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ON BACKTESTING
Editor,
The letter to the Editor in your February 2000 issue titled "Candlesticks Formulas" and your response hit the nail on the head of what your magazine is all about -- giving your readers trading ideas to develop on their own. You then asked other readers to share their tips. But then, later in that section, when reader Dwight Cook does exactly that in the letter titled "Backtest Results," your response seems to have completely missed the point. His system of using a simple moving average crossover to trade mutual funds worked great in his backtest. All you had to do was backtest it against the same sample of data that Jay Kaeppel used in his study to find out if it was comparable. I think what Dwight really wanted to know was whether his system works better than Kaeppel's in the same sample period (at least, that's what I wanted to know).
Next, I agree that backtesting is indeed an area with no easy answers. I often find that if a system is optimized in a backtest and then forward-tested on new data, the results are very revealing. A forward-test cannot be curve-fitted, and a good system should hold up with a hit rate and percent return that is close to the backtested figures.
I hope this is helpful to your readers.
Todd Colbeck, via E-mailWhale Securities
New York, NY
IT'S WHAT YOU KEEP
Editor,
Thank you so much for Ted Tesser's January 2000 article, "It's What You Keep That Counts." It was most informative and helpful.
On the other hand, "Increasing Return With Covered Calls" by Joe Demkovich and Eugene Theriot in the same issue was utterly irresponsible in claiming that "selling covered calls is practically a no-lose proposition." A covered call is a synthetic short put position, and no prudent speculator would ever claim that selling naked puts is nearly a no-lose proposition.
Finally, I have a question about the Chicago Board Of Trade's Liquidity Data Bank, which was explained by Jayanthi Gopalakrishnan in "Market Profile Exotics: The Liquidity Data Bank," also in the January S&C. Does the Chicago Board of Trade filter out spread trades from its volume figures for LDB? Since spreads can be priced anywhere within the day's range, including spread transactions could cause the LDB to inaccurately reflect true trading volume at a particular price.
Kevin G. Stone, via E-mailTinley Park, IL
Regarding "Increasing Return With Covered Calls," see also the next letter and response from Eugene Theriot. Regarding the CBOT's Liquidity Data Bank, we've sent your question concerning how the CBOT computes its data on to the CBOT. -- Editor
INCREASING RETURN WITH COVERED CALLS
Editor,
I was upset by the article "Increasing Return With Covered Calls" by Joe Demkovich and Eugene Theriot in your January 2000 issue. My concerns follow, with excerpts from the article and my ensuing comments:
1. "One of the most conservative investing actions you can take is to sell covered call options."
Really? Since a covered call is equivalent to a naked put, do the authors consider naked put selling to be another conservative investing action?
2. "Almost any time might be a good time to sell calls on a stock you own, but it will be most profitable when options are overpriced."
This statement is fraught with peril. First, it is weak. Almost any time might be a good time to do anything. Second, what are the criteria for identifying an "overpriced" option? The authors are unspecific. The ability to identify overpriced options will ultimately determine the profitability of the strategy.
3. " ...volatility..."
Volatility is only mentioned four times in the article. Option traders trade volatility, not direction, so the trader's ability to manage volatility will determine his ultimate success in the options market. This is an important idea that many option traders do not understand.
4. "Selling covered calls is practically a no-lose proposition with more flexibility than people think."
This conclusion does not follow from the evidence in the article. Prove its value statistically or keep your pen in your pocket. Since approximately 80% of professional money managers underperform the S&P 500, if this simple strategy produced a "no-lose" outcome, this approach would be used and sold. Anyone? I suspect the search for empirical evidence to substantiate the "value" of covered call selling will be fruitless.
My suspicion, also statistically unsubstantiated, is that selling naked puts would outperform selling covered calls because of the usual volatility skew in the equity markets. (OTM puts trading at higher volatility than OTM calls, since investors are more worried about meltdowns than meltups.)
Kenneth J. Libert, via E-mailNewark, DE
Gene Theriot replies:Thank you for the opportunity to comment on the points raised by Mr. Libert. We have keyed our responses to the points in his letter.
1. Selling naked puts can be a conservative strategy if you are selling puts on stocks you would like to own. However, covered calls feel less scary to beginners, and most brokers have lower restrictions for selling covered calls than naked puts. Therefore, selling covered calls is a strategy that is accessible to more investors, especially those who are new to trading options or who have investments in an IRA.
2. We stand by the statement that almost anytime would be good for selling covered calls. The main exception, as mentioned in the article, is when the stock price is depressed. If the price is depressed and you don't think it will recover, you should sell the stock. If you think it will recover, an option with a strike price high enough to encompass the recovery may not bring in enough income to be worthwhile.
3. We agree that volatility is important in determining the price at which options trade. However, it isn't necessary to know either the actual stock volatility or the implied volatility to sell covered calls. If you are happy with the income from the proposed call and would be happy with the gain resulting from the sale of the stock at the strike price plus the call income, then sell the call. That's easy enough for beginners, and that was the article's target population.
4. Selling a covered call brings in sure income and the risk is an opportunity risk. There is no risk of losing money by selling the call, only the possibility of losing gain above the strike price if the stock price rises markedly. That is what we meant by "practically no-lose."
Selling puts is another profitable strategy. We mentioned that one strategy is to sell calls until the stock is called away and then sell puts until the stock is put to you. This works especially well if your stock trades in a channel and you sell calls when the stock is near the top of the channel where the risk of it being called away is smaller, and if the stock is called away, sell puts later when the stock price is near the bottom of the channel. We don't know if selling puts or covered calls is more profitable, but we agree that the major investor concern is meltdown. You have already accepted this risk when you bought the stock. Selling the call doesn't increase this risk; selling the call moderates it.
OPTIONS CALCULATOR
Editor,
I read with great interest the excellent article "Increasing Return With Covered Calls" by Joe Demkovich and Eugene Theriot in the January 2000 STOCKS & COMMODITIES.
What option calculator was used in Figure 3 (on page 43), and how I can obtain a copy?
Paul Lovelady, via E-mailWest Palm Beach, FL
Gene Theriot replies:
Thanks for your kind comments.
The tool is one of several that Joe Demkovich and I have created. The tools are available from https://JoeAndGene.home.att.net. The tools and other information can be downloaded and used for 90 days with no charge. After that period, we ask for a one-time payment of $100.
The tools can accept data from TC2000, myTrack, or in manual mode, in which it is necessary to enter the stock price and volatility. Technical support is available by E-mail addressed to JoeAndGene@att.net.
SEARCH FOR STOCK-TRADING SYSTEMS
Editor,
I read your magazine as well as other financial magazines and I invest in stocks, but I have become discouraged in using newsletters to invest. I've never been able to equal their performance and have never gotten their buy or sell prices.
I am interested in investing in stocks using software to generate buys and sells. I do not want to develop my own trading formula. Your publication appears to be the only one devoted to software investment programs. I'm not looking for a software recommendation from you; I know there's no perfect system for everyone and you can't make individual recommendations for readers.
But is there some service or newsletter -- maybe something like what Hulbert does for mutual funds -- that tests the various systems on the market to check the validity of the claims made by the system vendors? There are so many system publishers all claiming huge returns; I would like to winnow this all down to an honest few that fit my investment style.
I know your magazine reviews software, but I'm looking for help in finding the best system based on performance and based on what I want it to do. I don't believe all the claims I read could be true.
Tim Kraft, via E-mailAccording to George Pruitt of The Futures Truth Company, which publishes a newsletter that follows and ranks various futures-trading systems, there aren't many services that track or report on stock-trading systems as Futures Truth does for futures systems (or as the Hulbert Financial Digest does for mutual funds). Moreover, there are plenty of newsletter advisory services but fewer computerized stock-trading systems. But, he added, The Futures Truth Company plans to launch a second newsletter tracking stock-trading systems. Look for an announcement of that new service later this year. In the meantime, Pruitt suggests paper-trading some of the newsletters' recommendations to check results.
In addition, you can also visit the Securities Exchange Commission's Website at https://www.sec.gov for general advice on purchasing products, and for futures traders, visit https://www.nfa.futures.org, which offers the BASIC repository of information on companies and services related to the futures industry. As for more general advice, you can also check with the Better Business Bureau, the Attorney General's office, and Dept. of Consumer Protection in the state where the company operates for any past complaints lodged against a company.
See also the next letter for more advice. -- Editor
SIFTING THROUGH THE CLAIMS
Editor,
I read with interest in the March 2000 S&C the letter to the Editor from Philip Nixon titled "Opening Position" regarding advertisers' claims about trading system returns.
Trading, or investing for that matter, your own money is the ultimate endeavor in self-reliance. In other words, part of being a trader is standing on your own two feet. Every step of the way is built on self-reliance. You have to start the educational process yourself by picking up the first book, buying a study course, attending seminars, and then finally placing the orders. In fact, the sense of individuality required is part of the appeal of trading for many people.
Consequently, having an editor screen the advertising is unnecessary. The trader simply has to ask a few questions of the product seller. What sort of questions? How about these:
Is there any documentation providing evidence that the techniques have worked in the past? Most research must be done with historical data, so don't expect brokerage statements covering the same period as the test data used. If the answer is no, then ask why not. And of course, historical success still doesn't guarantee future profitability, but there should at least be some documentation; otherwise, you should move on. Also, try replicating the historical analysis. This is very important because you must ensure that the track record was not created with the benefit of hindsight.
Is the product seller actually trading the technique? Can he produce brokerage statements showing that he himself is practicing what he preaches? If not, then why not? After all, if the technique is as good as the advertiser states, then why doesn't the advertiser trade it himself? The fact that the advertiser is willing to sell the technique is not itself cause for alarm. Every trading method has its up and down periods, and wanting to offset the down periods with an educational product line is not unreasonable.
I have more than 20 years' experience in the markets, and I believe that part of the formula for success comes from taking total responsibility for what happens to you and your account. Asking questions such as I have outlined here is part of taking responsibility. Perhaps you could write in your next Opening Position more guidelines that will help people to find the education material that will help them to meet their goals.
Thom Hartle, vice presidentWizard On Wall Street, Inc.
Thom Hartle is former Editor of Technical Analysis of STOCKS & COMMODITIES. He is currently an independent trader and developer of the study course "Multiple Time Frame Structure." -- Editor
BRINGING A SYSTEM TO MARKET
Editor,
I have read many issues of your excellent magazine. Keep up the good work.
I have been trading both stocks and futures for a number of years. Over the past 18 months I have developed my own mechanical trading system. I honestly believe this system works better than most systems I have come across. The results have been fantastic, but unfortunately, most of it has been on paper. What I need to know is: How do I go about writing my own mechanical system and eventually selling a limited number? I am not a computer programmer so you'll have to start from the beginning.
Why am I selling my idea? Simply because I am in a rush to make a lot of money. I don't want to wait five years before making a million. I look forward to your reply.
Mark Crisp, via E-mailSince we are the publisher of a technical analysis magazine and not a business consultant, we can only offer a few casual suggestions: For starters, you might try Jack Schwager's Complete Guide To Designing And Testing Trading Systems offered by Omega Research at https://www.omegaresearch.com/jackschwager, which was reviewed in the July 1999 issue of STOCKS & COMMODITIES.
Second, see the previous letter titled "Sifting Through The Claims" for advice on what consumers should expect from you.
Third, contact the Securities and Exchange Commission (SEC) and National Futures Association (NFA) for any regulatory guidelines surrounding offering a system for sale.
Fourth, if you're not a computer programmer, consider offering your system as a manual or coursebook rather than as a program. Finally, check some past S&C articles on developing a trading system to learn about what a good system should include and how your rules should be properly backtested. Good luck! -- Editor
ORIGINAL CHARTS BY THE MASTERSEditor,
I'm looking for prints/posters/originals of charts drawn by hand or marked up with analysis from famous traders of the past (for example, Elliott, Gann, Dow, etc.). Any idea where I could find something like this? I saw a picture of a hand-drawn Gann chart in your December 1999 issue.
Jeff Gruber, via E-mailRobert Prechter sells a book that is a collection of reprinted original material by R.S. Elliott and others. See https://www.elliottwave.com/books/index.htm. Lambert-Gann Publishing of Pomeroy, WA, sells a lot of original material by W.D. Gann. See https://www.wdgann.com.
We don't know of anyone who offers the writings or charts of Charles Dow. -- Editor
ERRATA: BOOKS FOR TRADERS
Editor,
In the March 2000 Books For Traders, we incorrectly attributed the publisher of Mind Of The Market: Spiritual Lessons For The Active Investor to John Wiley & Sons. The book was actually published by Fraser Publishing Company, PO Box 494, Burlington, VT 05402, phone 877 996-3336, E-mail info@fraserbooks.com, https://www.fraserbooks.com. In addition, the book Meltdown, listed on the same page, was published by Prentice Hall, (www.prenticehall.com), not Fraser. We regret the errors. -- Editor