Saturday, May 10, 2008

2fer Turtle Books - Reviewed

Warning, this developed into a rather lengthy review.
Proceed with caution.
You have been warned ;-)

I have much to share with you and I've been having a little difficulty getting back into the groove of posting about my progress, so I thought I could continue my way back into regularly posting with this book review. Actually this is a 2fer book review. Recently I read both The Complete TurtleTrader: The Legend, the Lessons, the Results and Way of the Turtle: The Secret Methods that Turned Ordinary People into Legendary Traders. I found both to be well written and easy to read even though the two told rather different stories in different ways. I particularly enjoyed Curtis Faith's style as it was clear, to the point, and well communicated. It practically reads itself and that's quite a feat for the subject matter. Covel's Complete TurteTrader was more of a journalistic look into the primary player's lives. Rather than a traditional review, I'm intending this to be a journey of my discoveries from reading these books, a what I learned, rather than a what they said.

The Complete TurtleTrader was a fun read. It seems to be rather well researched and has plenty of reference materials quoted to support it's voracity. Michael Covel does impress upon us an interesting view of Richard Dennis, of whom Covel seems especially fond. While I felt it was entertaining, it was not very educational for learning the turtle trading system. One thing that spoiled my experience of Covel's clean prose is the multiple times that he referred to trading/the market as a "zero-sum-game". I can't let someone get away with that. After all, even if a stock moves in your direction you could still lose money between slippage and commissions, aka Cost of Trade. Do you think Cost of Trade = Free? I could have let it go if he didn't repeat it at least 3 times. How can one have done such a brilliant job everywhere else in his research, yet still believes the myth that the markets are a zero-sum-game? This gives me pause. Yes, there are arguments to support the concept of the markets as a zero-sum game, but practicality and the experience of losing on Slippage and Cost of Trade tells me: while the markets may be a zero-sum game on the whole, individual participants don't share this benefit.

I was sucked in by Covel's representation of Richard Dennis' personality. He sounds like a friend that you think is either brilliant or crazy or some combination of both. An admirable quality. I like people who shake things up. The brave souls that go against the current way of doing things in order to bring everyone into a future where it can be done better are a valuable dissonance. The descenting voice almost always has something to say that is a benefit to hear. I have an outlook in which I want to improve the quality of life for everyone to whatever degree that I am able. This tends to bias me towards thinking that others have similar motivation. It may not be the truth, but if I can lead the way in what I do, maybe others can too. We're in this thing together whether wanted or not. Why not work together to improve it for everyone? Dennis' actions could certainly be interpreted as an act of giving back what he'd been given but I can't speak for another man's motives. The Turtle experiment created something for the record books and broke down some of the walls that separate the people from the market. It makes for a good story and I think Dennis may have simply done the experiment for the publicity and the sheer fun of doing something destined to become legendary.

Although citing the Turtles experiment is often used as proof that anybody can become a successful trader, there are too many unacknowledged points that don't provide support. You can get closer to the truth if you state what happen. Those few individuals (about 10% of those interviewed) hired based on Richard Dennis and William Eckhart's criteria had mixed results both during and after the program. Some of those became very successful traders, much of which could be attributed to their experience as a Turtle. So, if you define anyone as "a few out of a selected few" then yes, anyone can become a successful trader. Personally, I believe in the power of belief. If you believe you can become a successful trader than you will do so.

Despite Covel's criticism and denouncements of Curtis Faith's claims, Way of the Turtle made for a worthwhile read and was more educational than The Complete TurtleTrader. Covel goes out of his way to speak ill of Curtis Faith. While preparing this review, I discovered that Michael Covel isn't currently a trader and never was. Does that invalidate his writing? Certainly not, but it may help explain his adherence to the zero-sum-game dogma. While Covel may have collected a lot of information about trend following from others who are successful traders, it undermines his credibility as an authority on the subject. It's like a way of saying: while I know this works and you can get really great results, I don't do it myself because I don't believe it. What reasons can excuse a non-practitioner to sell you on something he doesn't do and hasn't ever done? While Faith no longer trades and seemed to have eventually wiped out, at least he actually did it. (see: Turtle Review Correction)

I say that Faith's book was more educational because he talks in depth about the actual rules, explains risk better than anyone else I've read, and supports his information with math. Yes, it is more technical than Covel's book, but the reader reaps the reward for the intellectual effort exuded. Faith successfully brings home some valuable aspects of risk and an interesting argument about efficient markets. One way to make money in the market is to exploit an inefficiency also known as finding an edge. If the markets are efficient, where could we find an inefficiency that could give us that edge?

Faith proposes that the inefficiency is the perception of the market participants and lays a foundation for psychology as the inefficiency. After all, why is AAPL trading at $183.45 a share? Because someone who owns a share of AAPL is willing to sell for $183.45 and someone else is willing to buy for $183.45. All market participants collectively agree that it's worth $183.45. This agreement is based on the participant's viewpoints about AAPL. If you're buying, you do so expecting it will go up. We're all in it for the money. Why would you buy something if you thought that it's overpriced? All of these competing interests have different expectations. Because group behavior is more primitive than an individual's behavior, you can profit from understanding how the group behaves as a whole. This is the realm in which you can have your edge as a trader.

It is also a strong statement for the ability of technical analysis to uncover certain patterns of behavior that result in the ability to choose a direction with a certain percentage of confidence for a profitable trade. A price chart is the history of each day's agreements amongst all market participants. Past price data is the agreement paper-trail. With that in mind, can we make money by looking for previous situations that are similar to current market condition? I believe that there is room to find an edge by looking at the past price data. Have you felt the pain of a trade go against you? Have you felt the joy of a trade that worked perfectly? I have. It could be stated that price is a gauge of the emotional response exhibited by market participants. The explanation of why "buy on misery and sell on euphoria" works is in the domain of behavioral psychology.

Faith's writing has helped me understand how a trader makes money. It's as if my job as a trader is to exploit the nature of group behavior. Will this make my trading perfect? No way, but it does give us a starting point. The rest is setting up a system that makes more money that it loses and leaves me with money to continue to stay in the game even in the event of the inevitable drawdowns. Any profitable system must mitigate loses and therefore employ risk management. Faith's explanation about risk is really eye-opening. It still gives me pause and forces me to look into how I diversify my strategies so no single event or risk will take me out of the game. It's not just a matter of diversifying the types of products traded, it's a matter of diversifying strategies.

Certain risks (directional, time-sensitive, etc...) are inherent in certain strategies (selling stock, buying options, etc...). Balancing these risks using multiple strategies with different risk profiles is an invaluable way to mitigate risk. This is also known as hedging and is a smart practice when you understand the kind of risks we are exposed to in the markets. Hedging strategies have overhead, but many can balance your portfolio in a way that is both profitable and not overly exposed to any single type of risk or risk element.

The Turtle trading rules wouldn't be described properly as employing hedging strategies, but the nature of the way Faith explains risk makes me feel more comfortable using hedges to mitigate risk. That's the opposite of what the Turtles were doing. They were going for high risk, high reward. You can capture big moves with a trend following system and when you do, you make big bucks but the contained drawdowns are more frequent. One reason it can work is because most people can't deal with losing that often and eventually less people are competing with your trading system. If your trading system has truly stood the test of time it will begin to work again because similar market conditions will return and there will be less competition. It may be more or less effective in the future than in the past. If you've tailored your system for a short sampling of time, you can become quite vulnerable to the kind of excessive repetitive drawndowns and be wiped out before more cooperative market characteristics return. The Turtles managed risk by having set units that would represent the same amount of money risked in each of the products they traded.

Another key distinction Faith brings is the tendency for outcome bias which helps to explain how recent outcome tends to color your view. For example, how do you feel if the last 7 trades went against you? 5 consecutive winners? You get the point, but a string of losses that are perfect executions of your system is the sort of thing that can cause you to bail on a system that will start working again. This is why any system you choose should be thoroughly backtested using robust statistic (another point Faith explains quite well) over a long enough period of time to weed out the noise and for you to get a better idea of how this holds up to many different market conditions.

I'm realize I didn't say much about what the authors actually said, but I did warn you that this is a personal account of what I walked away with. During this time I've also been listening to the thinkorswim Wednesday chats and I've also more recently finish Mark Douglas' Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude. No doubt that both of those will influence everything I just wrote about. You could be wondering: how did he get that from those books? The answer: I may not have, but I think I've fairly characterized my opinion of these books. I think they're both a good read, but now you know which one will deliver the kind of story that suits your interest.

Aside from the books themselves, this review: On The Turtle Myth: Michael Covel vs. Curtis Faith and the referenced materials it incorporated aided my research about the Covel/Faith argument.