The Trading Pitt is the only club at the University of Pittsburgh, and one of the few across the United States that focuses on what it takes to trade today’s markets. You can visit their website here http://www.thetradingpitt.com/ or watch or read some of their student presentations on trading and investing after the jump:

What is your club’s curriculum? What investment and trade styles do you teach?

In the past, our club has mostly focused on day, quantitative, and swing trading. We have members interested in a wide variety of assets and trading styles that must be incorporated into our curriculum. One of my main objectives as president this year is to focus more directly on each member in order to cater to their individual interests. Smaller groups will be assigned as members will have the opportunity to work with others to tweak their own trading styles though collaboration with peers of similar interests. Hopefully this change will pander to a much broader spectrum of students while at the same time strengthen the community of traders we are attempting to build.

What is the organizational structure of the Trading Pitt?

At the Trading Pitt we have a President who plans and conducts each meeting along with an executive board assigned to assist the president which currently consists of a vice-president, secretary, business manager, communications manager, trading education manager, and a VP of career development. In addition, we are currently looking to add a technology supervisor.

Is Facebook the real deal?

In my opinion, with the changes Facebook continues to implement and rising privacy concerns, Facebook will be very small to non-existent in about 10 years.

Who has the best StockTwits/Twitter account?

Me (@Hew_Dat)

Here are 4 presentations that the club has compiled in the past:

The Importance of Indexes and Beta Trading

Understanding, Monitoring, and Utilizing ETF’s

Understanding the FX Markets

Using Trends and Trend Following Strategies

Index Arbitrage:

In my past life, I managed a sizable mostly-equities portfolio made up of different strategies.   One strategy was index arbitrage:  when the futures were trading out of line with the underlying index, we would sell the expensive one and buy the cheap one.   This trade, once we lock in our funding cost (via another trade), is a perfect hedge (minus dividend risk!).

Pairs Trades:

Another strategy was pairs trades:  we might buy $HD and short $LOW, or buy $KO and short $PEP.   This, it should be obvious, is not a PERFECT hedge, but we would expect that our risk in being long $HD and short $LOW is less than our risk in just being long $HD, or our risk in being long $HD with a generic market hedge against it (ie, short S&P Futures). In other words, when we hedged with an asset which we expected to be highly correlated, we figured to be reducing risk relative to our other options.   Guess what – we could be wrong!   $HD could implode while $LOW took all of their business away, and our hedge could make our trade performance worse than it otherwise would have been.   That happens sometimes, but it doesn’t mean that the other side of the trade wasn’t a “hedge.”

Merger Arbitrage:

Similarly, we ran a merger arbitrage portfolio.  When company XX was acquiring company YY for stock, we’d buy the stock in target YY and short the acquirer XX in the proper ratio so that if/when the deal closed our positions would net out to zero and we’d capture the spread.   Guess what we used as part of a hedge for this trading book?  We carried a short S&P 500 futures position on a ratio basis.   Is this a great hedge?   Hell no – it’s about as far from perfect as one can get – but merger arbitrage performance tends to have a positive beta:  as the market does well, the deals get done.  When the market blows up, like it did in 2007/8, financing dries up, deals break, etc.    Might we have come up with an even better hedge – perhaps something like a bank financing index?   Absolutely, but we used the S&P hedge as a simple “better than not having it” hedge.   Having that offsetting futures position ate into some of our profits but also reduced our risk.

I read this book in the fall of 2008. Changed my life. I picked it out of the trash while working on my jump shot in the front yard of my house. I had missed a few jumpers off the front rim when I went to kick something out of anger and saw the book sitting on the top of our trash can. My dad was throwing it out to make room for his running shoes.

I packed the book into my bag not knowing anything about it, and headed off to school. What transpired next was a beautiful case of the Alchemist. Turned out the author, Victor Niederhoffer, had gone to school in the Boston area like myself, and wrote about it in his book. Niederhoffer takes his readers inside the mind of a trader with humility and self-introspection. He weaves together squash, chess, horse handicapping, trading, and his relationship with his father. After I finished the book, I joined my school’s chess club, and lost a bet at the same Suffolk Downs that Niederhoffer had spent his collegiate days at.

Granted, Niederhoffer has run two failed hedge funds. I’ll still take it, though.

It opens:

I must buy $400 million without anyone’s knowing, or else I will turn the market. But I am all alone. And brokers will rush ahead to buy as soon as they know what I’m doing. I pick up two phones and press the speaker on another. “What’s your dollar bid and offer for 12.5 yards of yen?” I say. I wait a second and then say, “I buy dollars.” And with three words, I just bought $375 million against the yen. I am whole again.

Technical Analysis of Stock Trends
by Robert Edwards and John Magee

All-Star Charts, J.C. Parets, came to Harvard the other day to talk to students, faculty, and investment professionals. He gave a shout-out to the, “the bible of technical analysis” AKA Technical Analysis of Stock Trends by Robert Edwards and John Magee.  This was two days ago, and I’m 3/4 of the way through the book. It is indeed the bible of Technical Analysis — J.C. was right on.

In the past, I’ve considered myself to be a value investor who looked for long-term value plays based on a company’s financial statements. Value investments were my modus operandi, and I was skeptical of any other trading strategy. I used to believe in that saying, “Estimating how well stocks will do in the future from how well they have done in the past is like driving a car while looking in the rearview mirror.” What a stupid quote, and what a fool I was for believing it.

Uncover the Secret Hiding Places of Stock Market Profits
By Joel Greenblatt

Joel Greenblatt is a savvy investor who plays the market by the motto “KISS” – keep it simple, stupid. In this book he touches up on an incredible list of profitable opportunities for any trader to take advantage of including: spinoffs, following insiders, risk arbitrage and merger securities, bankruptcies, restructurings, recaps, stub stocks, leaps, warrants, and options.

This is a quick read and it will show you how easily even the most novice investor can make a few bucks by simply paying attention to the market each day, and reading company financial documents.

Market Wizards: Interviews with Top Traders
By Jack D. Schwager

Read my post on Paul Tudor Jones here to get the gist on this book.

Reminiscences of a Stock Operator
By Edwin Lefevre

#15 on Forbes’ 75 smartest books. A fictional one, but largely designed and crafted based on the life of the prolific Jesse Livermore. These quotes bring the house down:

To learn that a man can make foolish plays for no reason whatever was a valuable lesson. It cost me millions to learn that another dangerous enemy to a trader is his susceptibility to the urgings of a magnetic personality when plausibly expressed by a brilliant mind. It has always seemed to me, however, that I might have learned my lesson quite as well if the cost had been only one million. But Fate does not always let you fix the tuition fee. She delivers the educational wallop and presents her own bill, knowing you have to pay it, no matter what the amount may be. Having learned what folly I was capable of, I closed that particular incident.

The game of beating the market exclusively interested me from ten to three every day, and after three, the game of living my life. Don’t misunderstand me. I never allowed pleasure to interfere with business. When I lost it was because I was wrong and not because I was suffering from dissipation or excesses. There never were any shattered nerves or rum-shaken limbs to spoil my game. I couldn’t afford anything that kept me from feeling physically and mentally fit. Even now I am usually in bed by ten. As a young man I never kept late hours, because I could not do business properly on insufficient sleep. I was doing better than breaking even and that is why I didn’t think there was any need to deprive myself of the good things of life. The market was always there to supply them. I was acquiring the confidence that comes to a man from a professionally dispassionate attitude toward his own method of providing bread and butter for himself.

What I have here are 5 investment and trading books for new market participants. If you’ve found yourself at the brass gates, ready to enter the Den, my advice is only this: fill your holster with a book written by a seasoned market expert. It will be surprisingly useful when you are in a stand-off between a buy and a sell order. You’ll want to quick draw the knowledge you’ve reaped from one of these beauties before making your final decision.

The StockTwits network has several books on the market. In the last few months the demigod of links, Abnormal Returns, published a book and so did the Reformed Broker Josh Brown. In addition, there is the StockTwits Edge book, which is a published collaboration by the entire network, and James Altucher who writes about personal philosophy, and markets.

Certain characteristics go along with profitable trading plans.  Profitable day trading tends to fall into one of two strategies.  For lack of better names I will call them Short-Term and Long-Term.

1. Short-term strategies are designed to make a quick profit and exit quickly in order to limit risk.  They tend to have a higher number of trades per day than other strategies and they are often based on breakouts and breakdowns (new moves above or below the initial trading range).  In order to overcome the cost of commissions and make a profit, these strategies need to show a high percentage of winning trades – 60% is about the lowest required to overcome commission costs and still make a nice profit.  Many good strategies will wait for the initial market range, then buy as the market moves above that, or short if the market drops below that initial range.

2. Longer-term strategies are designed to catch that big, but less-frequent move.  The ideal Long-term strategy will buy near the open, the market goes up all day, then sell at the close.  Since this rarely happens, strategies like this show a lower percentage of winning trades – less than 40% and often around 20%.  They can have large losing days.  Since this type of strategy will have more losing days than winning days, it can be hard on the wallet and the psyche.  You must not trade “too big” (too many contracts) with this strategy or you will lose too much money and be out of the game before a winner comes along.  Long-term strategies are like roller coaster rides.  Traders employing the long-term style need to have a lot of confidence that it works and have strong will to follow it.

Most of us should probably be looking for short-term strategies because they are more consistent.  Observe your market:  look for how big the intra-day moves are based on a 5- or 10- minute chart and make a strategy to capture those moves.
Use trailing stops!  They keep you in the market when your trade is moving in the right direction and get you out when it moves against you.  Determine how much room to give your trailing stops so that you can profit at least 60% of the time.  For more information on day trading strategies, I recommend the book, The Four Steps to Trading Success, by John Clayburg.

Each quote below is taken Blake Masters Tumblr blog. He is a student in the class who summarizes each lecture and posts them  online.  

Spot a Great Company

Great companies do three things. First, they create value. Second, they are lasting or permanent in a meaningful way. Finally, they capture at least some of the value they create.

Great companies last. They are durable. They don’t create value and disappear very fast.

Consider disk drive companies of the 1980s. They created a lot of value by making new and better drives. But the companies themselves didn’t last; they were all replaced by others. Not sticking around limits both the value you can create and the value you can capture.

The most common multiple is the price-earnings ratio, also known as P/E ratio, which is equal to market value (per share)  / earnings (per share). In other words, it is the price of a stock relative to a firm’s net income. The P/E ratio is widely used but does not account for growth.

To account for growth, you use the PEG, or Price/Earnings to Growth ratio. PEG equals (market value / earnings) / annual earnings growth. That is, PEG is PER divided by annual growth in earnings. The lower a company’s PEG ratio, the slower it’s growing and thus the less valuable it is. Higher PEG ratios tend to mean higher valuations. In any case, PEG should be less than one. The PEG is a good indicator to keep an eye on while growing your business.

LinkedIn ($LNKD) is another good example of the importance of the long-term. Its market cap is currently around around 10 billion dollars and it’s trading at a (very high) P/E of about 850. But discounted cash flow analysis makes LinkedIn’s valuation make sense; it’s expected to create around 2 billion dollars in value between 2012 and 2019, while the other 8 billion dollars reflects expectations about 2020 and beyond. LinkedIn’s valuation, in other words, only makes sense if there’s durability, i.e. if it’s around to create all that value in the decades to come.

Freshwater Schools believe in neoclassical economics. Laissez Faire is their motto. Their core belief, that the economy is rational and capable of running itself, is the light that guides their view. This free-market bravado insists that government intervention is unnecessary; even in the wake of an economic crisis. Freshwater Schools see each crisis as a necessary component of the business cycle that ultimately works to improve the economy in the long-run by weeding out prior inefficiencies and trimming old fat. Think of of this as something similar to the what an Ironborn Priest says in Game of Thrones, “What is dead may never die, but rises again, harder and stronger.” (Yes, I just related the downturn in the business cycle to a Game of Thrones quote.)

At odds with the Freshwater Schools are the Saltwater Schools who believe that government intervention is necessary for the economy. They follow the monetarist model set by economist John Maynard Keynes — the classic advocate of how to spend your way out of a downturn. Ideally, Saltwater Schools would like to guide the economy with the governmental tools at their disposal that include the control of interest rates, budgets, and money supply. Do you suffer from a down economy? Ah, well we have just the fix: lower interest rates to spur borrowing, and increase public spending to enhance the velocity of money and jobs created. 

A favorite article of mine on this subject was written by Paul Krugman for the New York Times back in 2009. About half way through this piece, Krugman dips his feet in the brackish water where the Freshwater Schools meet the Saltwater Schools. He says:

“Macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.”

“Even so, you might have thought that the differing worldviews of freshwater and saltwater economists would have put them constantly at loggerheads over economic policy. Somewhat surprisingly, however, between around 1985 and 2007 the disputes between freshwater and saltwater economists were mainly about theory, not action. The reason, I believe, is that New Keynesians, unlike the original Keynesians, didn’t think fiscal policy — changes in government spending or taxes — was needed to fight recessions. They believed that monetary policy, administered by the technocrats at the Fed, could provide whatever remedies the economy needed.”

Another interesting anecdote comes from Jim Luke, a well-traveled professor who blogs at EconProph.com:

“The fresh water view holds that fluctuations are largely attributable to supply shifts and that the government is essentially incapable of affecting the level of economic activity. The salt water view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity).”

“Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operating results of his companies.’’

- Benjamin Graham
Author, Professor, Investor

“I’d say that my investment philosophy is that I don’t take a lot of risk, I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to take substantial amounts of financial risk ever, because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.’’

- Paul Tudor Jones
Tudor Investment Corp.

“The investment business is about being confident enough to know that you’re right and everyone else is wrong. Yet you have to be humble enough that you recognize when you’ve made a mistake. Earlier in my career, I think I had the confidence part pretty solid. But the humbleness part I had to learn.’’

- Bill Ackman
Pershing Square

“In the land of the blind the one eyed is king.”
“The key [to running a hedge fund] is simple. Deliver what you say you are going to deliver.” 

- Israel “Izzy” Englander
Millenium Partners LP

The equities and equities futures markets are all closely influenced by each other, including the S&P, Dow, and Nasdaq futures, and their associated equities markets: the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index.  They all move closely together – like a school of fish.  The main difference is that the Nasdaq, which has more Tech sector stocks in it, is more volatile and tends to have bigger moves.

There is a seasonal factor to the equities markets as published by The Stock Traders’ Almanac, by Yale and Jeffrey Hirsch.  They wrote that most of the gains in the stock market (which will include the stock futures markets) come from November 1 to April 30 of the following year.  At some point in the Spring – right about now – the market has a correction of 10-20% and takes a breather for a few months until the Fall when it starts back up again.

Now, of course, if you trade the stock market or the equities futures like I do (the Dow mini’s), then this will directly influence your trading.  You can look for spots where the market is making highs and likely to reverse.  And if you didn’t notice, this is an edge that I have been writing about.

For example, Priceline.com ($PCLN) has been shooting up like a rocket in recent years – it was at $200 less than 2 years ago.  The only times it has slowed down at all was a brief but sharp pull back in the Spring of 2010 that lasted a couple months and a consolidation last year over several months.  Isn’t it interesting that both came right at the beginning of the slowdown for equities.  Hmm….. Coincidence?  I think not.

This also happens repeatedly in the whole equities market ($DJIA).  Notice how the high came exactly on time in early May 2011 (at #1) then the attempt to continue the uptrend failed 2 months later (at #2).  Then came a 15-20% sell-off.  The high wasn’t reached again until later in the year or early 2012.

Even if you trade commodities futures like gold or oil, knowing that many markets correlate with other markets, I would certainly like to know if this pattern holds true for whatever market I am trading if I were you….  If this pattern doesn’t hold true for your market, maybe you can find other patterns that will.  And that, my friends, is one way to find an edge in whatever security you trade.

1.) How would you define behavioral economics?

@ritholtz, @ppearlman, and @deniseshull

The Altman Z-Score, initiated in 1968 by Edward I. Altman while an assistant professor at NYU, was one of the the first mainstream bankruptcy calculations. Altman’s calculation dominated Wall Street during the 1980s and 1990s because it gave investors a quick glimpse at the probability of a company going bankrupt. Altman’s Z-score is calculated using a company’s balance sheet and income statements but it has also been used to evaluate sovereign risk and credit in the Eurozone. The Altman-Z score is calculated like this (from Wikipedia):

Z = 0.012T₁ + 0.014T₂ + 0.033T₃ + 0.006T₄ + 0.009T₅

T₁ = Working Capital / Total Assets. (Measures liquid assets in relation to the size of the company.)

T₂ = Retained Earnings / Total Assets. (Measures profitability that reflects the company’s age and earning power.)

T₃ = Earnings Before Interest and Taxes / Total Assets. (Measures operating efficiency apart from tax and leveraging factors.)

T₄ = Market Value of Equity / Book Value of Total Liabilities. (It is a possible warning signal when the market value of the firm is substantially below the book value.)T₅ = Sales/ Total Assets. (A measure for total asset turnover and efficient use of firm assets.)

Once the Altman Z-score has been calculated, the probability of bankruptcy falls into three sets: A company with a  Z-score greater than 2.99  is considered to be in a “Safe Zone” and has a low likelihood of bankruptcy, a Z-score between 2.99 and 1.81 is considered to be in a “Grey Zone” and could go in either direction, and a Z-score less than 1.81 is in a “Distress Zone” and has a high probability of bankruptcy.

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Although the Altman Z-score has been around the longest, over the last few years many new calculations have risen. An alternative to Altman’s Z-Score is the Joseph Piotroski Score. Piotroski created this metric for value investors and it is praised for its simplicity, ease of use, and accuracy. It is an excellent way for non-quantitative traders and investors to evaluate their company’s financial strength. Here is how it works: Look at the nine bullets I’ve listed below and score one point if your stock passes a bullet point and zero if it doesn’t pass a bullet point. The maximum score is 9 (excellent financials) and the lowest score is 0 (poor financials):

1. Net Income: Score 1 if last year’s net income is positive.
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2. Operating Cash Flow: Score 1 if last year’s cash flow is positive.
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3. Return On Assets: As a measure of profitability, score 1 if last year’s Return on Assets (ROA) exceeds prior-year Return on Assets.
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4. Quality of Earnings: Score 1 if last year’s operating cash flow exceeds net income, as a measure that warns for potential accounting gimmicks.
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5. Long-Term Debt vs. Assets: Score 1 if the ratio of long-term debt to assets is down from the year-ago value.
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6. Current Ratio: Score 1 if Current Ratio has increased from the prior year.
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7. Shares Outstanding: Score 1 if the number of shares outstanding is no greater than the year-ago figure, as a measure of potential dilution.
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8. Gross Margin: Score 1 if full-year Gross Margin exceeds the prior-year Gross Margin to measure the company’s competitive position.
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9. Asset Turnover: Score 1 if the percentage increase in sales exceeds the percentage increase in total assets, as a measure of the company’s productivity.

Both the Altman Z-Score and Piotroski Score are excellent tools to help monitor the risk of your investments. I personally have had the most success using the Piotroski Score, but both are equally valuable. This is part 1, which covers Altman and Piotroski while Part 2 covers Shumway and Campbell.