At May 2008 Issue

DRAWDOWN VS.
SYSTEM DEATH
p. 20
SYSTEM TEST: The 4-percent model p. 34 INTERVIEWS: Vitaliy Katsenelson on active value investing
p. 38
NIGHT AND DAY TRADING in the E-Minis p. 16
Ari Kiev on handling trading stress p. 44
TREASURIES AND INFLATION PROTECTION: What you see isnt what you get p. 28 GOLD AND COFFEE on the run pp. 60, 57 60.
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CONTENTS:
MAY 2008 VOLUME 9, NO. 5 TRADING STRATEGIES FOR THE FINANCIAL MARKETS
Trading Strategies Night and day in stock index futures

Find out what the overnight futures action really portends for the next day session in the E-Mini stock index futures. By Active Trader Staff
13
System death: When good systems go bad

Autopsies of two trend-following systems offer clues about when to abandon a losing strategy. By Christian Smart, Ph.D.
20
Advanced Strategies TIPS, treasuries, and insurance

Do TIPS really have any advantage over regular T-notes and T-bonds? By Howard L. Simons
24
Trading System Lab The 4-percent model

Testing suggests classic system still has legs. By Volker Knapp
In every issue
39 ETF Snapshot
Volume, volatility, and momentum statistics for exchange-traded funds.
52 Global Marketplace
International market performance.
3 4 5 6
Editors Note Contributors Letters Opening Trades
58 Trading Resources
New products, services, and books.
40 Stocks & Futures

Snapshot
Volume, volatility, and momentum statistics for futures and stocks.
60 Trading Calendar 62 Key Concepts 64 Upcoming Events
www.activetradermag.com May 2008 ACTIVE TRADER
Contents continued Contact Active Trader:

Editorial inquiries: editorial@activetradermag.com
28
Active Trader Interview Vitaliy Katsenelson: Market skeptic

This portfolio manager and author of Active Value Investing explains how to survive a possible long-term range-bound market. By David Bukey
Comments, suggestions: suggestions@activetradermag.com For advertising or subscription information, log on to: www.activetradermag.com
34
Q&A Ari Kiev on trading stress and leadership

The fact that trading is a high-stress profession is no secret, but theres more to understanding it and controlling it - than you might think. By Mark Etzkorn
54
The Economy U.S. economic briefing

Updates on economic numbers and how the market reacted to them.
56 38
The Face of Trading Brushing up profits
By Active Trader staff
Trading Basics The maxi world of mini futures

A review of the wide range of mini futures contracts available to U.S. traders. By Steven Graubart
Inside the Market

By Jeff Ponczak
Trade Diary
65 67
Catching a ride on the gold express. Overbought moment in the market offers a selling opportunity.
41
Rogue trader shredded in wheat market

MF Global trader racks up $141 million loss in wheat futures gambit. By Chris Peters
Other stories:
Department of Justice advocates new futures clearing structure Coffee perks up to multi-year high Tempers flare over Wall Street arbitration Gold keeps teasing the $1,000 mark Managed money Global news Quick scalps
Editors NOTE
Historic times
Thank goodness theres no inflation if there
most important fuel source a linchpin of the global economy costs 10 times more than it did a decade ago and darn near twice what it did a year ago, you have to marvel at our ability to recalibrate our psyches, and thus our economies, to such a sea change. But psyches are such fragile things (just ask the stock market). At least our cars havent increased tenfold in price. Oils one thing, but golds history-inthe-making run is something else. For the time being, were really dependent on oil its pretty difficult to completely erase your carbon footprint, regardless of how much you might like to but theres no industrial or commercial purpose for gold
were, the U.S.s flaccid

uman beings can adjust to just about anything. To wit, the price of crude oil: When our
currency would only exacerbate the problem, having fallen recently to new lows against most major currencies.
that can explain its surge the past year or so. Nonetheless, it seems hell bent on reaching the $1K mark, although one can only guess at the tragicomedy that might unfold after it does so. The grains when was the last time they were the it commodity sector? are picking up 2008 where they left off in 2007 (including rice!); ditto for the rest of the metals. And the soft commodities coffee, cocoa, and sugar have gotten in on the fun, too.
And all this after the commodity bull had supposedly hoofed it south for retirement. Gee, thank goodness theres no inflation if there were, the U.S.s flaccid currency would only exacerbate the problem, having fallen recently to new lows against most major currencies. One of the most laughable aspect of inflation tracking is that the official statistics remove the volatility energy and food components from the so-called core inflation numbers. No, you wouldnt want to food and energy to muddy the picture who spends money on that stuff? Maybe golds rally isnt so crazy after all.
Mark Etzkorn, Editor-in-chief
This Months CONTRIBUTORS
For all subscriber services:

Active Trader Magazine P Box 567 .O. Mt. Morris, IL 61054-0567 (800) 341-9384 www.activetradermag.com
Editor-in-chief: Mark Etzkorn metzkorn@activetradermag.com Managing editor: Molly Flynn mflynn@activetradermag.com Senior editor: Jeff Ponczak jponczak@activetradermag.com Senior editor: David Bukey dbukey@activetradermag.com Associate editor: Chris Peters cpeters@activetradermag.com Contributing writers: Thom Hartle, Howard L. Simons, Marc Chandler, Keith Schap, Thomas Stridsman, Robert A. Green, Jim Kharouf Editorial assistant and Webmaster: Kesha Green Art director: Laura Coyle lcoyle@activetradermag.com President: Phil Dorman pdorman@activetradermag.com Publisher, Ad sales East Coast and Midwest: Bob Dorman bdorman@activetradermag.com Ad sales West Coast and Southwest only: Allison Ellis aellis@activetradermag.com Classified ad sales: Mark Seger seger@activetradermag.com
Volume 9, Issue 5 Active Trader is published monthly by TechInfo, Inc., 161 N. Clark Street, Suite 4915, Chicago, IL 60601. Copyright 2008 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.
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 financial market issues. Dr. Christian Smart is a mathematician, cost analyst, trading systems developer, and part-time trader. He develops and sells trading systems through his Web site, www.drsmarttrading.com. Dr. Smart has a Ph.D. in applied mathematics and is the author of numerous technical publications in mathematics, reliability engineering, cost analysis, and investing. He has presented the results of his latest research both in the U.S. and abroad. Thom Hartle (www.thomhartle.com) is director of marketing for CQG and a contributing editor to Active Trader magazine. In a career spanning more than 20 years, Hartle has been a commodity account executive for Merrill Lynch, vice president of financial futures for Drexel Burnham Lambert, trader for the Federal Home Loan Bank of Seattle, and editor for nine years of Technical Analysis of Stocks & Commodities magazine. Hartle also writes a daily market blog called hartle & flow (www.hartleandflow.com).
Volker Knapp has been a trader, system developer, and researcher for more than 20 years. His diverse background encompasses positions such as German National Hockey team player, coach of the Malaysian National Hockey team, and president of VTAD (the German branch of the International Federation of Technical Analysts). In 2001 he became a partner in Wealth-Lab Inc. (www.wealth-lab.com), which he is still running. Jim Kharouf is a business writer and editor with more than 10 years of experience covering stocks, futures, and options worldwide. He has written extensively on equities, indices, commodities, currencies, and bonds in the U.S., Europe, and Asia. Kharouf has covered international derivatives exchanges, money managers, and traders for a variety of publications.
LETTERS Diary of a hedge fund manager

My name is Ali Meshkati. I am currently rebuilding after having my macro hedge fund blow up at the end of 2005. I was formerly ranked no. 1 in my field (http://trackrecordlive.com/wpcontent/uploads/2007/12/sp32-20031106-114131.gif) I started my hedge fund with $1 million in 2002 and by the beginning of 2004 had over $10 million under management in my fund and in private managed accounts. While being small relative to other funds, I was on the fast track until I became enthralled by my own success and broke every trading rule in the book the same trading rules that led to my success for more than a decade in the markets. I started a Web site www.trackrecordlive.com that will serve as a trading diary during my attempt to climb back, illustrating the combination of capturing large gains in the markets with a newfound approach that controls volatility and limits risk to the absolute minimum. On the site I have taken the pen name Captain Ahab, which I felt was very fitting given that Captain Ahab in the book Moby Dick sought revenge on the whale that destroyed his ship. Similarly, the market destroyed my vessel and took my leg now I am seeking revenge. The market is my Moby Dick. Unfortunately for me, I had to suffer a fall from grace before these lessons became ingrained within me as a trader. Now that they are, I think the lessons and insights will be extremely valuable to all. Ali Meshkati
Oscillator coding
I have tried to match the results displayed in The Aroon oscillator (Active Trader, March 2008) with an Aroon oscillator I've put into TC2007. The author uses five bars as the [look-back] period. Can you tell me the exact settings your staff used to get these results, please? StockCharts.com says the standard setting is 25 bars, and TC2007 asks for a smoothing average time period. Bob Baron
We don't know what the smoothing average time period is; it might simply be the term the program uses for look-back period. Youll have to contact the software vendor directly on that one. At any rate, the only parameter were familiar with is the look-back period i.e., the number of bars used in the indicators calculation. This number, of course, is modifiable. No look-back period is carved in stone, although default settings might be suggested.
Everybody is a star
I am very inspired by reading The Face of Trading section and am requesting to submit a short excerpt from my trading history and experiences. I am a self-taught trader who has branched into options, currency, and futures. I have established myself as my own trading entity part time as I transition out of full-time [work] to become a stay-athome trader. Please advise on how I can submit a request to be featured. S. Biddle We always want to hear from traders. You can send information to editorial@activetradermag.com be prepared to document your trading with brokerage statements!
ACTIVE TRADER May 2008 www.activetradermag.com
OPENING Trades
Stocks: Status quo to the downside

Confounding bull holdouts and traders looking for at least a bounce, in March the U.S. stock market broke down below its February consolidaSource: TradeStation tion and positioned itself to make a run at the January low. After selling off to 1,270 on Jan. 23, the S&P 500 index (SPX) bounced back nearly 10 percent to 1,396 by Feb. 1. After that it moved sideways, eventually falling 8.3 percent from the Feb. 27 high to the March 10 low below 1,273. The picture around the globe was equally bearish; few major equity markets gained ground in 2008 through mid-March. Reviewing exchange-traded funds (ETFs) based on country stock indices revealed one ETF the iShares MSCI Taiwan Index Fund (EWT) that was in positive territory intraday in the 20 trading days up to March 10, but it eventually closed the day in the red. However, the market roared to the upside on March 11 in response to the Feds latest liquidity injection.
ETF iShares Silver Trust StreetTRACKS Gold Trust iShares COMEX Gold Trust DB Commodity Index Tracking Fund iShares FTSE/Xinhua China 25 PowerShares Golden Dragon USX China Sym SLV GLD IAU DBC FXI PGJ +/35.29% 21.30% 21.26% 19.52% -23.95% -26.24%
Gold fever: 1,000 and?

Gold spent most of the first half of March consolidating and teasing traders by approaching the $1,000 mark twice rallying above $990 before pulling back into the $960s and $970s, and finally leaping up to $1,001.00 on March 13. In response to feverish speculation in gold prices, Deutsche Bank recently introduced three exchange-traded notes (ETNs) to let traders make leveraged, inverse, or inverse leveraged bets on gold.
Source: TradeStation
The two weakest international ETFs were mainland China-based: the PowerShares Golden Dragon USX China and the iShares FTSE/Xinhua China 25 were both down around 25 percent. In terms of U.S. sectors, the one area of unequivocal strength was metals. Three of the four ETFs boasting double-digit 20-day returns on March 10 were gold and silver based, and the fourth was a broader commodity index.
Bonds and notes soar

Interest-rate futures continued to climb as stocks continued to fall. The March 10-year T-note contract (TYH08) topped 120 on March 10 before reversing the next day as stocks rallied. The contract broke out of a week-long consolidation and easily surpassed the 11905/32 January high.
6
All three ETNs DB Gold Double Long (DGP), DB Gold Short (DGZ), DB Gold Double Short (DZZ) track the DB Liquid Commodity Index-Optimum Yield Gold by various percentages. The short ETN attempts to mimic the indexs inverse (-100 percent), while the other two represent either 200 or -200 percent of its performance. For coverage of golds current run, see Gold express may lose steam above $1,000 on p. 49. Disclaimer: Some Active Trader staff members had long positions in gold when this was written in mid-March.
Source: TradeStation www.activetradermag.com May 2008 ACTIVE TRADER
Euro tops $1.5000 for the first time

The U.S. dollars respite from the 2007 meltdown that culminated in late November proved to be short lived. The euro/U.S. dollar pair (EUR/USD) catapulted above 1.500 on Feb. 27, pushing above 1.5400 by March 7. The same day, the U.S. dollar index (DXY) broke down to a new alltime low of 72.46. For more currency analysis, including statistics on what the euro has done when it has made similar moves in the past, see the free March issue of Currency Trader magazine (www.currencytradermag.com).
Source for both charts: TradeStation
Futures volume sets new records

If last year was any indication, 2008 should be another record year for futures trading volume. Spurred by increasing demand for many commodities and record prices in many markets, 2008 has gotten off to a better start than 2007. And according to data released by the Futures Industry Association (FIA), 2007 global futures volume was up 28 percent over 2006, with more than 15 billion contracts traded. The FIAs numbers are based on voluntary submissions from 63 exchanges in more than 30 countries.
Oil $100: The new $30?

After a weak January, energy prices regained momentum mid-February to trade at record highs fueled in part by the U.S. dollars decline. Oil first traded above $100 on Jan. 3 before falling to $85.42 a barrel within three weeks. April crude oil futures (CLJ08) broke above $100 again on Feb. 19, but another week passed before the contract closed above the $100 mark. Crude then cracked its inflation-adjusted high of $103.76 on March 3, closed above $105 three days later, and jumped above $110 on March 13. Following oils lead, gasoline and heating oil futures also climbed to all-time highs. April gasoline futures (RBJ08) climbed to a historic $2.7556 per gallon on Feb. 20, and April heating oil futures (HOJ08) jumped to $2.9863 a gallon.
Gas ETF hits the road

The U.S. gasoline fund (UGA) was launched by Victoria Bay Asset Management and the American Stock Exchange on Feb. 27. Unlike other ETFs, which track the moves of selected companies within the energy sector, UGA is based on the price of near-month gasoline futures (RB) traded on the New York Mercantile Exchange (NYMEX). Other energy-related ETFs that follow NYMEX futures include the U.S. oil fund (USO) and the U.S. natural gas fund (UNG), which also follow near-month contracts. Alternately, the U.S. 12-month oil fund (USC) tracks the 12 monthly crude oil futures contracts.
Source: eSignal
Tit for tat

News that New York Governor Eliot Spitzer had been allegedly taped arranging a tryst with a call girl was met with cheers from the floor of the New York Stock Exchange. Spitzer had aggressively prosecuted corruption on Wall Street in his previous job as New York attorney general.
Opening Trades continued
Volatility hits grains

Grain prices became more volatile in February as wheat, corn, and soybean futures soared. May wheat (WK08) gained 14.9 percent in February, hitting an intraday high of $13.494 per bushel on Feb. 27. After several limit-down moves, the contract fell 21.7 percent to $10.56 on March 4. May soybeans (SK08) climbed 17.6 percent in February before dropping 14.4 percent from its $15.864 March 3 high. May corn futures (CK08) followed a similar pattern, sliding 4.2 percent from its $5.472 high set on the same day. Corn futures had rallied 34.7 percent over the previous three months. And dont forget the forgotten grain rice. Although its the staple food of billions of people, rice futures are a fairly low profile market in the U.S. Nonetheless, the May contract (RRK08) rallied from 14.250 to 18.550 from January to March 11 a 3-percent gain, and a new all-time high.
Source: eSignal
An aftertaste in coffee, sugar, and cocoa?

Like most commodities, coffee and sugar prices continued to rally in late February. In early March, however, both markets declined roughly 15 percent from their recent multi-year highs. In January, prices of Arabica and Robusta coffee were at their highest levels in more than a decade as January exports fell 9.4 percent compared to last year. But May coffee futures (KCK08) dropped to $1.5145 per pound on March 7. (See Java jolt: Somethings brewing in coffee on p. 46 for analysis of the coffee market.) Sugar futures gained 20 percent in February as the May contact (SBK08) reached a high of $0.1507 per pound on March 3 before slipping 15.3 percent within a week. The cocoa market was hot in January and February as May cocoa futures (CCK08) climbed 36.5 percent. After topping $2,845 per metric ton on March 5, the May contract slipped 5 percent by March 10. Political turmoil, harsh weather, and disease have weakened West Africas cocoa output as of late, driving prices to record levels.
Source: eSignal
King cotton
May cotton futures (CTK08) climbed 13.4 percent in the first three days of March to reach a record high of $0.9286 per pound. But those heights didnt last long as the May contract plunged 17.6 percent by March 11. Cottons early March spike followed a bullish February in which it rose 20.76 percent - the largest monthly gain since last summer and the fourth biggest monthly increase in 12 years.
Exercise those options

Retail options traders gave up profits by failing to exercise certain call options just before a stock pays dividends, according to a new study published in the Journal of Financial Markets. The article, written by professors at Vanderbilt and Indiana University, estimates individual options traders ignored $491 million in unrealized profits from January 1996 to April 2006, most of which was captured by market makers through dividend arbitrage, a strategy that profits when call option holders dont exercise deep in-themoney calls just before a dividend is issued. Although transaction costs are one reason retail traders forego exercise, they dont completely explain why all these profits were left on the table. For more options news, strategies, and analysis, go to www.futuresandoptionstrader.com.
Trading STRATEGIES
Night and day in stock index futures

Forget about whether the futures are up or down before the morning bell. Analyzing the entire range of the night session and putting this information in the context of the previous days price action sheds more light on what will happen in the upcoming day session. BY ACTIVE TRADER STAFF
lthough the E-Mini S&P 500 (ES) futures trade nearly 24 hours a day, most traders divide the market into two sessions: the day session, which coincides with pit trading in the full-sized S&P 500 contract (SP) as well as the regular trading hours of the
FIGURE 1: UP DAY AND NIGHT
New York Stock Exchange and Nasdaq; and the night session, which is when the three aforementioned markets are closed. Financial news stations typically report whether the stock index futures are up or down before the open of the day session, with the implication that strength or weakness in the futures has some predictive value. Traders know, however, the relationship between the pre-market futures and the regular day session is foggy, at best: Strength or weakness implied by the futures may play out in the opening minutes (or seconds) of the regular session, or not at all. Are there any useful patterns between the overnight session and the day session? Rather than simply observing whether the futures are up or down immediately before the day session, lets analyze how the night session responds to exceptional strength in the preceding day session, and whether the night sessions subsequent behavior has any predictive value for the following day session. To get started, lets define the overnight and regular trading sessions.
Night and day

The E-Mini S&P 500 trading session begins at 3:30 p.m. CT for one hour, at which point the Globex electronic market closes for its daily 30-minute maintenance period. At 5:00 p.m. trading resumes and the market officially closes the next day at 3:15 p.m. For the purposes of this analysis (and in keeping with common trader practice), the day session open is 8:30 a.m. CT, which matches the beginning of the regular trading day
Strong day and night sessions tend to precede further bullish price action.
Source: CQG Integrated Client
FIGURE 2: NIGHT REVERSAL EXAMPLE

for stocks as well as pit-traded futures. The day sessions close is 3:15 p.m., 15 minutes after the close of the NYSE and the Nasdaq. Accordingly, the night session encompasses all trading between 3:30 p.m. CT and 8:29 a.m. the next day. The study compares the day and night sessions from Feb. 1, 2007 to Jan. 31, 2008.
Strength and weakness patterns

Now we need to classify the behavior in the different trading sessions as strong or weak. Our goal is to characterize the markets behavior in the day session and in the night session, and determine if the relationships between these two sessions indicate anything about the next day sessions performance. Here are the rules for day sessions: 1. Large day sessions: If the day sessions range exceeds the average range of the most recent five day-sessions ranges, the range is considered large. 2. Up close vs. down close: If the large sessions close is in the upper third of its range, the session is considered an up session. If the close is in the bottom third of the large sessions range, the session is considered to be a down session.
Large up-closing day sessions followed by down-closing night sessions were often followed by selling the next day.
Source: CQG Integrated Client
Next, well check whether the night session closes strongly or weakly: 1. If the night sessions close is in the upper third of its range, it is considered an up session. 2. If the night sessions close is in the lower third of its range, it is considered a down session. 3. If the night sessions close is in the middle third of the range, the session is considered neutral.
Notice this is not a comparison of how the night session closed relative to the previous day session, but a measure of where the night session closed (at 8:29 a.m.) within its own range. The large day session and strong- or weak-closing day session definitions were chosen because these moves usually occur in reaction to news. The research then sought to determine when the subsequent night session perpetuated or reversed the momentum of these sessions. For example, after a large up-closing day session, did the night session follow suit by closing in the upper third of its range, or did it switch gears and close in the bottom third of its range? First, the study measured the result after large up-closing day sessions were followed by up-closing night sessions: the net (close-to-close) change for the next day session was calculated (i.e., the change from the previous days 3:15 p.m. close to the current days 3:15 p.m. close).
continued on p. 1 1
10
Trading Strategies continued
TABLE 1: DAY AND NIGHT SESSION CLOSE IN SAME DIRECTION

6/8 Large up-closing day + up-closing night Average 8.44 Median 7.125 Max. 25.50 Min. -2.00
E-Mini S&P traded after these different scenarios.
Test results
The first column in each half of Table 1 3/6 Large down-closing day + down-closing night contains a ratio. The denominator is the Average Median Max. Min. number of times the condition occurred, -1.71 -3.375 29.00 27.50 while the numerator is the number of times the subsequent day session closed While rare, instances of both the day and the night sessions closing boded well in the same direction as the previous day for the next days trading. However, a weak day session followed by a weak session. For example, the top half of Table night session resulted in ambivalent (but slightly negative) price action. 1 shows there were eight large up-closing day sessions that were followed by upTABLE 3: NIGHT SESSION REVERSALS closing night sessions, and the next day session closed up six times after these 5/17 Large up-closing day + down-closing night events (Figure 1). The average and mediAverage Median Max. Min. an close-to-close gains were 8.44 and -4.5 -3.5 32.25 -39.25 7.125 points, respectively, with a maximum gain of 25.50 points a worst loss of 2/14 Large down-closing day + up-closing night -2.00 points. Average Median Max. Min. Even rarer were combinations of large 8.69 8.625 27.25 -14 down-closing day sessions followed by The largest and most reliable moves followed night sessions that reversed the down-closing night sessions (bottom half momentum of the preceding day sessions especially when a large downof Table 1). This occurred just six times, closing day was reversed by an up-closing night. and the subsequent day sessions were split 50-50 between gains and losses. The TABLE 2: NEUTRAL NIGHT SESSION CLOSES average and the median close-to-close 7/14 Large up-closing day + neutral-closing night changes of -1.71 and -3.75 points, howAverage Median Max. Min. ever, indicate a slight negative bias. 0.0536 0.5 24.75 -19.25 Table 2 shows what the E-Mini S&P did after large up- and down-closing day 5/13 Large down-closing day + neutral-closing night sessions were followed by neutral nightAverage Median Max. Min. session closes (those that closed in the 3.8654 9.5 24.75 -36.25 middle third of the night sessions range). There were more examples for these Neutral night sessions after strong up-closing day sessions did not exhibit much conditions than those in Table 1. When of a connection to the next day sessions trading, but a down-closing day followed by a neutral night session tended to be followed by bullish behavior. large up-closing day sessions were followed by neutral night sessions (top half The next portion of the analysis studied the opposite scenario: of table), the next day session was essentially neutral as well: what happened after large down-closing day sessions that were gains and losses were split 50-50 and the average and median followed by down-closing night sessions. Table 1 details how the moves were both less than one E-Mini S&P point incremen11 www.activetradermag.com May 2008 ACTIVE TRADER
tal gains of 0.0536 and 0.50, respectively. Related reading After the 13 combinations of large Whats the time? down-closing day sessions and neutral Active Trader, August 2003. night sessions, the next day session closed Do markets have intraday price characteristics short-term traders can use to lower only five times an indication that improve their strategies? We crunch some numbers to find out when the market a neutral night session in these circumis moving and when its snoozing. stances means the selling pressure might Note: This article is also contained in the Thom Hartle Trading Strategy and have come to an end. The average and Analysis collection, Vol. 1: 2001-2004, a discounted set of articles packaged in a median close-to-close moves were 3.87 single PDF file. and 9.5 points, which indicates a degree of bullishness. Stock index futures: Numbers you should know The final part of the analysis measured Active Trader, March 2007. Before you design a trading system or place a trade, you need to understand what happened after a large up-closing or how the market youre trading behaves. Arm yourself with stats you can build down-closing day session was reversed by on. a night session that closed in the opposite direction (Table 3). These patterns had Deciphering intraday price action more total examples than the previous Active Trader, June 2007. Reanalyzing the E-Mini S&P 500 with recent price data finds subtle shifts in shortscenarios and also had more interesting term behavior. results. Large up-closing day sessions followed Following through in the S&Ps by down-closing night sessions occurred Active Trader, December 2003. 17 times, and the next day session closed Strong closes and large ranges are often interpreted as signs of potential followhigher only five times meaning the through, but this study unveils another way to find out what todays market action says about tomorrows. (Note: This article is also contained in the collecmarket reversed and closed lower 12 of tion below.) 17 times (70 percent). The average and median close-to-close changes were Stock Index Futures Trading Collection -4.5 and -3.5 points, respectively. Stock index futures traders: Futures on the S&P 500, Nasdaq 100, Russell 2000, The combination of large down-closing Dow Industrials, and other benchmark stock indices are among the most actively traded contracts in the world. This collection of 16 Active Trader articles covers a day sessions reversed by up-closing night variety of techniques for analyzing and trading these instruments. sessions exhibited the strongest tendency of all the scenarios in the analysis (Figure You can purchase and download past articles at 2). The E-Mini S&P closed lower the next www.activetradermag.com/purchase_articles.htm day session only two of 14 times, which means the market reversed the sell-off and sider results statistically valid. Analyzing more data and confirmclosed higher 86 percent of the time. The average and median ing the results of this study would help validate its conclusions. close-to-close moves were gains of 8.69 and 8.625 points, Nonetheless, having these tables available and tracking the respectively. day session and night session comparisons are helpful for any intraday stock index futures trader. Overall, it appears night sesWatch for night reversals The one caveat of this study is the low number of occurrences of sions that reverse a previous strong or weak day session are the most promising signals. each setup. Generally, 30 or more examples are needed to conACTIVE TRADER May 2008 www.activetradermag.com 12
Trading STRATEGIES
System death:
When good systems go bad
A look at two troubled strategies shows how to spot problems in a trading system before losses really pile up.
BY CHRISTIAN SMART, Ph.D.
ot every trade can be a winner, and most traders endure losing streaks at some point. But if your trading system is losing money, how do you know if it is suffering just a brief drawdown or if the system is on its last leg? When a trading approach or system becomes too popular, it often stops working. If, for instance, too many traders use a trend-following approach, which buys (sells) the market after it reaches new highs (lows), the technique will eventually fail at least temporarily. Increased slippage will occur as more traders rush into the market at obvious breakout points, and countertrend traders will begin to exploit trend followers predictable behavior by taking the other side of the trade, and trends will then fade shortly after they develop. But trend-following systems arent dead. In his book The Way of the Turtle (McGraw-Hill, 2007), Curtis Faith describes the system death phenomenon as cyclical, meaning systems live, die, and are reborn depending on market
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conditions, popularity, and other factors. When popular systems suffer an extended period of losses, traders abandon them; but those shunned systems eventually begin working again. Handling drawdowns is difficult, but paying close attention to a systems performance offers clues about whether you
on p. 62.)
Trade rules for simple breakout system

The idea behind breakout systems is price will continue to move in the same direction after it exceeds the highest high or lowest low of the previous N days (or weeks, or minutes, etc.). If, for example, price climbs to a new 60-day high, it may trend even higher, and if price drops to a new 60-day low, it could drop further. The breakout system used here is a simplified version of one traded by the turtles Curtis Faith and other students of Richard Dennis and William Eckhardt in the early 1980s. To catch bigger trends, the strategy enters the market on a longer-term breakout signal (55 days) and exits on a shorter-term signal (21 days): 1. Enter long on a stop when todays high exceeds the highest high of the previous 55 days. 2. Exit long on a stop when todays low is less than the lowest low of the previous 21 days.
When a trading approach or system becomes too popular, it often stops working.
should continue trading or abandon the technique before you lose too much. Dissecting the performance of two simple trend-following strategies uncovers some early warning signs of system death. (For more details about the following systems, see Key concepts
3. Enter short on a stop when todays low drops below the lowest low of the previous 55 days. 4. Exit short on a stop when todays low is higher than the highest high of the previous 21 days. Money management: The system uses fixed-fractional position sizing, risking 0.5 percent of recent volatility as defined by the 15-day exponential moving average (EMA) of a markets average true range (ATR) on each trade. To calculate position size, use the following formula: Position size = (CE*%V) / (MV*PV) where, CE = current account equity %V = percent volatility (percentage of current account equity to risk per trade) MV = market volatility (15-day EMA of ATR) PV = point value Suppose the Nikkei 225 index futures (NK) 15-day ATR is 250 and the account size is $1,500,000: Current account equity (CE) = $1,500,000 Percent volatility (%V) = 0.5% Market volatility (MV) = 250 Position size (number of contracts) = (1,500,000 * 0.005) / (250 * 5) = 6 contracts. Figure 1 shows a long trade example in eurocurrency futures (EC) in November 2006. Price broke above the previous 55-day high on Nov. 21, 2006
FIGURE 1: UPSIDE BREAKOUT IN THE EURO
The breakout system bought the euro after it rose to a new 55-day high on Nov. 21, 2006 and exited with a small loss six weeks later.
and the system went long the next day. Six weeks later later the euro fell to a 21day low on Jan. 5, 2007 and the system exited with a slight loss. The system was tested from Jan. 1, 1986 to Dec. 31, 2007 on a diversified portfolio of 12 futures markets: British pound (BP), cotton (CT), gold (GC), copper (HG), Japanese yen (JY), natural gas (NG), Nikkei 225 (NK), gasoline (RB), sugar (SB), soybeans (S), 10-year T-notes (TY), and 30-year T-bonds (US). Each trade deducted $75 for slippage and commissions.
System death: Quick or slow and painful?

Table 1 lists the 55-21 breakout systems back-test results from 1986 to 2007. Like most trend-following systems, it has a low win/loss ratio of 26 percent that is offset by a large ratio of average winners to losers (2.99). The system gained an average 10 percent per year from 1986 to 2004. By that point, however, trend-following systems
had grown in popularity, and their effectiveness began to wane. Figure 2 (p. 16) shows the breakout strategys equity and drawdown curves. In 2004 it lost 26 percent and reached a new maximum drawdown of 37 percent, exceeding its previous maximum drawdown of nearly 40 percent in 2000. Lets assume a system dies when it reaches a new yearly maximum drawdown twice as large as any previous year. By any definition, however, the system suffered a quick death in 2004 with this 12-contract portfolio. But remember: Performance tends to be cyclical, and systems can be resurrected after profitability improves.
Warning signs
There were warning signs prior to the breakout systems swift, yet temporary, demise in 2004. Figure 3 (p. 17) plots the strategys annual returns, which trended downward and fell below zero in 2002 a red flag.
continued on p. 15
14
TABLE 1: BREAKOUT SYSTEM PERFORMANCE

Profitability Initial balance: Net profit: Return on investment (ROI): Compound annual ROI: Max drawdown: Longest drawdown (in years): MAR ratio: Sharpe ratio: Return retracement ratio: Sterling ratio: Std. dev. of daily percentage returns: Value at risk: Expectation: Kelly: Sum of up % / sum of down %: Percent new highs: $1,500,000 $4,170,514 278.03% 6.22% 58.72% 6.28 0.11 0.23 0.20 0.34 1.42% 3.51% 7.78% 0.01 1.07 2.66% Trade statistics No. trades: Number of wins: Number of losses: Win/loss: Long wins: Long losses: Short wins: Short losses: Avg. $ win to avg. $ loss: Max. consecutive wins: Max. consecutive losses: Days winning: Days losing: Avg. days in winning trade: Avg. days in losing trade: 4,165 1,087 3,078 26.1% 583 1,543 504 1,535 2.99 6 31 2,802 1,767 29 5
Although the system made money overall since 1986, it suffered a maximum drawdown of 59 percent in 2005, which no one would tolerate.
Source: Mechanica (www.mechanicasoftware.com)
Legend:
Net profit: Profit at end of test period, less commission. Return on investment (ROI): Net profit divided by initial capital. Compound annual ROI: Compounded annual growth rate. Max drawndown: Largest percentage decline in equity. Longest drawdown (in years): Longest period the system is between two equity highs. MAR ratio: Annual return divided by largest drawdown. Sharpe ratio: Average return divided by standard deviation of returns (annualized). Return retracement ratio: Compounded annual growth rate divided by an average maximum daily retracement from a prior equity peak or subsequent low. Sterling ratio: Compounded annual growth rate divided by the average maximum drawdown, less 10 percent. Std. dev. of daily percentage returns: Standard deviation of systems percentage gain or loss on each day. Value at risk: A measure of estimated losses over a specific time period. Expectation: Winning percentage multiplied by average winner minus losing percentage multiplied by average loser.
Kelly: Percent of trading capital that should be risked on each trade to maximize total returns with a fixed-fractional money management strategy. Sum of up % / sum of down %: The percentage return of all winning days divided by the total percentage return of all losing days. Percent new highs: Percentage of days on which a new equity high is made. No. trades: Number of trades generated by the system. Number of wins: Number of winning trades. Number of losses: Number of losing trades. Win/loss: The percentage of trades that were profitable. Long wins: Number of profitable long trades. Long losses: Number of unprofitable long trades. Short wins: Number of profitable short trades. Short losses: Number of unprofitable short trades. Avg. $ win to avg. $ loss: Average winner divided by average loser. Max. consecutive wins: The maximum number of consecutive winning trades. Max. consecutive losses: The maximum number of consecutive losing trades. Days winning: Number of days in which ROI is positive. Days losing: Number of days in which ROI is negative. Avg. days in winning trade: The average holding time for winning trades. Avg. days in losing trade: The average holding time for losing trades.
Studying the systems monthly performance is even more illuminating (as shown in Figure 4). In March 2003, the system lost 20 percent, dropping almost twice as much as in any previous month. This plunge preceded a string of 12 losing
15
months March 2005 to February 2005 and could have acted as an early warning signal to avoid the system, at least temporarily. Had you spotted this weak performance, you might have avoided drawdowns
of 37 percent in 2004 and 55 percent in 2005. Finally, contrarians may have noticed how popular trend-following had become in 2004 Michael Covels book Trend Following was published amid a great deal
Mechanica Software code

55-21 breakout system SYSTEM = 1 COL1 = HIGH[55] COL2 = LOW[21] COL3 = LOW[55] COL4 = HIGH[21] COL5 = CLOSE COL6 = ATR[1] COL7 = EMA[COL6,15] SIZING[1] = POINTVALUE * COL7 'Entry Code IF CLOSE[1] > COL1[1] THEN BUYOPEN IF CLOSE[1] < COL3[1] THEN SELLOPEN 'Exit Code IF LONG > 0 THEN SELLSTOP = COL2[1] IF SHORT > 0 THEN BUYSTOP = COL4[1] 80-20 MA crossover system (SYSTEM = 2: short code) SYSTEM = 2 COL1 = CLOSE COL2 = EMA[COL1,20] COL3 = EMA[COL1,80] COL6 = ATR[1] COL7 = EMA[COL6,15] SIZING[1] = POINTVALUE * COL7 'Entry Code IF COL2[1] > COL3[1] THEN BUYOPEN 'Exit Code IF LONG > 0 AND DAYSINTRADE = 1 THEN MEMORY[1] = COL2[1] - 4 * COL7[1] IF LONG > 0 AND DAYSINTRADE > 1 THEN SELLSTOP = MEMORY[1] IF LONG > 0 AND COL2[1] < COL3[1] THEN SELLOPEN (SYSTEM = 1: long code) SYSTEM = 1 COL1 = CLOSE COL2 = EMA[COL1,20] COL3 = EMA[COL1,80] COL6 = ATR[1] COL7 = EMA[COL6,15] SIZING[1] = POINTVALUE * COL7 'Entry Code IF COL2[1] < COL3[1] THEN SELLOPEN 'Exit Code IF SHORT > 0 AND DAYSINTRADE = 1 THEN MEMORY[1] = COL2[1] + 4 * COL7[1] IF SHORT > 0 AND DAYSINTRADE > 1 THEN BUYSTOP = MEMORY[1] IF SHORT > 0 AND COL2[1] > COL3[1] THEN BUYOPEN Money management code (both systems) STARTDATE = 19860101 STARTUPCASH = 1500000 NEWCONTRACTS = (.005 * TOTALEQUITY) / SIZING[1]
You can copy this code at www.activetradermag.com/code.htm
FIGURE 2: BREAKOUT SYSTEM EQUITY AND DRAWDOWN CURVES
of press coverage. When any particular method becomes popular enough to be the subject of an entire book, it is probably wise to avoid that technique for a while. In late 2005, performance improved; the strategy gained 3.5 percent in both 2005 and 2006 and climbed another 12 percent in 2007. While not spectacular, these modest returns may signal the renewed effectiveness of breakout techniques. Although drawdowns were still relatively large compared to previous periods, they were decreasing, another good sign.
continued on p. 17
In 2004 this breakout system lost 26 percent, reaching a new maximum drawdown of 37 percent. The strategys decline exceeded its previous maximum drawdown of nearly 40 percent in 2000.
16
FIGURE 3: ANNUAL RETURNS

market. Conversely, the system sells short when the short-term MA crosses below the longer-term one, because price is falling. In this example, a 20-day SMA represents the short-term moving average, and an 80-day SMA represents the long-term one. Trade rules: 1. Enter long and exit short at the next days open when the 20-day moving average of closing prices rises above its 80-day moving average. 2. Exit long and enter short at the next days open when the 20-day moving average of closing prices drops below its 80-day moving average. This stop-and-reverse (SAR) system is always in the market as it goes long after closing short trades and sells short after exiting long trades. Table 2 (p. 18) shows the crossover systems performance from 1986 to 2007, using the same futures portfolio used in the simple breakout system. This system has compounded annual gains of 13.96 percent, meaning it was more than twice as profitable as the breakout system. But the MA crossover system is always in the market, so it is exposed to more risk than the breakout approach. Figure 5 shows the MA crossover systems equity and drawdown curves. For years, the strategy performed well until it had two consecutive losing years in 2003 and 2004, falling 15 and 18 percent, respectively. That drawdown grew to 60 percent in 2005. Its clear the system began to fail in 2003, and it bottomed out in 2005. This MA crossover system died for the same reason the breakout system did:
The breakout systems annual performance fell below the zero line in 2002 a red flag.
FIGURE 4: MONTHLY RETURNS
In March 2003, the system lost 20 percent, dropping almost twice as much as in any previous month a warning signal to avoid the system, at least temporarily.
In 2007, for example, the maximum drawdown was less than 20 percent, about half of its maximum drawdown in 2004.
Moving average crossover system

Another trend-following example is a moving average (MA) crossover system
17
that tracks two simple moving averages (SMA) with different lengths. A shorterterm moving average responds faster to price changes than a longer-term MA. When a short-term moving average crosses above its longer-term equivalent, price is rising, so the system buys the
Both strategies are trend followers. Again, however, warning signs emerged before performance took a nose dive in 2003. Had you examined the crossover systems quarterly returns, you would have found a striking anomaly (see Figure 6). Prior to 2001, the strategy posted eight quarterly losses of more than 10 percent from 1986 to 2000. But in each case, a large quarterly loss was followed by either a gain or a smaller loss in the next quarter. In Q4 2001, the MA crossover system lost 11 percent, followed by a 16.5-percent loss in the next quarter an unprecedented drop at the time. And this volatility spike preceded even larger losses. Although the strategy recovered to reach new equity highs in early 2003, it
continued on p. 19
FIGURE 5: CROSSOVER SYSTEM EQUITY AND DRAWDOWN CURVES
The MA crossover strategy performed well until it had two consecutive losing years in 2003 and 2004, falling 15 and 18 percent, respectively. But it recovered to hit new equity highs in 2006 and gained nearly 60 percent that year.
TABLE 2: DUAL MA CROSSOVER SYSTEM PERFORMANCE

Profitability Initial balance: Net profit: Return on investment (ROI): Compound annual ROI: Max drawdown: Longest drawdown (in years): MAR ratio: Sharpe ratio: Return retracement ratio: Sterling ratio: Std. dev. of daily percentage returns: Value at risk: Expectation: Kelly: Sum of up % / sum of down %: Percent new highs: $1,500,000 $26,801,140 1,686.74% 13.96% 59.76% 3.19 0.23 0.50 0.64 1.09 1.62% 4.22% 19.38% 0.06 1.11 4.49% Trade statistics No. trades: Number of wins: Number of losses: Win/loss: Long wins: Long losses: Short wins: Short losses: Avg. $ win to avg. $ loss: Max. consecutive wins: Max. consecutive losses: Days winning: Days losing: Avg. days in winning trade: Avg. days in losing trade: 922 272 650 29.50% 153 309 119 341 3 10 20 2,921 2,648 157 30
The crossover strategy beat the breakout approach (Table 1) with a 13.96-percent compound annual ROI. But it also had a crippling 60-percent drawdown in 2005.
18
lost 33 percent in Q2 2004. This equity decline could have acted as a signal to avoid the system. Figure 5s equity curve shows the crossover system rebounded to reach new equity highs in 2006 and gained nearly 60 percent that year.
FIGURE 6: QUARTERLY RETURNS
Life after death?

It pays to study a systems equity curve, because strategies tend to die after sudden and unprecedented drops in equity. If your strategys performance drops quickly and sharply, you should probably stop trading it, especially if those losses are unusually large. Also, pay attention to what strategies people are trading by monitoring blogs and message boards. The more popular a system is, the greater the odds it will fail. The good news: Dead systems often show new signs of life after they become
The MA crossover system lost 11 percent in Q4 2001, followed by a 16.5-percent loss in the next quarter. This equity decline could have acted as a signal to stop trading the system.
unprofitable and lose popularity. Both systems discussed here started to work again recently. But dont try to time this cycle too closely. Instead, wait for a
system to start winning again before trading it.

For information on the author see p. 4.
Related reading
By Christian Smart: Controlling risk in a breakout system Active Trader, March 2008. Back testing trade strategies without sizing your positions correctly can produce misleading results. This study of two related breakout systems tells the tale. Filtering Bollinger Band breakouts Active Trader, December 2007. Does volatility make or break your strategy? Avoiding choppy market conditions strengthens this system. Other articles: Trend strength indicator Active Trader, August 2005. This system expands and modifies basic moving average concepts that a market is in an uptrend when price is above a moving average (the magnitude of the trend being dependent on the length of the moving average), and the farther price is above the average, the stronger the momentum. Short-term WMA crossover system Active Trader, May 2004. These buy and sell signals are based on crossovers of two weighted moving averages (WMA), which react more quickly to price moves than a simple moving average (SMA). Moving average crossover Active Trader, July 2002. This system goes long when a short-term and long-term moving average intersect. Building a better trend indicator Active Trader, May 2001. How accurately are you defining the trend for your shortterm trading? Heres an alternative to traditional moving average techniques that will let you know when the market is in buy mode or sell mode. Breakout trading technique article collections (basic and advanced): The Basic breakout trading technique collection features 12 articles that explain and illustrate basic breakout concepts, including breakout trading strategies based on chart analysis and simple breakout-channel calculations. The techniques cover time frames from intraday to multi-week. The Advanced collection includes 10 articles that explain different trading systems, strategies, and concepts based on breakout trading. Also, there are special Trading System Labs that illustrate trailing stop and walk-forward testing techniques for breakout systems.
You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
19
Advanced STRATEGIES
TIPS, treasuries, and insurance

Traders and investors who buy TIPS thinking theyre getting protection against inflation may be disappointed by a comparison to regular treasuries.
BY HOWARD L. SIMONS
raders are bettors at heart, so lets make a collective bet right now: Very few traders see themselves as being in the insurance business. This is no doubt a matter of self-perception as the insurance industry is seen as dull and bureaucratic, while many traders view Animal House as the highest achievement of American cinema. The sentiment is reciprocated as well. Insurance mogul Warren Buffett takes potshots at derivatives wherever and whenever he can, even though his businesses are nothing but a giant derivative trade. But many of the concepts of trading options trading, especially are explained best in insurance terms. You pay a premium to insure against an event and you either forfeit that premium or collect if the event occurs. The concept extends to futures markets, too. A hedger who sells forward in a backwardated market or who buys forward in a carry market is exchanging a known loss against the risk of an even greater loss if he remains unhedged.
Protected Securities (TIPS) involves insurance against unexpected increases in inflation. The principal on TIPS increases (after a lag) along with the all-urban consumer price index, not seasonally adjust-
ed (CPI-U). Certain economists and many investors have become enamored with TIPS for two separate and disparate reasons. Economists like to think the difference in yield between conventional
FIGURE 1: TIPS BREAKEVEN RATES IGNORE REPORTED INFLATION
TIPS and inflation insurance

The market for Treasury Inflation20
Comparing TIPS breakeven rates and the year-over-year change in the CPI-U (lagged two months) reveals the TIPS market has no predictive relationship to reported inflation.
FIGURE 2: TIPS UNDERPERFORMED AS BREAKEVEN RATES FELL

treasuries and TIPS the so-called breakeven rate of inflation is rich with information on the course of inflation. Investors like to think TIPS will protect them from the ravages of inflation. Both are wrong. Lets take a look at the relationship between TIPS breakevens and the yearover-year change in the CPI-U, lagged two months; this is the best statistical fit between the two series. Stare at Figure 1 and search for how well the TIPS market predicts reported inflation. The proper conclusion is it does not. What about protecting investors against inflation? Lets assume, for the sake of argument, whoever is selling TIPS to you is not a complete fool. Their expectations of inflation are going to be the same as the markets, plus or minus a margin of error. How could they be otherwise, unless we assume TIPS sellers are endowed with superhuman forecasting abilities that the rest of us are denied? This implies TIPS should be priced against future inflation in an actuarially fair manner, similar to how other insurance rates are set. If this is the case, TIPS can provide protection only against unexpected inflation i.e., that quantity in excess of the markets expectations at the time. This implies properly priced TIPS should return no more than treasuries over time unless TIPS sellers underpriced the risk of future inflation. Figure 2 compares the total return of a Vanguard TIPS-based mutual fund to the Merrill Lynch index of 10- to 15-year treasuries, both re-indexed to June 2000. The two series matched each other closely until the Federal Reserve abandoned its rate-hike campaign in August 2006 (green vertical line). The implication here is investors began overpaying for inflation protection at that point.
continued on p. 22
The total return of a TIPS-based mutual fund and the Merrill Lynch index of 10- to 15-year treasuries tracked each other closely until the Federal Reserve abandoned its rate-hike campaign in August 2006, implying investors began overpaying for inflation protection at that point.
FIGURE 3: TIPS AND NOMINAL TREASURY RETURNS AS A FUNCTION OF U.S. EQUITY RETURNS
There is significant evidence treasury yields fall faster than TIPS yields, with no change in inflation expectations.
21
Advanced Strategies continued
FIGURE 4: COMPARING REAL AND NOMINAL 10-YEAR HISTORIC VOLATILITY
Treasuries and crisis insurance

However, what if TIPS breakevens were not solely the result of inflation expectations, but were distorted by swings in treasury yields? We are all familiar with the flight-to-quality phenomenon the rush into T-bonds for safety whenever the stock market does a face-plant on the pavement. If investors flee into conventional treasuries and do not flee at an equal pace into TIPS (why should they?), then treasury yields would fall faster than TIPS yields and the breakeven rate would fall with no change in inflation expectations required. There is substantial evidence this occurs (Figure 3). Mapping the daily percentage changes of TIPS and treasury yields going back to February 1997 against the daily return on the broadbased Russell 3000 index shows the regression beta for treasuries is significantly lower than it is for TIPS (-0.0912 as opposed to -0.0507). Moreover, while the variance of treasury returns relative to TIPS returns is much larger when stocks rally, it is even larger when stocks falter. The flight-to-quality observed for treasuries does not exist in TIPS even though the two securities both bear the full faith and credit of the U.S. Treasury. There are three reasons for this. First, when stocks decline, inflation expectations can diminish. Second, the short call option on government honesty embedded in TIPS you are at the mercy of the government telling you what their increased obligation to pay more as the result of higher inflation is can increase and diminish the prospective return on TIPS. Third, because TIPS are taxed on their inflationaccrued principal much in the same way zero-coupon bonds are taxed on phantom income, the embedded short call
continued on p. 23
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Before February 2003, TIPS volatility was often less than treasury volatility. Once the Fed abandoned its inflation-fighting campaign and began flooding the markets with liquidity, the volatility situation reversed and TIPS volatility moved above treasury volatility after September 2007.
FIGURE 5: THE EMBEDDED CALL OPTION IN NOMINAL TREASURIES
The distribution of large positive returns for T-notes dwarfs that of TIPS. The price jumps that tend to occur on days with bad economic news or stock market declines have no counterpart in TIPS prices.
Advanced Strategies continued
option on that element of TIPS payoff function can increase and diminish the prospective return on TIPS. If we view T-bonds as insurance against a financial disaster such as the 2007 credit crunch, the comparison starts to come clearly into view. The impulse to buy insurance against an immediate loss of current investments is more powerful than the impulse to buy insurance against the CPI-U over a forward 10-year averaging period, is it not?
Deceiver on two grounds. The first is they let down economists who thought the derived breakeven rate gave them a free lunch a perfect and frictionless window into inflation expectations. The second is they let down investors who thought the principal accrual gave them a free lunch protection against inflation with no concomitant reduction in return.
Will any of this change TIPS popularity with either group? Not a chance. Those who sell the promise of a free lunch can stay in business for years. Maybe we should talk about Social Security and company-paid medical insurance next.
Insurance and volatility

We can compare these relative impulses by comparing the realized volatility of TIPS and treasuries. Prior to February 2003, TIPS volatility often was less than treasury volatility (Figure 4). The two measures converged but the deviations often were for TIPS volatility to be less than treasury volatility, especially during stock market downturns. The February 2003-July 2007 period was characterized by generally declining breakevens. Once the Federal Reserve abandoned its inflation-fighting campaign in favor of flooding the markets with liquidity in response to the credit crunch, the volatility situation reversed. Demand for inflation protection surged, and TIPS volatility moved above treasury volatility after September 2007. A second way of looking at the relative insurance demands of TIPS and treasuries is to map the distribution of their returns (Figure 5). The distribution of large positive returns for T-notes is much higher than expected and dwarfs that of TIPS. These price jumps tend to occur on days with bad economic news or stock market declines; there are no corresponding surges in TIPS prices.
Related reading
Other Howard Simons articles:
Gold: Sound and fury, signifying nothing Active Trader, April 2008. Gold has burst to new highs as the U.S. stock market and dollar have tanked, but dont believe the easy explanations about the yellow metals role as an inflation barometer or hedge. Had enough of the dollar and stuff? Active Trader, March 2008. Analysis shows the relationship between the dollar and commodity prices isnt what most people think. Oil prices and global petroleum inventories Active Trader, February 2008. Is an oil shock and even higher prices a real possibility? Bonds and the first rule of trading Active Trader, January 2008. Where do we stand after a 25-year bond bull market? Get ready to adjust your T-bond and T-note strategies. Howard Simons: Advanced Currency Concepts, Vol. 1 A discounted collection that includes many of the articles listed here.
A tip on TIPS
So there we have it: TIPS are the Great
23
You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
TRADING System Lab
The 4-percent model

FIGURE 1: SAMPLE TRADE
BY VOLKER KNAPP
Market: Stocks. System concept: The 4-percent model is a mechanical trend-following approach developed by Ned Davis and popularized in Martin Zweigs book Winning on Wall Street. It is based on weekly percent changes in the Value Line Composite index, also known as the Value Line Geometric index (VLG). The model goes long when the market makes a 4-percent up move (on the assumption this indicates an uptrend and price will continue to
The system typically has long holding periods. In this case, a long trade that opened in January 2005 was still open more than a year later.
Source: Wealth-Lab Pro 5.0
rally) and gets out (or sells short) during downtrends. The system tested uses the Value Line Arithmetic index (VLA) which, like the VLG, equally weights every stock in the Value Line Investment Survey 1,700 stocks across a broad spectrum of capitalizations and industries. The VLA is constructed by calculating the ratio of each stocks closing price to its previous close e.g., if todays price is 52.64 and yesterdays price was 51.22, the ratio would be 1.03 (52.64/51.22). All the ratios are summed and then divided by the total number of stocks in the index. (For more information about the VLG and VLA go to www.valueline.com/news/vlv070406ut.html.) The most notable aspect of this technique is its simplicity; there is nothing to calculate except the weekly close of the VLA. The system generates a buy signal when the index rises at least
24
4 percent from the previous weeks value, and does the opposite when the index drops 4 percent. This method is comparable to the Donchian four-week breakout rule, which goes long when price exceeds the highest high of the past four weeks and goes short when price drops below the lowest low of the past four weeks. The essential goal of both models is to avoid trading insignificant market swings while staying on the right side of the dominant market trend. This system takes long trades and stays out of the market during downtrends. Figure 1 shows a typical trade. Strategy rules: 1. When the VLA rises 4 percent or more from the previous weeks close, go long at the market
FIGURE 2: EQUITY CURVE
on the next bar. 2. When the VLA falls 4 percent or more from the previous weeks close, exit tomorrow at market. Money management: Allocate 10 percent of equity per position. Because it would be impossible to take a 10-percent position in all 17 stocks in the portfolio whenever a buy signal is generated, trades are prioritized by lowest price (i.e., positions are established in lower-priced stocks first) to capture as many opportunities as possible. Starting equity: $100,000. Deduct $8 commission and 0.10 percent slippage per trade. Test data: The system was tested on the Active Trader Standard Stock Portfolio, which contains the following 17 stocks: Apple Inc. (AAPL), Boeing (BA), Citigroup (C), Caterpillar (CAT), Cisco Systems (CSCO), Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), International Business Machines (IBM), Intel (INTC), International Paper (IP), J.P. Morgan Chase (JPM), Coca Cola company (KO), Microsoft (MSFT), Starbucks (SBUX), AT&T (T), and Wal-Mart (WMT). Data source: Fidelity (www.fidelity.com). Test period: February 1998 to January 2008.
continued on p. 26
The system outperformed buy-and-hold for the majority of the test period.
FIGURE 3: DRAWDOWNS
The biggest drawdown occurred in 2002 in the depths of the post-2000 bear market. None of the other drawdowns exceeded 30 percent (top). Aside from a nearly two-year stretch that ended in 2001, the time between new equity highs was not excessive for a trend-following system (bottom).
25
Trading System Lab continued
STRATEGY SUMMARY
Test results: Despite its simplicity, the 4-percent model is a surprisingly robust trend-following strategy. The system outperformed buy-and-hold by a small margin, producing a slightly higher net profit (240.9 percent vs. 233.9 percent), with annualized gains coming nip and tuck as well (13.1 percent vs. 12.8 percent). However, a look at the equity curve (Figure 2) reveals the prolonged depth of the buy-and-hold drawdown in the aftermath of the 2000 market collapse, which took the market almost six years to overcome. The 4-percent system, though, continuously set new equity highs after 2001. Although the systems equity line is quite jagged, its risk is considerably lower than buy-and-holds, with the typical drawdown lasting only six months to a year. The maximum drawdown (which occurred more than five years ago) was less than 25 percent (Figure 3), compared to buy-and-holds devastating 61 percent drawdown. The system made only a handful of trades (98), but the average trade returned a whopping 15.3 percent. A high payoff ratio (the absolute average profit divided by the absolute average loss) of 2.7 and a high profit factor (4.4) are results you would expect from a trend-following system, but a 64.3-percent win rate was quite a surprise. The systems most significant drawback is its excessive exposure; it spent nearly 66 percent of the time in the market. The
Drawdown Max. DD: Longest flat period: -24.45% 544 bars Avg. loss (losers): Avg. hold time (losers): Max consec. win/loss: -10.90% 124.71 10/4
Profitability
Net profit: Net profit: Profit factor: Payoff ratio: Recovery factor: Exposure: Total commission: $240,916.71 240.92% 4.44 2.74 4.83 65.97% $1,568.00
Trade statistics
No. trades: Win/loss: Avg. profit/loss: Avg. holding time (bars): Avg. profit (winners): Avg. hold time (winners): 98 64.29% 15.34% 168.54 29.91% 192.89
PERIODIC RETURNS
Avg. return Monthly 1.14% 3.41% 13.02% Sharpe ratio Best return 0.53 0.48 0.48 15.50% 28.14% 43.61% Worst return -11.15% -14.55% -8.60% % profitable periods 42.50 46.34 54.55 Max consec. Max consec. profitable unprofitable 5 5 2 4 3 1
Quarterly Annually
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 maximum drawdown. Exposure The area of the equity curve exposed to long or short positions, as opposed to cash. Max. DD Largest percentage decline in equity. Longest flat period Longest period, in days, the system is between two equity highs. No. trades Number of trades generated by the system. Win/loss The percentage of trades that were profitable. Avg. profit The average profit for all trades. Avg. hold time The average holding period for all trades. Avg. win The average profit for winning trades. Avg. hold time (winners) The average holding time
for winning trades. Avg. loss The average loss for losing trades. Avg. hold time (losers) The average holding time for losing trades. Max consec. win/loss The maximum number of consecutive winning and losing trades. 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.
26
FIGURE 4: ANNUAL RETURNS

average holding time was around 170 days, equivalent to buying around Christmas and selling just before Labor Day. This sluggishness is most likely a result of the systems rudimentary exit strategy. Equity growth came in stages, and up years alternated with down years (Figure 4). There were six winning years and four losing years and the average annual profit was 13 percent. However, the losses were noticeably smaller.
There were four losing years, but none were consecutive and all were smaller than the smallest winning year.
Bottom line: Despite its simplicity, the systems performance was clearly better than the overall markets (represented by the buy-and-hold approach) in terms of both return and risk. The systems primary drawbacks were its relatively high exposure and occasional tendency to miss some big moves. Generally, a pullback in the index will save the system before
hard times set in, as was the case before the declines of Sept. 11, 2001, late 2002, and 2005. But sometimes the systems logic fails, as it did in late 1999 and last year. Despite an advancing market in 2007, notice how the system sat on its hands throughout 2007; not a single trade was triggered. (On the other hand, the system did not get caught in the January 2008 meltdown.) One possible way to make the system more responsive would be to base the signals on recent troughs or peaks in the index. For example, a buy signal could occur when the VLA rises 4 percent or more from its most recent trough.
FIGURE 5: PROFIT DISTRIBUTION

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
Four stocks AAPL, CSCO, HPQ, and SBUX accounted for the majority of the systems profits.
Source: Reports-Lab
future results; historical testing may not reflect a systems behavior in realtime trading.
27
Active Trader INTERVIEW
Vitaliy Katsenelson: Market skeptic

Are stocks stuck in neutral? This professional investor and author claims the market has fizzled out.
BY DAVID BUKEY
italiy Katsenelson is a portfolio manager, author, and teacher who isnt shy about discussing the problems he sees with stocks today. Price-to-earnings (PE) ratios and profit margins (earnings / sales) are at historically high levels and will likely drop in the near future, which means stocks could trade in a rangebound market for years. The trouble began when the last longterm bull market ended in 2000 as the S&P 500 index traded at 33 times earnings more than twice its 100-year average of 15.2 (on a one-year trailing basis). Although PE ratios have dropped somewhat over the last seven years, Katsenelson thinks they will fall further because stocks are still expensive by historical standards. And when PE ratios slide, stock returns suffer because that decline cancels out any positive effect of earnings growth.
28
Despite his gloomy outlook, Katsenelson is an optimist who believes investors have many opportunities to make money even if the stock market remains volatile. As a professional value investor, Katsenelson searches for undervalued stocks with earnings and dividend growth an approach well-suited for rangebound markets as stocks bounce around, but ultimately go nowhere. Katsenelson, 34, grew up in the Russian city of Murmansk, above the Artic Circle, and emigrated to the U.S. with his family in 1991 after the Cold War ended. His family settled in Denver where he attended the University of Colorado. In college, Katsenelson took a parttime job at Investment Management Associates, building a database for the firm. He then began executing trade orders and became fascinated with stocks.
I was using Bloomberg and taking Finance 101, and it just clicked, he says. After graduating with a bachelors degree in finance, Katsenelson earned an MBA and became a Chartered Financial Analyst (CFA). Katsenelsons recent book Active Value Investing: Making Money in Range-bound Markets (John Wiley and Sons, 2007) digs deep into historical fundamental data to show how high PEs drag down stocks, while low PEs often give them a boost. All of his claims come from analyzing up to 200 years of price and earnings values. Although he has a long-term market outlook, Katsenelsons timing couldnt have been better. He finished Active Value Investing months before the housing bubble popped and the credit market seized up, but its premise has been surprisingly accurate as the S&P 500 has declined 17 percent from its Oct. 11 high (as of March 6).
FIGURE 1: A FALLING PE RATIO KILLS GROWTH
The books first section explains how stocks current dilemma resembles the beginnings of the three previous secular, or long-term, range-bound markets of the past century, each of which lasted 13 to 18 years. The remaining chapters define the tenets of value investing, describe how to customize it for range-bound markets, and illustrate how valuation tools such as discount cash flow (DCF) analysis can help you buy and sell stocks profitably. In the hands of a less-talented writer, these topics might seem dry or tedious, but Katsenelsons enthusiasm is infectious, and his discussions are filled with colorful anecdotes and self-depreciating humor.
including TheStreet.com, MarketWatch.com, and Minyanville.com. In mid-February, Katsenelson spoke with us about whats in store for U.S. stocks and the themes of his book.
AT: Why do you think the U.S. stock market is in a range-bound market right now? VK: First, Im referring to long-term, secular markets more than five years. The long-term cycle has many cyclical periods in it. The last one lasted 16 years (1966-1982) and included five cyclical bull markets, five bear markets, and one rangebound market. In my book, I distinguish between bear and range-bound markets, which is a huge difference. Both start at high valuations, but during long-term bear markets, economic growth remains negative. Its a good bet the U.S economy is resilient, and the market will recover from this cyclical decline. But if you dont think thats true, then its a bear market. If I had to assign probabilities to the type of market we have ahead of us, Id say 2 percent (bull), 20 percent (bear), and 78 percent (range-bound). For a secular bull market to develop, you need average not great economic growth, which is a misconception. Stocks PE ratios also need to expand, but PEs must expand from a low base.
In previous
range-bound markets, high-PE stocks significantly underperformed low-PE stocks.
These days, Katsenelson works as a vice president and partner for the same money-management firm where he started nearly 12 years ago. He also teaches classes on practical equity analysis and portfolio management at the University of Colorado at Denvers Graduate School of Business. In addition, Katsenelson occasionally writes articles for the Financial Times, Barrons, and several Web sites
Wal-Marts price hasnt changed much since 1999 because two factors are working against each other earnings climbed 300 percent, but its PE ratio declined from 44 to 16.
Source: http://contrarianedge.com
AT: So PE ratios are too high? VK: Yes. The return from a stock is derived from two sources price appreciation and dividends. In the long run, however, price appreciation can be explained by earnings growth and PE contraction or expansion. When the stock market moves, that movement can be explained by three factors earnings, PE changes, or a combination of the two. At the end of bull markets, stocks PE ratios are very high. If you assume economic growth remains
continued on p. 30
29
Active Trader Interview continued
constant, then investors are willing to pay more for the same growth. In 1999, for example, Wal-Mart (WMT) traded at 44 times earnings. In the past eight or nine years, WMT hasnt gone anywhere, while earnings have tripled at the same time. Two factors are working against each other earnings climbed 300 percent, but the PE ratio declined from 44 to 16. Wal-Mart didnt go anywhere because its PE contracted. Both forces worked against each other to create a rangebound market (see Figure 1, p. 29).
AT: Is that what you meant when you wrote in Active Value Investing that range-bound markets are brutally toxic to high-PE stocks?
Looking at numbers
without thinking is dangerous.
faster too. You cant really compromise on that one. Next, the balance sheet is extremely important, because you want a financially strong company. The economy is either in recession or on the brink, so in todays environment, accessing capital markets, financing your debt, and borrowing money becomes a privilege.
AT: Has that really changed in the past six months? VK: Exactly. But if Microsoft (MSFT) was founded in 1966, it still would have done well, because it had an incredible growth rate that was sustained for 30 years. It wouldnt have performed as well as it did, though. If you think youve found another company like Microsoft, then buy it. But realize that for every Microsoft, there are a lot of Ataris companies that failed. VK: Yes. During an economic expansion, companies consider access to capital markets as a birthright. If a company needs money, theyll get it. But during economic contractions, banks are more stringent about lending. These days, the ability to borrow money becomes an important competitive advantage in itself. If a company cant borrow money, its value drops. And if you can borrow money, you can probably buy that company for 20 cents on the dollar.
AT: Because earnings were rising and the PE ratio was dropping, price didnt go anywhere? VK: Exactly. If you think Wal-Marts earnings will grow at an average rate, then you need to subtract PE contraction from what WMT earns. Therefore, its stock returns wont be high. In the book, I examined the 1966-82 range-bound market and measured how stocks with different PEs performed. I divided S&P 500 stocks into five quintiles, according to PE. Then I tracked performance of those stocks many times 1966-82, 1968-82, and so on. What happened if you bought high-PE stocks and held them for different periods 16 years, 14 years, 12 years, etc.? High-PE stocks significantly underperformed low-PE stocks. Even if a company grew earnings at an above-average rate, its PE ratio dropped at a much faster rate, which killed the benefits from higher growth.
AT: In your book, you mention three main criteria for a good stock in a range-bound market quality, valuation, and growth. In this environment, its tough to find stocks that meet all three components perfectly. When should you compromise, and how can you find stocks that meet at least two of your guidelines? VK: The first element of a quality stock is a sustainable competitive advantage, which acts as an electric fence around a companys cash flows. And if the company is growing at an above average rate, it also guarantees those cash flows will grow
AT: Am I correct in assuming the problems in the short-term credit markets commercial paper in August 2007 were a big deal? Shortterm debt really is essential to a companys survival, right? VK: Absolutely. Companies that have debt have to make an interest payment every month. But at some point, the debt matures, and they must refinance it. [Commercial paper] matures every 30 days. In good times, refinancing was an automatic process, but not now.
30
When picking stocks, make sure the company has a strong balance sheet and high free cash flow, so they can borrow money in any environment. Or even better select stocks of companies without debt. I love companies with no debt and a lot of cash, because its tough to go bankrupt. Free cash flow is the cash remaining after a company has paid for its ongoing expenses and future growth. Companies can do great things with free cash flow buy back stock, pay dividends, and buy their competitors for pennies on the dollar, if the opportunity arises. However, Microsoft spent billions of dollars investing in companies in different industries such AT&T (T) in the 1980s and 1990s, a stupid move. Also, a company that generates a high return on capital (ROC) has a couple of advantages. First, if it has had a high ROC for years, and you can project into the future, then it probably has a sustainable competitive advantage, which is great. And a high return on capital means earnings growth is cheaper, because the company isnt capital intensive. Finally, it indicates the company has high free cash flow. All those numbers are interrelated.
I love to buy stocks that analysts hate.

promises. Make sure management isnt focusing only on short-term performance and making compromises to please Wall Street. Management should have enough selfconfidence to be honest and acknowledge when they make mistakes. If you dont admit mistakes, then you will probably ignore problems, which will only get worse. Warren Buffet is honest and admits when he makes mistakes, which is why people respect him so much. Look at how much stock management owns. If they own a great deal of stock, their interests are aligned with yours. But if they own a small portion of the company, they could run it into the ground and move on.
(profits/sales) were above average and will likely drop, reverting to their long-term average. Yesterday, I calculated which sectors have those vulnerable higher profit margins energy, materials, industrials, technology, and financials. Therefore, if you own stocks in those sectors, try to normalize their earnings.
AT: How do you normalize earnings? VK: For example, I analyzed American Express (AXP) a couple of weeks ago, which reported 2007 earnings per share (EPS) of $3.38, adjusted for one-time items. To normalize earnings, I noticed credit-card defaults were at an all-time low of 3.3 percent. Going forward, defaults will increase as they revert toward the mean. Instead of 3.3 percent, I used 5 percent, and earnings dropped to $2.60 instead of $3.38. Then, I used earnings of $2.60 to calculate AXPs value. The point is to adjust those earnings for potentially lower profit margins.
AT: It seems there arent any shortcuts. For instance, you shouldnt pick stocks based on just one or two variables, simply by screening for stocks with low PE or price-to-book-value ratios, right? VK: Yes. Looking at numbers without thinking is dangerous. Some stocks trade at low PE ratios for the right reasons. If, for example, you scanned for low PE stocks last year, a lot of home-building and financial stocks would have appeared. But when home builders trade at low PEs, they are expensive, because their earnings are at a cyclical high. I recently wrote an article for Barrons arguing that companies profit margins
AT: In your book, you say investing is often an ambiguous exercise. Will you elaborate on that statement? VK: Lets discuss discounted cash flow analysis, which tries to estimate what a company will earn in the future. Then, you choose a discount interest rate to convert future cash flows into todays money. By definition, thats what a company is worth the core of all fundamental analysis. But you make a lot of assumptions.
continued on p. 32
31
AT: Regarding the three dimensions of a good stock, quality seems to be the most important, but also the most subjective aspect, right? VK: Yes. Its difficult to quantify everything. Especially management, which is probably the most subjective component, but it makes a huge difference. Listen to conference calls and be a skeptic. When management speaks, they make certain
Active Trader Interview continued
FIGURE 2: A CONTRARIAN VIEW OF NOKIA Lets say I crunched the numbers prescription drugs. And their for a result of $10.70, and that stocks declined over a two-month stock trades at $10 today. The period. problem is most analysts would If you examined the news, it claim the company is $0.70 sounded horrible. And if you rely undervalued, but I made so many on headlines to invest, that would assumptions to derive that numhave forced you to sell either ber, you cant be that specific. stock. Instead, the company is fairly valHowever, you need to quantify ued, because if I change the the impact of bad news. Most assumptions slightly, Ill get a difinvestors didnt realize 95 percent ferent value. of transactions at Walgreens were A lot of fundamental-analysis paid by insurance companies. tools act like a shotgun, not a Therefore, WMTs plan didnt sniper rifle. When I value compaaffect CVS or WAG much, because nies, I look for a general value, it only influenced customers who and I have no delusions about a paid for drugs directly five percompanys exact worth. Many cent. If you used common sense, analysts try to calculate exact you would have realized investors numbers, but thats nearly imposoverreacted when they sold CVS sible. Precise numbers can give and Walgreens. In 2004, Nokia looked cheap to Katsenelson investors a false sense of security. Another example is Nokia who thought its loss of U.S. market share was Try to understand whats driv(NOK). In 2003 and 2004, its overblown. Its price tripled within three years. ing the value in each company. stock was beaten down because it Source: eSignal You can calculate discounted cash was losing market share in the flows in about five minutes. You U.S., which had been 15 percent just need to find operating cash of their sales. By 2004, the U.S. AT: Earlier, you mentioned the imporflows, take out capital expenditures, and dropped to just 7 or 8 percent of their tance of being a skeptic when investdetermine the right forecasting period. sales. ing. How can that mindset help The key is to use your own assumpinvestors find good stocks? tions to determine a companys value with AT: You dont want to look too far discounted cash flow analysis. This tool is VK: First, you need to distinguish out, right? handy, because you can plug in lower between a good company and a good assumptions for growth. Even if you stock. A good company meets the quality VK: You can with some companies. For assumed Nokia would grow at a slower and growth dimensions, while a good example, American Express has such a rate, it was still worth more than its stock stock appears when you can buy it at a strong brand name, which creates a price of $12 in 2004. perfect margin of safety (a certain percentstrong competitive advantage. I feel comIf you asked what would happen to age below its fair value, determined by DCF fortable looking 10 years in the future NOKs sales if it lost U.S. market share analysis). AXP will still be in business, making Investors often focus more on the com- completely from 8 percent to zero? more money. But with companies such The answer was it had little impact on pany than its stock, which creates opporas Blockbuster (BBI) or NetFlix (NFLX), NOKs value, because 92 percent of sales tunities. Two years ago, CVS Caremark who knows? came from the rest of the world. (CVS) and Walgreen Co. (WAG) were And since 2004, Nokia has tripled beaten down because Wal-Mart (see Figure 2). announced its plan to introduce generic
32 www.activetradermag.com May 2008 ACTIVE TRADER
AT: How should value investors adapt their approach for rangebound markets by buying stocks below their fair values to increase their margin of safety? VK: Yes. They should also look for high dividend yields and stick to high-quality stocks. They also need to be more proactive sellers.
AT: When you calculate a stocks fair value with discounted cash flow analysis, is that value your sell target? VK: Thats right. Over time, a stocks fair value changes, depending on earnings growth. For example, we bought Microsoft when it traded at $22 in June 2006, and it went up to $28. And we bought more shares recently, because even though price rose, earnings grew more, so now Microsoft is cheaper than when we bought it.
Suppose you know a company is worth $1 in the long run, and it trades at $0.70 today. Many fund managers will dump the stock, because they could lose their jobs before the stock rose to $1. But if you can afford to hold the stock for a couple of years, you can often make money. In the past, I ignored stock analysts reports, but I dont now because Im looking for those time-arbitrage opportunities. These reports have a short-term focus as analysts try to predict what EPS numbers may be reported next quarter. If an analyst doesnt like a stock in the short run, thats great, because I have a longer time horizon. I love to buy stocks that analysts hate.
stocks from which to choose. Although Im not predicting the market, there is a very high probability the markets long-term slope will flatten because of high PEs and profit margins. And if Im wrong, the opportunity cost is low. If a full-blown bull market develops, my strategy should still perform as well as or better than the overall market. If a range-bound market appears, my strategy should beat other ones, and if a bear market emerges, you still own highquality companies that grow earnings and pay dividends. And you bought them with a high margin of safety. Therefore, that strategy should still outperform the market.
AT: You also mention your approach isnt about timing the market, but timing individual stocks. Whats the difference? VK: Its very difficult to systematize the market-timing process. When you time the market, you must identify the event as well as its timing. Also, you must know the market will react to it. Lets assume you predicted the subprime mortgage crisis and its timing the summer of 2007. Thats brilliant, but the market didnt care [because the Dow still jumped 8.5 percent from mid-August to mid-October 2007.] Timing the market is so difficult because of human emotions. And there are so many factors that influence markets. However, you can create a system to time stocks. First, calculate a companys worth and the required margin of safety. If you analyze enough stocks, its just a matter of time until stocks hit your buying price. And you have hundreds of
AT: One of the themes of Active Value Investing is that Wall Street has a short-term outlook. Instead of blaming mutual fund managers, you suggest its just human nature to want instant gratification. VK: Its a cultural issue. Over the years, marketing departments have taken over the mutual fund business it changed from [value] investing to tracking the hottest fund. When mutual fund managers buy a stock, they need it to climb in the shortterm, because they have short-term incentives. This situation creates opportunities that I call time arbitrage.
AT: Your book mentions a couple of Web sites where investors can find ideas such as Joel Greenblats strategy of ranking stocks by low PE ratios and high return on shareholder equity taken from his book The Little Book that Beats the Markets (magicformulainvesting.com). That seems like a quick way to find good stocks. Do you have any other suggestions? VK: Stockticker.com and gurufocus.com are a good source of ideas. These Web sites may point you in the right direction, but theyre no substitute for your own research. For instance, many investors buy stocks that Warren Buffett has bought. If you followed Warren Buffett blindly, you would have done fine, except theres a delay in that information. So, Buffett might have sold [a stock] already, and you think he still likes it. Also, when stocks drop, you really must know why you own it to maintain a rational state of mind.
33
Q& A
Ari Kiev
on trading stress and leadership
Trading coach Ari Kievs two most recent books target trading stress and the challenge of building a successful hedge fund. BY MARK ETZKORN
ou cant accuse Dr. Ari Kiev of resting on his laurels. Having barely had time to enjoy the release of his 2007 book, Mastering Trading Stress: Strategies for Maximizing Performance (Wiley Trading, 2007), the psychotherapist, former Olympic advisor, and trading coach has just seen his sixth trading book, Hedge Fund Leadership: How To Inspire Peak Performance from Traders and Money Managers (Wiley Trading, 2008), hit bookstore shelves. In a recent conversation, Kiev, who was once a consultant to Steve Cohens SAC Capital Management, discussed the impetus for writing Mastering Trading Stress. Ive always dealt a little bit with stress in the various books Ive written over the years, he says. I decided I had enough material about it, including particular case examples showing how people dealt with it and how it impinged upon their trading, that it would be worthwhile to put together a complete book. Kiev, who has dealt with stress management and post-traumatic stress disorder in other areas of his work, sees direct
correlation with the mental challenge of the markets. It seemed to me that people experiencing stress in the markets were experiencing some of the same symptoms as people who had post-traumatic stress disorder, he says. This tended to impact the way they were trading: Their decisions were less thoughtful, more impulsive, and more fearful, and they were often paralyzed. [This comparison was] a useful paradigm to explain what traders go through, and to help them understand this and find a way to work more objectively, rather than overreacting to their own exaggerated interpretations of what was going on in the market. AT: In trading, doesnt everything ultimately revolve around stress and how to deal with it? Are there other stresses aside from the stress of potentially losing money?
dealing with failure or striking out. Also, when youre right, youre only making money on a very small percentage of your trades that is, the bulk of your profitability comes from only 3 to 5 percent of your trades so theres stress in not being as successful as you might like and in managing expectations. Theres stress in terms of dealing in a world of uncertainty, because youre making predictions, taking bets, and handicapping with insufficient information. Youre dealing with a situation in which youre not completely in control and you have to learn to handle that. AT: In the book you talk about personality types. One that jumped out as potentially being problematic in trading was the perfectionist personality. AK: I think if youre a perfectionist, [you may be well suited] to being a good analyst: Youre never satisfied with the data you have, so you keep digging to get a more complete picture and as much understanding as you possibly can. But that desire to have all the information is something you have to let go of if youre going to be a portfolio manager,
AK: There is a range of stresses. Even under ordinary circumstances theres the fact that if youre a really good trader youre probably right only 55 to 60 percent of the time, so theres the stress of
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Successful traders have learned to master their anxieties and use the adrenaline response that occurs when in a highly intense situation to improve their focus and tenacity; they dont let it interfere too much. They know what they need to do to produce certain results and theyre willing to do the necessary work, but theyre not hung up on what the result is.
which is a job in which you have to operate with insufficient information. You have to rely a little bit more on your intuition and ability to see patterns, trends, and how things are [evolving]. Thats a stressful thing its not like being an accountant whos adding up numbers and having the luxury of reviewing them over and over. The most successful traders and portfolio managers have learned to master their anxiety, and they utilize the adrenaline response that occurs when theyre focused and concentrating in a highly intense and competitive situation. They use it to improve their concentration, tenacity, and intensity; they dont let it interfere too much. They have a goal, a target: They know what they need to do to produce certain results and theyre willing to do the necessary work, but theyre not hung up on what the result is. AT: But you also say theres no best
personality for trading.
AK: Ive been involved in selecting people as portfolio managers and have done all kinds of psychological evaluations to try to understand the range of personality characteristics that might make up the ideal performer. Successful traders have a range of personalities. The critical thing is they must be risk takers who are comfortable with uncertainty and have a certain degree of abstract reasoning ability. They have to enjoy trying to piece together the mosaic of information needed to make a good investment, and they need some degree of caution, thoroughness, and coachability. But not everyone has all these things and not everyone has the same mix of them. You can learn to manage your strengths and weaknesses, and you dont necessarily need to have all the ingredients to begin with. Some people who are very cautious become successful portfolio managers, and you also find big risk takers who learn how to balance their risk-taking propensities with risk-management principles that are consistent with good portfolio management. AT: Ultimately your conclusion is that you cant completely eliminate stress, correct? You can only learn to manage it? AK: You cant eliminate it. You really want to learn how to ride with it, not to cover it up. You have to be able to admit youre having difficulty, youre uncertain,
or youve made mistakes; you have to be able to say, This was the bet, and it didnt work, lets cut the position and move on and put our capital and effort into higher-conviction ideas where weve done more work and have a little bit more confidence in the outcome. The natural inclination is to hold on to a loser and rationalize the loss Well, if I like it at $20, I like it even more at $15, and even more at $10. You have to keep evaluating the quality of a trade idea and whether the reason you got into the position is still valid and justifies holding it even when its going against you. AT: How do you draw the line between confidence and arrogance in trading? AK: A confident person is someone who has knowledge about his strengths and weaknesses, has a replicable process that allows him to analyze and invest in a profitable way, and is able to adjust as the data changes. When hes going through a drawdown, hes comfortable paring down [his positions], rather than starting to think catastrophically that things are desperate and he has to swing for the fences. He recognizes there will be fluctuations and black-swan events throughout the year, but hes confident hes survived them in the past and hell survive them again. As a result, he doesnt flail about when things arent working. He prepares, he does more work, he deploys less capital, and he waits for the markets to become more rational before going back in with larger positions. An arrogant person believes his press clippings and is not humble enough to recognize the market is bigger than he is, that its a sign of strength to admit when youre wrong to take your lumps and get ready for recovery when conditions are better. Arrogance is sort of a protective overcontinued on p. 36
35
Q&A continued
confidence designed to cover up feelings of vulnerability and inadequacy, whereas confidence is a quiet understanding that youre ultimately going to prevail if you follow your plan. AT: What are some tactics traders can
use to defuse especially tense or stressful situations?
some other kind of exercise, or by staying away from alcohol and late nights during the week in order to keep themselves physically fit and mentally prepared to deal with the high stress and intensity of trading. AT: Sounds like a healthy body,
healthy mind kind of thing.
AK: First, traders need to recognize there are going to be stressful periods when they lose focus and trade from an emotional perspective rather than objectively. The best thing to do is develop a regular routine say, on a daily basis of meditation, relaxation, visualization, and related techniques that help you become more centered. Yoga is a good example. I worked with one guy who spent 45 minutes every morning doing yoga and, in the course of being in this relaxed meditative state, visualized various scenarios and how he would handle trades depending on what the circumstances were, what data came out, and what moves took place in the market. This allows him to review what hes going do in advance; he has a few scenarios embedded in his thinking and he has developed the ability to get centered and relaxed in the face of stress. You dont develop the ability to do this when youre stressed, you need to learn to do it [through regular practice] you develop the habit, so that during the course of the day as you become tense, flustered, or frustrated, youre able to chill out and take a few minutes to get back into that meditative state in which time slows, your heart rate and breathing slow, youre calmer and able to see the data more clearly, and youre less likely to overreact impulsively, which often gets you into trouble. Preparation and experience in getting relaxed are very useful. Now, some people get to this state of mind by jogging or
36
AK: Absolutely. AT: Can you talk a little bit about the
topic in your other book on leadership qualities in traders?
decisions and challenge points of view. These things take a certain amount of work it doesnt happen automatically. Good portfolio managers and traders who start hedge funds often have very little experience managing other people. It takes a certain amount of coaching, selfawareness, and willingness to interact with people in a more meaningful way than you might have considered necessary than when you were just running a portfolio. AT: Is there an analogy to the very successful hitting coach in baseball who wasnt actually a great hitter himself? Are there people who arent necessarily the greatest individual traders but who have the ability to assemble the right team and teach the right skills? AK: Thats an interesting question. The way it seems to work in most hedge funds is that the guy who sets it up has already been successful at managing a portfolio, but if you interview a variety of hedge-fund leaders, as I did for this book, youll find they come from diverse backgrounds: portfolio managers, analysts, bankers, asset gatherers. Some people are better at managing people, others are better at creating an organization, and others are better at defining the process. Theres no one way it has to be done. The commonality is an awareness of the need to empower people. But people do this in varying degrees. In some places the head guy is very collegial and makes partners out of people; in others its a more authoritarian situation. I think the one generalization would be that, just as I discovered traders trade very differently, to be successful [as a hedge fund manager] you have to figure out what process works for you, develop a methodology and strategy around your strengths, and then recognize when you need additional assets or qualities from other people, who you then
AK: In the course of teaching people about managing stress, I came face to face with what the best hedge-fund and portfolio managers do that differentiates them from those who arent so successful. Besides stress management techniques and a trading-to-win philosophy, they have a goal and reverse engineer their strategy to determine what kind of positions they need to take in terms of the deployment of capital, they have good risk-management statistics so theyre able to evaluate how theyre doing based on their stats and can make adjustments (whether theyre holding losers too long, getting out of winners too soon, or making money in the short-term, intermediate term, or long-term), they identify the most successful patterns in their trading and begin to trade in a more success-oriented way. Its a very labor-intensive process to be successful, but the more you do these things, the [easier it is] to handle trading stress because youve taken out some of the mystery from a game that has a lot of mystery to it. Now, leadership comes into selecting people to be on your team, guiding them, sharing your vision and getting people to buy into it, and aligning incentives so people stay with you more than a couple of years. [The team] really becomes invested because they feel appreciated, and empowered, and theyre able to make
Related reading
Previous Ari Kiev articles and interviews: Entering the trading zone: Q&A with Ari Kiev Active Trader, June 2000. Given his past career as a consultant to Olympic athletes, its not surprising that psychiatrist and trading coach Dr. Ari Kiev draws frequent parallels between success on the athletic field and success in the market.
Q&A: Psyching out risk with Ari Kiev Active Trader, January 2003. In challenging market environments, even seasoned traders can find themselves breaking rules and taking unnecessary risks. Dr. Ari Kiev discusses how to make the best of bad times. Managing losses, by Ari Kiev , Active Trader, March 2001. How a trader manages losses is a key to trading success. Mind over money management, by Ari Kiev , Active Trader, June 2001. The risk door swings both ways: Taking too much risk or not taking enough can sabotage your trading. Learn how to improve your understanding of risk and trade according to the prevailing market conditions. Psychological roadblocks to successful risk management, by Ari Kiev , Active Trader, April 2001. How you handle risk goes a long way in determining whether youll be a profitable trader. Overcoming stress and emotions and having a specific plan are crucial to trading success. The psychology of handling risk, by Ari Kiev , Active Trader, January-February 2001. Effective trading requires the ability to separate emotions from actions. Learning how to analyze your reactions to your trades can help you better respond to the realities of a situation instead of responding to your interpretations.
Note: These articles (except Q&A: Psyching out risk with Ari Kiev) are also part of the Trading Psychology Collection, a discounted set of articles in a single PDF file.
bring into the team. Self-awareness is critical. You have to be able recognize whats needed to win, but not be so arrogant to think youre the only one who can do it. You have to be willing to admit when other people can do certain things better than you, and empower them to take on those functions. Now, thats just managing a portfolio. Managing a hedge fund adds other dimensions: Its managing more people, more money, investors, a back office its managing a company, and you have to make a decision whether to trade and also manage, or get someone else to manage. Different people have different models. You have to be willing to face your strengths and weaknesses, be open, and trust and empower people to get the most out of them. You have to recognize the subtleties regarding what makes for top-notch performance and what motivates people. Everybody has something to contribute. The key is to figure out what someone can contribute naturally. What is it they do instinctively and can be helped to improve upon, rather than trying to get them to change, which only leads to frustration? There are really a lot of parallels with the work Ive done for years in psychotherapy in trying to help people get a better handle on themselves to make a difference in their own lives to have a goal, a step-by-step plan, to be able to tap into their own inner potential so they are self actualized in a greater way than they might be otherwise be. I think all of this is what you find in what you might call transformative leadership, or authentic leadership, where the leader is functioning in terms of what works best for him while recognizing that other people arent necessarily going to be like him. Theyre going to bring something else to the table, and thats the beauty of it all.
Ari Kiev books: Hedge Fund Leadership: How To Inspire Peak Performance from Traders and Money Managers (Wiley Trading, 2008). Mastering Trading Stress: Strategies for Maximizing Performance (Wiley Trading, 2007). Hedge Fund Masters: How Top Hedge Fund Traders Set Goals, Overcome Barriers, and Achieve Peak Performance (Wiley Trading, 2005). The Psychology of Risk: Mastering Market Uncertainty by Ari Kiev and Ken Grant (John Wiley, 2002). Trading in the Zone: Maximizing Performance with Focus and Discipline (John Wiley, 2001). Trading to Win: The Psychology of Mastering the Markets (John Wiley, 1998). You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
37
The Face of TRADING
Trading setup
Hardware: PC with dual 2.0-GHZ processors and 3.25 GB RAM; 22inch flat-panel monitor.
Brushing up profits
BY ACTIVE TRADER STAFF
Name: Steve Reeves Age: 56 Lives and works in: Seattle, Wash.
Software: TradeStation. Internet connection: Cable. Brokerage: On-line direct access, Ameritrade, TradeStation.
I became interested in his on-balance volume (OBV) work and started following his stuff, Reeves says. Reeves was starting his dentistry career, but he began trading stock options on the side. He charted stock prices by hand, including tools such as the advance/decline line, and found he really enjoyed the analysis. Trading has been a good accompaniment to dentistry for him. They are really separate brain functions, Reeves says. One is pretty mechanical, while the other is all thinking and much more emotional. Through the years, Reeves has continued to pursue trading on the side, trying different methodologies and strategies. It has been very humbling, he says. He attended workshops by trader Linda Bradford Raschke during the 1990s, which he found to be helpful. He has also tried mechanical system trading. System trading is not really for me, Reeves says. Over time [a system might] test out, but I just dont like taking big drawdowns. I think some systems are good, but you have to sit through the bad times, and it is hard for me to sit and watch a stock go down. I have a low risk tolerance for large losses I like to sleep at night. Ultimately, Reeves found a method within his comfort zone. He may check the markets in between patients, but he tries not to make decisions during the day. I try to spend an hour after work going
38
n 1980 a childhood friend gave Steve Reeves a copy of Joe Granvilles Granville Market Letter.
through charts and putting orders in, he says. One of the biggest drawbacks is the time trading consumes each day. It soaks up too much time, he says. I can spend a whole day watching, but it is better not to make decisions during the day. Reeves remembers the early days when he created charts by hand and had to wait for the newspaper to get stock prices. You had to wait till the next morning to find out how things were doing, he says. But in some ways, Reeves prefers the old days. Real-time feeds have made it hard, he says. Its really emotional; it gets you because you can see all the squiggles. I guess Im a little addicted to it, he adds. I try to go on vacation and not do anything. But its hard. You can even get information on your phone. Outside of trading: Reeves has been a practicing dentist for nearly 30 years. Trading methodology: Reeves has settled on a swing trading method, incorporating elements he learned from Raschkes trading seminars. He puts on about 10 stock trades per week, focusing on a small group he has followed for years, plus some exchange-traded funds (ETFs). He usually holds positions for about four to six days. He is a 100-percent technical trader and monitors several indicators, including Linda Raschkes 3-10-16 oscillator, volume, Bollinger bands, and the twoday rate-of-change. His trading philosophy is to trade with the trend, buying on pullbacks. He places orders at night and tends to focus on long trades; if he wants to put on a short trade, he typically uses ETFs, such as the Ultrashort S&P 500 Proshares. Reeves
monitors daily charts to make trading decisions and notes that some pullbacks tend to last three to five days, while others last seven to 10 days. Reeves tries to buy the first pullback after a lower low, after it looks like a bottom has been made. In addition to the price pullback, he may act on a signal from the Bollinger Band for example, when price hits the bottom band. With Raschkes 3-10-16 oscillator method, Reeves says a buy trigger occurs in an uptrend when the slow line is moving up and the fast line is moving down. Im looking to buy if its a shallow pullback, he says. Reeves will place a stop at the last swing . low on the daily chart. On the upside, Reeves doesnt use set objectives, but prefers to monitor positions as they develop. I try to take off half my position when I have a decent gain, after three or four up days, he says. Ill take half off and move my stop up to a two-bar daily close. Most important lesson learned: You have to follow your own parameters and your own risk levels. Everyone is different. You have to make your own decisions. Best thing about trading: Being right [and the satisfaction of knowing] I followed my rules and my discipline. When not trading: Reeves works at his dental practice and enjoys photography, hiking, skiing, and golfing. Best trading books/Web sites: Street Smarts by Linda Raschke and Larry Connors and Dow Theory Letters published by Richard Russell. For definitions of the indicators referenced in this article, see Key concepts on p. 62.
ETF Snapshot
Date: March 6
The following table summarizes the trading activity in the most actively traded exchange-traded funds. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each markets liquidity, direction, and levels of momentum and volatility. See the legend for explanations of the different fields.
Market Positive one-year performance

UltraShort Financials*** Brazil United States Oil Fund Gold Gold FTSE/Xinhua China 25 Index Energy Oil Services UltraShort Russell 2000*** Emerging Markets Malaysia Taiwan Hong Kong UltraShort S&P 500*** Materials Mexico Consumer Staples Industrial UltraShort Dow 30***
Symbol
SKF EWZ USO GLD GDX FXI XLE OIH TWM EEM EWM EWT EWH SDS XLB EWW XLP XLI DXD
Sector
Leveraged inverse index Regional Energy Metals Metals Index Energy Energy Leveraged inverse index Emerging Markets Regional Regional Regional Leveraged inverse index Materials Regional Consumer Industrial Leveraged inverse index
Volume
6.55 M 16.31 M 4.08 M 10.83 M 4.83 M 7.51 M 23.44 M 7.91 M 8.82 M 23.13 M 4.57 M 11.78 M 8.14 M 25.19 M 13.94 M 4.36 M 3.27 M 6.80 M 5.64 M
1-year RS rank
81.14% 76.78% 67.41% 50.65% 44.04% 38.93% 32.72% 31.62% 30.42% 20.36% 18.61% 16.08% 12.50% 11.96% 10.75% 9.46% 5.06% 3.70% 0.17%
10-day move/rank
20.10% / 93% -0.77% / 100% 8.48% / 72% 3.80% / 36% 7.86% / 42% -4.92% / 73% 2.42% / 33% 3.00% / 13% 9.85% / 100% -3.10% / 100% -6.77% / 82% 7.04% / 41% -3.15% / 41% 5.98% / 91% 0.95% / 11% -2.97% / 67% -0.37% / 0% -1.77% / 67% 4.37% / 92%
20-day move/rank
24.43% / 84% 12.41% / 56% 21.54% / 100% 8.81% / 67% 16.80% / 94% -1.55% / 11% 12.35% / 91% 13.50% / 97% 8.88% / 34% 3.60% / 32% -7.35% / 100% 18.78% / 94% -4.04% / 28% 3.31% / 19% 6.36% / 56% 1.92% / 26% 1.42% / 26% -0.82% / 16% 2.22% / 11%
60-day move/rank
50.01% / 95% -3.74% / 26% 20.83% / 67% 23.14% / 94% 18.06% / 73% -27.93% / 85% -0.43% / 0% -2.99% / 29% 35.25% / 92% -15.47% / 83% -7.70% / 95% -1.92% / 19% -21.60% / 95% 29.68% / 97% -3.95% / 55% -10.11% / 73% -7.67% / 100% -10.35% / 83% 24.38% / 97%
Volatility ratio/rank
.78 / 97% .44 / 60% .46 / 87% .26 / 53% .53 / 57% .22 / 52% .36 / 12% .29 / 0% .49 / 45% .40 / 78% .72 / 92% .21 / 15% .26 / 43% .44 / 43% .42 / 23% .48 / 55% .32 / 28% .30 / 30% .45 / 45%
Negative one-year performance

S&P Home Building Index XHB Index 9.19 M Financial XLF Financial 122.86 M Dow Jones U.S. Real Estate IYR Real Estate 9.93 M Retail XRT Retail 5.59 M Ultra S&P 500** SSO Leveraged index 7.79 M Russell 2000 Value Index IWN Index 3.10 M Consumer Discretionary XLY Consumer 6.47 M Semiconductor SMH Technology 11.14 M Japan EWJ Regional 25.97 M Ultra Nasdaq 100** QLD Leveraged index 11.19 M Russell 2000 Index IWM Index 89.10 M Retail RTH Retail 9.01 M Russell 2000 Growth Index IWO Index 3.45 M S&P Midcap 400 Index MDY Index 4.68 M S&P 500 Index SPY Index 224.58 M EAFE* EFA Index 13.30 M Technology XLK Technology 3.86 M Health Care XLV Health Care 3.32 M Nasdaq 100 QQQQ Index 163.03 M Dow Jones Industrial Average DIA Index 15.37 M Russell 1000 Growth Index IWF Index 3.86 M Singapore EWS Regional 4.54 M UltraShort Nasdaq 100*** QID Leveraged inverse index 36.31 M Utilities XLU Utilities 6.13 M * Europe, Australasia, and the Far East ** Tracks twice the move of this index.
Legend Vol: 30-day average daily volume, in thousands (unless otherwise indicated). OI: Open interest, in thousands (unless otherwise indicated). 1-year RS rank: 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.
-46.35% -6.95% / 70% -8.63% / 52% -8.94% / 10% -32.17% -8.83% / 88% -11.20% / 80% -22.21% / 96% -30.96% -4.24% / 79% -6.38% / 53% -16.92% / 84% -26.54% -6.37% / 100% -4.53% / 43% -15.68% / 84% -22.17% -5.73% / 92% -3.49% / 10% -28.99% / 98% -21.41% -5.33% / 100% -5.14% / 43% -14.23% / 88% -18.32% -3.43% / 100% -2.25% / 17% -12.75% / 83% -17.83% -1.28% / 29% 1.94% / 50% -14.90% / 72% -17.02% -1.38% / 27% -0.08% / 0% -14.46% / 99% -17.01% -6.82% / 86% -3.84% / 20% -39.98% / 98% -15.36% -4.68% / 100% -4.13% / 45% -15.70% / 94% -11.96% -3.08% / 60% -2.42% / 36% -11.10% / 92% -9.30% -4.72% / 100% -3.96% / 35% -16.88% / 99% -8.02% -3.65% / 100% -2.25% / 38% -13.24% / 93% -6.90% -2.77% / 91% -1.50% / 14% -13.15% / 97% -4.79% -0.34% / 0% 1.66% / 25% -15.58% / 87% -4.26% -2.18% / 43% -1.39% / 14% -18.14% / 93% -3.46% -3.57% / 100% -4.01% / 56% -12.63% / 100% -1.88% -3.10% / 85% -1.49% / 26% -19.42% / 100% -1.78% -1.95% / 92% -1.19% / 8% -11.43% / 96% -1.56% -2.04% / 91% -0.11% / 0% -12.99% / 96% -0.67% -3.96% / 56% 1.28% / 29% -19.31% / 86% -0.41% 7.33% / 92% 2.95% / 17% 49.93% / 100% -0.29% -2.07% / 40% -4.00% / 39% -14.12% / 100% *** Tracks twice the inverse, or opposite, of this index.
.68 / 90% .44 / 90% .35 / 53% .43 / 80% .25 / 38% .42 / 58% .40 / 82% .18 / 40% .32 / 37% .12 / 23% .36 / 45% .59 / 80% .31 / 42% .41 / 38% .33 / 38% .23 / 20% .15 / 20% .41 / 53% .18 / 20% .35 / 42% .29 / 23% .30 / 70% .25 / 30% .39 / 60%
60-day move: The percentage price move from the close 60 days ago to todays close. The Rank fields 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 10day 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-hundred-twenty 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 figures 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 shortterm volatility (10-day standard deviation of prices) divided by the long-term volatility (100day standard deviation of prices). The rank is the percentile rank of the volatility ratio over the past 60 days.
39
STOCKS & FUTURES Snapshot

The following tables summarize the trading activity in the most actively traded stocks and futures contracts. The information does NOT constitute trade signals. It is intended only to provide a brief synopsis of each markets liquidity, direction, and levels of momentum and volatility. Volume figures are for the most-active contract month in a particular market and may not reflect total volume for all contract months. For a more extensive futures snapshot, see Futures & Options Trader magazine (www.futuresandoptionstrader.com).
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, while price activity for CBOT futures is based on the highest-volume contract (pit or electronic).
Stocks snapshot as of March 6
Positive one-year performance

Apple Inc. Exxon Mobil Oracle EMC Corp. Applied Materials Inc. Intel Corp.
Symbol
AAPL XOM ORCL EMC AMAT INTC
Volume
47.21 M 25.57 M 45.01 M 42.37 M 27.60 M 77.60 M
1-year RS rank
37.47% 18.83% 15.63% 15.40% 9.82% 4.03%
10-day move/rank
-0.50% / 12% -2.77% / 89% 1.80% / 100% -2.33% / 50% 4.41% / 33% -2.12% / 54%
20-day move/rank
-0.88% / 0% 3.77% / 27% -2.29% / 6% -2.46% / 15% 15.16% / 97% -0.25% / 0%
60-day move/rank
-37.76% / 100% -7.64% / 87% -9.04% / 89% -22.97% / 65% 10.06% / 97% -28.34% / 96%
.12 / 2% .44 / 48% .22 / 18% .10 / 28% .43 / 82% .11 / 8%
Negative one-year performance

Washington Mutual Citigroup Wachovia Corp. American International Group Inc. Bank of America Comcast Corp. JP Morgan Chase Wells Fargo Pfizer Dell Inc. Cisco General Electric AT&T Inc. Yahoo! WM C WB AIG BAC CMCSA JPM WFC PFE DELL CSCO GE T YHOO 38.28 M 98.36 M 29.20 M 26.24 M 47.20 M 24.23 M 36.64 M 36.11 M 40.51 M 31.35 M 77.87 M 43.68 M 34.08 M 59.13 M -72.01% -57.94% -50.65% -37.92% -28.32% -24.54% -23.45% -19.33% -15.03% -13.37% -8.21% -4.25% -4.19% -1.44% -29.67% / 100% -15.49% / 100% -17.81% / 100% -9.90% / 60% -13.48% / 100% 0.61% / 0% -13.23% / 100% -9.47% / 83% -3.62% / 82% 0.83% / 27% 3.23% / 50% -2.46% / 65% 1.60% / 20% 0.99% / 0% -31.31% / 92% -21.36% / 96% -20.41% / 91% -17.70% / 91% -13.73% / 94% 12.50% / 55% -14.52% / 89% -7.48% / 44% -4.43% / 78% 1.89% / 71% 3.73% / 71% -3.92% / 55% -3.79% / 30% 0.46% / 0% -38.20% / 54% -38.30% / 90% -36.52% / 100% -30.22% / 100% -19.51% / 82% 7.82% / 78% -18.90% / 100% -12.24% / 52% -11.52% / 100% -22.50% / 63% -12.79% / 34% -11.74% / 67% -8.97% / 85% 11.98% / 52% .35 / 100% .25 / 95% .52 / 100% .54 / 90% .70 / 100% .12 / 18% 1.08 / 92% .64 / 90% .50 / 58% .13 / 27% .12 / 12% .17 / 20% .15 / 0% .10 / 3%
Futures snapshot as of March 6
Market
E-Mini S&P 500 10-yr. T-note 5-yr. T-note 30-yr. T-bond E-Mini Nasdaq 100 2-yr. T-note Crude oil E-Mini Russell 2000 Mini Dow Eurocurrency Corn Gold 100 oz. Soybeans Natural gas Wheat E-Mini S&P MidCap 400
Pit E-symbol symbol Exchange

ES ZN ZF ZB NQ ZT ER YM 6E ZC ZS ZW ME TY FV US TU CL CME CBOT CBOT CBOT CME CBOT NYMEX CME CBOT CME CBOT NYMEX CBOT NYMEX CBOT CME
Volume
2.20 M 1.49 M 786.7 516.5 440.0 350.2 280.2 258.5 191.9 165.6 129.1 127.4 85.1 69.4 45.1 27.0
OI
2.32 M 2.18 M 1.63 M 940.8 398.5 1.07 M 309.9 646.2 92.7 196.5 311.4 284.5 130.7 122.4 90.2 107.7
10-day move/rank
-2.90% / 92% 0.08% / 11% 1.02% / 77% -0.76% / 20% -3.48% / 86% 0.84% / 79% 7.37% / 67% -5.07% / 100% -2.04% / 92% 3.73% / 67% 6.22% / 72% 2.94% / 29% 2.66% / 0% 9.57% / 70% 8.22% / 50% -3.68% / 100%
20-day move/rank
-1.65% / 14% 0.06% / 11% 1.03% / 44% -0.92% / 28% -1.94% / 20% 0.86% / 43% 19.70% / 97% -6.24% / 61% -1.35% / 14% 6.34% / 100% 11.09% / 50% 7.37% / 60% 9.45% / 53% 20.24% / 96% 7.84% / 28% -3.61% / 38%
60-day move/rank
-13.22% / 97% 3.68% / 55% 4.64% / 89% 1.70% / 6% -19.59% / 100% 2.83% / 95% 20.04% / 74% -16.66% / 98% -11.58% / 97% 4.31% / 59% 39.46% / 96% 20.11% / 87% 28.89% / 78% 38.54% / 95% 23.31% / 53% -14.12% / 96%
.33 / 38% .34 / 67% .38 / 83% .51 / 87% .17 / 22% .30 / 82% .50 / 85% .36 / 50% .36 / 45% .77 / 92% .20 / 42% .24 / 52% .24 / 50% .32 / 57% .61 / 80% .42 / 43%
EC C GC S NG W
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.
40
INSIDE the Market

BY JEFF PONCZAK
In this section
Privacy amendment proposed 43 DOJ critiques futures clearing structure Quick Scalps Managed money Coffee heating up 44 44 45 46
Rogue trader shredded in wheat market

Rogue trader costs firm $141.5 M with unauthorized trades in wheat futures. BY CHRIS PETERS
Debate over investor arbitration 47 SEC proposes new ETF rules Stock firms Gold: $1,000 then what? Global news 48 48 49 51
F Global Ltd. (MF), a futures and derivatives brokerage firm that accounts for a large portion of CME trade volume, lost $141.5 million on Feb. 27 after liquidating more than 15,000 wheat contracts. MF Global trader Evan Brent Dooley had taken the positions in overnight trading before the regular trading session opened on Wednesday, Feb. 27. Wheat futures had been experiencing record volume and price moves prior to the debacle. Wheat had increased 76.6 percent in 2007 to $8.85 per bushel, and another 35.5 percent between Jan. 2 and Feb. 26, 2008. Prices consistently hit their daily limits for two weeks in early February, prompting the Commodity Futures Trading Commission (CFTC) to approve an increase in daily price limits from 30 cents to 60 cents and the doubling of speculator margin calls. The day before Dooleys trades would cost MF Global nearly 6 percent of their total assets, May wheat (WK08) jumped more
41
than 8 percent to 1,214.50 (Figure 1). Representatives for MF global wouldnt comment on the exact nature of Dooleys
trades, except that he held positions in several contract months. Although the total number of contracts was excessive,
FIGURE 1: WILD WHEAT
Wheat futures declined in pre-market trading when Dooley was rumored to have shorted thousands of contracts, but the market shot higher in the regular session as MF Global extricated itself from the positions.
FIGURE 2: ROGUED
the number in each contract may not have been large enough to trigger speculative position limits. MF Global CEO Kevin Davis stated in a conference call the following day that under normal conditions the retail trader limit controls used by the firm would have prevented such actions by a single trader, but these controls were turned off for internal trades because of their effect on execution speed. Later statements made by the firm attributed the mishap to system failure. In an interview with the Wall Street Journal shortly after MF Globals stock plummeted almost 30 percent the incident, Dooley himself after unraveling the trades, the largest single day said, the computer system loss in the stocks history. failed on a lot of things. Source: eSignal The evidence suggests Dooley shorted wheat, placing orders The evidence suggests from home using MF Globals retail order entry system before pit trading opened in Dooley shorted wheat, the hope prices had peaked. The market opened nearly 10 percent lower than the placing orders from previous days close, but quickly shot up nearly 20 percent in the next few hours. home using MF Globals MF global became aware of the position, which greatly exceeded Dooleys retail order entry system own account balance, and immediately began liquidating the positions, incurring the $141.5 million loss. Dooley, who before pit trading according to the National Futures Associations Web site had been registered opened in the hope with the firm for more than two years, was immediately fired. prices had peaked. MF Globals fiscal third quarter report released on Feb. 1 had highlighted net
revenue growth of 29 percent year-over-year and futures and options volume growth of 47 percent. After the event, the CME group released a statement: MF Global has met and continues to meet its obligations to CME Clearing and remains in good standing as a clearing member of the exchange. The IntercontinentalExchange released a similar statement. Despite the reassurance, MF Global stock (MF) fell 40 percent in the two days following the incident (Figure 2), and on Feb. 29 Credit Suisse, UBS, and Lehman Brothers all downgraded the stock. On the same day, MF Global announced six of the companys executive officers and board members purchased $3 million worth of MF Global stock in a move to reassure shareholders. In a letter to clients on March 2, MF Global reiterated client funds were unaffected by the loss and that the company had made the necessary adjustments to their systems to prevent any further unauthorized trading. Since then, they have hired two consulting firms: FTI Consulting to review their retail order entry systems, and Promontory Financial Group to assess their overall risk environment. A federal investigation by the U.S. Attorneys Office in Chicago has since been launched to look into the nature of Dooleys trades. At press time, there was
continued on p. 43
42
Inside the Market continued
Rogues gallery
no indication of legal action against Dooley. MF Global has stated they are not the focus of the current federal investigation. According to a CFTC press release on Dec. 26, 2007, the CFTC settled previous actions against MF Global for violations arising out of their mishandling of hedge fund accounts. The settlement required MF Global and one of their associates to pay more than $77 million in fines and restitution. Among other things, the document stated MF Global failed to have sufficient internal controls, policies, and procedures concerning external communications with third parties and changes to Internet access of account information. MFG also failed to institute sufficient internal controls, policies, and procedures to detect and deter possible wrongdoing. Dooley could not be reached for further comment.
Losing $141 million isnt something anyone in any old job can do it takes a trader. Nonetheless, a hit of this size is rather unremarkable in the pantheon of rogue trader incidents in the modern era. Heres how Evan Dooley stacks up against some of the other loose cannons of the past two decades. Year 2008 2008 2004 2002 1996 1995 1995 1992 Trader Evan Dooley Jerome Kerviel Luke Duffy John Rusnak Yasuo Hamanaka Nick Leeson Toshihide Iguchi Anthony Catalfo, Donald Zimmerman Loss $141 mil. $7 bil. AU$360 mil. 350 mil $2.6 bil. $1.6 bil. 557 mil. $6 mil Market Wheat futures Stock index futures FX options FX options Copper Nikkei futures U.S. T-bonds T-bond futures/ options Institution MF Global Socit Gnrale National Australia Bank Allied Irish Banks Sumitomo Corporation Barings Bank Resona Holdings Lee B. Stern, Goldenberg Hehmeyer
The list contains only individuals who were taking unauthorized or illegal positions hence the absence of multi-billion-dollar blowups resulting from institutionally sanctioned trading, such as Amaranth (2006), the venerable Long-Term Capital Management (1994), and Metallgesellschaft (1994). The 1992 entries, Anthony Catalfo and Donald Zimmerman, made the list because of the audacity of their ploy and the fact that it brought down one of the unfortunate clearing firms (Lee B. Stern) through which they were doing business. With virtually no money they essentially bluffed their way onto seats at the Chicago Board of Trade and (almost) executed their one-day-and-go-away plan of triggering a panic in the T-bond market by shorting massive quantities of bond futures and simultaneously buying boatloads of bond puts on an employment report day. The market actually went their way for a while before the ploy was discovered and their positions were liquidated.
SEC proposes customer privacy safeguards
ith identity theft such a high-profile problem in the online economy and the trading industry being such a high-profile part of that economy the Securities and Exchange Commission (SEC) has proposed changes to existing industry practices designed to protect investor information. In March the SEC voted unanimously to propose amendments to Regulation S-P which outlines privacy , obligations for SEC-regulated businesses. In the SECs statement Erik Sirri, Director of the SECs Division of Trading & Markets, said, Todays proposal should help guard against growing problems such as identity theft and intrusions into online brokerage accounts. It also includes a pragmatic exception that
would continue to protect information while providing an orderly mechanism for departing representatives to take limited customer information to their new firms. This should help give firms flexibility while facilitating the transfer of accounts, promoting investor choice, and providing firms with legal certainty. According to the press release, the proposed amendments would provide more specific requirements for safeguarding information and responding to information security breaches, and would update Regulation S-Ps safeguarding and disposal provisions. The comment period for the proposal will end 60 days from the date of publication of the proposed rule in the Federal Register.
43
DOJ takes stand on clearing

BY JIM KHAROUF
Department of Justice (DOJ) comment letter roiled exchange stocks and raised industry fervor in February when it advocated radical changes to the clearing structure for U.S. futures exchanges. The DOJ called for an end to exchange control of financial futures clearing and an examination of a single clearing house for the futures industry, similar to those found in U.S. securities for stocks and options trades. The 22-page letter, written in response to the Department of Treasurys request for comment on the regulatory structure of U.S. financial markets, pointedly states that the current clearing house structures run by futures exchanges impede competition and recommended that the U.S. Treasury review the clearing system in place today. The letter, written by the same DOJ staffers who approved the CME Groups acquisition of Chicago Board of Trade (CBOT) last July, said the department believes that the control exercised by futures exchanges over clearing services has made it difficult for exchanges to enter and compete in the trading of financial futures contracts. DOJ also called for fungible futures contracts and a clearing structure that more closely resembles those that service the U.S. stock markets, served by the Depository Trust Corporation, and the U.S. options markets, served by Options Clearing Corporation. DOJ urged the Treasury to propose a thorough review of futures clearing and its alternatives, including a careful examination into whether a regime more similar to that in the equities or options markets is feasible and would lead to significant consumer benefits. DOJs comment letter also says if regulatory policies that encourage and facilitate exchange competition were adopted, futures clearinghouses would likely clear
for multiple exchanges and treat identical contracts as fungible. Futures exchanges would, in turn, compete in terms of price, quality of execution systems and the speed and completeness of information available to market participants.
CME spirals
CME Groups stock plummeted on the news, falling $103.55 or 17.5 percent Feb. 6 to $485.25, a day after the stock slipped 3.2 percent when the comment
continued on p. 45
Quick Scalps
Meet the Nasdaq OMX Group
The Nasdaq Stock Market completed its combination with OMX AB (a former Nordic financial exchange operator), creating the Nasdaq OMX Group, the worlds largest exchange company according to the Feb. 27 announcement. As part of the transaction, Nasdaq OMX Group also became a 33 1/3-percent shareholder in DIFX, Dubais international financial Exchange (Borse Dubai is a 19.9-percent shareholder of Nasdaq OMX Group). OMX Nordic Exchange, while no longer a legal entity, represents the common offering from Nasdaq OMX exchanges in Helsinki, Copenhagen, Stockholm, Iceland, Tallinn, Riga, and Vilnius.
ICE, OCC cross margin Russell contracts

IntercontinentalExchange (ICE) announced in March it received regulatory approval from the Commodity Futures Trading Commission (CFTC) for crossmargining Russell Index futures and options contracts. The ICEs most actively traded Russell-based instrument is its Russell 2000 futures contract. The approval will allow the ICEs clearing arm to cross-margin positions with the Options Clearing Corporation (OCC), which is the clearing organization for U.S. exchange-traded equity and equity index options. Cross-margining reduces the margin requirements for qualifying traders, who would otherwise have to pay the full margin rates for related instruments traded on the different exchanges. Risk-reducing positions e.g., a long position in one Russell contract complemented by a short Russell position in a contract on the other exchange would receive a reduced margin rate. Specifics of the cross-margining program can be found at https://www.theice.com/clearing_cross_margin.jhtml.
Osaka and ISE want to launch revitalizing Japanese options platform

The Osaka Securities Exchange (OSE) and International Securities Exchange (ISE) have signed a Memorandum of Agreement (MOA) that outlines their plans to build a cooperative relationship as the first step toward the formation of a joint venture and the launch of a new, jointly owned options trading platform. The venture is designed for the Japanese options market. In the joint press release, OSE President and CEO Michio Yoneda says, [T]his initiative will help to revitalize the Japanese equity options market and to establish it as a useful investment tool for investors.
44

letter became public. And New York Mercantile Exchange (NYMEX) shares fell 17.6 percent or $18.78 Feb. 6 to $87.88, while IntercontinentalExchanges (ICE) shares slipped 7 percent or $8.75 to $115.90. CME and NYMEX had announced they were in merger and acquisition talks. Both stocks slowly recovered but still were below the pre-DOJ letter prices. CME and other exchanges stand to lose a major source of revenue if a single futures industry clearinghouse is created as the DOJ suggests. Last year, CME reported $1.76 billion in clearing and transaction fees, up from $1.34 billion in 2006. Total CME 2007 revenue was $2.12 billion, vs. $1.6 billion for 2006. It is not clear how much of that revenue comes specifically from clearing fees because CME has always bundled the transaction and clearing fees into one price. CME CEO Craig Donohue did his best to allay concerns that the U.S. government was aiming to take away the CME clearinghouse. He told analysts in a special conference call that the issue raised by the DOJ has been debated and discussed for many years within the industry in various forms. This is simply a comment letter, Donohue says. This is not something thats never been talked about. The tugof-war between exchanges and intermediaries with respect to controlling the clearinghouse has a lot more to do with business interests than it does with the public benefit. Donohue also fended off questions about the DOJs apparent contradictory stance first approving its acquisition of CBOT, which effectively granted the combined exchange about 90 percent of the U.S. futures execution and clearing business and then stating that such a structure is anti-competitive. The DOJs comments focused on financial futures contracts, not those of commodities such as energy futures, which are highly competitive between the NYMEX and ICE.
Go slow
Market participants voiced reservations about the DOJs proposed solution and none believed change is likely anytime soon. The Treasury, led by Sec. Henry Paulson who spearheaded the call for comments on achieving more competitive U.S. financial markets, will be undergoing a transition in the coming months with a new president starting next January. Sharon Brown-Hruska, vice president in the securities and finance practice at NERA Economic Consulting, is a wary of such a major structural change. You want to be fair to the clearing firms and the exchanges, Brown-Hruska says. The government should be cautious when engaging in micro-structure management or trying to dictate what the perfect structure of the industry is or should be. Others questioned why the DOJ was coming in with its comment letter now, about two months after the deadline for comment letters for the Treasury. CFTC commissioner Bart Chilton said in a statement he found several aspects of the DOJ letter troubling. For one, Chilton said the focus is clearly outside the parameters of what the Treasury had requested which was comment on regulatory oversight of U.S. financial markets. Many of the prior comments dealt with merging the CFTC and the Securities Exchange Commission. The business model the DOJ staff is now condemning received, only a few short months ago, the legal blessing of the DOJ following its extensive, compre-
Managed futures performance: Barclay Trading Groups January 2008 rankings Top 10 traders ranked by January 2008 return managing more than $10 million as of 1/31/08.
Trading advisor
January
return (%)
2007 YTD return (%)
$ Under mgmt.
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
Friedberg Comm. Mgmt. (Divers.) Emil van Essen (Spread Trading) Kelly Angle Inc. (Genesis) Hawksbill Capital Mgmt. (Gl. Divers.) Mulvaney Capital Mgmt. (Gl. Markets) DUNN Capital Mgmt. (WMA) Claughton Capital Keck Capital Management Fort Orange Capital Mgmt (Gl. Strat.) Rochester Capital (Managed Futures)
62.90 31.00 30.48 23.63 21.65 19.94 19.87 17.91 16.98 15.85
62.90 31.00 30.48 23.63 21.65 19.94 19.87 17.91 16.98 15.85
16.9M 19.0M 23.0M 42.5M 98.0M 57.7M 30.5M 22.6M 16.4M 30.0M
Top 10 traders ranked by January 2008 return managing less than $10 million as of 1/31/08.
1. 2. 3. 4. 5. 6. 7. 8. 9. 10.
Somers Brothers Capital (Divers.) Abundance Fund, LLC Edge Inv Mgmt (Gl Diversified) Barbashop LLC Linn, Hare, Huckabay (Apex) Visioneering R. & D. Co. (V-100 E) Red Rock Capital (Diversified) Montague Financial (Pascal) DUNN Capital Mgmt. (Combined) Dreiss Research Corp.
24.60 23.61 21.25 18.00 17.58 17.09 16.46 15.67 14.69 14.57
24.60 23.61 21.25 18.00 17.57 17.09 16.46 15.67 14.69 14.57
3.1M 1.1M 2.4M 2.0M 2.0M 1.1M 3.4M 1.8M 9.4M 1.4M
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)
45
hensive, and exhaustive review of the CME/CBOT merger, Chilton says. Another industry executive says the futures industry does not need a single clearing entity, but rather a change in the way clearing houses interact with one another. Many FCMs and customers are frustrated by exchanges which fail to offer margin offsets on competing products at
other exchanges, which ultimately forces market users to post margin at two exchanges. Im not in favor of spinning off clearing into one entity and I dont think that adds value, the executive says. But regulators should mandate cooperation among clearing houses. The Futures Industry Association (FIA)
issued a statement supporting the DOJs recommendation for a review of exchange-controlled clearing. In 2003, the FIA also pushed for other clearing changes such as directed clearing, or clearing choice. But such debates have raised the dialog and then quietly been shelved. This time, it may be different.
Java jolt: Somethings brewing in coffee

FIGURE 1: ICE COFFEE
Nearby ICE Futures US coffee futures surged to multiple-year highs in February and analysts say there could be more to go on the upside. After the May 1997 top at 280.00, coffee declined into 2001 before creeping higher, forming the large base evident on the monthly coffee chart (Figure 1). Most analysts agree the coffee market has etched a major long-term bottom on the charts, and the recent price action portends even higher prices to come. We have a big base going back to the late 1990s, says Paul Hare, executive vice president at the Linn Group. [The market has] established a bottom, there is no question about it. This years rally through the 140.00-apound level (topping the May 2005 high of 139.50) was a significant upside breakout. When you come out of a formation like this over the past 20 years youve had big moves out of your base, Hare says. Fundamentally, the case for higher coffee is there. Producer stocks have been falling recently. Judy Ganes Chase, president of JGanes Consulting, has forecast a 138-million-bag figure for world production in 2008-2009 vs. a consumption estimate of 133 million bags. Through 2009-2010 we will see limited supply, she says. Consumption is getting close to production, agrees Hernando de la Roche,
our morning cup of joe may get more expensive over the next several months to a year.
Coffee futures have been percolating higher since the 2001 bottom. Despite the early March correction, industry watchers expect coffee to push higher.
managing director at Hencorp Futures in Miami. Citing historically low inventory levels and rising consumption levels (1 to 2 percent per year), de la Roche says the balance between supply and demand will be tighter every year. This is the first time both Arabica and Robusta (the two primary coffee grades) have rallied together not as a direct result of frost or drought in Brazil, Ganes says. Brazil is the worlds largest coffee producer and exporter. In recent months, coffee futures have been driven higher in part by pervasive fund buying as trend and momentum players jump on commodity market ral-
lies. Nonetheless, Ganes adds, even when you take that out of the equation and go back to the underlying fundamentals they are pretty solid. May coffee futures corrected in early March (Figure 2), but overall analysts werent fazed by the retreat. Analysts are pointing to the 200.00 mark as a clear upside target for the market. Beyond that, Hare says the 2.1200 zone is a key Fibonacci retracement target (61.8 percent of the May 1997-December 2001 sell-off) as a possible objective into the summer months. Given the way coffee has trended on a historical basis, he even sees the potential for a spike to 250.00 or 260.00.
46
Groups exchange barbs regarding investor arbitration

recent survey conducted by professors at Pace University and the University of Cincinnati College of Law was not very friendly to the arbitration process used by Wall Street to resolve disputes with investors. More than 3,000 investors, lawyers, and security employees who had been involved in arbitration between January 2002 and December 2006 were surveyed, and only 28 percent thought the process was fair. Furthermore, only a quarter of investors surveyed thought the process was fair. The survey was commissioned by the Securities Industry Conference on Arbitration (SICA), and the results did not please the folks at the Securities Industry and Financial Markets Association (SIFMA). SIFMA published a response entitled The Thinking Persons Guide to Interpreting the Latest Survey on Subjective Perceptions of Fairness of Securities Arbitration in which it questioned the process used in conducting the survey and downplayed the results. The survey focuses solely on subjective perceptions by arbitration participants and does not address objective standards of substantive or procedural fairness, the response says. The survey, for example, attempts to analyze fairness, in part, by participants views about the alleged time and cost inefficiency of arbitration, and about the alleged bias of arbitrators. Yet, individuals perceptions about these particular factors can be proven to be inaccurate because these factors have already been measured objectively and empirically. For starters, SIFMA points out the survey consisted of 40 multiple-choice questions and was sent to about 30,000 people. However, only 10 percent of that group responded and, of that total, almost 60 percent settled before the
47
Thirty-five percent of customers would not choose arbitration in the future because they believe it is unfair; 44 percent did not think arbitration was conducted without bias.
hearing concluded. However, a lawyer for SICA called SIFMAs response out of touch, and Jill Gross, co-author of the study, says SIFMA was denigrating the observations and views of an entire class of arbitration participants. According to the survey, almost 35 percent of customers would not opt for arbitration in the future because they believe the process is unfair, and 44 percent did not think arbitration was conducted without bias. Unfortunately, arbitration is the only route aggrieved investors have if they believe they have been wronged. Before opening an account, brokerages require investors to sign an agreement that they will seek arbitration and not opt to go to court if there is a dispute. Of those in the survey who had been lawyers, plaintiffs, or defendants in a court case over the past five years, 63 percent say arbitration was very unfair compared to court. A lawyer for SIFMA claimed the investors who responded to the survey but did not go through the entire process, opting instead for an early settlement, are
unqualified to comment on the process. However, a SICA spokesman says a participant doesnt need to see the arbitration to the end to determine if there is bias involved. More than 55 percent of arbitration cases were settled in 2007, up from 36 percent in 2003. However, while 42 percent of investors won their cases in 2006, that number dropped to 37 percent in 2007. Still, SIFMA believes an increase in settlements shows investors are happy with the process, saying nobody would agree to settle unless they believed the settlement was fair and adding that many on the brokerage side also believe the process is unfair, balancing out the results. The Thinking Persons Guide states, Customers, on the one hand, felt they were not fully compensated for their losses. Securities firms, on the other hand, felt that customer awards were overly generous. The fact that both sides were somewhat dissatisfied with the outcome does not reflect that the process is biased. Rather, it is a good indication that the system is taking a balanced approach and producing results that are within an acceptable range of fairness. However, state regulators have sided with investors, claiming the survey points out the need for removing industry members from arbitration panels. Bryan Lantagne, chairman of the arbitration working group sponsored by the North American Securities Administrators Association (NASAA), says Were trying to see whether the investors believe [the arbitration system is] fair. Now we have a report that shows that they dont, and everyones trying desperately to put a spin on this. These numbers really speak volumes to what the investors believe. Thats crucial to the forum. If they feel theyre forced to go into a forum thats biased, it perverts the program.
SEC wants to streamline the ETF pipeline

xchange-traded funds (ETFs) have been the golden child of the equities industry for several years, and the SEC has proposed new rules to make it easier for ETFs to operate. In early March the SEC proposed two new rules under the Investment Company Act to permit exchange-traded funds (ETFs) to operate without obtaining
individual exemptive orders from the Commission a process that adds time and costs to bringing new ETFs to market. The proposed rules would increase investor choice by eliminating a barrier to entry for new participants in this fastgrowing market, while preserving investor protections, said Andrew J. Donohue, Director of the SECs Division of
Investment Management, in the SECs press release. Permitting most ETFs to come directly to market without the cost and delay of obtaining an exemptive order would also allow staff to focus on more novel and difficult requests. The comment period for the proposal will end 60 days from the date of publication of the proposed rule in the Federal Register.
STOCK PRICES OF TRADING-RELATED FIRMS

Company Symbol Exchange Closing price 3/6
1.74 1.41 17.2 18.96 21.9 9.37 0.07 3.03 3.77 0.195 18.39
1-month change
% change high
4.19% 1.44% -2.33% -6.05% -10.25% -10.51% -12.50% -14.89% -18.04% -18.75% -34.99%
52week low
3.86 2.5 21.31 25.72 34.95 14.87 0.45 5.76 25.79 0.33 32.2
52week vol.*
1.45 1.1 13.82 17.41 20.78 9.28 0.009 3 2.08 0.1035 14
Avg. daily ($)

8,062 23,892 5.59 M 12.5 M 1.23 M 537,739 82,605 3,056 39.9 M 82,491 1.95 M
Market cap
Brokerages Track Data Terra Nova Financial Group TD Ameritrade Charles Schwab OptionsXpress TradeStation AB Watley Siebert Financial E*Trade AlphaTrade Man Financial Global Exchanges/Trading firms IntercontinentalExchange New York Mercantile Exchange Nyfix CME Group Nasdaq Stock Market Interactive Brokers NYSE Euronext Penson Worldwide Market makers/Specialists Knight Capital Group LaBranche Miscellaneous Value Line Interactive Data Corporation eSpeed MarketAxess
TRAC TNFG AMTD SCHW OXPS TRAD ABWG SIEB ETFC APTD MF
NASD OTC BB NASD NASD NASD NASD Pink Sheets NASD NASD OTC BB NYSE
0.07 0.02 -0.41 -1.22 -2.5 -1.1 -0.01 -0.53 -0.83 -0.045 -9.9
$14.6 M $38.2 M $10.2 B $21.9 B $1.38 B $414 M $2.04 M $67.3 M $1.74 B $9.05 M $2.21 B
ICE NMX NYFX CME NDAQ IBKR NYX PNSN
NYSE NYSE Pink Sheets NYSE NASD NASD NYSE NASD
132.44 99.38 4.1 505.45 38.79 29.71 61.6 9.35
16.54 11.5 0.25 20.2 -1.37 -2.89 -7.43 -2.32
14.27% 13.09% 6.49% 4.16% -3.41% -8.87% -10.76% -19.88%
194.92 148 7.5 714.48 50.47 35.93 101 34.91
114.62 86.61 3.6 475.17 26.57 21.00 62.05 9.245
2.22 M 2.21 M 54,860 1.00 M 2.54 M 981,843 4.20 M 270,056
$9.29 B $9.23 B $150 M $26.9 B $4.44 B $1.19 B $16.3 B $237 M
NITE LAB
NASD NYSE
15.92 4.34
-0.66 -1.07
-3.98% -19.78%
18.49 9.3
11.5 4.03
2.30 M 675,448
$1.55 B $267 M
VALU IDC ESPD MKTX
NASD NYSE NASD NASD
40.25 27.77 11.38 8.83
0.34 -0.76 -0.62 -0.65
0.85% -2.66% -5.17% -6.86%
56 33.68 12.97 19.87
31.1 22.92 7.02 9
4,661 268,142 235,523 224,839
$402 M $2.62 B $356 M $272 M
*over last three months
48
Gold express may lose steam above $1,000

FIGURE 1: PARABOLIC RALLY
ou dont have to look far these days to find a commodity market scoring new all-time highs. However, in the days leading up to spring, one particularly sexy market gold finally climbed above the psychologically significant and historic $1,000-an-ounce mark. Gold has been moving higher since 2001, although the lions share of the current rally has occurred since April 2003 and the months since June 2007 have been especially explosive (Figure 1). However, starting in 2001, the U.S. Federal Reserve embarked upon a historical monetary policy easing cycle that ultimately took the fed funds rate down to 1 percent. The U.S. dollar entered a major bear market around that time and commodity markets boomed across the board. Gold bugs woke up after more than a decade of hibernation. For several years, the rally in the gold market was a quiet upward march, with the price of the yellow metal climbing to $456.50 in December 2004. By mid-2006 gold had vaulted to around $725, followed by nearly a year of consolidation. In August 2007 the Fed launched a new easing cycle after a year of holding rates steady. Gold was trading sideways after the May 2006 peak until the Fed started cutting rates, says Dan Vaught, futures analyst at Wachovia Securities. The dollar continued to fall, which continued to bolster commodity prices. Gold and all internationally traded commodities that are priced in dollars see a negative correlation between the dollar and the price of the commodity, he says. But whats happening now goes beyond
49
This monthly chart of continuous gold futures highlights the huge gains the market has made in recent months.
anything that can logically be squeezed out of the fundamentals.
Self-fulfilling prophecy?
A bevy of factors have fed the new gold mania, which has intensified in recent months. Flight-to-safety concerns regarding the U.S. sub-prime debacle supported gold in late 2007 and beyond, and concerns that global inflation would pick up amid the strong world-wide demand for commodities also underpinned the yellow metal. Historically, gold has been seen as both an inflation hedge and a flight-tosafety vehicle. Plenty of purely speculative money has been chasing the gold market. The continued capital influx has tended to exaggerate this move, Vaught says. With the U.S. stock market pushing
lower and real estate markets collapsing across the U.S., investment money has flowed into the commodity arena. Commodities have been the success story, he says. There are tremendous amounts of capital being thrown at this market as traders and funds look for assets that are performing well.
Its not just gold

Gold may be the marquee market, but virtually all metals have been rallying across the board, with double-digit gains in both the precious and industrial sectors. Terence Gabriel, senior technical strategist at Ideaglobal in New York, points out that gold futures gained 45 percent from the end of February 2007 to the end of
FIGURE 2: FLIRTING WITH $1,000

February 2008. During that same period, silver rallied 40 percent, copper soared 41 percent, and platinum skyrocketed 74 percent. Gabriel noted that platinum and palladium have both gone ballistic in part due to recent South African mine shutdowns. The market catalysts for industrial and precious metals are not necessarily the same, though. According to Gabriel, industrial metals have the benefit of strong emerging market demand for the actual use of the materials, while precious metals benefit from dollar weakness and instability, which may be leading into forward-inflation expectations.
The energy connection

With crude oil topping $100, the passthrough costs of higher energy prices have the potential to ripple through virtually every aspect of the global economy. The big inflation concern really goes back to energy, Vaught says. Gold traditionally has been closely associated with the energy sector. As long as crude oil prices remain strong, gold will remain strong. Ultimately, when and if crude turns downward, I think gold bulls would be hard pressed to sustain this rally.
After consolidating between roughly $960 and $995, on March 13 gold finally cleared the $1,000 psychological hurdle.
This is only about money chasing money. When asked if he thought gold was overvalued, Vaught says unlike most other commodities, Gold value is such a nebulous concept.
The $1,000 barrier Bubbles and fair value

Leonard Kaplan, president of Prospector Asset Management and long-time gold watcher, says the financial world over the last eight years has been all bubbles, citing the Nasdaq top in 1999, the real estate bubble, and now commodities. Is any of it real? he asks. Of course not. [The recent upward spiral in gold prices] is total mania. There are 10,000 hedge funds with hundreds of billions of dollars throwing money at gold. Will it end very badly? Yes. But will it end a week from now, a month from now, or three years from now? No one knows. Gold is worth about half of where it is right now. If you can produce gold at $350/400 ounce, why is it worth $950? Just as this story went to press, gold pierced the $1,000 mark, another notch on its historical-significance belt (Figure 2). Most market watchers agree the level has acted as a magnet, as round numbers so often do. What happens next, though, is very much open to debate. The parabolic structure of the rally would tend to suggest that we are close to the end of the move, Gabriel says. It is a dangerous market once it gets over $1,000. He is forecasting a near-term thrust above $1,000 perhaps a top at $1,025 or even $1,100. From there, however, he believes the market is vulnerable to a hefty correction, possibly to the $750 to $800 level.
Looking at reward/risk at over $1,000, the next move favors a correction, Gabriel says. It is a crowded trade to chase gold at $1,000. However, Gabriel expects a late-spring, early-summer sell-off to present another buying opportunity in the continuing long-term uptrend in gold. Expectations remain high the U.S. Federal Reserve will continue its easing stance in an effort to stave off recession into mid-year (the next scheduled interest-rate meeting is on March 18). Lower interest rates weigh on the U.S. dollar, which in turn could continue to support gold and other commodity prices. Again, the big question is, how far and for how long? There are huge risks to overheated markets. As long as the Fed continues to be the slut of Wall Street, I think metals go higher, Kaplan says. It is very difficult to know what can prick a bubble. His advice for those interested in trading gold: Go to Las Vegas. The odds are better.
50
Interest-rate monitor
The Bank of Canada lowered its overnight target rate 0.50 percent to 3.5 percent. The Bank of England lowered its bank rate 0.25 percent to 5.25 percent in February and held steady in March. The Reserve Bank of Australia raised its overnight lending rate 0.25 percent to 7.25 percent. The Bank of Japan (BOJ) raised its overnight rate 0.25 percent to 0.50 percent. Reserve Bank of New Zealand held rates steady at 8.25 percent. European Central Bank (ECB) held rates steady at 4.0 percent. Bank of Japan (BOJ) held rates steady at 0.5 percent. in biomedical manufacturing rather than the impact of the slowing U.S. economy, according to a government press release. GDP has increased 10.8 percent over the past year. Singapores Q4 unemployment fell to 1.6 percent, down from 1.7 percent in Q3 and down 1.0 percent from the same period last year. Growth in the construction sector doubled in 2007 compared to the previous year, contributing to the decade-low unemployment estimate. The Central Bank of Philippines lowered its overnight borrowing rate 0.25 percent to 5.0 percent in January, marking four consecutive months of 0.25-percent decreases.
Global News
EUROPE
The European Central Bank (ECB) held overnight interest rates steady at 4 percent at its March 6 meeting. Frances Q4 GDP increased 0.7 percent, a 4.2-percent gain from a year ago. Decreases in household and government expenditure, industrial production, and exports contributed to the slowest quarterly economic growth in more than a year. Germanys unemployment rate fell in December for the sixth consecutive month to 7.8 percent 1.2 percent less than a year ago. Unemployment has fallen steadily in Germany since January 2006 when it hit 10.4 percent. Germanys GDP grew 0.3 percent in Q4, due in part to an increase in exports. This brings the growth since Q4 2006 to 3.7 percent. UK unemployment fell 0.2 percent to 5.2 percent in the OctoberDecember period, down 0.3 percent from the same period last year. This coincides with a 74.7-percent employment rate, the highest level since comparable employment recording began in 1971. In February, the Bank of England lowered its overnight lending rate 0.25 percent to 5.25 percent, the same rate as a year ago. It held rates steady at its subsequent meeting on March 6. Czech Republic incumbent President Vaclav Klaus was reelected for a five-year term, defeating University of Michigan economics professor Jan Svejnar in a heated race requiring three separate rounds of voting. The Czech National Bank raised its two-week repo rate 0.25 percent to 3.75 in February. This rate has increased steadily from 1.75 percent in April 2005. The National Bank of Poland raised its 28-day intervention rate from 5.0 percent to 5.25 percent in January. This marks the fifth increase in the last 10 months after hitting a recent 4.0-percent low in 2006.
51
The Swedish Riksbank raised its repo rate 0.25 percent in February to 4.25 percent, the eleventh increase in two years. The National Bank of Romania raised its monetary policy rate 1.0 percent in February to 9.0 percent, a 2.0-percent increase since June of last year.
ASIA & AUSTRALIA

Japans Q4 GDP grew 0.3 percent compared to the previous quarter, a 1.2-percent increase from year ago. Japans unemployment rate was 3.8 percent in December, the same as in November. This level is 0.2 percent less than the rate reported in December 2007. The Reserve Bank of Australia raised its cash rate 0.25 percent to 7.0 percent in February. This rate has increased steadily since early 2005 when it was 5.25 percent. The Australian unemployment rate fell 0.2 percent to 4.1 percent in January, 0.6 percent less than a year ago. Over the past decade, the unemployment rate has fallen 3.8 percent. Hong Kongs November-January unemployment rate held steady at 3.4 percent from the previous threemonth period. This is the lowest figure in 10 years. Employment surged to over 3.55 million, another record high. Singapores GDP rose 2.42 percent in Q4 a slowdown from the previous quarter due mostly to a sharp decline
AMERICAS
Canadas unemployment rate fell 0.2 percent in January to 5.8 percent, equal to the 33-year low recorded in October 2007. Employment has continued to climb in many sectors, bringing the employment rate up to a record high of 63.8 percent. The Bank of Canada lowered its overnight funding rate 0.25 percent to 4.00 percent, the lowest rate since April 2006.
AFRICA
South Africas Q4 GDP rose 5.3 percent from the previous quarter and 4.6 percent from a year ago. Expansion in the manufacturing and construction industries played a significant part in this growth.
Global MARKETPLACE
FOREX (VS. U.S. DOLLAR)
Current price vs. U.S. dollar
0.96312 0.16266 0.59898 0.03244 0.009655 1.52127 0.92718 0.04167 0.71971 0.14087 0.79807 1.98464 1.00772 0.12843 0.03192 0.02481 0.12747
Rank* Country
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Currency
Swiss franc Swedish krona Brazilian real Taiwanese dollar Japanese yen Euro Australian dollar Russian ruble Singapore dollar Chinese yuan New Zealand dollar British pound Canadian dollar Hong Kong dollar Thai baht Indian rupee South African rand
1-month gain/loss
5.43% 4.89% 4.87% 3.71% 3.25% 3.14% 2.51% 2.43% 1.90% 1.08% 1.00% 0.74% 0.61% 0.17% -1.66% -1.86% -4.49%
3-month gain/loss
7.84% 4.58% 7.67% 4.81% 6.47% 3.33% 6.49% 1.86% 4.09% 3.99% 4.48% -2.99% 2.21% 0.09% -3.59% -2.05% -13.36%
6-month gain/loss
16.49% 11.81% 17.08% 7.20% 11.79% 11.74% 12.58% 6.96% 9.86% 6.23% 15.17% -1.46% 5.96% 0.09% 2.24% 1.51% -7.82%
52-week high
0.9699 0.1635 0.6001 0.03255 0.00970 1.5302 0.9497 0.04178 0.7204 0.1406 0.8213 2.1161 1.1038 0.129 0.03396 0.02549 0.1555
52-week low
0.8005 0.14 0.453 0.02983 0.00805 1.3072 0.7672 0.03799 0.6468 0.1285 0.6642 1.918 0.8455 0.1277 0.02782 0.02237 0.1242
Previous rank
2 8 14 6 1 7 5 10 3 4 12 13 15 11 16 9 17
As of March 6 *based on one-month gain/loss
ACCOUNT BALANCE
Rank Country
1 2 3 4 5 6 7 8 9 10 11 12 Singapore Switzerland China Hong Kong Netherlands Taiwan Sweden Russia Germany Japan Canada Brazil
2007
41.395 65.534 379.162 22.796 55.891 25.402 25.903 72.543 175.371 195.904 25.603 10.253
Ratio*
27 15.8 11.7 11.2 7.4 6.8 6 5.9 5.4 4.5 1.8 0.8
2006
36.288 58.708 249.866 20.586 8.6 24.661 27.707 95.322 147.134 170.437 20.792 13.276
2008+
42.208 64.106 453.146 20.456 6.7 28.365 25.584 49.181 174.137 195.145 17.909 4.299
Rank
13 14 15 16 17 18 19 20
Country
Mexico France India UK Australia U.S. South Africa Spain
2007
-6.368 -39.363 -23.131 -96.687 50.816 -784.341 -18.495 -138.916
Ratio*
-0.7 -1.6 -2.1 -3.5 -5.7 -5.7 -6.7 -9.8
2006
-2.425 -27.712 -9.503 -77.236 -41.49 -811.483 -16.608 -106.399
+ 2008
-10.588 -48.885 -32.301 -105.144 -52.988 -788.293 -19.237 -154.849
Totals in billions of U.S. dollars *Account balance in percent of GDP +Estimate Source: International Monetary Fund, World Economic Outlook Database, October 2007
52
NON-U.S. DOLLAR FOREX CROSS RATES

Rank
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Currency pair
Franc / Canada $ Franc / Pound Real / Canada $ Real / Pound Real / Aussie $ Franc / Euro Franc / Yen Aussie $ / Canada $ Aussie $ / Pound Real / Euro Real / Yen Euro / Yen Canada $ / Pound Aussie $ / Euro Aussie $ / Yen Pound / Euro Pound / Yen Canada $ / Euro Canada $ / Yen Aussie $ / Franc
Symbol
CHF/CAD CHF/GBP BRL/CAD BRL/GBP BRL/AUD CHF/EUR CHF/JPY AUD/CAD AUD/GBP BRL/EUR BRL/JPY EUR/JPY CAD/GBP AUD/EUR AUD/JPY GBP/EUR GBP/JPY CAD/EUR CAD/JPY AUD/CHF
March 6
0.95606 0.48535 0.59459 0.30186 0.64617 0.6331 99.76636 0.92038 0.46725 0.39376 62.04962 157.582 0.50784 0.60955 96.04732 1.30461 205.585 0.66246 104.392 0.96295
1-month gain/loss
4.79% 4.66% 4.23% 4.10% 2.30% 2.22% 2.10% 1.89% 1.76% 1.67% 1.56% -0.11% -0.13% -0.61% -0.72% -2.33% -2.44% -2.45% -2.56% -2.76%
3-month gain/loss
5.50% 11.16% 5.33% 10.99% 1.10% 4.37% 1.29% 4.18% 9.77% 4.20% 1.13% -2.95% 5.36% 3.06% 0.02% -6.11% -8.88% -1.08% -4.00% -1.25%
6-month gain/loss
9.93% 18.22% 10.49% 18.82% 4.00% 4.25% 4.21% 71.03% 14.25% 4.78% 4.74% -0.04% 7.53% 0.76% 0.75% -11.82% -11.85% -5.17% -5.20% -3.35%
52-week high
0.9751 0.4889 0.5946 0.3019 0.6544 0.6369 101.852 0.9493 0.4753 0.3995 66.2821 168.96 0.5219 0.646 107.831 1.4968 251.095 0.7476 124.527 1.0755
52-week low Previous

0.8044 0.4005 0.5213 0.2431 0.5883 0.5942 92.152 0.8439 0.3975 0.3569 54.3068 149.227 0.4373 0.5727 85.975 1.3001 203.462 0.639 98.32 0.9452 1 2 5 8 11 4 13 3 6 10 19 17 12 7 16 9 18 15 20 14
GLOBAL STOCK INDICES

Rank
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Country
South Africa Brazil Canada Mexico Japan Singapore Hong Kong U.S. UK Italy Australia France Germany Switzerland India
Index
FTSE/JSE All Share Bovespa S&P/TSX composite IPC Nikkei 225 Straits Times Hang Seng S&P 500 FTSE 100 MIBTel All ordinaries CAC 40 Xetra Dax Swiss Market BSE 30
March 6
31,079.15 62,975.00 13,360.44 28,717.04 13,215.42 2,917.92 23,342.73 1,304.34 5,766.40 25,148.00 5,531.90 4,678.05 6,591.31 7,269.90 16,542.08
1-month gain/loss
11.47% 6.79% 3.83% 2.82% 0.89% -0.48% -0.54% -1.67% -1.86% -2.55% -2.57% -2.87% -3.74% -3.91% -8.81%
3-month gain/loss
7.73% -4.28% -3.53% -8.13% -16.75% -17.86% -21.03% -13.47% -11.09% -16.01% -16.94% -17.55% -16.99% -16.84% -16.44%
6-month gain/loss
2.27% 15.40% -3.15% -6.81% -18.71% -15.81% -2.94% -11.78% -8.66% -18.43% -11.71% -16.11% -13.52% -17.67% 5.93%
52-week high
31,728.18 66,529.00 14,646.80 32,851.10 18,297.00 3,906.16 31,958.40 1,576.09 6,754.10 34,369.00 6,873.20 6,168.15 8,151.57 9,548.10 21,206.80
52-week low
24,005.35 42,051.00 12,011.68 25,282.30 12,572.70 2,859.08 18,738.50 1,270.05 5,338.70 24,545.00 5,253.50 4,505.14 6,384.40 6,950.90 12,316.10
Previous
9 3 2 1 13 12 11 4 5 10 7 14 15 6 8
GLOBAL SHORT-TERM INTEREST RATES

Country
U.S. Japan Eurozone UK Canada Switzerland Australia New Zealand Brazil Korea Taiwan India South Africa
Interest rate
Fed Funds Rate Overnight call rate Refi rate Repo rate Overnight funding rate 3-month Swiss Libor Cash rate Cash rate Selic rate Overnight call rate Discount rate Reverse repo rate Repurchase rate
Rate
3 0.5 4 5.25 3.5 2.75 7.25 8.25 11.25 5 3.375 6 11
Last change
0.5 (Jan. 08) 0.25 (Feb. 07) 0.25 (June 07) 0.25 (Feb. 08) 0.5 (March 08) 0.25 (Sept. 07) 0.25 (March 08) 0.25 (July 07) 0.5 (Sept. 07) 0.25 (Aug. 07) 0.125 (Dec. 07) 0.5 (Dec. 07) 0.5 (Dec. 07)
Sept. 07
4.75 0.5 4 5.75 4.5 2.75 6.5 8.25 11.25 5 3.25 6 10
March 07
5.25 0.5 3.75 5.25 4.25 2.25 6.25 7.5 12.75 4.5 2.875 6 9
GLOBAL BOND RATES

Rank Country Rate
Government Bond BUND 10-year bonds Short sterling 10-year T-note
March 6
138.97 117.24 93.73 94.28 116.245
1-month
0.82% 0.28% -0.19% -0.28% -0.73%
3-month
2.04% 1.77% -0.28% 0.86% 2.76%
6-month
2.41% 3.07% -0.38% 0.78% 6.49%
High
139.45 118.08 94.355 94.92 119.03
Low
130.96 109.92 93.46 93.6 103.21
Previous
3 2 4 5 1
1 Japan 2 Germany 3 Australia 4 UK 5 U.S. All data as of March 6
53
THE Economy
FIGURE 1: QUARTERLY GDP PERFORMANCE
U.S. economic briefing

FED MINUTES REVEAL CONCERN ABOUT ECONOMY AND INFLATION
Date and time: Feb. 20 at 2:15 p.m. ET Summary: The Federal Open Market
Committee (FOMC) acknowledged economic conditions had decelerated sharply in recent months, according to minutes from its meeting on Jan. 29 and 30. The Fed cited several sources of the economic troubles: sluggish home sales, slowed consumer spending, reduced industrial production, weakened labor market, and rising inflation. The following tables compare the S&P 500s daily and weekly reactions to economic releases as well as historical behavior since 1997 (or earlier). The S&P 500 climbed at least 0.69 percent on CPI and PPI report days in late February, while it fell 0.84 percent following a dismal jobs report on March 7.
Fourth-quarter GDP growth remained at 0.6 percent, according to a preliminary (second) estimate. In 2007, average quarterly GDP growth was 2.5 percent, its lowest performance since 2002.
Source: Bureau of Economic Analysis Seasonally adjusted *advanced **preliminary
FIGURE 2: PAYROLLS VS. UNEMPLOYMENT RATE
Rate changes Report day Five days later Unchanged rates Report day Five days later
Historical moves since 1994

0.31% -0.06%
February payrolls fell by 63,000 in February, the largest decline since March 2003. In addition, the unemployment rates three-month average hit a two-year high.
Source: Bureau of Labor Statistics Seasonally adjusted

0.21% 0.38%
FIGURE 3: OVERALL VS. CORE INFLATION
FOURTH-QUARTER GDP REMAINS WEAK

Report: Gross domestic product for Q4 2007
(preliminary estimate)
Date and time: Feb. 28 at 8:30 a.m. Actual: 0.6 percent Previous: 0.6 percent Consensus: 0.8 percent S&P 500 reaction
-0.89% -3.36%
GDP Report day Five days later

54

0.00% 0.43%
The PPIs annual gain jumped to a new high in January, while the CPI and core readings rose slightly.
Source: Bureau of Labor Statistics Not seasonally adjusted
FIGURE 4: ISM MANUFACTURING INDEX
PPI LEADS INFLATIONARY PRESSURES

Report: Consumer Price Index (CPI) Date and time: Feb. 20 at 8:30 a.m. Actual: 0.4 percent (core 0.3 percent) Previous: 0.4 percent (core 0.2 percent) Consensus: 0.3 percent (core 0.2 percent) S&P 500 reaction
0.83% 2.41%
CPI Report day Five days later

0.06% 0.15%
In February, the ISM manufacturing index dropped 2.4 points to 48.3, its lowest value since April 2003.
Report: Producer Price Index (PPI) Date and time: Feb. 26 at 8:30 a.m. Actual: 1.0 percent (core 0.4 percent) Previous: -0.3 percent (core 0.2 percent) Consensus: 0.4 percent (core 0.2 percent) S&P 500 reaction
0.69% -2.95%
Source: Institute of Supply Management
Seasonally adjusted
PPI Report day Five days later

0.11% 0.41%
FIGURE 5: S&P PERFORMANCE

The S&P 500 fell 3.27 percent in February amid recession worries, following a 6.12percent loss in January. The market dropped another 2.8 percent in the first week of March.
Source: eSignal
MANUFACTURING INDEX FALLS TO FIVE-YEAR LOW

Report: ISM manufacturing index Date and time: March 3 at 10 a.m. Actual: 48.3 Previous: 50.7 Consensus: 47.5 ISM manufacturing Report day Five days later S&P 500 reaction
0.05% -2.81%

0.28% 0.53%
FIGURE 6: S&P 500 REACTION TO NEWS
DROP IN PAYROLLS POINTS TO RECESSION

Report: Employment Date and time: March 7 at 8:30 a.m. Non-farm payrolls Actual: -63 K Previous: -22 K Consensus: 25 K Unemployment rate Actual: 4.8 percent Previous: 4.9 percent Consensus: 5.0 percent S&P 500 Historical moves Employment reaction since 1994 -0.84% 0.12% Report day
The S&P 500 gained or lost roughly 0.8 percent on report days in February and early March. However, the market managed to bounce off intraday lows and close up 0.1 percent when the ISM manufacturing index hit the Street on March 3.
55
Trading BASICS
The maxiworld of mini futures

After only a decade, mini futures contracts are some of the most actively traded futures in the world. Get the facts on the growing list of U.S.-traded mini futures. BY STEVE GRAUBART
he launch of the E-Mini S&P 500 futures contract in 1997 offered an alternative vehicle to trade the S&P 500 stock index. Over time, its smaller size attracted large numbers of traders who could not afford the margin (upwards of $20,000 per contract) and risk profile of the fullsized, pit-traded S&P 500 futures contract. Although in retrospect its advantages might seem obvious a smaller contract that offers more precise trade sizing and the ease of instantaneous electronic trading the success of the EMini S&P was hardly assured. And to the surprise of many longtime floor traders, by 2003 the E-Mini S&P futures had passed the once-dominant pit-traded contract in volume. It hasnt looked back since. Since then, futures exchanges have launched many other mini-sized trading products. Along with many new stock index products have come offerings in grains, energy, currencies, and metals. Table 1 lists the product specifications for actively traded mini futures contracts traded at the Chicago Mercantile Exchange (CME), New York Mercantile Exchange (NYMEX),
and the U.S. branch of the Intercontinental Exchange (ICE). Many of these contracts, including several mini stock-index contracts, are among the most actively traded U.S. futures (see Stocks and Futures Snapshot, p. 40).
Trading in bytes
One common characteristic of all the mini contracts is that they are traded electronically, regardless of exchange. Before electronic trading assumed the primary position in the U.S. futures market, exchanges electronic trading systems (such as the CMEs Globex) were outlets to try out new contracts with relatively low overhead. Today, however, electronic volume outstrips pit volume, and new contracts are almost always launched electronically even if they also have pit trading. Electronic trading hours are usually different from pit trading hours. For example, the E-Mini S&P trades virtually 24 hours a day (except for Sundays): 5 p.m. to 3:15 p.m. (CT) the next day, with a 15-minute break until 3:30, followed by trading until 4:30 p.m. and a 30-minute break until 5 p.m. By contrast, the pit-traded S&P contract trades 8:30 a.m. to 3:15 p.m. This means the price data for the two contracts is actually different e.g., the intraday highs and lows are likely to be different for the E-Mini and standard S&P contracts. This, of course, will impact your analysis. Mini contract sizes vary from 20 percent (stock indices) to 50 percent (crude oil and some metals) of full contract size, with margin proportionally smaller. For example, one full point (1.00) of the E-Mini S&P 500 contract represents $50, compared to $250 for the full-sized S&P 500 futures contract, and the E-Minis $4,500 per contract margin is one-fifth the full contracts $22,000 margin.
Related reading
The futures advantage Active Trader, October 2002. Part I of our two-part guide showing the unique characteristics of futures. The Article explains basic principles, highlights key trading concepts and helps minimize the risks of trading in this arena. Market mechanics Active Trader, November 2002. Article highlights the unique properties of futures and the mechanics of futures contracts that will allow you to focus on strategy instead of things like rollover and price limits. Futures contracts and rollover Futures & Options Trader, April 2007. From a strategic perspective, theres really no difference between stock and futures. Generally, the same approach used to exploit trading opportunities in stocks can be applied to futures, and vice versa. However, futures do have characteristics that make trading them slightly different from trading stocks.
Trends in minis
Interest in mini futures contracts doesnt appear to be waning. Three-quarters of the contracts in Table 1 increased their average daily volume from January 2007 to January 2008, although the most popular markets continue to be the stock indices.
Theyre not that mini

Finally, despite their smaller contract sizes, trading mini futures on minimum margin is still risky: The leverage you are employing when trading mini contracts is still very high compared to stock trading, for example. Make sure you fully understand the instrument you want to trade before putting money at risk.
Note: Some of these articles are also part of the Futures Basics Collection, a discounted article set packaged in a single PDF file. You can purchase and download past articles at www.activetradermag.com/purchase_articles.htm
56
TABLE 1: U.S.-TRADED MINI FUTURES CONTRACTS

Contract Symbol Exchange
Stock indices: E-Mini S&P 500 E-Mini NASDAQ 100 E-Mini Russell 2000 E-Mini MSCI EAFE E-Mini MSCI Emerging Markets E-Mini S&P MidCap 400 E-Mini S&P SmallCap 600 Mini-sized Dow NYBOT Russell 1000 Index Mini NYBOT Russell 2000 Index Mini Currencies: E-Mini Euro FX E-Mini Japanese yen Eurodollar 5-Year E-Mini Bundle Energy: miNY Light Sweet crude oil miNY natural gas miNY gasoline RBOB miNY heating oil Metals: Mini-sized gold Mini-sized silver miNY gold miNY silver miNY copper Grains: Mini-sized corn Mini-sized soybean Mini-sized wheat *As of Feb. 25, 2008
Contract size
$50* index $20* index $100* index $50* index $50* index $100* index $100* index $5* index $100* index $100* index 62,500 Euros 6,250,000 yen $100,000
% of full contract
Sample price
Tick size/ value

0.25/ $12.50 0.25/ $5.00 0.10/ $10.00 0.10/ $5.00 0.10/ $5.00 0.10/ $10.00 0.10/ $10.00 1/ $5.00 .05/ $5.00 .10/ $10.00 0.0001/ $6.25 0.000001/ $6.25 0.0025/ $12.50 2.5/ $12.50 .005/ $12.50 1/ $21.00 1/ $21.00 10/ $3.32 $.001/ $1.00 $0.25/ $12.50 $0.0125/ $31.25 $0.0020/ $25.00 1/8/ $1.25 1/8/ $1.25 1// $1.25
Average daily volume January January 2008 2007
Change
Initial margin*
Launch date
Sept. 1997 June 1999 Oct. 2001 March 2006 Oct. 2007 Jan. 2002 July 2007 April 2002 May 2007 Aug. 2007 Oct. 1999 Oct. 1999 Oct. 2006 June 2002 June 2002 Jan. 2006 Jan. 2006 Oct. 2001 Oct. 2001 Dec. 2006 Dec. 2006 Dec. 2006 April 2003 April 2003 April 2003
ES NQ ER2 EFE EMI EMD SMC YM RF TF
CME CME CME CME CME CME CME CME ICE ICE
20% 20% 20%
1,355.75 1,781.00 694.90 2,043.60 1,159.20
2,631,279 552,590 318,766 892 324 34,654 397 224,229 610 324
1,030,104 339,124 167,592 132 N/A 18,792 N/A 107,702 N/A N/A
155% 63% 90% 576% N/A 84% N/A 108% N/A N/A
$4,500 $3,250 $5,250 $6,250 $4,688 $4,000 $2,250 $3,125 $2,600 $3,000
20% 20% 20%
801.30 368.50 12,395 739.00 694.90
E7 J7 E5B
CME CME CME
50% 50% 10%
1.4805 9,294 96.0838
1,597 112 4
1,696 25 11
-6% 348% -64%
$1,418 $1,350 $1,485
QM QG QU QH
NYMEX NYMEX NYMEX NYMEX
500 barrels 50% 2,500 million mmBtu 25% 21,000 gallons 50% 21,000 gallons 50% 33.2 troy oz. 1,000 troy oz 50 troy oz. 2,500 troy oz. 12,500 lbs. 1,000 bushels 1,000 bushels 1,000 bushels
98.230 8.891 2.5220 2.7381
17,496 4,577 5 6
39,743 12,061 1 293
-56% -62% 400% -98%
$3,544 $1,688 $4,050 $3,375
YG YI QO QI QC
CME CME NYMEX NYMEX NYMEX
33% 20% 50% 50% 50%
937.5 18.077 944.50 18.035 3.7980
9,218 2,507 58 35 30
5,959 1,558 38 14 20
55% 61% 53% 150% 50%
$1,121 $812 $2,363 $3,038 $3,882
YC YK YW
CME CME CME
20% 20% 20%
$5.22.2 $14.20 $10.49.4
675 2,309 343
768 2,158 220
-12% 7% 56%
$270 $594 $810
57
TRADING Resources
NEW PRODUCTS & SERVICES

ATC Analytics, LLC has released NexTrend version 7.0. The allinclusive software, available starting at $9.95 per month, provides traders of every level with information and tools needed to make informed decisions. NexTrend is a full-featured, downloadable multi-tasking program. The software, username, and password can be used anywhere in the world. NexTrend offers online stock quotes, scanning, real-time news, alarms, and history for domestic and international securities. More information about ATC Analytics and its products can be found at www.nextrend.com.
The Commodity Futures Trading Commission (CFTC) has approved trading in additional Eurex products for the U.S. market effective immediately. The approval comprises the futures on the Dow Jones STOXX Large 200 Index and Dow Jones STOXX Small 200 Index as well as six Dow Jones STOXX 600 sector indices. These newly available futures enable U.S. customers to trade specific segments and sectors of the European stock universe represented by the DJ STOXX 600 Index. Eurex launched futures on the two DJ STOXX size indices on July 23. These futures on the DJ STOXX Large 200 Index and DJ STOXX Small 200 Index supplement the futures available on the DJ STOXX Mid 200 Index, which was approved by the CFTC in 2007. The DJ STOXX 600 sector index futures cover the insurance, media, utilities, travel and leisure, personal and household goods, industrial goods, and services sectors and complement the banking sector futures, which are already available to U.S. customers. More information is available at http://deutsche-boerse.com. also doubles the number of technical studies and line tools available. In addition, many new add-ons are available, including Option Chains, Market Depth, Premium News as well as QuoTrek, a mobile product that brings real-time quotes, charts, and news to BlackBerries, smartphones, and other handheld devices. Full product information is available at www.LiveCharts.com.
DiscoverOptions provides options education and resources to help traders find opportunities in all market conditions, including bearish markets. The DiscoverOptions Education Center (www.DiscoverOptions.com) provides articles, lessons, Web casts, and other content for all levels of options traders. DiscoverOptions provides a clearer understanding of how using options can help minimize risk, generate additional income, and allow traders to profit under virtually any market condition. The DiscoverOptions Personal Mentoring Programs curriculum is taught by options professionals who work with students one-onone, showing them how to identify profitable trades in variable markets using proven back-tested strategies. Rosenthal Collins Group (RCG) has introduced a package of advanced Java-based interactive charts from Barchart.com on its
RCG Onyx 2 trading platform. The new service represents the most advanced Java-based charting technology that Barchart has offered to date. The charting, available on the Internet both through the RCG Onyx 2 trading platform and RCG Onyx Web, the online account management tool, includes real-time and historical price and volume information for the major futures exchanges in North America. It provides multiple interactive charting types, including bar charts, candlestick charts, and dozens of technical studies. Users can view charts for multiple commodities at a time and can customize them by designating time periods analyzed and trading styles. RCG and Barchart are offering continuation charts for futures contracts, enabling users to capture the roll when contracts expire and to select charts based on daily, weekly, or monthly activity. More information can be found at www.rcgdirect.com.
FXCMs No Dealing Desk trading platform recently added an

additional bank as a price provider, bringing the total to seven global banks that compete to provide pricing for FXCMs Trading Station. Over the last three months, typical spreads have already tightened. For a complete list of currency pairs and their new tighter spreads, go to www.fxcm.com.
eSignal has upgraded its LiveCharts product. LiveCharts offers users Web 2.0 functionality via eSignals social networking site and also links with Quote.com. Running entirely on eSignals data network, LiveCharts is powered by PlusFeed data, a low latency, consolidated data feed service from Interactive Data Real-Time Services. LiveCharts is a java-based application that integrates streaming charts, portfolios, and real-time news on any Web browser. This upgrade includes a new, customizable modular interface, major international stock exchanges, and the popular currency spot market, in addition to data for major U.S. stocks, options, and futures markets. This LiveCharts upgrade
58
Saxo Bank (www.saxobank.com) now offers FX options to private investors in the U.S. after its success in Europe and Asia. Saxo Bank was the first forex options trading provider to offer options trading for 31 major forex crosses directly on live streaming prices without dealer intervention to private investors. Options can be quoted with one-day to one-year expiries, as well as zero to 100 deltas.
BOOKSHELF
Mastering Trading Stress: Strategies for Maximizing Performance
By Ari Kiev Wiley, 2008 Hardcover, 224 pages $49.95 Trading can be emotionally and psychologically taxing. As markets grow increasingly complex and volatile, so do the stresses involved in trading them. In this book, psychiatrist Ari Kiev discusses where this stress comes from, how it affects traders, and how to reduce it. Real-life traders provide examples of how they manage stress, enhance performance, and improve profitability.
Technical Analysis Tools: Creating a Profitable Trading System

By Mark Tinghino Bloomberg Press, 2008 Hardcover, 295 pages $39.95 Instead of relying on a single indicator, most traders use many technical analysis instruments. In this book, Mark Tinghino discusses several technical approaches and explains how to create a profitable system. He covers the relationship between fundamental and technical analysis, how to time buying and selling, and how to use spreads to manage risk.
Winning with Options: The Smart Way to Manage Portfolio Risk and Maximize Profit
By Michael C. Thomsett AMACOM, 2008 Paperback, 248 pages $19.95 Geared toward the average trader, this book describes options as a smart and practical way to protect and enhance a portfolio. The book introduces readers to many aspects of option trading and offers strategies to help manage risk and turn a profit through basic concepts and real-life examples.
The ART of Trading: Combining the Science of Technical Analysis with the Art of Reality-Based Trading
By Bennett A. McDowell Wiley, 2008 Hardcover w/ DVD, 320 pages $70.00 This multimedia package discusses the Applied Reality Trading (ART) and includes ART trading software. It explains how to ignore others opinions and suggestions and develop a system that aligns with your personality. Whether enhancing a fundamental approach or creating a purely technical one, this book attempts to provide all the tools traders need.
Beating the Market, 3 Months at a Time: A Proven Investing Plan Everyone Can Use
By Gerald Appel & Marvin Appel FT Press, 2008 Hardcover, 218 pages $24.99 Rather than handing your hard-earned cash over to a professional investment manager, this book claims that by spending only one hour every three months you can take matters into your own hands, using the authors recommendations and simple investment techniques. These father-and-son investment advisors offer advice on portfolio construction, increasing investment safety, improving rates, and identifying strong market sectors. They demonstrate how to quickly evaluate, adjust, and optimize performance.
The Rookies Guide to Options: The Beginners Handbook of Trading Equity Options
By Mark D. Wolfinger W&A, 2008 Hardcover, 232 pages $34.95 In his book, Mark D. Wolfinger explains how options work and how you can employ them to earn profits and manage risk. Aimed at the novice investor, it offers step-by-step instructions on option systems from basic techniques to more complicated strategies such as iron condors and double diagonals. He explains when different strategies should be used depending on the situation and objectives.
59
TRADING Calendar
LEGEND
CPI: Consumer price index ECI: Employment cost index First delivery day (FDD): The first day on which delivery of a commodity in fulfillment of a futures contract can take place. First notice day (FND): 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 Last trading day (LTD): The final day trading can take place in a futures or options contract. PPI: Producer price index PMI: Purchasing managers index Quadruple witching Friday: A day where equity options, equity futures, index options, and index futures all expire.
May 2008
1
March personal income March construction spending April ISM business report
2 3 4 5 6 7 8 9 10 11
April unemployment March factory orders
April ISM non-business report
Q2 productivity and costs (prelim) March consumer credit March wholesale inventories March trade balance
CBOT: Chicago Board of Trade CME: Chicago Mercantile Exchange NYMEX: New York Mercantile Exchange
12 13 14
April federal budget March business inventories April retail sales April CPI April production and capacity utilization May Philadelphia Fed survey LTD: June crude oil options (NYMEX)
S
28 4 11 18 25
M
28 5 12 19 26
T
29 6 13 20 27
W
30 7 14 21 28
T
1 8 15 22 29
F
2 9 16 23 30
S
3 10 17 24 31
15
16
May University of Michigan consumer sentiment index (prelim) April housing starts LTD: All May equity and index options
60
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.
17 18 19 20
April leading indicators April PPI April Chicago Fed national activity index LTD: June crude oil futures (NYMEX)
CPI ECI PPI Productivity and costs Employment Personal income Business inventories Durable goods Retail sales
21 22 23 24 25 26 27
Markets closed Memorial Day May consumer confidence April new home sales LTD: June gold options (NYMEX) April existing home sales LTD: June T-bond futures (CBOT)
Trade balance Housing starts Production & capacity utilization Leading indicators Consumer confidence Univ. of Michigan consumer sentiment Wholesale inventories Philadelphia Fed survey Existing home sales Construction spending Chicago PMI report ISM report on business ISM non-manufacturing report
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.
28 29 30
April durable goods LTD: May gold futures (NYMEX) Q1 GDP (prelim) May University of Michigan consumer sentiment index (final) April personal income May Chicago PMI
on business New home sales Chicago Fed national activity index Factory orders Federal budget Consumer credit
10 a.m. 10 a.m.
10 a.m. 10 a.m. 2 p.m. 3 p.m.
Note: For expiration dates of commodity futures and options, as well as first notice and first delivery dates, see the calendar in Futures & Options Trader magazine (www.futuresandoptionstrader.com).
The information on this page is subject to change. Active Trader is not responsible for the accuracy of calendar dates beyond press time.
61
Key CONCEPTS
3-10 oscillator: The difference between a three-day simple moving average and a 10-day simple moving average, plus a second line which is a 16-period simple moving average of the 3-10 line. In Trader toolbox (Active Trader, March 2004) trader Linda Raschke said, On a chart, I usually just alter the settings for the MACD, changing the moving average type from exponential to simple and the moving average lengths to 3, 10 and 16.
The indicator is similar in concept to the moving average envelope, with an important difference: While moving average envelopes plot lines a fixed percentage above and below the average (typically three percent above and below a 21-day simple moving average), Bollinger Bands use standard deviation to determine how far above and below the moving average the lines are placed. As a result, while the upper and lower lines of a moving average envelope move in tandem, Bollinger Bands expand during periods of rising market volatility and contract during periods of decreasing
Advance-Decline line: A breadth indicator that measures aspects of supply and demand not always reflected directly in price. The indicator is a day-to-day running total of the number of stocks that have closed higher on the day (advancing) minus the number of stocks that have closed lower on the day (declining). A version using the week-to-week figures can also be used as a longer-term indicator. The most commonly referenced A-D line is the one calculated on New York Stock Exchange (NYSE) stocks, but the indicator can be calculated on any index or exchange. Calculation A-D line = [AS(today) DS(today)] + AD(prev)
market volatility. Bollinger Bands were created by John Bollinger, CFA, CMT, the president and founder of Bollinger Capital Management (see Active Trader, April 2003, p. 60). By default, the upper and lower Bollinger Bands are placed two standard deviations above and below a 20-period simple moving average.
Upper band = 20-period simple moving average + 2 standard deviations Middle line = 20-period simple moving average of closing prices Lower band = 20-period simple moving average - 2 standard deviations
where AS(today) = the number of advancing stocks (those that closed higher than the previous days close) DS(today) = the number of declining stocks (those that closed lower than the previous days close) AD(prev) = previous days A-D line value Bollinger Bands highlight when price has become high or low on a relative basis, which is signaled through the touch (or minor penetration) of the upper or lower line. However, Bollinger stresses that price touching the lower or upper band does not constitute an automatic buy or sell signal. For example, a close (or multiple closes) above the upper band That is, add the difference between the number of advancing stocks and declining stocks today to yesterdays A-D number, which is the running total of all previous days. A nominal value is often used to begin the A-D calculation. or below the lower band reflects stronger upside or downside momentum that is more likely to be a breakout (or trend) signal, rather than a reversal signal. Accordingly, Bollinger suggests using the bands in conjunction with other trading tools that can supply context and signal confirmation. Bollinger Bands: Bollinger Bands are a type of trading envelope consisting of lines plotted above and below a moving average, which are designed to capture a markets typical price fluctuations.
62
Donchian breakout (channel breakout, breakout system, n-bar breakout): Named after the man who popularized the
continued on p. 63
Key concepts continued
approach, Richard Donchian, this approach refers to buying a price move above an n-bar (n-day, n-week, or n-minute, etc.) high and selling on a move below a n-bar low. Donchians original system was called the four-week rule and consisted of buying and selling moves above and below the four-week high and low, respectively. Pure breakout systems are often designed in stop-and-reverse (SAR) fashion: when a buy signal occurs, any existing short position is liquidated and a new long position is simultaneously established; when a sell signal occurs, the long position is liquidated and a new short position is established. Thus, the system is always in the market. One basic variation is whether a trade is triggered by a simple penetration of the n-bar high or low or by a close above an nbar high or below an n-bar low.
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.
Moving average convergence-divergence (MACD): Although it is often grouped with oscillators, the MACD is more of an intermediateterm trend indicator (although it can reflect overbought and oversold conditions). The default MACD line (which can also be plotted as a histogram, as is the case in the accompanying article) is created by subtracting a 26-period exponential moving average (EMA) of closing prices from a 12-period EMA of closing prices; a nineperiod EMA is then applied to the MACD line to create a signal line.
Momentum (or price momentum): A generic term used to describe the rate at which price changes as well the name of a specific 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:
MACD = EMA(C,12)-EMA(C,26) Signal line = EMA(MACD,9)
On balance volume (OBV): A running sum of daily market volume weighted by whether the market closes up or down for the day. Joe Granville introduced the indicator in his book New Strategy of Daily Stock Market Timing for Maximum Profits. To get the current OBV reading, todays volume is added to or subtracted from the previous OBV reading based on whether the market closes up, down or unchanged on the day. The formulas are:
If today closed higher than yesterday: (Ptoday Pn days ago). yesterdays OBV + todays volume
The most basic ROC formula is todays price divided by the price n days ago:
If today closed lower than yesterday: yesterdays OBV - todays volume
(Ptoday/Pn days ago).
If today closed unchanged from yesterday: yesterdays OBV
Alternate calculations for rate of change are 100*(Ptoday /Pn

63 www.activetradermag.com May 2008 ACTIVE TRADER
UPCOMING Events
Event: The Options Initiative Two-day Seminars Dates: April 10, July 17, Nov. 20 Location: CBOE Options Institute, Chicago For more information: Call (877) THE-CBOE Event: 17th Annual FIA Futures Services Division OpTech Conference Date: April 17 Location: New York City For more information: Call (202) 466-5460 Event: Trading Index Options Hedge Fund Strategies and Portfolio Protection Date: April 22 Location: Hilton Resort & Villas, Scottsdale, Ariz. Date: May 6 Location: Hyatt Regency Tech Center, Denver, Colo. For more information: Call (877) THE-CBOE Event: Real Trading with Dan Sheridan Date: April 24 Location: Hilton, Scottsdale, Ariz. Date: July 24 Location: CBOE Options Institute, Chicago For more information: Call (877) THE-CBOE Event: 30th Annual Law & Compliance Division Workshop Date: May 7-9 Location: Renaissance Harborplace Hotel, Baltimore For more information: Call (202) 466-5460 Event: The Options Intensive Two-day Seminars Dates: May 22, Aug. 21, Oct. 23, Dec. 4 Location: CBOE Options Institute, Chicago For more information: Call (877) THE-CBOE Event: Traders Expo Los Angeles Date: June 18-21 Location: Ontario Convention Center For more information: www.tradersexpo.com Event: TradeStations Two Day Futures Symposium Date: June 26-28 Location: Wyndham Drake Oak Brook Oak Brook, Ill. For more information: Call (800) 808-3241 Event: Forex Trading Expo Date: Sept. 12-13 Location: Mandalay Bay Resort & Casino, Las Vegas For more information: www.tradersexpo.com Event: Traders Expo Las Vegas Date: Nov. 19-22 Location: Mandalay Bay Resort & Casino, Las Vegas For more information: www.tradersexpo.com
64
ADVERTISING Index
Advertiser Active Trader Bookstore www.invest-store.com/activetradermag/bookstore CMS Forex www.cmsfx.com eSignal www.esignal.com E*TRADE FINANCIAL www.getpoweretrade.com Expo Trader Brasil www.traderbrasil.com Fidelity www.fidelity.com/switch2 FXCM www.fxcm.com ProShares www.proshares.com Interactive Brokers www.interactivebrokers.com International Traders Expo www.latradersexpo.com MB Trading www.mbtrading.com MoneyShow.com www.moneyshow.com TradeStation www.tradestation.com Trade The News www.TradeTheNews.com Wealth Lab www.wealth-lab.com Xview www.xview.com
TRADE Diary
Reversing a pattern in gold pays dividends.
TRADE
Date: Monday, Feb. 25. Entry: Long April 2008 mini gold futures
(YGJ08) at $933.90.
Reason(s) for trade/setup: Having topped

$900, robust gold trading has morphed into something approaching public gold fever as more ordinary investors read about the markets supposed inevitable rise to $1,000 and beyond. Hype aside, what scant historical parallels exist support the notion that gold is in a selffulfilling prophecy mode that will propel it to the major round-number price of $1,000. (After that, its anyones guess.) Futures Insight: Gold (Active Trader, April 2008, p. 40) showed that gold has favorable odds of rising for the first two months after seven-month, 33-percent rallies, the most recent of which had concluded in January. The median closing gain in the first month was 5.75 percent; 7.96 percent for the second month. Extending this pattern would roughly forecast a $981 February close (the actual close turned out to be $975) and a $1,001.87 March close. After paying the price for over-eager entries in the volatile gold market (see the Trade Diary on p. 88 of the April issue of Active Trader), this trade represented an attempt to get back on the correct side of the market i.e., waiting for price to pull back and buying at a relative low price rather than going long on a short-term upside breakout and hoping the move would continue.
Source for all charts: TradeStation
We got in on the third day of a correction after the Feb. 21 high (just below $960). Although the $933.90 entry price was a little more than five points above the Feb. 25 low, it represented a nearly $25 (2.6-percent) correction from the Feb. 21 high. (Note: The trade was actually entered in the electronic market before the open of the Feb. 26 day session.)
Initial stop: $922.90, which is $5.70 below the low of the entry
day. Although from that perspective the stop is rather tight, it is nonetheless $17 (1.8 percent) below the entry price.
Initial target: $984. The target was based on the prior

upswing, from Feb. 13 to Feb. 21, which resulted in a low-tohigh gain of nearly 60 points. Adding that amount to the entry day low created a target around $988.00.
Trade Summary
Date 2/25/08 Stock YGJ08 Entry 933.90 Initial stop 922.90 Initial target 984.00 IRR 4.55 Exit 974.10 Date 2/29/08 P/L 40.20 (4.3%) LOP 44.50 LOL -5.30 Length 4 days
Legend 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).
65
RESULT
Exit: 974.10 Profit/loss: +40.20 (4.3 percent). Trade executed according to plan? No. Outcome: Other than the early exit, the trade
was executed according to plan. The entry timing was definitely better on this trade than for our other recent gold trades; the market closed nearly $14 above the entry price on Feb. 26 and pretty much marched straight upward for the next three days. We did get out too early, though. On Feb. 29 the market lost some momentum intraday after topping above $978. After three days of higher highs, lows, and closes and a nearly $50 gain from the Feb. 26 low to the Feb. 29 high, it seemed time to take money off the table and wait for a pullback before considering re-entering for another run at $1,000 rather than risking another one of this markets dramatic corrections. (We dont trust this market!)
Of course, the next day gold jumped as high as $993 and hit $995 two days later. However, it subsequently retreated twice to around $960 (the first time, the day after it first reached $993). It can be a challenge taking profits in a market making alltime highs because there are no existing reference points. Conservatively extrapolating from the markets recent up moves (other up swings had, in fact, been larger than the one we used to estimate a target) is as viable an approach as any. However, this trade is another example of the benefits of taking partial profits. We could have exited part of our position early and potentially enjoyed $20 more of profit on the remainder of the position. Final note: As planned, we re-established a long position around $5.00 below this trades exit price. For more coverage of the gold rally, see Gold express may lose steam above $1,000 on p. 49.
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 flexible 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.
66
TRADE Diary
Trade plan not followed to the letter, but close enough. TRADE
Date: Wednesday, Feb. 27, 2008. Entry: Short March 2008 mini Dow futures (YMH08) at 12,721. Reason(s) for trade/setup: With price
approaching the implied chart resistance of the Feb. 1 high and the market still in a downtrend, we will look to go short on an intraday up move. The market jumped higher a little after 9:30 a.m. CT, and we went short after it failed to quickly surpass the new 12,752 intraday high.
Initial stop: 12,774, which is 24 points above the sessions high. Initial target: 12,619, which is 5 points above the sessions low we expect the market to at least test the days range. Take profits on partial position and lower stop.
RESULT
Exit: 12,657. Profit/loss: +64 (0.5 percent). Trade executed according to plan? No. Outcome: The market moved sideways to slightly higher for more than two hours after the entry. (It might be interesting to test the odds of a move in either direction out of a consolidation
that has lasted more than n bars, after an up or down move of x percent.) The market eventually resolved itself to the downside and we got out at what amounted to the third down thrust, lowering a stop order along the way. We exited the position early, and in its entirety, because we decided the initial target was too aggressive: The market had fallen relatively far relatively fast (almost 100 points in less than an hour), and was also approaching possible support around 12,640. We actually expected to re-enter on the short side after a bounce, but the market kept rallying strongly enough to dissuade us.
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 flexible 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.
Trade Summary
Date Stock 2/27/08 YMH08 Entry 12,721 Initial stop 12,774 Initial target 12,619 IRR 1.9 Exit 12,657 Date 2/27/08 P/L 64 (0.5%) LOP +76 LOL -41 Length 3 hours
Legend 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).
67

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DRAWDOWN VS.

NIGHT AND DAY TRADING in the E-Minis p. 16

Ari Kiev on handling trading stress p. 44

$4.95 U.S. / CANADA

Printed in the U.S.A.

Trading Strategies Night and day in stock index futures

System death: When good systems go bad

Advanced Strategies TIPS, treasuries, and insurance

Trading System Lab The 4-percent model

Editors Note Contributors Letters Opening Trades

40 Stocks & Futures

60 Trading Calendar 62 Key Concepts 64 Upcoming Events

www.activetradermag.com May 2008 ACTIVE TRADER

Contents continued Contact Active Trader:

Active Trader Interview Vitaliy Katsenelson: Market skeptic

Q&A Ari Kiev on trading stress and leadership

The Economy U.S. economic briefing

Trading Basics The maxi world of mini futures

Inside the Market

Rogue trader shredded in wheat market

www.activetradermag.com May 2008 ACTIVE TRADER

were, the U.S.s flaccid

Mark Etzkorn, Editor-in-chief

www.activetradermag.com May 2008 ACTIVE TRADER

This Months CONTRIBUTORS

For all subscriber services:

www.activetradermag.com May 2008 ACTIVE TRADER

LETTERS Diary of a hedge fund manager

ACTIVE TRADER May 2008 www.activetradermag.com

Stocks: Status quo to the downside

Gold fever: 1,000 and?

Bonds and notes soar

Source: TradeStation www.activetradermag.com May 2008 ACTIVE TRADER

Euro tops $1.5000 for the first time

Futures volume sets new records

Oil $100: The new $30?

Gas ETF hits the road

Tit for tat

Opening Trades continued

Volatility hits grains

An aftertaste in coffee, sugar, and cocoa?

Exercise those options

Night and day in stock index futures

FIGURE 1: UP DAY AND NIGHT

Night and day

FIGURE 2: NIGHT REVERSAL EXAMPLE

Strength and weakness patterns

ACTIVE TRADER May 2008 www.activetradermag.com

Trading Strategies continued

TABLE 1: DAY AND NIGHT SESSION CLOSE IN SAME DIRECTION

E-Mini S&P traded after these different scenarios.

BY CHRISTIAN SMART, Ph.D.

Trade rules for simple breakout system

www.activetradermag.com May 2008 ACTIVE TRADER

FIGURE 1: UPSIDE BREAKOUT IN THE EURO

System death: Quick or slow and painful?

ACTIVE TRADER May 2008 www.activetradermag.com

Trading Strategies continued

TABLE 1: BREAKOUT SYSTEM PERFORMANCE

www.activetradermag.com May 2008 ACTIVE TRADER

Mechanica Software code

You can copy this code at www.activetradermag.com/code.htm

FIGURE 2: BREAKOUT SYSTEM EQUITY AND DRAWDOWN CURVES

ACTIVE TRADER May 2008 www.activetradermag.com