Basic trading techniques Prof Vittorio de Pedys ESCP

Basic trading techniques Prof. Vittorio de Pedys, ESCP Europe

Asimmetric perception of risk Asimmetry win-lose Loss Aversion : losing is more painful ! Loss curve is steeper

VALUE GROWTH VALUE OF ASSETS VALUE OF GROWTH MARKET PRICE VALUE OF ASSETS VALUE OF GROWTH

• GROWTH STOCKS – HIGH P/E AND di P/BV • VALUE STOCKS – LOW P/E, P/BV, P/SALES , P/cash flow BUT HIGH dividend yield

Since risk and return go hand-in-hand, it can be expected that a higher return is necessary to compensate a higher level of risk. Therefore, while different types of investment offer different returns … • If you invested $1 in 1925, your ending wealth will be very different if the $1 is invested in small company stocks, large company stocks, Tbonds and T-bills ? Source : Ibbotson Associates (2006) Stocks, Bonds, Bills, and Inflation 2006 Yearbook 5 5

Dividends are very important. Much more than you realize…

Italian stock market since 1998

Main stock markets rebased since 1998

COME REAGISCONO I MERCATI AI DATI

NOTE • *PER OBBLIGAZIONARIO INTENDIAMO LE EMISSIONI A MEDIO LUNGO TERMINE, OSSIA CON SCADENZA SUPERIORE AI 12 MESI (TIPICHE DEL MERCATO MONETARIO). • *CON IL SEGNO POSITIVO INDICHIAMO PER L’OBBLIGAZIONARIO UN RESTRINGIMENTO DEI RENDIMENTI, PER L’AZIONARIO UNA SALITA DEL CORSO, PER IL VALUTARIO UN APPREZZAMENTO DEL CAMBIO. DISCORSO ANALOGO, MA INVERSO, PER IL SEGNO NEGATIVO. • *** INDICI DI FIDUCIA SONO QUELLI CHE TENDONO AD ANTICIPARE IL POSSIBILE LA POSSIBILE DIREZIONE DI UN ‘ECONOMIA (AD ES. IL SUPER INDICE USA) O DI UN SETTORE (AD ES. L’ISMMANUFACTURING USA O L’IFO IN GERMANIA), IN BASE ALLA FIDUCIA ESPRESSA DAGLI OPERATORI INTERVISATI (AD ES. ANALISTI, ECONOMISTI, IMPRESE E CONSUMATORI) SULLE CONDIZIONI CORRENTI E ATTESE NEI SUSSEGUENTI 6 MESI.

MY IDEAS ON TRADING

BASICS trading and investing are a technique. But there is a lot of psychology: behavioural finance. Your behaviour and techniques can be improved if you monitor them 12

My ideas on trading: SPECULATORS • Speculators try to understand the psychology of the market • When to buy and when to sell is more important than what • Pareto applies to speculators: 80% lose money and 20% make BIG money • There is no automatic relationship between value and market price • Markets rise (decline) because there are forced buyers (sellers) • The consensus is wrong at the extremes • Markets discount events up to 9 months ahead • You must follow the trend, not economic news • You must adapt the size of your position to volatility • You can be a contrarian only in the short term

My ideas on trading : TYPICAL MISTAKES 1. I refuse to define a loss 2. I do not close a losing trade, even when i realize potential is strongly diminished 3. I remain frozen in my market view 4. I focus on the money impact of my trade, instead of potential movement based on the instrument’s behaviour 5. I trade to extract revenge , trying to get back from the market what the market has taken away from me 6. I do not follow my own rules or the trading system 7. I freeze looking at bid or offer, even if i believe there is a good potential for a trade 8. I disregard my instincts 9. I have a long streak of winning trades, followed by just one losing trade which gives back all gains 10. I do not turn around my position even if i realize market has changed direction 14

My ideas on trading : NECESSARY SKILLS • 1. i focus on my abilities do not stress economic results • 2. i objectively recognize my strenghts and weaknesses • 3. i learn to adapt to market changes • 4. i identify the amount of risk where i am comfortable • 5. i trade immediataly as soon as i am convinced the opportunity is there • 6. i let the market tell me when is «too much» , not myself • 7. i keep being objective at all times 15

My ideas on trading : STEPS TO GROW • Do not focus on making money (it is a result) but on what i need to learn and how i need to change to interact profitably with the market • Front losses : predefine a loss for every trade • Understand when the market is telling us that the trade is not right (at which price level i am wrng ) • Front losses 2. : immediately close losing trades without hesitation as soon as it touche sits stop-loss. Never let a losing trade run • Do not get lost in the sea of available info. Learn what you are good at and focus on that • Execute trades immediately • Let the market talk to you : what is it telling me? How much strength? Where is it changing direction? What is dealer’s prevailing opinion? • Do not have pre-defined beliefs. Think and observe the market as if you do have a position , even if you have it 16

My ideas on trading : THE TRUTH. LET’S FACE IT 1. MARKET IS ALWAYS RIGHT 2. POTENTIAL TO GAIN OR LOSE IS WITHOUT LIMITS 3. PRICES MOVE PERPETUALLY WITH NO BEGINNING OR END 4. THE MARKET IS AN UN-STRUCTURED ENVIRONMENT (WE SET OUR OWN RULES) 5. WHEN YOU TRADE, REASONS ARE COMPLETELY IRRELEVANT 6. WE CANNOT CHANGE THE MARKET: WE CAN ONLY CHANGE OUR WAY OF PERCEIVEING IT 7. IT IS MY DECISION WHEN TO TRADE IN WHEN TO GET OUT , HOW MUCH, WHAT, ETC 8. EACH TRADER GIVES HIMSELF WHAT HE DESERVES

Basic risk management

SOME PIECES OF ADVICE • Benefits of diversification are not infinite: on the contrary, they decrease as you add asset classes. • The only diversification that works is with highly decorrelated asset classes (for ex. Stoks/bonds) • In normal distribution 3 standard deviations cover 99% of events : this gives a false sense of safety • Volatility is not stable across time • Volatility increases at times of crisis and decreases when markets are positive • The only way to stress test your portfolio is to set all correlation to 1 and see if you can live with the results

Illusion of normal distributions. . . The probability to be between the mean plus or minus 1 standard deviation • If we were to keep on generating observations for a long time period, the aberrations in the sample would disappear, and the actual historical distribution would start to look like the underlying theoretical (normal or Gaussian) distribution • Normal distribution looks like a bell-shaped curve The probability to be between the mean plus or minus 2 standard deviations 20 The probability to be between the mean plus or minus 3 standard deviations

The decalog of simple but good risk management…. 1. If it can happen, it will 2. If something can go wrong , it will 3. Volatility is like energy : once created it is conserved forever (even if it falls ) 4. No strategy is totally “market neutral” 5. “mean reverting” takes too much time to be useful : you die before 6. In moments of panic fundamentals become irrelevant