The competitive side of me says push on and make more money (make hay while the sun is shining). Don't change the model (assuming your model works) and press on.     -Scott Brooks

A point Jon Krakauer wrote about in Into Thin Air is that mountain climbers need to haul ass when the weather is good since they have to expect bad weather rolling in at some point and they won't be able to move. In my experience, good markets are infrequent and that's the time to trade with full effort. When the opportunities dry up, it's best to hunker down and spend the day surfing the internet or taking a vacation.

I've seen many traders ease up when the goings good and then be in a desperate position to trade when the market is quiet. Being wrong in both situations always leads to an early exit in the business.

Ryan Maelhorn comments: 

Suppose it is February 1st, which it almost is, and suppose that already, your fund is up 20%.  This is amazing for any given month, and pretty good for the YTD as well.  I don't know what 20% sounds like to everyone here but that is double the drift of the market as a whole, so I will assume for this writing that ending the year up 20% is seen as a pretty good year.  This being the case, how long should one go without making a trade?  Should the fund close up shop for the rest of the year?

How does one measure time as risk?  At some point, it becomes illogical not to make another trade.  We can think of this on the maximum scale — the length of our lives, and realize that if we never make another trade for the rest of our lives, nor any investments, our money would start to be riddled away by various expenses, taxes, and inflation.  What are the concerning factors such as having a good year early, the possible closing of the fund next year and the desire to try for a record year, etc.? What is a good formula to value time as risk?  How many hours of non-involvement in the market should one percentage of our total capital buy?

Russell Sears offers: 

Don't invite me to Vegas … I can't take it, too nerve racking. Everything within me rebels the longer I stay, knowing that the house will grind me down. Every loss hurts twice, once the wallet, second the mind.

However, stocks are different. You have the edge. You are the house and time is on your side.

At the start of 2006, I believe I counted the average return when the economy is not in a recession, and when it is in a recession. The bottom line is that unless you expect a recession, stocks are the place to be. If 2007 gives the average return of no recession, which I think is likely, the S&P would be at 1602, which is very close to what Markman predicted in his MSN money column.

Russell Sears adds: 

At the start of 2006, I believe, I counted the average return when the economy is not in a recession, and when it is in a recession.

This is an excercise that I believe a reader should do by hand, at least I found it a learning experience.

Alan Millhone comments:

My father began building spec homes in 1955 and he always did remodeling and insurance repairs. I began working with his crew when I was 13 during the summers and he always expected more out of me than his regular crew of carpenters. I have had new employees who were amazed that I could tell them how long it should take to move a dump load of gravel or sand by wheelbarrow or how long it takes to tar coat a basement wall and then install a French drainage system around the perimeter of a home. I do have years of experience in construction and I mostly learned from the ground up, and have been around several good contractors over the years and have always listened to what they expounded on 'tricks of the trade.' Owning and renting apartments is another 'niche' in the market that is not for the faint of heart! Most think all you have to do is collect the rent … However, you have maintenance of units, renters who will not pay, and you have to legally evict them. You need to be a little bit of a handyman if you own units, so it is not for everyone. Also, you have to know when to raise rents. I was asked once by a fellow who owns a lot of rentals if I knew the best time to raise rents. He told me at Christmas time! … People cannot afford to move then. Yes, a bit cold harded, but many renters will not give you any breaks. The best time to raise rent is when a unit becomes empty. I always scout around the area and get a feel of what other apartment owners are charging. I would not mind building a few new units, but material prices are currently too high to make the numbers work.

Now in return for my treatise on renting, I expect the spec. list to help educate me a little on investing.

Victor Niederhoffer responds:

You seem to do very well in real estate. For someone who knows the field, I imagine real estate is as good as stocks. Jim Lorie once told me that the main difference between the returns of stocks and real estate was that you could get a very good return from stocks through index funds without knowing anything about it, but in real estate to get that return, you had to know a lot about it.

James Sogi adds:

It's up 20%.

How can one maximize gains? Say if it's up but it does not want to liquidate, could a trailing stop on a portion give a synthetic option? We've discussed them and they are inefficient, but path dependency prevails, so they might have function. Another way to think about the question is say you are up 2% on a trade on your margin, do you liquidate with the idea of buying back lower? Let's assume your risk factor has gone up. Do you lighten up? I think our conclusion last time was to adjust leverage in a market with drift to protect gains. That seems to be the answer to catching further gains, but reducing risk ala. Gardiner Principal: be small when wrong and large when right. The corollary of which is to adjust leverage to the probabilities thereof.




Based on my own thinking as well as the Chair's emphasis on games in his writings, I have decided to study Game Theory. I have looked into the basics where available online. As with a lot of math, it seems that in an effort to spell out and/or prove their own theories, most authors end up using more mathematical language, more decision trees and etc. than is really needed. I find that after I study a subject, the details aren't really that important to me anymore. What is important, and what sticks, is an overall philosophy learned while studying the subject.

I went through the same thing while studying Bayesian Statistics. After reading hundreds of pages and going over and over mind-numbingly complex mathematical formulae, I still feel Bayesian statistics can be described, not only adequately, but completely, in a paragraph or so. Maybe something like this:

Future probabilities can be directly predicted from past occurrences. What happened the majority of the time in the past should continue to happen. If it stops occurring, to the point that in all recorded occurrences, it turns the corner from happening the majority of the time to happening the minority of the time, then it will continue to be the minority into the future.

Now maybe some of the more learned here can tell me what great parts of Bayes I have left out. But it seems silly to me to give someone a 500 page book to study from when the above paragraph and a bit of common sense serve to be just as well, unless of course, that someone is planning to become a professor of statistics on a college level.

Anyway, I came across this book while researching game theory: Game Theory: Analysis of Conflict by Roger B. Myerson

It garnered rave reviews on Amazon.com:

To find the best way to present various materials, I went through virtually every game theory book in existence. For the presentation of the basic material on normal and extensive form games, nothing even came close to this book in clarity of presentation and depth of understanding of the issues. Most textbooks, even highly touted ones that are mathematically challenging, do not even come close, and rarely even present the material in a coherent form at all.

This sounds promising, has anyone read this? But still, I wonder if there is a book out there that covers, instead of how to dissect all possible games and create the most intricate strategies, something more like "lessons learned" from game theory, and something that covers the "philosophy" more than the math per se.

Does anyone know of anything like this?



I always think about this scene from the Princess Bride by William Goldman when thinking about Bacon’s switches.



The other day while otherwise occupied, I found myself straightening a paperclip and wrapping it in a coil pattern around a ball point pen. The end result was a small, impressive looking coil spring.

Pressing it in my fingers a few times, (ok, more than a few) I started thinking about why a coil spring seems able to bounce back from greater pressure than strait wire, or wire bent in other configurations. My thought was, the pressure is more evenly distributed over a larger area, which creates less stress on any specific area, allowing the coil to handle more pressure before permanently deforming. Regardless, this sent me to the internet curious about the mechanics of coil springs.

This leads to Hooke's law which states that the amount by which a material is linearly related to the force causing the deformation. According to Wikipedia:

Hooke's law only holds for some materials under certain loading conditions. Steel exhibits linear-elastic behavior in most engineering applications; Hooke's law is valid for it throughout its elastic range (i.e., for stresses below the yield strength). For some other materials, such as Aluminum, Hooke's law is only valid for a portion of the elastic range. For these materials a proportional limit stress is defined, below which the errors associated with the linear approximation are negligible. Materials such as rubber, for which Hooke's law is never valid, are known as "non-hookean". The stiffness of rubber is not only stress dependent, but is also very sensitive to temperature and loading rate.

What would be the market's elastic range or elastic limit, and how would it be defined? Relative short term highs and lows come to mind. Perhaps distance off a reference point, like the opening range concept, or opening of week, or month, or yesterday's close, or x periods ago. Would the elastic range for markets be different depending upon if the market is being stretched in the direction of long term drift, or in Abelson's direction?

Are the elastic properties of market prices more similar to (using above examples) steel, aluminum, or rubber? If they're like steel or aluminum, how could the useful range appropriate to reversal trading applications be defined? If like rubber, what would be the equivalent of temperature and loading rate? Perhaps interest rates (or change in rates) and a measure of rate of price change?

If one can identify or approximate the elastic range, where would be ideal buy/sell points? Too far out, and risk price exceeding the elastic limit. Too close, and one suffers though the trough of the elastic range, perhaps selling to soon out of relief, missing the upward spring. Never a perfect balance, however.

If the analogy is at all valid, are there different time scale coil springs in the market? For example, if a short term (small) coil has exhausted its elastic limit, but the intermediate range (large) coil is still within its elastic limit, would this have any impact on how to manage positions? Would such thinking risk, "turning that short term loser into a position trade" which all books say is a bad idea. Is it? If not, or if so, by what criteria?

If one turns the coil spring on its side and traces the up and down pattern, it makes a perfect cycle of highs and lows. If one were to pull the most recent coil beyond the elastic limit, the horizontal distance would increase, and the extremes would fail to meet the extremes of previous coils. Over specific durations of time, is there an expected periodicity between short term highs and lows based prior highs and lows? If such highs or lows have not been made within a calculated 'elastic range" does this anticipate a change in cycle, or an anticipated move beyond the recent elastic limit?

If one finds oneself in a trade that relative to intended time horizon has exceeded the expected elastic range, would shifting exit horizon or targets yield a better result?

Ryan Maelhorn responds:

If you stretch a coil spring too far it essentially becomes worthless. It turns back into mere wire. The 1999-2000 bubble could be seen as a ruining of the coil that took years to "fix." Price is what separates the elastic range of stocks. Stocks under $0.10 can gain or lose 500% in a single day, whereas the DJIA is said to have a huge rally if it climbs 3%. Also, if you pull the coil out somewhat and let it go, it will not only go back to its natural state, but compress slightly, and then stretch out just a tad before coming to rest. When penny stocks lose 50% or so from the open of the day, usually there will come a time during the day when they will bounce back slightly, perhaps as much as 20%, before continuing their decline. A move you wouldn't even see if you were only looking at daily price bars.



The American Heritage Dictionary lists the following four options for the definition of the word gamble:

1. To bet on an uncertain outcome, as of a contest.
2. To play a game of chance for stakes.
3. To take a risk in the hope of gaining an advantage or a benefit.
4. To engage in reckless or hazardous behavior: You are gambling with your health by continuing to smoke.

Certainly, according to definitions 1 and 3, and depending on your semantic leaning definition 2, we, as market participants seem to fit the bill of "gambler." It is the fourth definition listed above, however, that is really at the heart of this matter. Somewhere along the line, many centuries before any of us were born, the word "gambler," came not only to define one who takes on risk, possibly involving money, but one who does so in a crazed, irresponsible and, yes, reckless way. The image conjured by the word is always one of an old bum, living on the streets, who having been disowned by his family, and happens across a large monetary note, heads straight to the local casino or race track to lose it all. A helpless loser. A man or woman who could never raise a family or provide for anyone, even themselves. Gambling is seen as a type of disease, not unlike obsessive compulsive disorder, or alcoholism. There are twelve step programs and group therapies available. ! However this has never been the denotation of the word, but rather the connotation.

"Gambling is a serious addiction that undermines the family, dashes dreams, and frays the fabric of society." Thus spoke Bill Frist after the passing of his Unlawful Internet Gambling Enforcement Act this October second. The bill was due to be blocked for lack of parliamentary time, so Frist sneaked it into a Homeland Security bill, the "Port Security Improvement Act," which was guaranteed to pass based on its content. But can gambling only be done in a casino, online or otherwise? I wonder just how many people in the US have had their dreams dashed by online poker playing? Could it be more than 90% of those who play? That is the exact amount of new businesses that fail within their first year, an event that also dashes quite a bit of dreams, not to mention capital. Shouldn't First, according to his own logic, move to illegalize new business? Why is it that no one considers entrepreneurs gamblers?

A term usually approved of by more in our profession is that of "Speculator," which has the following strange definition:

A person who is willing to take large risks and sacrifice the safety of principal in return for potentially large gains. Certain decisions regarding securities clearly characterize a speculator. For example, purchasing a very volatile stock in hopes of making a half a point in profit is speculation, but buying a U.S. Treasury bond to hold for retirement is an investment. It must be added, however, that there is a big gray area in which speculation and investment are difficult to differentiate. Also called punter."

I wonder how this writer would characterize one who held a stock until retirement, or one who day traded bonds? Regardless, a speculator seems to be more respected than a mere gambler. No where does the word "reckless" appear in this definition, and indeed we start to see the immergence of respectability here. Even more respect is given to the "investor.":

1. A person who puts (money) to use, by purchase or expenditure, in something offering potential profitable returns, as interest, income, or appreciation in value.
2. A person who purchases income-producing assets. An investor as opposed to a speculator usually considers safety of principal to be of primary importance. In addition, investors frequently purchase assets with the expectation of holding them for a longer period of time than speculators."

Here we have the penultimate description of the respectable way to wager. Now we are "putting money to use," "consider[ing] safety of principal to be of primary importance." The word "risk" is not mentioned even once, much less "chance," and certainly not "game." It is interesting to note that the Unlawful Internet Gambling Enforcement Act act had to have special langauge which permitted "any activity governed by the securities laws (as that term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 for the purchase or sale of securities (as that term is defined in section 3(a)(10) of that Act)." It is also interesting to note the harsh 57% crash PartyGaming took on the London Stock Exchange after the US law was passed, a movement that was sure to reward many who were "gambling," and short the stock.

I just wondered what everyone else thought of these terms. Do they object to them? Do they feel offended when they are called as such? Do they prefer one over the other? My mind runs briskly to the top poker players in the world, how consistently they are at the top of the money lists, making hundreds of thousands of dollars each year. Any gambling book worth its salt informs the reader of how important it is to preserve capital, and of how much one must go out of their way to avoid gambler's ruin. It seems to me only logical to regard the top poker players as investors. In fact, maybe this is the crux. Could it be that one who takes chance and succeeds is an investor, while one who takes chance and fails is a gambler? Not unlike one who kills a household of people is regarded as a mass murderer, while one who kills the majority of the army of another nation is hailed as a conqueror?

Tom Ryan responds:

In the main, it seems to me that there are several distinct differences between gambling and speculating/investing, and this ties into the discussion on fractals and markets which has been dissected many times on the list before.

The first point is that diversification tends to help reduce risk in speculating but does little for you in gambling. Why? Because the pieces of paper we trade in the capital markets are actually legal claims on the economic engine of commerce, via either a rate of interest or a claim on future assets/profits/dividends. Provided that economic growth and health continues in the aggregate and nuclear winter is not coming, in the aggregate the value of these claims will rise over time, and therefore the more you diversify the higher the odds that you will participate in this rising tide. In gambling, playing more casinos, tracks, or playing different types of games does not increase your probability of success.

Secondly, in speculating/investing, one can usually reverse out of a position or decision…even though there is a cost to that, it is not 100%. In gambling you can't take a portion of your money back after the ball is in play on the wheel or the horses are on the back stretch. So in speculating there is far more potential to adapt to changing circumstances

Finally, increasing your significant time horizon helps reduce risk in speculating/investing but actually works against you in gambling as in the long run all gamblers go broke because of the combination of the odds and the vig that you pay to play. It has to be that way of course as the casinos have to take a net rake from the gambling public in the aggregate to have a business in the long run.

One of the issues with infinite variance is that it leads one to theologically consider that the game ending event could happen at any time, therefore the statements I made above about risk management would be false. However, one of the (many) problems with infinite variance in a social environment (capital market) is that it ignores the ability of people and groups of people, to learn, adjust, adapt, and evolve over time as circumstances change. For example, although we may not have the ability to avert a major disaster from a large asteroid hitting the earth today, we as a species are more aware of the danger today than 500 years ago, and 500 years from now maybe we will have the technology/capability to avert such a catastrophe. This adaptation and learning process is always ongoing in the markets due to competition. This is simply a long winded way of saying, markets are not snowflakes.

GM Nigel Davies Replies:

Perhaps one of the most interesting aspects of this question may be that those who object the most may be the ones who are most at risk. Life is inevitably a speculative game in which the line between calculated risk and gambling is often going to be quite blurred.

In any case it's better to know that you're playing a game. As a topical example I doubt that many people who take on large mortgages to buy property consider themselves to be 'speculators' (gamblers?) on property prices and interest rates, but that's exactly what they are.

Gibbons Burke responds:

Being called a gambler shouldn't bother a speculator one iota. He is not a gambler; being so called merely establishes the ignorance of the caller.

A gambler is one who willingly places his capital at risk in a game where the odds are ineluctably, mathematically or mechanically, set against the player by his counter-party, known as the 'house'. The house sets the odds to its own advantage, and, if, by some wrinkle of skill or fate the gambler wins consistently, the house will summarily eject him from the game as a cheat. The payoff for gamblers is not necessarily the win, because they inevitably lose, but the play - the rush of the occasional win, the diversion, the community of like minded others. For some, it is a desire to dispose of money in a socially acceptable way without incurring the obligations and responsibilities incurred by giving the money away to others. For some, having some "skin in the game" increases their enjoyment of the event. Sadly, for many, the variable reward on a variable schedule is a form of operant conditioning which reinforces a compulsive addiction to the game.

That said, there are many 'gamblers' who are really speculators, because they participate in games where they develop real edges based on skill, or inside knowledge, and they are not booted for winning. I would include in this number blackjack counters who get away with it, or poker games, where the pot is returned to the players in full, minus a fee to the house for its hospitality*.

Speculators risk their capital in bets with other speculators in a marketplace. The odds are not foreordained by formula or design - for the most part the speculator is in full control of his own destiny, and takes full responsibility for the inevitable losses and misfortunes which he may incur. Speculators pay a 'vig' to the market — real work always involves friction. Someone must pay the light bill. The marketplace does not kick him out of the game for winning, though others may attempt to adapt to or adopt his winning strategies, and the game may change over time requiring the speculator to suss out new rules and regimes.

That said, there are many who are engaged in the pursuit of speculative profits who, by their own lack of skill are really gambling; they are knowingly trading without an identifiable edge. Like gamblers, their utility function is not necessarily to based on growth of their capital. They willingly lose their capital for many reasons, among them: they enjoy the diversion of trading, or the society of other traders, or perhaps they have a psychological need to get rid of lucre obtained by disreputable means.

Reduced to the bare elements: Gamblers are willing losers who occasionally win; speculators are willing winners who occasionally lose.

There is no shame in being called a gambler, either, unless one has succumbed to the play as a compulsion which becomes a destructive vice. Gambling serves a worthwhile function in society: it provides an efficient means to separate valuable capital from those who have no desire to steward it into the hands of those who do, and it often provides the player excellent entertainment and fun in exchange. It's a fair and voluntary trade.

*A sub-category of the speculative gambler: Playing poker with a corrupt official can be an untrace-able means to curry favor by "losing" bribes in a game of "chance." The 'loss' is really a stake in a position where the "gambler" is really seeking a payoff in a much bigger game, and the poker game is his means to a speculative edge. An example of this is Rhett Butler in "Gone with the Wind", who played cards with his jailers in order to obtain special privileges. Mayor Royce in "The Wire" is another literary example, but this may have been modeled the real-life bribe-taking tactics of former Louisiana Governor Edwin Edwards (whose 'house' is now Oakdale Federal Penitentiary - the Feds kicked him out of the game for winning too much.)



Belief in the Law of Ever-Changing Cycles: The Best Way to Insure You Will Never be able to Accurately Predict Anything Ever Again.

Few players take into consideration the principle of ever-changing cycles of results. The would-be professional player must always understand that the form moves away from the public's knowledge. The principle of ever-changing trends works to force quick and drastic changes of results sequences when the public happens to get wise to a winning idea. — Robert L. Bacon, Secrets of Professional Turf Betting

When I first came across this idea, as presented to me by Vic in Education of a Speculator, I thought I had come across a huge revelation, an epiphany in the thinking of speculation. I came to find out rather quickly that this theory, while sound on some levels, can be one of the most ruinous patterns of thought one who must make predictions could ever fall into.

I have always been more than a bit intuitive. I learn by doing, and what I do I base on what I feel. Though raised by a highly analytical mechanical engineer, I have usually found that my initial thoughts on matters are often the most clear, and usually, the most sound. It is only after I really start to study and think things through over and over and start considering other people's opinions that I run into trouble. I am not the only person to believe in and notice the phenomenon of "beginner's luck." This is not to say I am faultless in my knowledge and anticipation of the world. I have made many mistakes, often ones that are obvious. I have held on to profits while watching them turn into losses, all the while thinking a bigger wave of profit was on the way that was never to come. At the same time I have refused to let go of losing positions until they reached enormous 70-80% losses, suffering badly from "get-even-itis." However, in doing so, I have gained knowledge of how to precede in my market career. I would never assume that because these actions cost me so dearly yesterday, that today they must certainly bring me vast profits.

The problem with the law of ever-changing cycles is that it destroys any sense of intuition, either God-given or hard earned, as well as evaporating any sense of confidence in one's self. I do not believe in the pure random walk, and neither do I believe that the market can be accurately predicted 100% of the time. What I do believe is that speculation is a skill that can be learned, and as with any other skill, through hard work and dedication, with time, it can be mastered (or close enough). This, combined with good money management, making sure you cut your losses short and never take on a position of such size that you can't get out of quickly, makes for relatively safe investing. However, belief in said Law, ruins all of this.

Take any investment strategy you might like, say even something as simple as checking which side of the level II book has the most inside participants at the open and then positioning yourself in accordance. I have used this strategy myself to good results in the past. Now apply The Law to it — since I have been using this strategy successfully for a while, it must surely be ripe to turn against me. "Nothing recedes like success." It is true, all empires eventually crumble, but the vital question, as it always has been concerning the market, is one of timing.

The safest time to invest is when everyone is selling. When the Buffalo are running themselves off the cliffs. Some random catalyst has arisen and everybody rushes to sell. The price charts obtain their most vertical angles and the volume bars spike massively. Eventually, the market will recover, it will reverse its course. This is a guarantee. It may not get back to its previous levels, and the reversal my be very short lived, perhaps lasting only an hour or so, but as sure as water is wet, there will come a point when the market will head back up for a period. Does this mean that every time a market has a particularly bad day that I should place a market order for the following day's open? Of course not. While one red day may be immediately met with a green day of equal force, it is just as probable that one bad day will turn into a string of bad days, perhaps a few bad weeks, or even months.

So, when should I begin to avoid my level II strategy, then? Or should I avoid it at all? Surely if The Law exists, it must itself be subject to the ever-changing. If the cycles are always changing, then eventually they are due to no longer change at some point. "Everything in moderation, even moderation itself." How long will it be until everyone catches on to The Law and it itself becomes useless? It is rather easy to see how this concept can slip one into a never ending downward spiral of self contradiction and doubt.

The only caveat here is that the definition does not call for all cycles to reverse all of the time, but only the ones that the public has caught on to. Of course, how does one track "the public?" It has been well documented that when any successful investment strategy becomes published, usually by academics; sooner, rather than later, it will cease to be effective. But again we have to deal with defining what signals declare that the public has caught on, and at what time it will pay to fade the strategy. An interesting study could be conducted here based on when strategies or new indicators are published, and how long on average it takes for them to become futile. But then again, The Law states if a relatively tight range of results is found, the average is due at a moment's notice to become of no use at all.

The only way out of all of this mess is to rely on century old market logic. The practice of waiting for confirmation. We must believe once we have found a strategy that is successful, that it will continue to be so until confirmation proves otherwise. Discussion of what this confirmation may be could take up another whole letter, but a decent signal may be the breaking of trendlines or ranges. If we were to chart the success of our system daily, and establish a lower range or trendline for our results; if that line were to be broken, and a subsequent short upswing were to occur which failed to take our results back in to the previous range, and then if another lower downswing were to ensue, it would be wise to start thinking about modifying or abandoning our set up. Eventually when the chart of our results reaches a drastically low level, perhaps only 10% of our previous success rate, the system may be prove useful again, but this time to go against.

Of course, The Law states, that as this idea has now been published, even if only a relatively small scale, it must be, at any moment, due to prove useless. I for one however, find it more useful to believe in systems until they prove consistently faulty, rather than spending so much time empirically studying the market, only then to believe that our findings are of no use whatsoever. Indeed, Bacon himself seems to back up this claim in his own work:

The beginner plunges ahead on a favorite that loses, then bets lightly on a fair-priced horse that wins. He keeps switching amounts and positions, so that he never has a worthwhile bet on a winner at a worthwhile price. He is always one race behind the form of a horse and several races behind the rhythm of the results sequences.

It would seem here that the cycles are not external, but internal, and that the best way to guard against the ever changing would be to remain steadfast to one's own system.


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