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Book Reviews

"This is a great book for novice and experienced traders. Soaking up its wisdom distilled from experience and introspection will help you become more successful. And that's true even if it doesn't make you a penny." --Aaron Brown, AQR

Tony Saliba Managing Expectations

The following is an excerpt from Managing Expectations by Tony Saliba

The Making of a Successful Trader

Until you’ve traded, managed a position, or risked your own money, it’s hard to understand the importance of discipline, mental awareness, along with handling the various emotional facets that will – no doubt – come your way. The discipline to have a pre-determined and iron- clad risk management plan in place ahead of time, possessing the willingness to allow your winners to run, and most importantly – acquiring the humility to lose money without making situations worse – are all part and parcel of what makes a good trader.

Decades of experience have taught me that a pre-trade risk management plan has helped to remove me from the situation – perhaps keeping me from making less than optimal trading decisions. A good trader simply cannot be afraid to lose money – for it happens to everyone. The chief problem with losing money in a trade is not merely the money – it’s the enticement to make irrational decisions – no doubt making things exponentially more risky.

We are trained to equate losing with shame. We are prone to avoid it at all costs. Sometimes losing stimulates a reaction to fight back. But for most of us, we permit losing trades to cause us to deny responsibility, avoid situations, and think irrationally. The result may well be a foolish decision to remove a stop in an options trade. Making blunders and losing trades no doubt have varying effects on individuals.

But if you can value and appreciate that traders will lose money, and sometimes lose money on a consistent basis, you will be well on the road to successful trade management. Guaranteed.

How to Deal with Market Outliers


The hardest part about successfully trading options is being willing to put in the days and weeks and months and years of discipline required. Many trade options attempting to chase the dream of “quick riches” and for some that does happen. However, for the most part, good traders spend most of their waking hours dreaming of the big payday yet knowing the realities of what could happen if they don’t do the hard mental work of remaining disciplined.

Baseball has a saying that, “the ball will always find you.” It’s uncanny but it seems the minute a player is out of position or not physically 100%, the ball seems to be hit to him! This parallel can and does apply to options trading as well. The biggest – sometimes catastrophic – losses occur when the trader lets his guard down with regards to position and trading discipline. You may get away with being overly “short options units” for months – perhaps years. However, one day you will experience a market event that could very well wipe away all the meager gains you achieved with your undisciplined approach.

Think back on some of the bigger market events we’ve had in the last three decades:

  • The U.S. stock market collapse in October 1987
  • 1994 U.S. bond market crash
  • Asian Financial crisis in 1997
  • Russian debt default and LTCM in 1998
  • Tech bubble of 2000
  • Great Recession of 2008

I was personally able to make large sums of money as the result of these major events. I didn’t make money due to luck nor due to skill. I was profitable because of my daily position, trade, and risk management routine. That self-scrutiny kept my options risk well defined. Additionally, my thorough, in-depth knowledge of options strategy and more importantly, how they perform during crisis, allowed me to make markets aggressively when everyone else was hiding.

Market outliers are sometimes very daunting to live through. Yet, I challenge you to always remember the following:

• Always know what strategies will do during extreme periods. Example: during very high periods of volatility, wingspreads will naturally become very cheap.

• Always know exactly what happens to your current position during both a “melt-down” or “melt-up”.

• Be aware of skew shifts and shadow deltas when hedging your position.

• Economic events seem to come in episodic waves and the next one is sure to be different from the last one.

• Volatility is typically persistent and it seems to persistently overshoot and undershoot what conventional wisdom otherwise believes.

• The vast percentage of your profitability is made in very small slices of time. Opportunity knocks very briefly.

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Brynne Kelly is an energy analyst extraordinaire who primarily focuses on crude oil, natural gas, and electricity.

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Download a sample of Brynne’s expert Energy Market Research. It’s 19 pages but well worth the read.

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By Jason Pearce

A Noteworthy Setup In Treasuries

Everybody seems to hate the bond market right now.  All the cool kids own stocks and commodities.  After all, the new US President is going to Make America Great Again and he’s willing to spend whatever it takes to get us there.  That’s not good for bonds.

However, there may be a good reason to consider a contrarian approach and start thinking about owning US Treasuries once again.  Whether you are looking at cash bonds, futures, or ETFs, things may be shaping up for a major trend change.  If so, the investor/trader who gets in early will be the one to reap the biggest reward.

Ebb and Flow

Last July the long end of the US Treasury market peaked at record highs.  The yield on the 10-year note sunk to a record low of 1.33% as investors were snapping them up hand over fist.  At the time, it made perfect sense.  First of all, the yields on comparable treasuries in Japan and parts of Europe were negative.  So an investor would pay the governments to take their money!  In that context, it made the still positive yield in the US Treasury markets seem like a pretty good deal.

Also, the world had just been sucker-punched by the outcome of the Brexit vote a few weeks earlier.  Stock markets made a quick and nearly immediate recovery after the vote, but the damage was already done.  Due to the negative surprise and ensuing whiplash in equities, investment safe-havens were now in high demand.

In a case of bond market déjà vu, July of 2016 was somewhat reminiscent of the July exactly four years earlier.  That was when the Greek debt crisis caused turmoil in the markets and safe-haven buying sent the US 10-year note yield to a then-record low of 1.39%.  As Mark Twain once said, “History doesn’t repeat, but it often rhymes.”

As is often the case, that turned out to be the very top of the bond market and low for yields.  At the time, nobody could imagine that Treasuries could decline in such an uncertain environment.  Yet that’s exactly what happened.  It reminds me of the classic Wall Street observation: People are the most bullish at the top and the most bearish at the bottom.

After reaching its zenith last summer, Treasuries have been hammered by continued improvement in the US economy, Trump’s election victory, a continued surge to record highs in the stock market, a rate hike from the Fed back in December, and the expectation of even more rate hikes for this year.  Now it seems that nobody can imagine that Treasuries could rally in such an environment.  It may be a good time to reread that Wall Street observation in the prior paragraph.

The Pendulum Has Swung Again

Bond market sentiment is at an extreme right now.  But it is not the extreme bullish sentiment that we saw last summer; it is now extreme bearish sentiment.  My, how rapidly things can change in just a few months.

Market speculators seem to think that Treasuries can only decline in the current environment.  This bearish sentiment accelerated right after the election as stocks rebounded.  The yield on the 30-year US Treasury bond made the biggest single day spike since at least 1977, driving the point home.

The general consensus has been that the Trump administration will be a big boon to the economy as they go on a massive debt-fueled spending spree.  If it materializes, it would cause a significant uptick in inflation and interest rates.  Also, a major tax overhaul is being promised.  Naturally, the bond market would suffer under the weight of all this economic stimulus.

A Stretched Rubber Band

Just how bearish is the prevailing market opinion right now?  Fortunately, we can measure this opinion with more than just cheap words.  According to the weekly CFTC reports, speculators reached the biggest net short position on record just a few weeks ago.  Not just a short position in one particular instrument, but short across the entire yield curve.  From Eurodollars (short-term deposits)…to 5-year notes…to 10-year notes…to 30-year bonds.  They’re betting heavy on the short side.

These Commitment of Traders (COT) reports are used as an indicator to determine when markets are vulnerable to major trend reversals.  Traditionally, one should look to take a contrarian approach to how the speculators are positioned.  It is important to remember, however, that these reports are not to be used as a timing mechanism.  Record positions can and often do continue to grow.  As Keynes said, “The market can remain irrational longer than you can remain solvent.”

That being said, I believe that these COT reports are one of the better sentiment indicators out there.  This is because the data doesn’t just show the market participants opinions, it shows their positions.  In other words, we find out if they’re putting their money where their mouth is.  And right now, all their money is highly-leveraged on a short bet on US treasuries.

Of further interest, Deutsche Bank pointed out that the size of this massive net short speculative position is a four sigma event.  Experienced traders should know that the market does not fit neatly within the confines of a Gaussian bell curve.  History has proven that market events create tails that are much fatter than should be expected.  But you still have to admit that a market move of four standard deviations away from the mean is one heck of an extreme!  This is not a sustainable situation.

Even if the spec crowd is right on the treasury market, they are currently so heavily short that a simple bear market rally could cause massive short-covering as buy stops are triggered.  It may be starting already, as they have been trimming back a bit on some of the short positions on the long end of the yield curve over the last couple of weeks.  Of course, this may be offset by the fact that they have added to short positions on the short end (Eurodollars).

If the short-covering does start to get some traction, it could have a domino-effect of pushing prices even higher and triggering buy stop orders, causing bonds to overshoot on the upside.  Wash, rinse, repeat.  The situation is akin to a rubber band that has been stretched to the point of breaking or snapping back violently and suddenly.  This means that there may be serious money to be made by the contrarian who finds a good setup on the long side of Treasuries.

Trumped Up Hopes

The US stock market made an about-face when the election results came in.  Donald Trump’s surprise victory was the catalyst for a multi-month run to new record highs.  As stated earlier, this is predicated on the idea that Trump will be a very pro-business President.  He has promised to lower taxes, roll back cumbersome regulations, and build infrastructure.

But here’s the problem with that: the markets seem to have already priced most of these expectations in.  This makes it vulnerable to corrections if progress occurs slower than expected.  After all, it will take at least a couple of years to get the infrastructure spending implemented.

Worse yet, what would happen if Trump doesn’t deliver on all of his promises?  Or what if the focus shifts negatively from building the economy to starting a trade war?  Then the stock market goes from being vulnerable to a correction to being vulnerable to a bear market.  In light of this, it appears that the market has currently put the cart before the horse.

Gimme Shelter

As most investors already know, a meltdown in the stock market usually results in a melt up in the bond market.  They don’t always move in opposite directions, but they certainly do during times of financial duress.  This is due to the safe-haven status of US Treasuries.  So when the stock market stumbles and Mick Jagger, a graduate of the prestigious London School of Economics, starts to sing Gimme Shelter, it will be high time to make a B-line to the bond market.

The odds of a setback in the stock market are increasing.  Regardless of what you believe Trump’s effect on the economy will be, there are other reasons that the stock market could be in for a reversal this year.  The duration of the current bull market, the size of the current bull market, and the convergence of different stock market cycles all indicate that this record bull market is long in the tooth.  By extension, this argues that the odds favor a recovery in the treasury market.   (We’ll go into more details about the stock market’s vulnerability in a later article).

Are Rate Hikes Good For Bonds?!

Back in December the Fed raised rates for the first time in a year and the second time in a decade.  With the US economy in expansion-mode for the last seven years and the unemployment rate dropping low enough to achieve the full employment level, it’s widely-expected that the Fed will raise rates even more this year.  Some analysts are even projecting two or three more rate hikes in 2017.  This should continue to drag the bond market lower as rates and bond prices are inversely related.


Higher yields on bonds could actually be the very thing that brings demand back into the Treasury market!

If the Fed raises rates a full percentage point in 2017, bond funds will suffer likely a loss for the year.  But the next year could produce positive cumulative returns.  This is because the interest and principal will be reinvested at a higher rate.  If you were to extrapolate the effect of the higher rate further into the future you will see that the annual return grows even more in each successive year.  Again, this is because the higher interest rates will compound the growth on the capital growth at a faster rate.

We all know what happens when a security offers a higher return: demand increases as more investors want in on the action.

The Fed’s Folly

Another way that further rate hikes could potentially be a boon for bonds would be if the Federal Reserve were to get too far ahead of the curve.  Tightening monetary policy too swiftly could choke off economic growth.  This would send rates right back down.  As a matter fact, treasury yields could go back down even before the Fed even starts to throttle back.

Before you go thinking that modern day central bankers are just too educated and experienced to do something that crazy, I’ll remind you of a central bank episode from just a few years ago.

Back in 2011, the ECB hiked rates two different times because of a temporary pickup in inflation.  The first rate hike was done in April.  This smashed the 10-year Euro bund down to a one and a half year low.  However, the rate hike was done during an economic crisis.  Remember the PIIGS?  Not a smart move.  The Treasury market even said as much.  When the ECB hiked rates again just a few months later in July, the Euro bund rallied to a multi-month high.  Not surprisingly, the rate hikes were undone before the year was out as the ECB had to backtrack and start cutting rates again.

Did you notice the part where the Treasury market rallied when the ECB continued to raise interest rates?  This is because the bond market is smarter than the central bankers.  The Fed may be able to change rates on the short end of the yield curve, but the long end of the yield curve is driven by market forces.

There are obviously a lot of differences between Europe in 2011 and the US in 2017.  The US is certainly in a much better position to justify rate hikes than the ECB was.  But my point here is that the track record for central banks is not one to put your faith in.  They have a knack for repeating their mistakes and the mistakes of others.  The bond market will not hesitate to call them on their folly and even run contrary to their mistakes in monetary policy.

Building a Base

Many ‘experts’ are saying that the 35-year bull market in bonds has finally come to an end.  Of course, many of these same ‘experts’ shouted this from the rooftops in 2011, 2012, 2013, 2014, and 2015 as well.

But just for fun, let’s suppose that the boy who cried “Bear!” is finally right.  What if this multi-decade bull market in bonds actually did come to an end at last year’s top?  Does that mean bonds will accelerate into freefall mode?

Not necessarily.  There is no historical precedent that indicates that T-bonds have to go into a death spiral from here even if the bull market is over.  If you want to get ‘macro’ for a moment, look at the last two hundred years of history for the US interest rates.  What happened when prior multi-generational bond bull markets came to an end?  They were followed by multi-year basing periods.

After the sizable rally off the 2016 low in yields and the pullback from the record high price, history suggests that there should eventually be some significant retracement of the move.  It takes time for markets to adjust to a new paradigm after a multi-decade trend.  If so, it means that bonds could establish a buyable bottom -if it hasn’t already done so- even if this is the start of a secular bear market.

Focus On Price

Anyone can call for a rally in bonds and be right…just as long as they don’t predict when it will happen.  But if you want a forecast to translate into profits, you have to be accurate on your timing.

One if the best ways to time the markets is to focus on the simplest and purest data set that we can find: price.  This is where you know longer care about the why; you only focus on the what.  Tune out all of the news, fake or otherwise, and simply focus on the price behavior of T-bonds.  You will see that the behavior of this market has been remarkably consistent.

I’m going to show you the simple pattern that has helped me identify many of the major tops and bottoms in T-bonds over the last decade or so.  It’s the macro view for Treasuries.  A lot of traders miss this view completely because they are so focused on the short-term zigs and zags.  In a world full of day traders, plagued by ADHD and Twitter addictions, having a macro view on things will give you a major advantage over the other market participants.

For the last thirty years, T-bonds have been trending higher in an upward channel.  Unfortunately, the price charts for the T-bond futures contracts is not as clean as I’d like it to be.  It does not adjust for when the Chicago Board of Trade changed the notional coupon for all Treasury futures from eight percent to six percent, which started with the March 2000 contracts.

Since the futures price data is not up to snuff, we can examine the inversion of the price pattern by looking at a chart of the 30-year bond yield.  Remember that price and yields move inversely.  Therefore, the bond bull market means that the yield has been trending lower in a downward channel for the last few decades.

Observations of ‘Interest’

Bond yields have basically been moving in a pattern of descending Major Swing Highs and Major Swing Lows for over three decades.  Every Major Swing High was lower than the last and every Major Swing Low was lower than the last.

The Major Swing Lows were established in July 1986 (7.12%), October 1993 (5.78%), October 1998 (4.69%), June 2003 (4.14%), December 2008 (2.52%), July 2012 (2.45%), and quite possibly July 2016 (2.10%).

The Major Swing Highs that followed were established in October 1987 (10.25%), November 1994 (8.17%), January 2000 (6.75%), May 2004 (5.60%), June 2009 (5.07%), and December 2013 (3.97%).

The next thing to investigate is the size of the rallies from the Major Swing Lows to the Major Swing Highs.  There are two ways to look at this: in basis-point terms and in percentage terms.

Measuring in terms of basis points, the size of the rallies from the Major Swing Lows to the Major Swing Highs was 313-bps. (1986 to 1987), 239-bps (1993 to 1994), 206-bps (1998 to 2000), 146-bps (2003 to 2004), 255-bps (2008 to 2009), and 152-bps (2012 to 2013).

Since rates were moving progressively lower during the last three decades, the sizes of the rallies off the Major Swing Lows were getting smaller as well.  The 2008 to 2009 rally was an outlier in the series, of course.  This is not a surprise since it occurred during –and because of- the Great Financial Crisis.

Measuring in terms of the percentage gain, the runs start to look even more uniform.  The rally off the 2008 financial crisis low was once again the exception in the bunch.  The yield on the 30-year bond increased 44% from the 1986 low, 41% from the 1993 low, 44% from the 1998 low, 35% from the 2003 low, 101% from the 2008 low, and 62% from the 2012 low.

Next, let’s look at the duration of these moves.  Knowing how long the rising yields took to complete the journey can help us set realistic expectations going forward.

The rallies from the Major Swing Lows lasted one year and three months (1986 to 1987), one year and one month (1993 to 1994), one year and three months (1998 to 2000), eleven months (2003 to 2004), six months (2008 to 2009), and one year and five months (2012 to 2013).

As you might have guessed already, the 2008 to 2009 event was an aberration as it only lasted half a year.  The rest of the rallies lasted between just under a year to just under a year and a half.

A Technical Takeaway on Treasuries

If this thirty-year pattern of the 30-year bond yield persists, here’s what we might expect going forward:

The rally off the July 2016 record low of 2.10% should last about a year or a little more.  Aside from the 2008-2009 rally, the durations lasted anywhere from eleven months to one year and five months.  If so, the ideal timeframe for a final high in yields and low in bond prices will be the second half of 2017.

In basis-point terms, the rally could add 150 to 200 basis-points from last summer’s record low.  That would project a peak in the yield between 3.6% and 4.1%.

In percentage terms, 30-year bond yields should increase 35% to 62% from the low.  That puts the target yield range between 2.84% and 3.4%.

Finally, the rally should not significantly exceed the 2013 Major Swing High at 3.97%.  In the last three decades, not one prior Major Swing High has been surpassed.

Bottom line: US Treasuries have already dropped precipitously from last summer’s peak and market speculators are record short down here at the lows.  Equity and bond markets are pricing in major infrastructure spending, tax cuts, and more interest rate hikes. 

If the stock market retreats or the Trump administration disappoints, a contrarian long position in Treasuries could offer a huuuuge (read  in Donald Trump’s voice) payoff. 

Watch the price action to determine the timing.  If the 30-year bond yield ever makes it up to either side of 3.5%, it’s time to watch closely for any signs of a reversal. 



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I received a great question via Twitter yesterday, and instead of just replying to the Tweet where maybe a handful of people might see it, I decided to record the answer for a wider audience. Thanks to @EdFowlkes for the question!

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tony saliba managing expectations options trading book

Aaron is one of the best podcasters out there and you should subscribe to his show and follow him on Twitter.

Here is his interview with Tony Saliba about his career and upcoming book. Over the 2 hour interview, Aaron and Tony speak about the lifecycle of a trader with 4 decades of experience.

You’ll find a great deal of wisdom about the hard lessons learned, how Tony learned risk management, creating finite risk with spreads, and how he developed his own style.

The goal for any aspiring trader or sophomore who wants to improve their game is the concept of longevity. Trading for massive gains is a great endeavor – the Commodity Corporation traders did that.

You’re probably heard the quote attributed to Ed Seykota: “The goal for a trader is to develop a system with which he is compatible.” This quote was the inspiration for my book Inner Voice of Trading. But what’s not in the quote is the concept of one’s time frame…how long do they want to trade.

One emotional blind spot that I see over and over is the disconnect between what traders do versus what they feel (emotions). Developing a set of rules won’t help you a bit if you are not placated. All the system will do is generate strong feelings – not entry and exit orders. The orders are just the vehicle to feel the feelings. You can’t disassociate that from trading. (We did not speak about trading in the Incline Village Trading Tribe – we worked on our feelings and emotions that came up around trading. There wasn’t any system design either.)

Right on top of that is the lack of thought that’s put into how long they plan on trading. Most just want to start making money (and stop losing). It’s hard for a newbie to project into the future how long they want to trade.

A good question to ask yourself to get this conversation going with yourself is “What do you want your trading to do for you? How does your trading serve you as a human being?” You might take a look at Maslow’s Hierarchy to find more questions for yourself in this area. Pay attention to how you feel about money emotionally, not winning or losing via your trades.

You can read about all of this in Managing Expectations to start your game plan.

Used with permission.

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