Dave: I see you did not come from a trading background, but rather from high tech. Do you believe this enabled you to gain an edge on the traditional trader?
James: In the mid 90s I started a web services firm called Reset which made websites for mostly entertainment companies. We made websites for, among others, Warner Brothers, Sony, HBO, New Line Cinema, Bad Boy Records, Interscope Records, and others. Before that, I went to both undergrad and grad school in Computer Science and also spent some time working at HBO.
The tech background helped when developing the software to model different market conditions quickly. Any situation or idea I had to model was easy to prototype with software. None of this stuff is rocket science and even a slight background in software is enough to help one model almost any situation.
The business background is more important. When starting a business, as with trading, you have to deal with pain, stress, and failure, in a variety of unpredictable situations. A friend once told me the quote, “if you only make 51% correct decisions when starting a business then you will be wildly successful.” The same holds true for trading.
Dave: OK, so your computer background led you to develop data models for the markets. These models enabled you to properly test multiple assumptions and beliefs about trading. What was the most surprising thing you found out from this testing?
James: I went through a phase where my eyes were filled with dollar signs like in a comic book. The first system I ever played with was Larry Williams' OOPS system. At first it seemed like a money machine to me. But then reality hits and although the OOPS system (buying gap downs on assets when they breach the prior day low to the upside) is a great system, it’s better as a starting point for exploring your own ideas. I guess the main idea I found is that countertrend trading is a lot better than going with the trend. Philosophically, “the trend is your friend” is very pleasing almost from a Zen perspective but doesn’t really work well in practice. That said, I always find myself feeling oddly relaxed when reading interviews with trend-followers like in the Covel book. But perhaps that’s the problem with it.
Dave: Are there any technical indicators that stood up to your rigorous testing, and if so, what are they?
James: The problem with any technical indicator is that they are all nice little packages that look very simple on the outside but when you dig deeper you find that they are made up a lot of assumptions and parameters that lead to the curve-fitting accusations. In general, all back testing is curve fitting but anything you can do to avoid this (i.e. don’t use technical indicators) helps deal with this.
Dave: What I found most interesting from your research is the fact that there is very little predictive qualities in candlestick patterns. This flies in the face of conventional trading wisdom. They simply do not work anymore. What do you attribute this to?
James: Too much money thrown into trading the markets. There are about 10,000 smart people at least (most likely much more) testing and trading for themselves, for hedge funds, for prop firms, for mutual funds, for market makers, etc). The basics are done.
Dave: What software do you use for testing market assumptions?
James: Wealth-Lab
Dave: How difficult is it to write the code for Wealth Lab. Is it something a non-programmer trader can do?
James: When I was in 6th grade I once answered a question the teacher posed by starting off saying “that’s easy” and she slapped me right in the face and called on someone else to answer. She said, “Never say that.” That said, “it's easy.” A lot of people shy away from WL because they use a Pascal-like language to build their chart scripts. However, the language they use wouldn’t even qualify to be a prequel to Computer Science 101 in high school. Its easy to learn, particularly when modifying any of the thousands of chart scripts posted to their site. I have no financial relationship with their company although I’m kicking myself for not trying harder to invest my wife’s hard-earned money in their company before they were bought by Fidelity.
Dave: Ok, lets jump into the meat of this interview. In your book, Trade Like A Hedge Fund, you go over 20 primary hedge fund trading strategies. I am going to focus on 4 of these strategies that I found most fascinating. The first one, Buying Bankruptcies, really opened my eyes to the potential in this method. Please tell our members about this strategy and why it works.
James: Typically, when a company declares bankruptcy, the stock is halted by the exchanges so the company has time to disseminate the news of their downfall. Note that it’s NEVER a surprise when a company declares bankruptcy. It's not like Worldcom was a $50 stock and then they whipped out a Chapter 11 filing while everyone was asleep. By that point Worldcom was the subject of dozens of lawsuits, headlines every day about corruption, all executives being fired, and the debt was trading for pennies on the dollar. The stock itself was around 10 cents on bankruptcy day.
Everyone who was going to bet on this bankruptcy was already short the stock. Not only were they short, but probably almost every executive was short the stock in order to hedge their worthless shares. And everyone who was long the stock as an investment had already most likely sold the stock by this point. Certainly all mutual funds were out of it by this time (they never hold a 10 cent stock).
So what happens, when a stock declares bankruptcy, it’s halted, and then the halt is lifted later that day. Well, nobody is selling (because they all already sold) and everyone is covering their shorts (the worst has already happened and it's not going to get any worse). So these stocks tend to double or triple in value within 2-3 days, as happened in the case of Worldcom, Enron, FAO Schwartz, and countless other mega-cap bankruptcies.
Dave: Along the same lines, you also suggest trading stocks that are going to be deleted from the indexes. Most people trade stocks that are being added to the index, as do the index funds. This deletion concept seems odd to me. How do you play deletions from the indexes?
James: We buy the day the stock is deleted, right (we hope) when all the irrational selling pressure being placed on the stock by index funds selling, is over. The same concepts apply as in the bankruptcy system.
Dave: The 200-day moving average is one of the most talked about and utilized technical indicator. Does the 200-day MA work in the traditional manner and what is the best way to use the 200-day MA?
James: So many media pundits use the 200-day MA to make a meaningless point to fill up airtime that its lost all value as a technical indicator.
Dave: What can you tell our members about trading gaps ? Does the traditional wisdom that gaps fill stand up to testing?
James: Gaps are the physical representation in the markets of the concepts of “fear” and “greed”. When there is fear, a stock gaps down. When there is greed, a stock gaps up. Most books talk about exhaustion gaps, continuation gaps, etc without ever demonstrating how to determine which gaps are which. Testing is the way to determine this and take advantage of the fear and greed associated with these moves. Normally I only like to trade gap downs. Gap ups tend to keep going. And who am I to get in the way of people’s passion?
Dave: Interesting, so going short is not the opposite of going long. Can you elaborate on this concept?
James: Let's look at the basic facts. Short selling doesn’t even work in a bear market. If you look over the past 15 years, almost any time the Nasdaq 100 index moved up over 4% or more in a day occurred during the bear market years of 2000-2002.
Another example is to look at the CSFB Dedicated Short Bias index made up of hedge funds that only short stocks. As a group they had a negative return in 2001. So the best short sellers ever, guys who spend 25 hours a day trying to short stocks and make people’s lives miserable, had a negative return in one of the worst bear market years ever. They stink.
Dave: The extreme convertible arbitrage certainly has the sexiest name. What is ECA and how can a trader utilize this complex sounding technique?
James: I love this strategy personally and it works great in bear market years such as 2002. It combines the concepts of mean reversion with ideas in convert arbitrage. The basic idea is that you find a stock that has been tanking (for instance, all the energy stocks in 2002) and you go long the preferred of that stock (if it exists) and short the stock. For instance, AES-C, the preferred of AES, was offering a 20% yield while AES was diving on fears of bankruptcy. A deeper dive on the stock showed that all of AES’s operations in other countries has debt that was non-recourse to the parent company, meaning that the preferred wouldn’t be effected and AES was most likely safe from bankruptcy, securing the 20% yield. That said, if AES went bankrupt then the stock would continue to plummet, making the short work out. The key is determining the proper ratio between the preferred and the common and for that you need a combination of backtesting and an understanding of the fundamentals.
Dave: Are there any final words you would like to leave us with?
James: Trading is the most miserable thing you can ever do with your life. Give it up now.
Dave: Wow, this has really been an insightful discussion. Thank you for joining us !
James: Dave, good luck with your venture and thanks for letting me do this.
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