) but not another (e.g., stocks).
Market order
The market order is the most basic order type. It is generally the default order type for brokerages (i.e., if you dont specify an order type, its a market order). A market order is designed to be executed immediately at the best possible price. Traders who use market orders are less concerned with price than they are with the certainty of the order being lled. If a stock is not particularly active, its possible a market buy order will be executed at the best offer or ask price (see Bid and offer basics). However, in a high-volume, highly active stock, where prices are frequently changing, the price you expect and the price you get may be vastly different. Getting a worse price than expected may not be that big a deal for long-term investors someone who buys $10,000 worth of stock with the intention of holding it for several years is often not very concerned with paying a few cents more than the quoted price. However, if youre a short-term trader, two cents here or a nickel there can seriously impact your ability to make a prot on the trade.
Market orders are generally the cheapest, because they are the easiest for the brokerage to execute.
Limit orders
Limit orders allow you to set the specic price at which you will buy or sell. If you place a limit order to buy at $25, you wont pay more than $25, and its possible (but not likely) youll pay less than $25. Likewise, if you place a limit order to sell at $30, you wont get lled any lower than $30, and theres a slim chance youll get lled higher. The downside to limit orders is that there is no guarantee an order will be lled. If a stock is trading at 25.03, it may or may not trade down to 25. If it doesnt, the aforementioned limit order will go unexecuted. Historically, limit orders have been more expensive than market orders, although in an effort to obtain business, its common for brokerages to offer enticements that include identical commissions for market and limit orders.
at 25. When (and if) the stock hits 25, the stop order becomes a market order to buy. Similarly, stop-limit orders can also be used to enter trades.
Trailing stop
A trailing stop lets traders move their stop up (for a long position) or down (for a short position) in set increments as the market moves in their favor. Trailing stops are designed to help traders protect open prots. While trailing stops were not available at many brokerages a few years ago, they have since become relatively commonplace.
Day order
Day orders are only good through the end of the current trading session, after which they are automatically cancelled. Most trade orders are, by default, day orders.
Good-till-cancelled (GTC)
A GTC order remains open until cancelled by the trader or the broker. A trader who enters a limit order can designate that order GTC. That will keep the order open so it can be lled at a later date (if the market ever moves to the limit price). Most brokers will set a limit on how long GTC orders can remain open (typically between 30 and 60 days for stock trades and until expiration for futures and options trades), so its important to check your brokerages policies before placing a GTC order. Also, brokerages sometimes assess an additional fee for GTC orders.
Stop orders
A stop order is an order that becomes live when a certain price level is reached. There are three kinds of stop orders: stop-loss, stop-limit, and stop. A stop-loss order is designed to cap losses on an open trade. Stop-losses are placed below (for long trades) or above (for short trades) the current market price, and will get traders out of positions before a loss exceeds a certain amount or an open prot loses any more ground. For example, a trader who enters a long trade at 25 may place a stop-loss at 24.50, hoping to cap his losses at 50 cents. However, there is one drawback to a stop-loss: When the stop price is hit, the order becomes a market order, so there is no guarantee the position will be exited at 24.50. In a fast-moving market, the price could blow through 24.50, and the order might get lled at a much lower price. One way to avoid this is to use a stop-limit order. A stop-limit order functions in the same way as a stop-loss, except when the stop price is hit, the order becomes a limit order. This guarantees the exit price will be no worse than 24.50. But there is a downside to stop-limit orders, as well: There is no guarantee the order will be lled, partially or at all. If price hits 24.50 and continues to fall rapidly, the trader may still have an open (and losing) position. Stop-limit orders can consist of two prices a trigger (or activation) price and the stop-out price. For example, a stop-limit order might be, Sell 100 shares at 24.50 stop, 24.40 limit. The rst price is the activation price (i.e., the price the market must trade at to make the order live) and the second price is the actual limit price that represents the worst price at which you will accept a ll. In this situation, as soon as the market trades at 24.50, an order is triggered to sell 100 shares no lower than 24.40. Again, there is always the risk you wont get lled at all. While the majority of stop orders are stop-losses or stop-limits, a plain stop order can be used to enter a trade. For example, if a stock is trading at 24.85, a trader could enter a stop order to buy
Fill-or-kill (FOK)
A ll-or-kill is an order that must be executed immediately or cancelled.
All-or-none (AON)
AON orders must be lled completely or not at all. If youve placed a limit order for 500 shares, and only 250 are available at that price, the order will be ignored until (and if) 500 shares become available.
Market-if-touched (MIT)
An MIT is a market order that is automatically activated when a designated price level is hit. This guarantees an execution will be made, although a trader using an MIT order takes the risk that all or some of the order might get lled at a price worse than the designated price level. Because of its specic limitation, this order type might be best used in highly liquid but relatively low volatility instruments that increase the odds of getting a favorable ll. A trader in a protable long trade might use an MIT order if analysis indicates the market might reach a certain price level but there is uncertainty whether the market will sustain that level for very long. In that case, the MIT order could be used to improve the chances (compared to a limit order) of getting out of the market, even at the expense of getting a worse price.
continued on p. 56
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Trading Basics
Market-on-close (MOC)
An MOC is a market order that is executed as close to the end of the trading day as possible. Some strategies are based on closing price and need to enter or exit a trade at or near that price. While placing a market order at the end of the day serves the same purpose, an MOC order can be placed at any time, eliminating the need for a trader to remember to place a last-minute order.
prot-taking order (or both) for that trade. (An order that simultaneously enters a stop-loss order and a prot-taking order for an open positions is sometimes referred to as a bracket order.)
Conditional or contingency orders

Depending on your relationship with your brokerage (i.e., how much money you have in your account), there is virtually no limit to the conditional trades you can design. For example, you could place a conditional order to buy a certain stock if it makes a 10-day high on volume greater than 10 percent of its average daily volume. Or, if the three major indices are all trading within 1 percent of their ve-day lows, sell a certain amount of a particular stock. Most online brokers only offer conditional orders to their most preferred customers; direct-access brokers are more likely to allow them to the customer base as a whole. However, an increasing number of brokerages are offering conditional orders based on a variety of market criteria (including indicator readings), while other brokerages offer automated trading of advanced trading strategies and conditional rules.
Market-on-open (MOO)
A market-on-open is the same as an MOC order, but executed as close to the open as possible.
Limit-on-close (LOC)
A limit order entered as close to the market close as possible.
Limit-on-open (LOO)
A limit order entered as close to the market open as possible.
Stop-close-only (SCO)
A stop order that is activated only if the stop price is triggered during the close of the trading session. If the stop price occurs before the market close, the order is ignored.
Discretionary orders
These orders give your broker permission (discretion) to execute an order as he sees best. For traders who trade only electronically, this type of trading is not available. It is primarily part of the remaining pit-traded futures markets and large institutional trading. Unless you have a very close relationship with your broker, these orders are not recommended.
Order cancels order or one cancels the other (OCO)

An OCO order cancels one order if another is lled. For example, if you were long and had both a stop-loss order below the market and a limit order to sell at a prot above the market, the two orders could be placed OCO that is, when one order is executed, the other is automatically cancelled. An increasing number of brokers are allowing more advanced OCO orders. For example, you could place a limit order to sell at a prot, a stop-loss to exit with a loss, OCO MOC (order cancels order, market on close). This means the trade will be exited on the close if neither of the other two conditions are met and the orders are automatically cancelled.
Do your homework
Remember, every brokerage is different. Check with your broker before placing any type of advanced or exotic order. Generally, the more complex an order is to a brokerage, the more the brokerage will charge you to execute it. Also, there may be restrictions on the rms liability for certain types of orders. Many online brokerages have separate trading programs one for traditional buy-and-hold customers and one for more active customers. Almost certainly, the latter will offer more order options. Brokerages have created many more specialized order types over the past few years often with proprietary names that may reect one or more of the order types shown here, and which may use an acronym that represents a very different order somewhere else. The downside of all the new choices is, unfortunately, a lack of standardization and the risk of confusion. Finally, if youre already feeling a little overwhelmed, keep in mind that its entirely possible to be a successful trader or investor with just market, limit, and stop orders. However, knowing what else is available and when to use it is never a bad thing. An order type is a tool, and like any tool, you must know the right one for the job to get the desired result.
One cancels all (OCA)

The OCA order is similar to the OCO type, except the OCA allows for placing more than two orders. For example, if you wanted to buy any one of three stocks (but not more than one) you could enter three buy-limit orders. The system will execute the order for the rst company to reach the limits set by the trader. The buy action will result in cancellation of the other orders.
One triggers another (OTA)

An OTA order is consists of two orders a primary order, and a secondary order that goes live when the rst order is lled. For example, you could enter an order to automatically buy Market B if when your limit order to buy Market A is lled. Or, a ll of the primary order could trigger the entry of a stop-loss or
56
The Face of TRADING
Nurturing patience
BY ACTIVE TRADER STAFF
Name: Ayad Amary Age: 35 Lives and works in: Allentown, Pa.
Trading setup
Hardware: PC with 2.3 GHZ process, 3.25 GB RAM, two 24-inch monitors, one 17-inch
Software: Sterling Trader Pro Internet: High-speed cable Brokerage: OptionsXpress
fter graduating from college in 1997, Ayad Amary took a job at John Hancock selling mutual funds and life insurance. He did well, but was always interested in learning more about the stock market. So did some of his customers, apparently. I was going out hustling insurance policies to business owners, and all they wanted to talk about were dot-com stocks, he remembers. On the side, Amary studied for and eventually earned his Series-7 license. In 2000 he resigned and went to work for a small regional brokerage rm and started building a customer book. He also started trading stocks for himself, then branched into options. I tried to carve out a niche with covered-call writing and income-generation strategies, he says. I had [a good customer] book, generating a lot of commissions because I had active customers. However, the rms goals shifted toward new business development. I wanted to sit at my desk and stare at my monitor and trade, Amary says. But he soldiered on until 2005, focusing on new client generation and building a respectable $15-million customer book. In 2005, he sold his client list to another broker and left the business to enter corporate pharmaceutical sales. Again, Amary achieved the highest sales status in the entire company, but he felt something was lacking. I did well, was making good money, had a company car and benets working only 25 hours per week, he says. It made me lazy and complacent. I didnt enjoy it but thought, how can I walk away when I
am making good money? In 2009, despite being in the top 5 percent of the sales force in the entire company, Amary was laid off. He received a nice severance package, and he knew it was time to do what he wanted. Im going to do it now, or Im going to be stuck in this corporate rut for the rest of my life, he says. With his severance money and income from his rental properties he owned, he began trading full time. Born in Syria, Amary moved to the U.S. when he was very young. I grew up around a lot of people, including my father, uncles, and cousins, who were gambling or playing poker at the house. He found that when he began trading, the mentality was similar. In the beginning, Amary admits he was looking for the action. But he also learned you cant bail yourself out at three in the afternoon if you are down $500. You have to take your losses sometimes. He read book after book early in his new trading career, but he didnt see consistent protability for more than a year. However, over time he developed a trading plan and found the patience you develop as a trader really does become a habit in the rest of your life. Trading approach: Trading stocks only, Amary puts on ve to 15 trades per day lasting two minutes to six hours. He primarily trades from the open until noon because he nds fewer opportunities in the afternoon. He focuses purely on price action, not indicators. Amary rst identies stocks that have gapped up or down at the open, which become his universe of stocks for the
day. While he trades several strategies, he estimates 50 percent of his trades are gap plays in which he trades the stock at the open in the direction of the gap, preferably if the gap is in the opposite direction of the daily trends. For example, in an uptrending stock that gaps down on the open, he would sell short half his full position size, entering on the rst one-minute bar that closes lower. Amary will expand to his full position size when the trade matures on the 5-minute chart i.e., on the rst 5-minute bar that closes lower. He places a stop-loss above the high of the day, with a target at previous support or at a pivot level from the daily chart. Became protable when: Amary was a member of a chat room when he started trading, and he would offer up his ideas to the room, many of which turned out to be winning trades. But Amary would also trade other ideas he didnt put out to the chat room. I thought, why dont I take only the trades I put out in the room? I was taking other high-risk positions that I shouldnt have been trading. He started to see consistent prots when he stuck to trading his best ideas. Best thing about trading: My time is my own. I dont have to answer to a boss or corporation. When not trading: Spends time with family and friends, works out, and plays cards with his buddies. Best books/websites: Trade Your Way to Financial Freedom by Van Tharp; Tradingwings.com.
57
ACTIVE TRADER Interview
A new hedge-fund world

In part 2 of our interview with Lars Kroijer, the former hedge-fund manager discusses the future of hedge funds, and the alternative to alternative investments for individual traders looking for a portfolio edge.
ts not like Im sitting in front of three computer screens at 7 a.m. anymore. Thats one of the ways Lars Kroijer describes life today. While he hasnt retired to a tropical island, he is far removed from the day-to-day hedge-fund grind he experienced as head of Holte Capital from 2002 to late 2007, and which he wrote about in his book Money Mavericks: Confessions of a Hedge Fund Manager. After closing his fund, spending some time traveling, and writing the book, Kroijer and his family moved back to the UK a little more than a year ago. He now sits on the boards of three hedge funds (run by good friends), which he says he enjoys. I wish Id had someone [to consult with] who had been through it already, just to talk through things, he says. Even to address the minutiae of running a hedge fund: What fraction of the portfolio does a trader have liberty to trade with? How much should you pay for a compliance consultant? What should you pay per square foot of ofce space? Theres all sorts of things like that.
Theres no doubt I was burnt out Id be the first to say that.

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Having experienced the hedge-fund boom years launching a fund at age 30, building it up to $100 million in less than a year, expanding it to $300 million, and closing up shop before the 2008 market debacle he has a unique vantage point from which to comment on the hedge-fund industrys past and future, and its strengths and weaknesses. It was the blunt assessment of some of these weaknesses, especially the issue of high fees, that rankled some of Kroijers hedge-fund compatriots, who took him to task as someone who turned on his industry but only after making a healthy prot in it himself. But Kroijer says he is simply pointing out what for him became mathematically obvious: the difculty for the end investor in a fund of funds to outperform the market when two layers of
Related reading
managers are extracting fees (the industry standard is a 2-percent management fee and a 20-percent incentive fee). An individual hedge fund can certainly provide an outperforming investment, but the deck is stacked against the investor when multiple funds are involved, even if they are all protable. Kroijer is actually quick to defend hedge funds more accurately, the potential value of any individual hedge fund. But aside from the fee issue, part of the problem, he notes, is the perception that hedge funds are a monochromatic asset class for example, U.S. biotech stocks when they actually represent diverse, distinct products. Then there is the PR problem hedge funds have faced (more so in Europe than in the U.S.) in the aftermath of the 2008 nancial crisis. The media sometimes makes it sound like this $2 trillion dark menace, where everyone gets together in a back alley and decides what to do, Kroijer says. Its not at all like that. Its 10,000 individual rms that are doing completely [different] things, and they often dont know the rst thing about what the others are doing. Lars Kroijer: Behind the hedge-fund curtain Active Trader, February 2011 Part 1 of our interview with Lars Kroijer.
Money Mavericks: Confessions of a Hedge Fund Manager (2010, Financial Times Prentice Hall)
The media sometimes makes hedge funds sound like this $2 trillion dark menace, where everyone gets together in a back alley and decides what to do.
Lumping all hedge funds together is like comparing apples to oranges to bananas. Youre investing in a rm and person, Kroijer explains. Im often in the position of speaking about hedge funds as being under one umbrella in my 30-second slot, I dont get to differentiate but I dont know anything about xed-income arbitrage, black-box investing, or silver vs. gold. But theyre all the basis of hedge funds. And that, he adds, is the raison detre of funds of funds.
There are many people who, for whatever reason, want to or have to invest in hedge funds, but they dont know what the next step is, so they go to the funds of funds, he says. Kroijer notes thats what pension funds did, after decades of avoiding hedge funds. He describes the situation of a hypothetical pension-fund manager: Hes sitting there thinking, Oh, we cant be the only pension fund in town without a hedge-fund allocation, but I still dont know whether gold is better than silver or what xed-income arbitrage is. But theres this very nice person at a big fund of funds with lots of snazzy presentations showing they can create uncorrelated positive returns. That sounds good. So he buys that its cheap at 1 percent per year. Kroijers sentiments about the industry are ultimately belied by his use of the words us and we when discussing hedge funds. Dont make us the villain for everything that happened, because were not, he says. That always annoys me the suggestion that somehow hedge funds caused the [2008] crash. First, I dont think they did, and second, its a little too easy for some of the politicians to place blame there. Were an easy villain because were opaque, the successful ones everyone hears about make staggering amounts of money, and we frankly dont do a good job of defending ourselves. If youre a politician, thats great. Except that theres never been a taxpayer dollar, pound, or Euro thats gone to bail out a hedge fund.
The future
Kroijer fully acknowledges the pre-2008 hedge-fund environment
continued on p. 60
59
Active Trader Interview
was something of a bubble too much money in too many funds doing too much of the same thing but he also points out market forces ultimately went to work on the industry: Something like 2000 hedge funds went out of business in 2008 and 2009, he notes. Thats a healthy sign. If you dont do a good job, you go out of business. Are the 2000-2007 days gone for good? The world has undoubtedly been transformed since Kroijer ran his fund, but even though he thinks the hedge-fund industrys challenges are large, he says they are not insurmountable. I think the industry will have to prove its worth, he says. And thats a fee question, as well as answering why the industry wasnt as protected in 2008 as everyone thought it was. If it can do that, theres no reason growth cant continue. However, he adds: But its a pretty high bar to clear. As he notes, its not as if investing itself has died, just that a certain model may have fallen out of favor. There will always be investing, it might just be other sectors whether its renewables, commodities, or whatever, he says. It might not be called market-neutral special situations hedge funds (the focus of his former fund), he says, laughing. Theres been massive growth in hedge funds, but at the same time, as big as people say the industry is, were not [as big as] banks, after all. Kroijer recounts taking part in a recent panel discussion about banks. Among the participants were representatives of UK-based banks, each of which Kroijer says had balance sheets comparable to the total world-wide assets of the hedge fund industry. Just think about that, he says. There is room for growth.
Its more as hobby, really, he says of the portfolio model. I followed up and did a great deal more work on it. But its slowly taking on a life of its own. Lots of people say they optimize portfolios, obviously, but in terms of a very cheaply created optimized product constructed from existing indices, its a struggle to nd [information], and its certainly not mass distributed. A couple of the large index providers have been very keen to move the idea forward.
You find a nugget of information, an angle in the market you dont think other people are doing, and its a real asset.
Creating your own alternative investment

After illustrating how difcult it is for end investors to outperform in a fund-of-funds situation, Kroijer concluded his book with thoughts on how to create a long-term investment portfolio with the potential to outperform the market while avoiding nasty episodes such as 2008-2009.
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The portfolio Kroijer describes consists of globally diversied equity ETFs (he also suggests adding corporate and government debt exposure), with downside risk potentially protected by deep out-of-the-money (OTM) put options. For simplicity, I have started with equities only, and the allocation is driven by correlations projected standard deviations and expected returns, which is driven by the standard deviation, he explains. In a more advanced version, you would clearly include bonds and other asset classes. Kroijer says a basic portfolio of this type could be put together using six or seven indices. The number really depends on how accurate you want to be vs. the hassle of setting it up, he notes. The weightings would be set through the optimization process, although you would probably have some restrictions to avoid corner solutions that look nothing like the real world such as Thailand being 98 percent of the equity portfolio. Kroijer points out the portfolio should be constructed according to an individual investors circumstances, with the overriding goal of acquiring the least-expensive exposure, factoring in taxes
The end run of a fund

Kroijer describes his former hedge fund, Holte Capital, as a market-neutral special-situations fund. He focused on finding trade opportunities through detailed analysis of company fundamentals most traders never get within a mile of uncovering, let alone understanding. We did a mix of things: a fair amount of merger arbitrage and intercatalyzation trades (trading different share classes or holding structures), as well as restructuring situations debt restructuring, legal cases, or other transformative events. Another area we developed was multiple pair trades [between] industries shipping and oil rigs, particularly. The approach reflected Kroijers interests and strengths. I love doing stuff like that. You find a nugget of information, an angle in the market you dont think other people are doing, and its a real asset. The firms run came to an end in 2007, triggered it part by a bad (but by no means disastrous) trade that triggered a modest drawdown and an initial large investor redemption. Kroijer made the decision to pull the plug. Within a span of five months, he had voluntarily returned the last investor funds early in 2008 before the financial crises kicked into high gear. The initial trade lost about 4 percent, and several other trades ultimately pushed the drawdown to around 10 to 12 percent, which is when the first redemption occurred. Holte had become known as a low-volatility fund, so this relatively tame drawdown likely caught investors a bit off guard. Although this episode unfolded after Holte had increased its leverage (something investors had been requesting for ages), it was still at fairly conservative levels, according to Kroijer. My frustration was that we were essentially doing the same thing we always were, but toward the end were finally [leveraged] the way we probably should have been all along, he says. The point is, it probably should not have [caught our investors off guard], as we had been painstakingly communicating that we were taking leverage up. In reality, I think the redemptions had more to do with their interpretation that I did not have the appetite to continue something a couple of them told me privately afterwards. Indeed, after the initial loss, some of his investors, whom he also considered friends, took Kroijer aside and asked him if his heart was still in it. Theres no doubt I was burnt out Id be the first to say that and if you read between the lines there were some issues at home also that werent great, he says. Those all played together to make it a good decision to call it a day when I did which, I dont know, might have been fortuitous timing. (As mentioned in the first installment of the interview, Kroijer actually found himself wishing he was in the market when the panic unfolded, curious to see how his fund would have held up.)
and trade fees. For some investors (again, he is thinking globally), futures may be preferable to ETFs, for example. He also mentions add-ons investors could use to further tailor the portfolio, such adjusting for their other investments for example, avoiding a particular countrys stock index if all your other assets are in that country. You should really set up a whole structure where the exposure is tailored to the underlying investor, he says. Some should do ETFs, some futures, some index funds, some individual stocks, etc. Kroijer adds the option element is not essential to the model. In fact, its highly likely you would end up not using options, he says. Statistically speaking, it rarely makes sense to do it systematically because it is far too expensive. The skew is huge and liquidity is not great. That point was more a theoretical one that you would love to have protection against correlations spiking in times of crises. But dont look for Kroijer to run his own hedge fund any time soon. You know, it was just an amazing experience, but I dont think Ive missed it enough to want to go back to doing it, he says. I think its one of those things that you have to want as much as youve ever wanted anything, and put your whole heart into it. I can see how that might perhaps change one day, but for now, no. Thats why its worked out really well to be on the boards of some hedge funds its not quite the same, but I do get some of the buzz.
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THE TRADING BUSINESS Strategies of Trading
Handling IRS notices and exams

If you find yourself confronted with an IRS notice, learn how to proceed to avoid tax trouble.
BY RObErT A. GrEEN, CPA
ecently, the IRS has been making life more difcult for traders. In 2009, it announced major new tax-exam programs on the upper income. (Upper income is dened as those making more than $250,000 per year.) Those making more than $1 million per year face even more scrutiny. The IRS also announced closer examination of passthrough entities, C-corps, global businesses (on transfer pricing), and foreign offshore accounts. Ive noticed another disturbing trend in IRS exams: the new computer-generated mail exam. In this case, IRS computers ag a taxpayer based on standard averages, and the computer generates an exam notice requesting tax documentation. These scary IRS notices force taxpayers to engage professionals at additional costs. Filing a tax return correctly with the right bells and whistles and fewer red ags is crucial for your 2010 tax returns.
What can you do?

The rst tip in dealing with the IRS is to get help before preparing your tax return. Adopt strategies to reduce red ags and explain your trader tax status and treatment in well-written footnotes accompanying the return. A proper trader tax return led on time will generally not be questioned, except for those with large net operating loss (NOL) carrybacks, which tend to draw
62
IRS attention. Large NOLs based on weak trader tax status should be carried forward instead. In this more challenging IRS environment, I suggest all traders especially part time, losing, and less-than-hyperactive full-time day traders form an entity in order to le a separate entity-level tax return (with trader tax status) apart from their individual tax return. The IRS wont be as skeptical about trader tax status on entity tax returns because W-2 wages are reported on separate individual tax returns. Traders get the shaft on using tax forms. Business trading expenses are reported on Schedule C (Prot or Loss from Business), but trading gains and losses go on different tax forms Schedule D (cash method) or Form 4797 (MTM). Traders should tie the two tax schedules together with income transfers and explain trader tax status in footnotes. Historically, the IRS has higher audit rates for Schedule C businesses because many cash businesses under-report income. Business traders
All income is taxable and needs to be reported, whether or not a third-party reports it to the taxpayer.
should use separate tax-ling entities such as partnerships, LLCs, and S-corps in lieu of Schedule C (sole proprietorships) to reduce this risk. Another important strategy for individual traders is to transfer trading gains to Schedule C to do away with a tax loss and show a break-even business. Net trading income on Schedule C invites questions on the self-employment (SE) tax. Some traders err in thinking they dont have to le taxes, or that they can procrastinate. Perhaps they think their trading losses offset their other income, such as consulting fees. They may be counting on using ordinary trading loss treatment based on qualication for trader tax status and a Section 475 MTM election but this could present problems. If trader tax status and Section 475 MTM is denied, traders might only be allowed a $3,000 capital-loss limitation, which may lead to a signicant amount of taxes owed. The new IRS rules call for a 100-percent penalty on the tax due. Its more important than ever to deal with your tax matters on time.
advice. On the other hand, if youre a close call on trader tax status and potentially messed up your MTM election or other matters, engage your trader tax expert to be your formal tax representative. In some cases, a CPA may decline to be your representative if he or she thinks you arent entitled to relief perhaps because you clearly botched the MTM election.
Exam reconsideration
Traders can reply to the IRS with a reconsideration request, asking the IRS to close its exam before it gets under way. If the exam was prompted because a trader led a Schedule C with a loss even though the trader had trading gains in excess of expenses, the trader should be able to get the exam closed (assuming he or she easily qualies for trader tax status). Other types of notices or exams can be closed with little work, too. The solution can be as simple as ling a corrected tax return with the proper tax treatment, i.e., ling Form 4797 rather than ling MTM losses incorrectly on Schedule C, and including a detailed footnote. IRS notices may include questions about business status. But these agents often use standard questions geared to assess hobby-loss treatment. Trader tax status requires the intention to run a business, thereby trumping the hobby-loss rules. Note the hobby-loss rules are part of Section 469 passive activity loss rules. Under the trading rule exception, a trading business is exempt from Section 469, which means an IRS agent cant apply the hobby-loss rules to a trading business (with trader tax status). The reconsideration reply letter should state the exam isnt necessary because of your facts and circumstances. Next, explain how you qualify for trader tax status. State that your business expenses are very low compared to other businesses. Make it clear you have no cash income (which is the IRSs main focus point on small business exams) and that your 1099-B and supplemental information show all proceeds and many elements of net income. Demonstrate that you have good accounting for your securities transactions and more. Proceeding improperly can jeopardize ordinary-loss treatment, deny business expenses, and leave you with capital-loss treatment, which can increase your tax bill signicantly. Inappropriate responses may also lead to stiffer penalties and less opportunity
continued on p. 64
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If youre a good customer meaning you have large trading gains and pay taxes on them you can safely be a little more aggressive on business-expense treatment.
Tax exam notices
If the IRS or your states department of revenue contacts you with questions or a notice of tax due, or to schedule an exam, dont panic or reply on your own. Consult a trader-tax professional and proceed under this persons advice, either representing yourself (the inexpensive approach) or by engaging the expert as your tax representative, with power of attorney. Your direction should depend upon your nancial resources and the complexity of your case. If you simply made an error on your tax return but you clearly qualify for trader tax status and elected Section 475 MTM on time, you may be able to x things quickly with a little expert
The Business of Trading
for penalty abatement requests.
Exams, appeals, and tax court

If youre faced with an exam, its smart to be represented by a trader tax CPA or tax attorney. You should have little to no contact with the IRS agents. Dont meet the IRS agent in person or answer his or her questions directly. This is what a tax expert is for. Help your expert by providing all the information needed in an organized manner. If you have a difcult agent and supervisor in the exam process who refuse to understand the nuances of trader tax, its often wise to agree to disagree at the exam level and take your case to the next level the appeals process. During an appeal, trader tax status and MTM treatment may be realized, provided you elected MTM on time. Sometimes, to negotiate an appeals agreement, its wise to accept disallowance of some business expenses so the IRS feels justied in its exam efforts; winning trader tax status and MTM is much more important. Appeals ofcers often focus on the big picture, such as trader tax status, and they may skip over expense items. The last resort is tax court often an expensive and more grueling process than a tax exam. If you go to tax court, you must show you acted in one manner or another contemporaneously and that you didnt change your position in hindsight, which costs the IRS a lot of money. A common example of this mistake is skipping a timely MTM election because of capital-loss carryovers, and later stating you elected MTM on time. The IRS will disallow MTM on technical grounds and easily win in tax court on this issue. Theres a legal procedure to le a MTM extension within six months of the original election due date. But this procedure is expensive and unlikely to win MTM. It involves the private letter
Dont be intimidated
ruling process, and to win you must demonstrate no hindsight or prejudice to the government and unusual and compelling circumstances. The IRS recently published streamlined methods for obtaining advanced approval on tax positions that may prove helpful.
Yes, the IRS is a heavyweight, but dont be intimidated. Traders are small businesses but they are non-cash businesses with few dollars in expenses, so you certainly shouldnt be scared if you have a strong case for trader tax status. If youre a good customer meaning you have large trading gains and pay taxes on them you can safely be a little more aggressive on business-expense treatment. Conversely, if youre a bad customer for example, a perennial money-losing or part-time trader its wise to be more conservative, since the IRS may be more prone to deny your trader tax status. In this case, consider skipping a NOL carryback refund return. Rather, carry the NOL forward instead, when it will cause much less attention from the IRS. Or, try to absorb your ordinary loss with a Roth IRA conversion. If necessary, you may also consider other less attractive, but useful alternatives to trader tax status, such as trading in your retirement plans and deducting reasonable trading expenses within them.
Dont let the IRS le your return
The IRS wants to raise tax revenue by finding more unreported income, rather than having to rely on Congress to raise tax rates or deny deductions.
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If you trade securities, the IRS receives a 1099-B that shows only proceeds, and it will surely send a tax notice claiming all or most proceeds are income. That tax notice will have tens or hundreds of thousands of dollars in back taxes, plus interest and a full assortment of nasty penalties. Contact the IRS before it contacts you, enhancing your chances of reduced penalties. Interest is statutory and it can never be abated. File your late tax returns as soon as possible, reporting your capital losses correctly, thereby making your tax notice balance due disappear. Plus, you can then carry over capital losses to subsequent tax years, which isnt possible unless you le the prior year tax returns. Dont wait more than three years or it will be too late to apply these capital-loss carryovers.
Whats new?
If you cant pay your taxes on time, at least le on time and request an installment plan. You can make corrections later. Failing to le a tax extension (calculated in good faith) is a mistake because the late ling penalties are much higher than the late payment penalties. Be honest and forthright with the IRS; dont ignore it. Forget about cheating on your taxes with offshore and tax-free state schemes. Remember, all foreign bank accounts over $10,000 at some point during a year also must be reported annually on Form TDF 90-22.1 due by June 30 of the following year. The IRS has a major program under way to catch offshore tax cheats. Also, keep in mind the penalty for not ling an income tax return has increased to the smaller of $135 or 100 percent of the unpaid tax.
Be honest and forthright with the IRS; dont ignore it. Forget about cheating on your taxes with offshore and tax-free state schemes.
Avoid bad advice
The sad reality is a large percentage of active traders dont handle their tax affairs properly, or theyre underserved by trusted professionals. A part-time accountant working in a locally branded tax storefront may not be qualied to deliver trader tax services. We have seen many cases where traders have gotten into tax trouble using a general tax store. Some of these rms offer audit guarantees, but they dont pay back taxes or for a new CPA to x things. Thats a hollow guarantee. The IRS recently proposed new standards for tax preparers to address what it perceives as too much bad advice coming from tax preparers who dont have sufcient education or experience. The proposed tax preparers requirements include registration, competency tests, continued professional training, and complying with a set of ethical standards. CPAs are exempt because they already reach and exceed these standards, but most storefronts
While the old rules still apply to the 2010 tax-filing year, new legislation requires brokerage firms to beef up reporting on Form 1099-Bs for securities traders (which currently only report proceeds) in 2011. The new 1099-B rules require additional reporting of average cost basis and short-term vs. longterm treatment on securities. As a result, the IRS will be able to double check net trading gain or loss reporting more easily. This 1099-B rule change may actually help traders. In the event of noncompliance, the IRS normally mails jeopardy tax bills to traders, discounting all missing cost basis information on 1099-Bs. These 1099-B rule changes are part of a major new IRS initiative to close the tax gap. It wants to find more unreported income, thereby raising tax revenue, without relying on Congress to raise tax rates or deny deductions. The tax-compliance gap in this country is too high; to close it, the IRS is compelling agents to report more income information on Form 1099s. The IRS can then match 1099-B (and other tax information documents such as W-2, K-1, and more) to tax returns, thereby finding tax cheats or inadvertent errors. Also, the 2010 health-care legislation included a controversial new rule requiring 1099s for all business payments more than $600. That could be reversed in 2011, before its effective date in 2013.
and many enrolled agents dont. In the end, far too many active traders miss out on trader tax benets they dont deduct allowable business expenses or elect and use ordinary-loss treatment on time. They overpay their taxes and dont receive the tax refunds theyre entitled to. Even when they do most things right, they le a return with a red ag, causing an IRS and/or state exam. You need an experienced trader tax expert in your corner from day one to handle this challenging IRS environment.
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THE Economy
U.S. economic brieng

FED LEAVES RATES UNCHANGED
Minutes: Federal Open Market Committee Date and time: Dec. 14 at 2:15 p.m. Summary: While the FOMC stated the economic recovery had continued through its December meeting, there was little else positive noted. The current environment is still hampered by high unemployment, which constrains household spending, and tight credit. Employers remain reluctant to add to payrolls, the committee said in its statement. The housing sector continues to be depressed. Longer-term ination expectations have remained stable, but measures of underlying ination have continued to trend downward. The committee announced it would once again hold the target range for the federal funds rate at zero to 0.25 percent. The following tables compare the S&P 500s daily and weekly responses to economic releases as well as historical behavior since 1997 (or earlier). The S&P rallied only slightly after the FOMCs announcement, but gained 0.53 percent over the following ve days. Rate chanGes
S&P 500 reaction Report day Five days later 0.09% 0.53% Historical moves since 1994 0.35% 0.44%
FIGuRe 1: QUARTERLY GDP PERFORMANCE
Q3 2010 marked the fifth straight month of economic growth since the economic downturn, which began in 2008.
Source: Bureau of Economic Analysis
FIGuRe 2: PAYROLLS VS. UNEMPLOYMENT RATE
Non-farm payrolls increased at a slower-than-expected rate, but unemployment dropped.

Source: Bureau of Labor Statistics Seasonally adjusted
FIGuRe 3: OVERALL VS. CORE INFLATION GDP GROWTH CONTINUES IN Q3

Report Date/time Actual Previous Consensus Gross domestic product for Q3 2010 (Third) Dec. 22 at 8:30 a.m. 2.6% 2.5% 2.7% S&P 500 reaction Report day Five days later 0.34% 0.41% Historical moves since 1994 0.03% 0.34%
Price levels remained mostly unchanged year-over-year, except for PPI, which dropped 0.8 percent to 3.5 percent.
Source: Bureau of Labor Statistics Not seasonally adjusted
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PPI MAKES UNEXPECTED JUMP

Report Date/time Actual Previous Consensus CPI Report day Five days later Report Date/time Actual Previous Consensus PPI Report day Five days later Consumer Price Index (CPI) Dec. 15 at 8:30 a.m. 0.1% (core 0.1%) 0.2% (core 0.0%) 0.2% (core 0.1%) S&P 500 Historical moves reaction since 80 -0.51% 1.05% 0.08% 0.14%
FIGURE 4: ISM MANUFACTURING INDEX
Producer Price Index (PPI) Dec. 14 at 8:30 a.m. 0.8% (core 0.3%) 0.4% (core -0.6%) 0.5% (core 0.2%) S&P 500 Historical moves reaction since 94 0.09% 0.53% 0.05% 0.31%
Despite falling slightly over the summer months, manufacturing sentiment remained high in 2010.
Source: Institute of Supply Management Seasonally adjusted
FIGURE 5: S&P 500

After an erratic November, the S&P gained throughout much of December and into the new year.
Source: eSignal
ISM ENDS STRONG IN 2010

Report Date/time Actual Previous Consensus ISM manufacturing index Jan. 3 at 10 a.m. 57.0 56.6 57.3 S&P 500 reaction Report day Five days later 1.13% 1.10% Historical moves since 1997 0.28% 0.28%
FIGURE 6: MARKET REACTION TO ECONOMIC REPORTS EMPLOYMENT RECOVERY SHOWS SLOW PACE
Report Date/time Actual Previous Consensus Actual Previous Consensus Employment Jan. 7 at 8:30 a.m. Non-farm payrolls 113K 79K 162K 9.4 9.8 9.7 S&P 500 Historical moves reaction since 94 Report day Five days later -0.18% 0.78% 0.13% -0.08% Unemployment rate
The S&P gained just over 1 percent on the release of the ISM report, during the first trading day of 2011.
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STOCKS Snapshot
All Snapshots are as of Jan. 4. Active Traders Snapshot tables summarize the trading activity in the most actively traded stocks, ETFs, and futures. The information does NOT constitute trade signals. It is intended only to provide a synopsis of each markets liquidity, direction, and levels of momentum and volatility.
Stock
SYMBoL
VoLUME
31.64 M 12.18 M 13.70 M 55.55 M 27.43 M 12.60 M 15.35 M 14.02 M 27.29 M 11.50 M 10.82 M 10.90 M 11.25 M 15.33 M 15.85 M 55.11 M 11.33 M 11.88 M 11.28 M 20.51 M 27.66 M 18.95 M 10.62 M 11.48 M 13.72 M 43.38 M 11.29 M 10.81 M 16.45 M 16.47 M 10.41 M 17.79 M 62.25 M 185.93 M 12.77 M 10.50 M 11.64 M 11.02 M 11.66 M 49.16 M 18.30 M 13.91 M 37.45 M 11.24 M 30.65 M 10.14 M 13.35 M 22.53 M 13.04 M 10.67 M
1-YEAR REtURN
158.00% 57.32% 57.12% 49.06% 42.04% 32.94% 32.25% 31.55% 29.12% 22.56% 21.77% 21.59% 19.06% 17.11% 14.99% 14.52% 13.68% 12.56% 10.72% 9.45% 8.65% 7.31% 7.07% 4.06% 3.89% 2.67% 2.18% -37.87% -23.28% -18.47% -18.07% -16.42% -16.35% -15.89% -14.80% -14.20% -13.52% -9.49% -8.70% -7.76% -7.01% -3.63% -2.92% -2.55% -1.41% -1.00% -0.65% -0.54% -0.34% -0.29%
10-DAY MovE / RANk

0.53% / 33% 2.82% / 85% -3.23% / 100% 3.15% / 84% 6.97% / 30% 4.03% / 25% 2.34% / 26% 1.27% / 30% -0.62% / 100% -3.75% / 36% -1.49% / 63% -3.10% / 100% -1.51% / 100% 6.97% / 90% 6.42% / 80% 5.14% / 40% 2.43% / 21% -0.49% / 50% 2.37% / 0% 2.57% / 72% 5.15% / 50% 3.71% / 80% 3.88% / 80% 3.09% / 74% -3.91% / 100% -0.38% / 0% 1.86% / 100% 0.95% / 0% 8.99% / 82% 9.70% / 100% 0.61% / 8% 4.15% / 100% 4.59% / 94% 12.84% / 84% 10.20% / 93% -4.88% / 65% 8.42% / 89% 1.06% / 0% 3.39% / 11% 1.00% / 11% 2.45% / 70% -0.41% / 17% 4.77% / 85% 0.79% / 10% 10.54% / 100% 1.38% / 88% 1.90% / 42% 11.85% / 100% -4.98% / 100% 2.72% / 0%
20-DAY MovE / RANk

-2.63% / 5% 3.48% / 33% -4.81% / 100% 4.38% / 24% 15.60% / 69% 13.13% / 80% 8.93% / 67% 5.05% / 67% 9.56% / 61% -3.44% / 62% -3.11% / 27% 1.41% / 13% 3.99% / 35% 12.98% / 100% 4.55% / 55% 11.44% / 72% 6.22% / 41% 1.10% / 6% 8.56% / 56% 5.58% / 100% 10.12% / 69% 5.03% / 37% 5.40% / 76% 5.48% / 58% -1.05% / 16% -2.53% / 70% 0.51% / 18% -1.57% / 3% 6.82% / 71% 9.37% / 69% -0.47% / 12% 1.82% / 19% 5.62% / 40% 22.34% / 100% 8.66% / 37% -10.46% / 100% 11.47% / 97% -6.68% / 89% 16.27% / 81% 4.65% / 47% -0.09% / 0% 3.12% / 62% 7.01% / 97% 2.03% / 24% 10.66% / 86% 1.85% / 39% 1.60% / 23% 16.05% / 95% -4.51% / 100% 7.30% / 62%
60-DAY MovE / RANk

27.96% / 35% 12.66% / 39% 56.65% / 56% 27.23% / 62% 13.13% / 18% 18.98% / 82% 24.75% / 99% 16.26% / 89% 12.43% / 28% 15.68% / 30% 13.88% / 28% -0.49% / 50% 8.72% / 23% 13.19% / 81% 11.31% / 34% 8.70% / 56% 21.91% / 90% 25.44% / 67% 19.95% / 80% 5.88% / 39% 21.97% / 88% 16.34% / 56% 8.00% / 55% 13.87% / 40% 8.19% / 40% 8.35% / 21% 0.66% / 10% -18.54% / 89% 6.63% / 84% 0.28% / 1% 21.15% / 20% 6.03% / 41% -8.72% / 58% 8.04% / 100% 45.21% / 96% 8.06% / 35% 12.44% / 98% 19.73% / 45% 13.75% / 88% 14.32% / 91% -0.02% / 0% -1.52% / 34% 3.03% / 19% 3.81% / 18% 12.34% / 100% 0.19% / 0% 14.50% / 21% 28.16% / 87% -2.03% / 71% 18.19% / 56%
VoLAtILItY RAtIo / RANk

.13 / 13% .10 / 23% .14 / 20% .11 / 23% .14 / 7% .19 / 0% .09 / 2% .06 / 2% .05 / 0% .08 / 0% .12 / 18% .30 / 85% .09 / 13% .36 / 87% .29 / 82% .19 / 8% .14 / 3% .12 / 2% .10 / 0% .30 / 83% .13 / 2% .14 / 23% .26 / 43% .11 / 45% .20 / 27% .09 / 0% .33 / 100% .13 / 0% 1.04 / 97% .32 / 67% .08 / 0% .36 / 90% .23 / 55% .49 / 83% .18 / 22% .18 / 13% .46 / 50% .06 / 2% .24 / 0% .09 / 0% .11 / 3% .12 / 0% .29 / 80% .10 / 0% .46 / 25% .23 / 78% .08 / 0% .29 / 50% .85 / 100% .07 / 0%
Positive one-year performance Las Vegas Sands LVS Apple AAPL Hecla Mining HL Ford Motor F MGM Resorts International MGM Fifth Third Bancorp FITB Comcast CMCSA EMC EMC Oracle ORCL eBay EBAY Halliburton Company HAL Altria Group MO The Home Depot HD Verizon Communications VZ Vale VALE General Electric GE Taiwan Semiconductor TSM Weatherford Intl Ltd. WFT US Bancorp USB AT&T T Wells Fargo WFC Exxon Mobil XOM News Corp. NWSA QUALCOMM QCOM Lowe's LOW Intel INTC Wal-Mart WMT Negative one-year performance Banco Santander STD Petroleo Brasileiro SA PBR Nokia NOK Seagate Technology STX Hewlett-Packard HPQ Cisco Systems CSCO Bank of America BAC NVIDIA NVDA Marvell Technology Group MRVL Morgan Stanley MS Research In Motion RIMM Chesapeake Energy Corp. CHK Microsoft MSFT Dell DELL Merck MRK Pzer PFE Corning GLW JPMorgan Chase JPM Johnson & Johnson JNJ Yahoo YHOO Alcoa AA NLY Annaly Capital Management Applied Materials AMAT
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ETF Snapshot
ETF SYMBoL LEvERAGE INvERsE VoL. 1-YEAR REtURN
62.55% 56.80% 38.59% 30.60% 23.82% 22.21% 21.98% 21.81% 21.59% 21.53% 20.54% 20.20% 19.70% 17.65% 16.99% 15.04% 13.79% 12.87% 12.74% 11.71% 11.67% 11.20% 10.20% 10.10% 9.79% 7.29% 6.30% 5.29% 4.69% 3.03% 2.88% 1.75% 0.94% 0.50% -65.72% -47.61% -46.03% -45.96% -44.06% -39.68% -30.04% -26.07% -6.48% -0.52%
10-DAY MovE / RANk

1.29% / 11% 1.54% / 0% 2.43% / 25% -0.21% / 0% 0.16% / 0% 0.12% / 0% 3.80% / 35% 1.56% / 35% -0.27% / 0% 5.22% / 100% 1.81% / 50% -2.56% / 60% 1.29% / 32% 2.85% / 45% 1.02% / 38% 3.70% / 75% 2.79% / 45% 5.69% / 50% 4.62% / 93% 1.87% / 65% 2.07% / 10% 1.91% / 45% 2.70% / 75% 1.65% / 65% -0.20% / 50% -0.19% / 100% 4.73% / 65% 8.10% / 100% 0.41% / 20% 1.42% / 50% 1.43% / 79% 12.72% / 70% 4.49% / 100% 0.73% / 13% -2.39% / 0% -1.50% / 0% -12.19% / 65% -5.41% / 30% -5.65% / 35% -2.76% / 35% -3.71% / 35% -1.94% / 57% 0.08% / 0% -1.55% / 50%
20-DAY MovE / RANk

-1.46% / 100% 10.48% / 20% 5.64% / 34% -0.50% / 100% 0.48% / 2% 3.00% / 10% 8.00% / 63% 3.09% / 43% -3.13% / 100% 2.81% / 30% 0.85% / 5% -7.49% / 100% 2.64% / 34% 4.64% / 59% 0.31% / 3% 2.13% / 31% 3.23% / 2% 11.11% / 81% 2.68% / 39% 3.06% / 27% 3.75% / 41% 3.44% / 45% 3.14% / 58% 2.55% / 46% 1.84% / 33% 2.59% / 33% 7.39% / 85% 4.26% / 67% -2.82% / 29% 2.40% / 25% 1.43% / 66% 19.75% / 82% 1.01% / 0% 3.24% / 75% -10.76% / 12% -7.29% / 15% -18.08% / 86% -10.83% / 47% -11.16% / 53% -5.76% / 37% -7.64% / 56% 3.88% / 25% -0.37% / 14% -0.48% / 7%
60-DAY MovE / RANk

27.94% / 40% 43.83% / 45% 23.35% / 38% 11.60% / 10% 9.55% / 19% 13.20% / 45% 19.25% / 55% 8.93% / 40% 2.35% / 17% 4.99% / 11% 2.76% / 16% 3.00% / 10% 11.09% / 36% 13.92% / 78% 15.46% / 42% 3.98% / 8% 16.81% / 57% 12.29% / 87% 4.52% / 10% 9.70% / 52% 12.32% / 62% 8.96% / 53% 7.72% / 64% 5.88% / 43% 3.83% / 24% 8.91% / 47% 10.71% / 95% 2.49% / 7% -10.27% / 63% 2.90% / 6% -0.68% / 35% 29.14% / 90% -0.26% / 6% 3.64% / 26% -35.23% / 47% -24.70% / 48% -28.58% / 93% -26.33% / 57% -25.56% / 56% -20.69% / 38% -17.56% / 56% 18.11% / 58% 5.34% / 45% 2.14% / 93%

.16 / 20% .08 / 0% .08 / 7% .08 / 7% .06 / 13% .06 / 2% .10 / 0% .05 / 0% .25 / 43% .24 / 77% .28 / 42% .23 / 28% .07 / 15% .28 / 65% .03 / 0% .28 / 68% .11 / 10% .24 / 10% .28 / 68% .08 / 17% .09 / 0% .09 / 2% .24 / 38% .09 / 13% .06 / 3% .12 / 7% .23 / 10% .47 / 100% .13 / 0% .14 / 28% .28 / 55% .27 / 12% .27 / 53% .11 / 12% .03 / 0% .03 / 0% .13 / 7% .05 / 0% .05 / 0% .05 / 8% .06 / 2% .21 / 15% .17 / 12% .32 / 88%
Positive one-year performance iShares Silver Trust SLV Small Cap Bull 3x Shares TNA Ultra QQQ ProShares QLD S&P Select Retail SPDR Fund XRT S&P Select Cons. Disc. SPDR XLY iShares Russell 2000 Index Trust IWM ProShares Ultra S&P 500 SSO S&P Select Industrial SPDR Fund XLI SPDR Gold Trust GLD iShares MSCI Hong Kong Index EWH iShares DJ US Real Estate Index IYR Market Vectors Gold Miners ETF GDX PowerShares QQQ Trust QQQQ iShares MSCI Taiwan Index EWT Semiconductor HOLDRS SMH Vanguard Emerging Mkts ETF VWO S&P Select Energy SPDR Fund XLE SPDR KBW Bank KBE iShares MSCI Emerging Market EEM S&P Select Tech. SPDR Fund XLK S&P Select Materials SPDR Fund XLB S&P Depository Receipts SPY iShares MSCI Japan Index Fund EWJ Diamonds Trust DIA S&P Select Con. Staples SPDR XLP S&P Select Homebuilders SPDR XHB S&P Select Financials SPDR XLF iShares MSCI Brazil Index Fund EWZ iShares Barclays 20+ Yr T-Bond TLT iShares MSCI EAFE Index Trust EFA S&P Select Utilities SPDR Fund XLU Financial Bull 3x Shares FAS iShares FTSE/Xinhua China 25 FXI S&P Select Health Care SPDR XLV Negative one-year performance Small Cap Bear 3X Shares TZA UltraShort Russ. 2000 ProShares TWM Financial Bear 3x Shares FAZ Large Cap Bear 3x Shares BGZ ProShrs UltraPro Short S&P500 SPXU UltraShort QQQ ProShares QID UltraShort S&P 500 ProShares SDS UltraShort 20+ Yr Tr. ProShares TBT United States Oil Fund USO PowerShrs DB USD Indx Bullish UUP
3x 2x
2x
3x
27.05 M 7.97 M 3.72 M 8.19 M 5.36 M 42.82 M 10.01 M 9.46 M 14.08 M 4.96 M 8.04 M 7.96 M 52.44 M 10.54 M 5.67 M 15.67 M 11.93 M 6.34 M 51.75 M 6.71 M 7.44 M 135.48 M 20.94 M 5.93 M 4.84 M 4.57 M 64.67 M 13.20 M 12.22 M 16.75 M 4.97 M 27.09 M 13.90 M 5.20 M yes yes yes yes yes yes yes yes 16.17 M 3.93 M 25.64 M 4.39 M 4.18 M 9.49 M 20.77 M 16.69 M 6.79 M 4.37 M
3x 2x 3x 3x 3x 2x 2x 2x
Leverage: 2x = double leverage; 3x = triple leverage. Volume: 30-day average daily volume. 1-year return: The percentage price move from the close one year ago (250 trading days) to todays close. 10-day move: The percentage price move from the close 10 days ago to todays close. 20-day move: The percentage price move from the close 20 days ago to todays close. 60-day move: The percentage price move from the close 60 days ago to todays close. The Rank elds for each time window (10-day moves, 20-day moves, etc.) show
the percentile rank of the most recent move to a certain number of the previous moves of the same size and in the same direction. For example, the Rank for 10-day move shows how the most recent 10-day move compares to the past twenty 10-day moves; for the 20-day move, the Rank field shows how the most recent 20-day move compares to the past sixty 20-day moves; for the 60-day move, the Rank field shows how the most recent 60-day move compares to the past one-hundredtwenty 60-day moves. A reading of 100 percent means the current reading is larger
than all the past readings, while a reading of 0 percent means the current reading is smaller than all previous readings. These gures provide perspective for determining how relatively large or small the most recent price move is compared to past price moves. Volatility ratio/rank: The ratio is the short-term volatility (10-day standard deviation of prices) divided by the long-term volatility (100-day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.
69
FUTURES Snapshot
MARkEt
E-Mini S&P 500 10-yr. T-note 5-yr. T-note EUR/USD 30-yr. T-bond Crude oil Eurodollar* E-Mini Nasdaq 100 2-yr. T-note Corn Gold 100 oz. E-Mini Russell 2000 Natural gas JPY/USD Mini Dow GBP/USD AUD/USD Soybeans CAD/USD Silver 5,000 oz. Wheat Sugar Soybean oil CHF/USD RBOB gasoline Heating oil Copper Soybean meal U.S. dollar index MXN/USD E-Mini S&P MidCap 400 S&P 500 index Live cattle Lean hogs Coffee Nikkei 225 index Cocoa Crude oil e-miNY NZD/USD Mini-sized gold E-Mini EUR/USD Mini-sized silver Fed Funds** Nasdaq 100 Natural gas e-miNY Feeder cattle Dow Jones Ind. Avg.
SYMBoL EXcHANGE VoLUME

ES TY FV EC US CL ED NQ TU C GC TF NG JY YM BP AD S CD SI W SB BO SF RB HO HG SM DX MP ME SP LC LH KC NK CC QM NE YG ZE YI FF ND QG FC DJ CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME CME ICE CME CME CME CME CME CME ICE CME CME CME CME CME ICE CME ICE CME CME CME CME CME CME CME CME CME CME 1.49 M 960.1 484.1 302.6 265.3 270.2 247.4 192.5 206.4 127.2 132.8 91.7 117.2 102.5 79.6 88.8 79.2 86.3 69.8 58.1 40.8 41.0 44.8 38.9 38.2 40.6 27.7 25.5 18.0 25.7 20.6 24.4 9.2 9.8 8.6 8.9 8.4 7.3 6.8 4.6 5.0 4.3 2.5 1.8 2.1 2.0 0.5
OPEN INtEREst
2.38 M 1.26 M 946.4 162.3 518.5 279.0 801.6 335.0 612.8 644.3 323.5 308.1 140.0 108.2 76.8 77.5 110.2 194.5 96.3 71.2 202.2 235.3 88.5 41.1 58.9 68.0 98.7 48.2 25.9 122.1 95.0 277.7 51.7 57.9 88.8 39.9 70.0 4.1 26.0 3.6 4.3 3.2 36.8 15.6 4.7 11.6 5.8
10-DAY MovE / RANk

1.93% / 40% 0.06% / 0% 0.02% / 0% 1.43% / 57% 0.72% / 25% 0.01% / 0% 0.06% / 29% 1.14% / 21% 0.03% / 40% 1.50% / 0% -0.53% / 29% 0.62% / 0% 10.20% / 91% 2.15% / 67% 1.89% / 75% 0.50% / 40% 1.29% / 56% 4.12% / 37% 1.86% / 87% 0.52% / 0% 2.57% / 20% -4.62% / 100% 3.40% / 40% 1.69% / 30% 1.52% / 11% 0.68% / 11% 3.88% / 15% 4.64% / 53% -1.57% / 50% 1.47% / 100% 0.52% / 0% 1.94% / 40% 3.31% / 50% 1.61% / 0% 4.28% / 13% 1.21% / 50% -0.64% / 25% 0.00% / 0% 3.48% / 57% -0.35% / 14% 1.43% / 57% 1.51% / 11% 0.00% / 0% 1.14% / 21% 10.27% / 91% 0.23% / 0% 1.89% / 75%
20-DAY MovE / RANk

3.54% / 52% -2.44% / 56% -1.68% / 47% -0.14% / 6% -3.18% / 52% 0.00% / 0% -0.13% / 41% 2.51% / 32% -0.05% / 13% 7.11% / 10% -2.63% / 100% 3.15% / 17% 4.03% / 24% 0.80% / 3% 2.34% / 39% -0.92% / 14% 0.66% / 18% 6.29% / 31% 0.34% / 23% -0.76% / 0% -0.48% / 0% 5.08% / 0% 6.18% / 30% 3.42% / 45% 3.09% / 13% 1.24% / 7% 9.01% / 69% 6.15% / 44% 0.13% / 0% 0.59% / 13% 2.90% / 10% 3.53% / 52% 2.71% / 41% 13.09% / 91% 14.72% / 83% 2.36% / 33% -0.10% / 0% 0.00% / 0% 0.22% / 0% -3.14% / 100% -0.14% / 6% -1.23% / 100% -0.01% / 55% 2.51% / 32% 4.01% / 24% 2.11% / 24% 2.34% / 38%
60-DAY MovE / RANk

9.03% / 54% -5.51% / 97% -3.29% / 96% -4.34% / 91% -9.69% / 88% 8.13% / 41% -0.20% / 83% 11.12% / 36% -0.13% / 67% 15.18% / 26% 2.49% / 20% 13.14% / 41% 27.88% / 98% 0.10% / 2% 6.14% / 44% -2.31% / 68% 1.82% / 2% 20.65% / 72% 1.36% / 23% 27.71% / 41% 9.73% / 25% 23.21% / 10% 21.94% / 50% 1.46% / 3% 11.48% / 37% 9.84% / 42% 15.75% / 40% 16.32% / 88% 2.62% / 78% 1.50% / 19% 12.55% / 50% 9.02% / 54% 11.12% / 94% 3.72% / 56% 35.46% / 93% 8.14% / 58% 7.01% / 70% 8.14% / 43% 1.84% / 17% 1.90% / 18% -4.34% / 91% 28.03% / 40% -0.03% / 88% 11.12% / 36% 27.95% / 98% 12.32% / 100% 6.14% / 44%

.08 / 0% .16 / 10% .18 / 20% .24 / 70% .15 / 7% .13 / 8% .53 / 95% .07 / 5% .44 / 68% .13 / 18% .27 / 52% .06 / 0% .71 / 100% .60 / 95% .09 / 5% .34 / 47% .24 / 65% .19 / 18% .52 / 63% .18 / 23% .24 / 42% .29 / 60% .14 / 8% .41 / 95% .10 / 0% .11 / 8% .22 / 43% .29 / 40% .33 / 90% .20 / 17% .05 / 2% .08 / 0% .59 / 85% .24 / 43% .25 / 18% .14 / 17% .43 / 53% .13 / 8% .59 / 90% .26 / 47% .24 / 70% .16 / 22% .00 / 0% .07 / 5% .71 / 100% .10 / 0% .09 / 3%
Note: Average volume and open-interest data includes both pit and side-by-side electronic contracts (where applicable). Price activity for CME futures is based on pit-traded contracts. Volume gures are for the most-active contract month in a particular market and may not reect total volume for all contract months. *Average volume and open interest based on highest-volume contract (December 2011). **Average volume and open interest based on highest-volume contract (March 2011). This information is for educational purposes only. Active Trader provides this data in good faith, but it cannot guarantee its accuracy or timeliness. Active Trader assumes no responsibility for the use of this information. Active Trader does not recommend buying or selling any market, nor does it solicit orders to buy or sell any market. There is a high level of risk in trading, especially for traders who use leverage. The reader assumes all responsibility for his or her actions in the market.
70
KEY Concepts
Momentum (or price momentum): A generic term used to describe the rate at which price changes, as well as the name of a specic calculation. Rate of change (ROC) is simply an alternate version of this basic indicator. The implications and interpretations of these two studies are identical. Momentum/ROC are similar to oscillators, such as the relative strength index (RSI) and stochastics, in that they are generally intended to highlight shorter-term price momentum extremes (overbought or oversold points). The most common calculation for momentum is simply todays price (typically the closing price) minus the price n days ago: (Ptoday Pn days ago). The most basic ROC formula is todays price divided by the price n days ago: (Ptoday/Pn days ago). Alternate calculations for rate of change are 100*(Ptoday/Pn days ago) or (Ptoday Pn days ago)/Pn days ago. Except for scaling, the resulting momentum and ROC indicators are the same; momentum simply expresses price change as the difference between two prices, while ROC expresses price change as a percentage or ratio. Sharpe ratio: Average return divided by standard deviation of returns (annualized). Variance and standard deviation: Variance measures how spread out a group of values are in other words, how much they vary. Mathematically, variance is the average squared deviation (or difference) of each number in the group from the groups mean value, divided by the number of elements in the group. For example, for the numbers 8, 9, and 10, the mean is 9 and the variance is:
{(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = 0.667 Now look at the variance of a more widely distributed set of numbers: 2, 9, and 16: {(2-9)2 + (9-9)2 + (16-9)2}/3 = (49 + 0 + 49)/3 = 32.67 The more varied the prices, the higher their variance the more widely distributed they will be. The more varied a markets price changes from day to day (or week to week, etc.), the more volatile that market is. A common application of variance in trading is standard deviation, which is the square root of variance. The standard deviation of 8, 9, and 10 is: sq. rt. 0.667 = .82; the standard deviation of 2, 9, and 16 is: sq. rt. 32.67 = 5.72.
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71
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TRADERS Bookshelf
Diary of a Professional Commodity Trader: Lessons from 21 Weeks of Real Trading
Peter L. Brandt Hardcover, 304 pages John Wiley & Sons Using a diary format, Brandt provides a play-by-play of 21 weeks of his 2009 trading, revealing what the experience was like and communicating the uncertainty that surrounds every trade and the discipline required to make tough decisions in the face of losing money. The author also touches upon his philosophy of speculation, market analysis, trade identication and selection, risk management, and the methods and rules he has used to trade successfully. Each trade includes charts, an analysis of the trade, and a detailed account of how it unfolded.
Alpha Trading: Protable Strategies That Remove Directional Risk

Perry J. Kaufman Hardcover, 320 pages John Wiley & Sons How do you make protable trades when there are no obvious trends? This book addresses the realities of trading when markets make no sense, when price shocks cause diversication to fail, and when it seems impossible to hedge[.] Author and trading system developer Perry Kaufman presents strategies and systems for protably trading in directionless markets, as well as those experiencing constant price shocks. Among its topics, the book details how to exploit new highs and lows, hedge primary risk components, nd robustness, and craft a diversication program.
Attacking Currency Trends: How to Anticipate and Trade Big Moves in the Forex Market
Greg Michalowski Hardcover, 304 pages John Wiley & Sons A guide for reading long-term trends in the foreign currency market, the book argues that to thrive in the marketplace, traders must anticipate, enter, and stay with trends in the foreign exchange market. The author explains the attributes of successful traders and discusses the tools and techniques traders need to read the markets and identify when a market is in a trend. Trade entry, position management, and exit techniques are also explored. Technical tools discussed include moving averages, trendlines, and Fibonacci levels.
Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market into a Casino
Jim McTague Hardcover, 264 pages FT Press This book starts with the premise that equity markets are now high-speed casinos rigged against individual investors. The author, Barrons Washington editor Jim McTague, writes about the twin causes: high-frequency traders and blundering regulators. The book dissects why the Flash Crash happened, and why it will happen again, and explores rational strategies for proting in this terrifying new environment.
Traders Bookshelf is a forum to announce new trading and nancial books. Listings are adapted from company press releases and are not endorsements or recommendations from the Active Trader Magazine Group. E-mail press releases to: editorial@activetradermag.com. Publication is not guaranteed.
TradeStation Made Easy: Using EasyLanguage to Build Prots with the Worlds Most Popular Trading Software
Sunny J. Harris Paperback, 744 pages John Wiley & Sons Endorsed by TradeStation Technologies, the books goal is to cover the essence of programming in TradeStations EasyLanguage and provide an easily understood guide to TradeStation that also provides tips for the user in designing a personalized trading system. Noting that TradeStations computer language can be confusing, especially for the novice, the author focuses on a consistent set of data and an elementary system throughout. Putting the basics of EasyLanguage in perspective, and accessible even to those with little computer experience, the book is designed to enable users to write simple and intermediate programs that will accurately express your theories and ideas about whatever market interests you.
Technical Analysis For Dummies, 2nd Edition

Barbara Rockefeller Paperback, 360 pages John Wiley & Sons Since the publication of the rst edition of Technical Analysis For Dummies, readers have been faced with many changes to the investment landscape, such as new interest rates, looming bank crises, and adjusting market climates. This updated edition includes information on the new indicators, handson applications for real-world situations, as well as practical examples to help investors make better trading decisions. Rockefeller goes beyond the fundamentals and helps readers spot investment trends and turning points, determine how markets are performing and make decisions using real data, and improve prots and portfolio performance.
72
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TRADING Calendar
LEGEND CME: Chicago Mercantile Exchange CPI: Consumer price index ECI: Employment cost index FDD (rst delivery day): The first day on which delivery of a commodity in fulfillment of a futures contract can take place. FND (rst notice day): Also known as first intent day, this is the first day on which a clearinghouse can give notice to a buyer of a futures contract that it intends to deliver a commodity in fulfillment of a futures contract. The clearinghouse also informs the seller. FOMC: Federal Open Market Committee GDP: Gross domestic product ISM: Institute for Supply Management LTD (last trading day): The final day trading can take place in a futures or options contract. PMI: Purchasing managers index PPI: Producer price index Quadruple witching Friday: A day where equity options, equity futures, index options, and index futures all expire.
March 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
January construction spending February ISM manufacturing report FND: March orange juice futures (ICE) FDD: March crude oil, natural gas, gold, silver, copper, platinum, palladium, corn, wheat, soybeans, soybean products, oats, rough rice, and T-bonds futures (CME); March sugar, cotton, cocoa, and coffee futures (ICE) FND: March heating oil and RBOB gasoline futures (CME) Q4 productivity and costs February ISM non-manufacturing report February employment report LTD: March forex options; April cocoa options and March U.S. dollar index options (ICE)
January consumer credit FND: March pork bellies futures (CME) FDD: March heating oil, RBOB gasoline, and pork bellies futures (CME); March orange juice futures (ICE) January wholesale inventories LTD: March cotton futures (ICE) January trade balance January business inventories February retail sales LTD: March orange juice futures (ICE); April coffee options (ICE)
LTD: March corn, wheat, soybeans, soybean products, oats, and rough rice futures (CME); March forex futures FOMC interest-rate announcement FND: March U.S. dollar index futures (ICE) LTD: March lumber futures (CME) February PPI and housing starts FND: March lumber futures (CME) FDD: March lumber futures (CME); March forex futures LTD: April platinum options (CME); March cocoa futures (ICE) February CPI, production and capacity utilization, and leading indicators March Philadelphia fed survey LTD: April crude oil options (CME); March index futures (CME); March index and equity options LTD: April orange juice options (ICE); March single stock futures (OC)
17 18
76
REPOrt tiMES
19 20 21 22 23 24 25 26 27 28 29 30 31
Economic release GDP
Release time (ET) 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m. 8:30 a.m.
February existing home sales LTD: March coffee futures (ICE) LTD: April crude oil and T-bonds futures (CME) February new home sales February durable goods FND: April crude oil futures (CME) Q4 GDP (third) March University of Michigan consumer sentiment
CPI ECI PPI Productivity and costs Employment Personal income Business inventories Durable goods Retail sales
February personal income LTD: March pork bellies futures (CME); April natural gas, heating oil, RBOB gasoline, gold, and copper options (CME) March consumer confidence LTD: April natural gas and March gold, silver, copper, platinum, and palladium futures (CME) FND: April natural gas futures (CME) February factory orders March Chicago PMI FND: April gold and platinum futures (CME) LTD: April heating oil and RBOB gasoline futures (CME)
Trade balance Housing starts Chicago Fed national activity index Production & capacity utilization Leading indicators Consumer confidence University of Michigan consumer sentiment Wholesale inventories Philadelphia Fed survey Existing home sales Construction spending Chicago PMI report ISM report on business
9:15 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 10 a.m. 2 p.m. 3 p.m.
April 1 2 3 4 5 6 7 8
March employment report and ISM manufacturing report February construction spending FDD: April crude oil, natural gas, gold, and platinum futures (CME) LTD: April live cattle options (CME); March cocoa options (ICE)
FND: April heating oil, RBOB gasoline, and live cattle futures (CME) March ISM non-manufacturing report
ISM non-manufacturing report on business New home sales
February consumer credit February wholesale inventories FDD: April heating oil and RBOB gasoline futures (CME) LTD: May sugar futures (ICE); May coffee and cotton options and April U.S. dollar index options (ICE)
Factory orders Federal budget Consumer credit
The information on this page is subject to change. Active Trader is not responsible for the accuracy of calendar dates beyond press time.
77
TRADE Diary
Going long after a bearish week in the crude oil market.
Trade Date: Friday, Jan. 7, 2010. Entry: Long March crude oil futures (CLH11) at 89.22. Reason for trade/setup: This trade was based on a weekly pattern reecting the markets condition at the close of the week ending Jan. 7: a lower weekly close and low with a high above the highest high of the previous four weeks. This seemingly mundane (and at rst glance, bearish) pattern has appeared only 14 times over the past 10 years, but it was followed by fairly consistent bullish price action over the following 12 weeks: the market was higher at least 61 percent of the time after seven weeks, and the odds of a higher close after two weeks was better than 75 percent. The trade intended to capture this initial thrust. A contributing factor is the markets proximity to $100 a conspicuous round-number price the market is likely to at least test. (Most analysts see low probabilities for extended or signicant follow-through above $100 see Oil irts with triple digits in new year on p. 16.) However, the trade does y in the face of the markets overall loftiness (its at its highest levels in more than two years) and the possibility of downside follow-through after a bearish week. The position was established on the Jan. 7 close. (Note: This was a paper trade.) Initial stop: 87.74, below the established support around 88 and
the Jan. 7 low of 88.45.
Source: TradeStation
Outcome: In its rst stage at least, this was one of those rare trades that couldnt have worked out much better. The market opened higher the Monday (Jan. 10) after the trade was entered, and the position was never in the red. The rally continued the next day, and early in the morning of Jan. 11, the market rallied to 91.69 just shy of the initial target then pulled back slightly. Since this effectively constituted a fulllment of the conditions for raising the stop-loss, the stop order was raised to 89.33 (a little above breakeven). When the market actually hit the target and traded up to 92 about an hour later, the stop was raised again to 90.06, locking in a prot on trade.
Go to www.activetradermag.com (Web only > Article follow-ups) after Feb. 7 to see the outcome of the second half of this trade.
Note: Initial targets for trades are typically based on things such as the historical performance of a price pattern or trading system signal. However, individual trades are a function of immediate market behavior; initial price targets are exible and are most often used as points at which a portion of the trade is liquidated to reduce the positions open risk. As a result, the initial (pre-trade) reward-risk ratios are conjectural by nature.
Initial target: 91.78. Take partial prots and raise stop. Secondary
target: 93.
ReSULt Prot/loss: +2.56 (half position). Trade SUMMarY

Date Jan. 7 Futures CLH11 Entry price 89.22 Initial stop 87.74 Initial target 91.78 IRR 1.73
Exit 91.78
Date Jan. 11
P/L (point) 2.56
P/L (%) 2.87%
LOP 3.06
LOL -
Trade length 2 days
IRR: initial reward/risk ratio (initial target amount/initial stop amount). LOP: largest open profit (maximum available profit during lifetime of trade). LOL: largest open loss (maximum potential loss during life of trade).
80

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BUY HIGH, SELL HIGHER: RELATIVE STRENGTH SYSTEM p.

TRADING STRATEGIES FOR THE FINANCIAL MARKETS

Tale of a hedge fund p. 58 Prepping for tax season p. 62

Intraday stock-index futures setup p. 18

Oil back in the spotlight p. 16

Printed in the U.S.A.

setup highlights optimal trading times. By Active Trader Staff

24 Trading international stock-index

30  Active alpha investing for

the markets new normal

68 Stocks Snapshot

71  New Products & Services

www.activetradermag.com March 2011 ACTIVE TRADER

Contents Contact Active Trader:

Advanced Concepts Base metals and Chinese monetary policy

Comments, suggestions: suggestions@activetradermag.com For advertising or subscription information, visit: www.activetradermag.com

 Are sliding prices for base metals a By Howard L. Simons

Trading System Lab Buy high, sell higher

The Business of Trading Handling IRS notices and exams

Trading Basics Order up: 2011

The Economy U.S. economic brieng

 Updates on economic numbers and

By Active Trader Staff

The Face of Trading Nurturing patience

Trade Diary Going long after a bearish week 

Active Trader Interview A new hedge-fund world

By Active Trader Staff

www.activetradermag.com March 2011 ACTIVE TRADER

www.activetradermag.com March 2011 ACTIVE TRADER

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U.S. stocks follow through into new year

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12/31/10 Nasdaq 100 S&P 500 Dow Russell 2000

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www.activetradermag.com March 2011 ACTIVE TRADER

Industry adjusts to Dodd-Frank

FiGUre 1: NEW REGULATIONS, NEW WATCHDOGS

Educating the individual investor

National consumer complaint hot line; Office of Financial Literacy

Banks and credit unions with assets over $10 billion

To the regulationmaking process

Emerging risks in the financial system

Rules for capital, leverage, liquidity, and risk management

Nonbank financial companies

Increase in brokerage costs?

The bottom line

BArclAY TrAdinG GroUpS MAnAGed fUtUreS perforMAnce AS of NoV. 30

www.activetradermag.com March 2011 ACTIVE TRADER

Oil irts with triple digits in new year

Underlying market dynamics

ACTIVE TRADER March 2011 www.activetradermag.com

TRADING TRADING Strategies Strategies

Time ltering scalp trades

BY ACTIVE TRaDER STaFF

The pattern: Three up and three down

Raw pattern performance

FIGUrE 1: TRADE SIGNALS

Time of day: Frequency and winning percentage

TABLE 1: POST-PATTERN PERFORMANCE

www.activetradermag.com March 2011 ACTIVE TRADER

24 Trading international stock-index

30 Active alpha investing for

68 Stocks Snapshot

71 New Products & Services

Are sliding prices for base metals a By Howard L. Simons

Updates on economic numbers and

Trade Diary Going long after a bearish week

TAbLE 1: iSHARES COUNTRY ETFS TRADING SINCE 1996