Wednesday, September 7, 2011

Is it safe to come out from behind the sofa yet ?

Is it safe to come out from behind the sofa yet ?

Last week I took some short term and some longer term positions in the German Dax Index and individual German companies. The next day I felt quietly smug as the DAX Rallied a few percent outperforming the rest of Europe.

There is a saying that pride comes before a fall, well 'smug' comes before a really big fall.

At the close yesterday my recent German positions were as follows
ESX1 (DAX ETF) Down 9.4%
IFX (Infineon) Down 13.5%
UTI (Paris Listed European Utilities ETF including EOAN.F RWE.F ) Down 6.3%

Of the three positions IFX is the trade, I will be happy to hold onto ESX1 and UTI for the long term.

IFX is the stock ticker for Infineon a German manufacturer of chips and micro controllers. The company's chips are used in cars, industrial processes, payments cards and smart power applications. The stock is interesting because it provides leveraged exposure to the rest of the German industrial complex.

The costs for the German automakers BMW, Porsche, Daimler and Volkswagen to produce a car include -
  • Design
  • Tooling
  • Aluminium
  • Steel
  • Petrochemical based plastics
  • Rubber
  • Copper
  • Platinum for catalytic converters
  • Wood - sustainably sourced
  • Leather
Then there is
  •     Marketing the luxury lifestyle
  •     Sponsorship of motorsport teams and series
  •     The cost of dealership premises and staff
  •     The cost of transporting the finished cars to dealerships
  •     The labour to actually build the car

As the car manufacturers increase production so all of their costs tend to increase as they compete for the same resources however for a chip maker like Infineon the costs are largely constant regardless of volume. As every new car includes hundreds of microelectronic components Infineon is a direct beneficiary of the marketing, design, distribution and dealership network of the luxury car manufacturers without having to spend a single cent on any of these resources.

I have in the past held profitable positions in both BMW and Volkswagen, however in the longer run my concern is that these two companies are competing head to head for the same market segments. Its no coincidence that Audi has named its model series 4,6 and 8 in an attempt to get ahead of the BMW 3,5 and 7 series with which they compete. It doesn't seem such a far fetched scenario that the two automotive manufacturers will market harder, equip their cars with more technology and reduce profit margins in order to win market share, in this scenario there is only on winner - Infineon.

If it wasn't for the extreme volatility in the Infineon share price I would be considering the company as a long term way to play the German luxury auto industry without the resource, labour and competitive pressures facing the auto stocks. The stock is too wild for me to hold for any length of time, but for trading a rally in the DAX Infineon is about as good as it gets.

Getting back to the market, peeking out from behind the sofa I see that DAX Index has recovered 4%, the auto makers BMW, Volkswagen, Daimler and Porsche have all gained an impressive 6% but the winner by far with 8.59% is Infineon.

As my position in Infineon is still down 5% I will be looking for a few more days like today before cashing in and closing the position.
Long DAX, IFX and others, a bit sheepish and definitely not smug !

Trade update DIG

The oil price dropped suddenly on Thursday to a loss of around 4%. Whenever oil suffers a sudden drop I look to trade a bounce back. On Thursday I bought DIG at 41.59 happy in the knowledge that not only was there a 4% drop that was likely to bounce back, but also that US oil facilities were being shutdown ahead of several approaching storms.

The next day oil fell almost another 4%.

Normally I would have doubled into an oil trade at this point, but at the moment I have two much capital committed between the XIV, DIG and DAX Trades. I held the original position and have just closed it this evening for a profit of 207 USD after costs.

Oil continues to be a dependable trade, I look forward to closing the next level of the XIV trade in order to free the capital for future double down opportunities in oil. A double down on Friday would have netted closer to 800 dollars.

This trade provides an interesting demonstration of 'compounded loses'. Oil is now back to or even slightly above its closing price on Wednesday, however DIG is still a long way short of a full recovery. I have saved the 5 Day chart for DIG and will use it in a future page explaining compounded loses in the 'Why is it so difficult to make money trading' section. In the meantime I am happy enough with the 207 USD profit.

Monday, August 29, 2011

The Trader and The Fisherman

The Trader And The Fisherman
I have enjoyed fishing throughout my life, whatever town or city I have lived in I have always managed to find a place to fish. There is a saying among regular fishermen that '20% of the fishermen catch 80% of the fish', I consider myself firmly in the 20% that catch most of the fish.

There is no luck or magic to fishing, I often fish with my father and when we are fishing in salt water he will always without exception catch more fish than me. In freshwater its the other way around, I will always without fail catch more than my father even though we are sat in the same boat. The reason is simply that we have a different approach. In salt water my father baits up to target specific species based on the type of ground we are anchored over, the time of year, the depth of water, the strength of the tide and possibly a whole list of other factors that I have no knowledge of. In fresh water when we are fishing for trout, I have the upper hand, depending on the sunlight, clouds, wind direction, season, temperature and many other factors I am better able to predict what the trout will be feeding on at what depths and in which parts of the lake.

Insect Imitating Artificial Fly Used To Catch Trout

Before I come to the trader, the best example I can give of the 20/80 rule of successful fisherman is from a holiday I took in Mauritius.

Everyday, tourists and local people would fish the deep water around the rocky outcrops that surround the shallow bays where the islands hotels are built. In the two weeks that I was there I don't think I saw a fellow tourist or even a local fisherman catch a fish larger than a place mat.

An hour or two before sunset, one by one these fishers would carefully pack away their gear ready to try their luck again the next day.

Ten minutes later as the beaches cleared I would be assuring my wife of less than a week that this time I really would be back in time to take her for dinner.

As the sun set and the sky darkened, the shallow waters of the bay would sparkle with the reflection of the hotel lights. I wasn't the only one to appreciate the attraction of this light show, as I walked along the sand, the shallow water would boil with life as thousands upon thousands of small bait fish jumped for their lives to escape my advancing shadow. The water could boil away for hundreds of meters as the commotion spread from fish to fish along the entire length of the bay where the fish had come to shelter from the danger in the darkness, like flocks of birds roosting together for safety.

I would walk the shore looking for the shadow of a tree or a boathouse where I could hide my own shadow while I sat and waited.

As I waited I would scan across the bay searching for movement and most of all listening. Every night the quiet would be shattered by the storm of a million small fish fleeing for their lives. I couldn't believe that night after night I was the only person witnessing this. Every night, within 15 minutes of sunset a shoal of large kingfish would arrive having left their daytime open ocean habitat and entered the shallow water of the reef that surrounds Mauritius. For less than half an hour the kingfish would launch a series of explosive attacks on the shoals of bait fish corralled in the shallow bays. Outside of this magic half an hour spectacle, the kingfish could be anywhere in the wide open ocean far outside the reef that surrounds Mauritius, far outside the range and even the imaginations of the oblivious daytime fishers.

Giant Trevaly - One of many species of fish know as Kingfish and the only one I have caught

So what does this have to do with trading ?

As I sit and write this I have my trading account open in another screen and just like the ocean, just because the market is there, I don't have to be in it trying my luck. Its not about luck. With the knowledge and the patience of an experienced fisherman I must wait until the conditions are right before entering.

I won't fish with the crowd, the crowd knows the best spots, 'this must be the best spot because theres a crowd' says the crowd to itself.

I will be far from the crowd, in places the crowd doesn't want to be. But when the day comes and the crowd discovers my spot I will be happy to move on selling my catch as I go.

Oil at 87.50, too crowded.

Germany, the DAX index driven down nearly 25% in a mater of days and yet home to some of the worlds most recognisable companies - Porsche, Addidas, BMW, BASF, Allianz, Mercedes (Daimler), Bayer, Merk, Volkswagen, Siemens, Thysenkrupp and mobile phone chip maker Infineon.

That's my kind of spot.

Cautiously buying the DAX, sitting back in the shadows and waiting for the crowd to bite.

Sunday, August 28, 2011

Day Trading The FTSE

A common approach to day trading is 'scalping' in this approach the trader aims to trim a small profit off the top of the market each day. An advantage of this approach is that it doesn't require the trader to make long term judgements about the market direction. It also allows the trader to reduce the amount of time that capital is in the market and at risk.

This strategy provides an attractive balance between risk and returns although fees are a particular concern with this approach, see the page 'Why is it so Difficult to Make Money Trading' above.

To make the most of this strategy the trader would normally use leverage. Leverage comes in many forms but effectively multiplies the investment magnifying any profit or loss.

In the US Market there are a wide range of leveraged ETFs providing 2* and 3* Leverage however in the UK there are only two LUK2 and SUK2.

LUK2 is a leveraged long ETF which should increase or decrease in value by two times the daily increase or decrease of the FTSE 100 Index.

SUK2 is a leveraged short ETF which should increase or decrease in value by minus two times the daily increase or decrease of the FTSE 100 Index. This is what is commonly know as an 'inverse' ETF because it moves in the opposite direction to the underlying index.

5 Day chart of LUK2 and FTSE

The red line represents the FTSE 100 Index, the blue line represents LUK2. The chart clearly demonstrates leverage at work, for one and two percent moves in FTSE, LUK2 is moving two, three and four percent. There is however one major concern with this chart, there is very little volume in LUK2. The breaks between the shaded areas show periods where no trading has taken place. A priority concern in entering any investment is 'Who am I going to be able to sell this to ?' With SUK2 the low volume situation is even worse.

5 Day chart of SUK2 and FTSE

The concern here is that on Tuesday not a single trade was completed in SUK2. On this basis I would avoid LUK2 or SUK2 despite them providing exactly the sort of leverage I would be looking for. This might not be the end of the story though, volumes in both products have increase significantly over the past few months and they may one day become as actively traded as their American counterparts. A US based equivalent of SUK2, QID which tracks the US NASDAQ 100 index sees an average daily volume of nearly eight million shares.

In the meantime I will investigate whether there is a market maker actively trading these ETFs. A market maker is an organisation whose roll it is to provide liquidity in the market by committing to trade in selected stocks and funds. If there is an active market maker the low volumes could be less of a concern provided that the spreads are reasonable.

I am also investigating using individual stocks as a proxy for the whole market, in particular I am looking at banks, miners and asset managers. I will post my thoughts on this approach in the coming days.

Another area I am investigating is the efficiency in terms of fees, spreads and execution of using ETFs vs Covered Warrants vs Individual stocks for placing days trades on the FTSE.

Friday, August 26, 2011

Trade Update - DIG

While watching the German flash crash yesterday I wanted a quick way to make a profit on a bounce off the lows. I chose oil on the basis that there is global demand support for the oil price so if the flash crash turned out to be something more sustained I would at least have a position that would find some support.

To make this trade I chose the leveraged ETF DIG. I bought at 39.30 and sold today at 40.35 for a profit of 101 dollars after costs.

The oil price is towards the top end of the range it has trade within for the past two weeks. If the flash crash had happened while it was lower in the range I would have committed more money and held on for longer, as it is my reason for entering the trade has passed and I will have to be happy with the 101 dollar profit.

XIV Trade Update

The XIV trade was initiated as a way to play falling volatility. Volatility has been near 12 month highs and due to its calculation methodology has the property of tending to revert towards a mean value.

On the surface this is a high probability trade, however due to the structure of the XIV ETN its prone to roll decay when spot VIX is higher than near month and next month VIX futures.

Volatility has remained sufficiently high this week to keep the XIV trade out of the money and in the roll decay zone.

Last night I took the decision to take risk out this trade ahead of the Jackson Hole meeting by closing one of the position for a loss of 90 dollars including costs. The position was initiated on the 19th at 7.39 and closed on the 25th at 7.35. The trade had been in the money 300 or 400 dollars on several occasions during this period however XIV has shown a tendency this week to give back any gains very quickly.

Today I intended to use XIV or its opposite VXX to trade any sharp intraday movements resulting from Jackson Hole. As the minutes of the meeting were announced, the market dropped sharply taking XIV as low as 7.00, I waited for the market to stabilise and bought XIV at 7.09. A little over an hour later I sold XIV for 7.39 for a profit of 340 USD including costs.

5 day price chart for XIV Showing profitable spikes that are given back if not captured. Missed the first caught the last one.

I still have two positions in XIV, both are out of the money. I intend to leave these in play and may add additional positions to take advantage of future intraday opportunities.

Tuesday, August 23, 2011

XIV and Roll Decay

Understanding the performance of many ETFs and ETNs is like peeling onions, there can be layer after layer of complexity, often more than enough to make your eyes water.

The XIV ETN is a defining example of this complexity. Quoting from the prospectus, first we have the full product name -

'XIV: VelocityShares Daily Inverse VIX Short-Term ETN'

Then we have this sentence from the first paragraph which summarises the aim of the product -

'The return on the ETNs is linked to the inverse of the daily performance of the S&P 500 VIX Short-Term Futures™ Index ER less the investor fee'

So what exactly is XIV and how can it be expected to behave ?

The Exchange Traded Note (ETN) XIV is widely positioned in the media as a way to short the VIX Index. This is an incorrect positioning of XIV. The issuer uses deliberate language to outline the product, this language will have been carefully reviewed by the issuers legal department.

The summary makes reference to several key points -

1) 'Less the investor fee' - there is an annual fee built into this product which is 1.35%, this fee is applied daily according to a calculation also outlined in the prospectus.

2) 'VIX' - VIX is an index, its basically a value calculated and published by Standard and Poors. It isn't something real, you can't buy a VIX.

3) 'VIX Short Term Futures' - While you can't buy a VIX as it isn't something physical, you can buy a futures contract for VIX. A futures contract is essentially an agreement between two parties that one will pay the other the difference between the value of VIX on a future date and the current value of the VIX. The party buying the contract will benefit if the value of VIX rises, the party selling the contract will benefit if VIX Falls.

4) 'Daily Performance' - this is a key piece of wording, all derivatives based ETFs and ETNs are now at pains to point out that they are 'Linked to Daily Returns' this is due to a wide range of factors which cause these products to significantly under perform over an extended period. Put simply most of them are mathematically guaranteed to lose money if held over an extended period. Hence the 'linked to' and 'daily performance'.

5) 'Inverse' - this means that the product is intended to return the opposite percentage of the 'VIX Short Term Futures' on a daily basis minus fees. While these points are common to many ETFs and similar wording will be found in many ETF prospectus, my interest is in the ability of XIV to provide short (inverse) exposure to the VIX index which is the context in which XIV is most often positioned.
The following chart shows the price action in VIX over the past 5 days

I have marked a line on the chart to indicate that over the past 3 days, VIX held at a level which was 30% higher than it closed on August 17th. Within the highlighted period there have been intraday moves of -15% at the open on Friday 19th and -17% at the open on Monday 22nd.

If XIV represented a suitable product for gaining short exposure to VIX, we should have expected corresponding spikes in the value of XIV which could have been sold for a quick profit.

The XIV Summary explicitly states that XIV provides returns inverse the 'S&P 500 VIX Short-Term Futures™ Index ER'. This index is not the VIX index itself but a basket of futures contracts to buy the VIX over the present month and next month. The following chart shows the performance of SPVXSP the ticker symbol for the 'S&P 500 VIXShort-Term Futures™ Index ER' index.

There are three observations when comparing the two charts

1) SPVXSP - Does not jump 30% and then stay there but rather gaps an initial 15% and then continues to rise at a gradual rate through the next two days

2) The intraday spikes in SPVXSP are much smaller, around 5-10% against 15-18% in VIX

3) Although VIX appears to be fading on Monday 22nd closing around 8% down on the preceding close, SPVXSP continues to rise closing around 10% up on the Friday close. As a final observation at the present time, VIx is down intraday to a level only 20% above its close on August 17th, whereas SPVXSP is still more than 30% above its value on the 17th.

All of the observations are explained by the difference between the spot VIX index and the SPVXSP Index which is composed of a basket of futures contracts on the VIX Index. Futures contracts generally respond less than the immediate or 'spot' prices that they follow. The assumption is that whatever short term disturbances are impacting the market, these will pass in time so the future price of VIX tends to discount these effects.

This is enough to explain the smaller jumps in price, but there is another more powerful effect at work which is not immediately obvious from the charts, its also the most important factor from an investment perspective.

The steady upward path on the SPVXSP is in part due to 'roll'. The SPVXSP index is calculated based on rolling futures contracts forward, that means that everyday, a portion of the futures contracts which are nearest expiry are sold and the proceeds reinvested in contracts further out in the future. The rapid spike in the spot price of VIX this week has caused a market condition know as 'backwardation' where the spot price is higher than the futures prices.

As I type the VIX Prices are
VIX September34.95
VIX December32.10
VIX January30.47

This is a very positive condition for SPVXSP, when the contracts are rolled forwards, ie. sold at today's price 38.2 and reinvested in the next months contracts at 34.95, SPVXSP increases in size as its possible to buy more contracts using the proceeds of todays higher price to buy next months lower priced contracts.

While VIX remains elevated, the number of futures contracts that are purchase each day is elevated, and also the next month and later contracts will creep up in price towards the spot price. There is a dual effect of increasing the number of contracts held and an increasing value of the contracts held.

As good as this is for SPVXSP, it is equally bad for XIV which provides inverse performance to SPVXSP.

While backwardation often occurs in VIX Futures, it is an exception from the norm and generally passes quickly. Under normal circumstances where VIX Futures are a at a premium to spot, SPVXSP will suffer roll decay through selling expiring contracts at prices lower than the replacement contracts can be purchased leading to a daily reduction in the total number of contracts held within the fund.

For the past few days, my trades in XIV have been on the wrong side of this, steadily losing value as SPVXSP benefits from the temporary backwardation in VIX Futures.

Although VIX Has fallen over 10% today, spot VIX is still at a premium over current month and next month VIX Futures, this will provide some support to SPVXSP which is only down 3.3%.

For my positions in XIV to really pay off I would need spot VIX to fall below the current month and next month futures prices.

I will be selling my positions into the current risk on rally ahead of Fridays Jackson Hole meeting. I may then reenter the positions depending on the Jackson Hole outcome.