The Art of Speculation Series 5 - Understanding Support and Resistance and Who sets it

When you look at a chart, you will notice there are days where the market is heading upward and days the market heading downward. These gyrations in prices are called the ‘tides of speculation’. These tides of speculation are the result of the battle between the bulls and the bears. When bear wins there will be a downtrend and when the bull wins there will be an up trend.



Support and Resistance Level

Support is a price area where the demand of the stock exceeds supply and hence will prevent a further drop in the price. Whenever the price of the stock touch the support level, buyers will appear to support the price level. It can be shown by the purple line on the above chart.

Resistance is a price area where the supply of the stock exceeds the demand and will prevent further advances in the stock price. Again when the stock price approach the resistance level, sellers will appear in numbers to offer their stocks. Thus will prevent any further rise in the stock. It can be shown by the red line on the above chart.

However, a lot of traders do not know the difference between a major and minor support and resistance. A major support refers to a situation where a stock is declining to retest the prior low. A minor support refers to a situation where a stock is declining to retest a prior high. Hence, the opposite will be true for the major and minor resistance.

As can be seen from the above chart, once the major resistance is broken it will become the minor support. This is because the stock will be retesting the recent high that is broken.

Trade using Support and Resistance

How do we trade using Support and Resistance? As shown by the above chart, any Breakdown from the support level ($60 in above) represents a shorting opportunity or a selling opportunity. This is where sellers overwhelm buyers.

Any Breakout from the resistance level ($47 in above) represents a buying opportunity. This is where buyers overwhelm sellers.

It is also important to understand that the price ranges between the support and resistance is not registered there for nothing. In fact there are SET by the Insiders and Big Money.
They are the people who have enough funds to set the support and resistance prices.

They are the people who have enough purchasing power to buy hundreds of thousands if not millions of shares in order to influence the support and resistance prices. The main reason for them to set the support and resistance prices, is that it will enables them to ‘Accumulate enough Shares’ before their next BIG Move. Sorry to say, it is not me or you or the rest of the folks out there that can influence those prices.

This is good news because when we know it is the insiders and big money that set those prices then we can more or less track their money trail. Knowing about insider buying and selling can boost your returns in the following ways.

1. Help you align with the savviest investors around

2. Help you discover hidden gems early

Any breakout from the resistance level represents a buying opportunity because this is where buyers overwhelm sellers. That means someone knows something that we don’t.

This is important because once a stock break through either the support or resistance level with good volume, then there is a strong tendency for it to continue in that direction for an extended period of time.

In conclusion, by understanding support and resistance, it will enable you to ‘Buy What the Big Money and Insider Buys’

Using Fourier Transform to study relationship between Politics and Oil, By Professor Tom Therramus

This is an interesting piece of article from Professor Tom Therramus which first appeared in oil-price.net. It shows how by using Fourier Transform, analyst are now able to predict the relationship between oil and politics. It is not surprising because all these events are somehow influenced by 'market cycles'. As for your information Fourier Transform has been used in many  physics and engineering applications. It is used in measuring aircraft wing vibrations, processing signals such as light waves, seismic waves, radio waves and also images.

 As far as i know, it has already been adapted into stock market analysis by studying the waves.Technical analyst from large brokerages and investment banks are using such tools to predict market movements. Stock market is known to run on waves presumably like a sine wave, so by incorporating Fourier Analysis as a tool to study the waves greatly enhances stock market predictability. Anyway below is the link for the article,

http://oil-price.net/en/articles/is-oil-fueling-rise-in-political-partisanship.php

Is Oil Fueling the Rise in Political Partisanship? By TOM THERRAMUS for OIL-PRICE.NET, 2011/11/21

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The Art of Speculation Series 4 - Stock Market Pyramiding

It is everyone’s objective to make money when investing in the stock market. Taking losses will be the last thing they had in mind. So when a stock goes down, they tend to buy more or average down because they believe that when the market rebounds later they are able to make back their losses ‘at one shot’. It is a conventional argument that in stock market investment, anything that is cheap is good and hence the bigger the price drops the more we should buy.

Pyramiding Up

When you have done your homework and analysis, there are two possibilities that may arise when you decided to take the plunge. One, the stocks that you bought moved up and the other is it moved down. The problem is how should you react to both situations? I am sure you would like to increase your profits when your stocks moved up. How can you do it?

There are two ways to increase your profits. One is by trading more frequently during the up trend and the other is by increasing your positions. Trading more frequently will be out of the questions because the commissions and taxes will kill you. The other alternative is to increase the size of your position or in other words leverage up.

Leveraging up or what we call pyramiding up is another strategy that can help you maximize your profits when the market goes up. The question is how much to pyramid up so that it will help you maximize your return and minimize your losses? Basically there are three ways to pyramid up and we shall examine them individually.

Three different scenarios

There will be three different scenarios when pyramiding up.

1. Buy on decreasing quantity when price go up
2. Buy on even quantity when price go up
3. Buy on increasing quantity when price go up

Lets analyze the above scenarios below based on the following assumptions.

1. total quantity bought is 500 shares
2. price increase at $1 per interval
3. shares bought on 5 different time intervals

Chart 1. Buy on decreasing quantity of shares for every dollar increase.

No	Price	Quantity	Total
1	$10	200	$2,000
2	$11	150	$1,650
3	$12	80	$960
4	$13	50	$650
5	$14	20	$280
Total		500	$5,540

The average price for this purchase is $11.08 ($5,540/500)


Chart 2. Buy even 100 lots for every dollar increase.

No	Price	Quantity	Total
1	$10	100	$1,000
2	$11	100	$1,100
3	$12	100	$1,200
4	$13	100	$1,300
5	$14	100	$1,400
Total		500	$6,000

The average price for this purchase is $12 ($6,000/500).


Chart 3. Buy on increasing quantity for every dollar increase
 

No	Price	Quantity	Total
1	$10	20	$200
2	$11	50	$550
3	$12	80	$960
4	$13	150	$1950
5	$14	200	$2800
Total		500	$6,460

The average price for this purchase is $12.92 ($6,460/500).

The Best Strategy when Average Up

As you can see from the above three charts, the lowest cost and best strategy is achieved in Chart 1. Total cost outlay is $5,540 and average cost is $11.08. Chart 3 is the most costly and inefficient strategy with total outlay at $6,460 and average cost is $12.92.

Now, what happen when the market corrects? In normal conditions, when the market corrects it will give back 50% of its gains. In this case, the gain is $14 - $10 = $4 and 50% of $4 is $2. Hence the stock price will retrace back to $12. As you can see, in Chart 3 the average cost is $12.92 and hence this strategy will be making a loss. Chart 2 will be back to square one, however Chart 1 still provides you with a winning strategy.

So, what we can learn here is that when we average up our bets, make sure that the quantity is on a descending scale.

Debunking Myths 3 - Hedge and Fund of Funds always outperform the Benchmark

A hedge fund is a private investment fund open only to institutional and high net worth private investors. Due to the Non-public involvement in this scheme, they are not under the jurisdiction of the regulators and are much left to themselves . Hedge funds are not required to register and report to the Securities and Exchange Commission and are therefore often regarded as “secretive” or “unregulated.”

A fund of funds, is actually a hedge fund that invest in other hedge funds. Its portfolio does not consist of stocks, commodities, real estates or other investment vehicles but of other hedge funds. 

It is akin to the Mutual Fund of Mutual Funds whereby this Mutual Fund selects and invests in mutual funds that outperforms.

The analysis below is based on the following assumptions.

1. The bench mark is S&P with a growth averages 10% per annum
2. Some data are from TASS, a hedge fund database

Inner workings of Hedge Funds

The term “hedge” does not necessary means that hedge funds are conservative or they mainly deploy hedging techniques in their investments. In fact, hedge funds use a wide array of strategies, and sometimes are not “hedged” against the market at all.

The beauty of hedge funds is that they can employ various strategies and they can invest in much more riskier investments than mutual funds. This may include real estate, art, derivatives, commodities, new startups, even website domain names. The hedge fund manager may use leverage, short selling and arbitrage in order to produce higher returns for investors.

Hedge fund managers also employ investment tools that can greatly increase returns. Unlike mutual funds, hedge funds can use short selling, invest in derivatives, leverage their portfolios, and hold highly concentrated positions - strategies that can amplify returns greatly.

Whenever there is a crash, there will be a group that did just fine because they are betting against the trend and that is for the market to crash. It seems that the strategy they employed known as ‘Market Neutral’ will always work in any market conditions. Market neutral strategy means long on good stocks and short on bad ones.

Other strategies that hedge funds use are Long/Short sector equity, Arbitrage, Emerging Markets, Merger and Acquisition arbitrage, Distress/Panic Sale Equities, Global Macro, Event Driven and many more.

When few of the many hedge funds make headlines on making a kill in the last crash, a lot of people believed that hedge funds offer better returns and everyone should be invested in hedge funds.

Law of Diminishing Returns on Funds

In reality performs much worse that most of us think. There are now more than 10,000 hedge funds managing more than $1.5 trillion. Unfortunately to invest in a hedge fund you need to have at least $1 million in liquid assets and the top notch hedge funds only concentrates on institutional investors who can easily invest $50 - $100 million.

However due to the ‘economies of scale’ in the funds, hedge funds found that the large amount of funds they hold also present a problem. The law of diminishing returns also applies to funds, the bigger your funds the less opportunity you will have. That means it will be harder for you to repeat your performance. A $1 billion fund is easier to achieve a 20% return than a $10 billion fund because a $10 billion fund needs to search for $10 billion opportunities. How many billion dollars opportunities are out there? This is what we call Diseconomies of scale in investment, whereby the bigger you are the harder for you to produce higher returns.

Hedge funds did worse that expected

Legendary hedge fund investor John Paulson was not sparred during the downturn last year. Paulson who had earlier make a name for himself, after generating returns of up to 600% by betting against mortgages in 2008 as the market crashed.  
Since 2010, some of Paulson's $30 billion funds have generated losses of more than 30% after waging some bad bets especially on Bank of America and Chinese company Sino Forest.

Lyxor, is Societe General’s managed account platform or Fund of Funds, had investment in about 100 hedge funds.

As of Oct. 2011, according CNNMoney, out of Lyxor’s group of 100 hedge funds only 25 had generated positive returns. Thirty funds lost more than 10% and nine funds, including Paulson's flagship Advantage fund, generated losses of more than 20%.That's worse than the S&P 500, which is only down about 8% from the start of the year.

More than 140 Asia-focused hedge funds shut down last year, due to the high market volatility, which dampened investor sentiment.
Credit Suisse said that by the end 2011, 67 per cent of global hedge funds were performing below their peak levels and 13 per cent have not earned a performance fee for four years or more.

Reasons for Bad performance

1) Too many of them.

Modern day hedge funds only started around circa 1995. During the 1990s, there are not many funds, so many of them actually make a killing in the market. Strategies that they employed like Long/Short sector specific like technology make a killing during and after the Dotcom bust. This is because they long before the crash and they short during the Crash. However, since then there are much more funds available. It is estimated that there are more than 10,000 funds are active now even though it is estimated that there are about 10% of the funds closed their doors every year. Each of them are employing almost the same strategy and hence the competition to produce higher returns has increased.

2) Non Disclosure of reporting

As we have mentioned earlier, due to the Non-public involvement in the industry, hedge funds are not required to report their performance or publish their results. Therefore, their reporting tends to suffer from data massaging and biasedness. According to a study by Professors Fung, Hsieh, Narayan and Ramadorai, the annual return of a hedge fund is about 14.4% net of fees. However, after adjusting for 2 biases namely ‘survivorship and incubation’ the percentage drop to about 10.5%. The question is what are these ‘Survivorship and Incubation’ biases?

Survivorship bias, which also occurred in Mutual Funds, is a situation where under performing or ‘dead wood’ funds are dropped from the evaluation process in the fund performance. So in other words only funds that perform favorably are included in the performance calculation.

Incubation bias is a situation where hedge funds starting new funds internally and only include funds that do well and exclude those that did badly from their performance reporting. It is similar to a large shopping center chain keeps opening new stores to boost their overall sales even though some are located just a couple of kilometers from each other. End result is cannibalizing of sales where old store sales are dropping while new stall sales are growing.

3) High cost or fees

No doubt most hedge funds have their own money invested in the funds as well and also staffed by some of the smartest fund managers around. They too are bogged down by the high cost of their remuneration. Their charges are best known as ‘two and twenty’. By this we mean that they charge 2% on their fees on assets (either they performed or not) and 20% commission on the profits they make. In order to make a 10% return on their investments, hedge funds need to garner in at least a 20% return to compensate for the fees, commissions, survivorship and incubation bias and taxes.

When you include fund of funds it is even worse. And Fund of funds, known to charge ‘one and ten’ on top of what the hedge funds make.  So for a Fund of funds to produce a 10% return, the fund manager needs to generate a 25% return from his portfolio.

4) High risk undertaking

Due to their nature of non reporting, they tend to take higher risk appetite in their investment undertakings. Hedge funds returns are at best erratic. Unlike Mutual Funds, that need to report quarterly, their earnings tends be known fairly quickly. Hedge funds however are not required to report their earnings tend to take riskier ventures in the last quarter, if their 3 previous quarters performed less that expected.

Quarters	Returns %
Qtr 1 2000	18%
Qtr 2 2000	20%
Qtr 3 2000	4%
Qtr 4 2000	25%
Qtr 1 2001	19%
Qtr 2 2001	-10%
Qtr 3 2001	26%
Qtr 4 2001	25%

A normal hedge fund performance might look like the above, where certain quarters perform favorably well and certain quarter sucks. The variance can be from -10% to 26%. So when one of the quarters under performs, the hedge fund managers will have to take on bigger bets so as to make up for the losses. In the end you know how they end up.

Shareholders vote with their foot

Hedge fund managers are human too, so taking risk is part of their job. If they judge the market wrongly, all they need to do is to fold up and look for another job at other funds or better still just hang on to the fund and collect the 2% fees on assets in perpetuity.  

So in the end, the risk is bigger for the investors than the hedge fund managers. If hedge funds consistently outperforms the benchmark, then reputable funds like Julian Robertson’s Tiger Fund, Soros’s Quantum Fund and  Long Term Capital Management would not have suffer heavy losses and eventually had to fold up. A friend of mine who used to be in the hedge fund industry, told me that shareholders in hedge funds vote with their foot and not with their brains. Even though you have performed marvelously for the past years, that does not mean you will be immune to shareholders revolt. If your performance sucks this year, you will still be kicked out.