So long as we’ve dredged up a little Cramer, how about we at least have a takeaway from it.

Allen was kind of enough to post this Howard Simons response to the “Great Ultra Market Knockdown” discussion over on Real Money.

Variance Swaps and ‘They’
6/22/2009 4:03 PM EDT

Charles, recall how when W.C. Fields was asked by the rube, “Is this a game of chance?” he was told, “Not the way I play it.”

One of the bigger contributors to end-of-day extensions is position-squaring by market makers in variance swaps. Variance moves as the square of volatility, so on such a day as this when the VIX is up about 10.7%, these market makers have to sell ever-greater quantities of stock at ever-lower prices to hedge. This process works in reverse, too, and I believe much of the kick higher after March 10, 2009, was attributable to the unwinding of such hedges.

But you have to get with the program. Buyers are not “they.” Sellers are “they.” And that extends to the various leveraged ETFs, too: Leveraged-down is bad, and leveraged up is, well, not so bad.

Now I can’t verify his numbers are correct, but the principle is spot on. Consider “they” as anyone effectively short market volatility in some fashion. Be it variance swaps, SPX straddles, whatever. And yes, even Ultra ETF’s. A third party that creates them for Direxion or ProShares is effectively short all he has created. Not every player in every product flattens out at exactly the close of each day, but it’s certainly a force on the margins. And the bigger the move, the more you need to hedge, so it can feed upon itself. Cramer’s Evil Cabal is often a quant-ish trader or hedge fund simply evening up. And yes, that evening up can take the form of shorting into weakness and chasing strength.

Now hedgies and traders not actually short volatility can indeed pile on, knowing they can squeeze the aformentioned players. Or at least try to squeeze them. But it’s not a layup to buy at 3pm every strong day and sell 3pm every weak day. It’s perhaps a good odds move, but it’s a risk trade that gets squeezed too in it’s own right.

And we haven’t even touched on actual longs selling stocks. That’s been known to happen too.

Bottom line is it makes better TV to have some Sith Lord sitting around controlling every market in the world, but it’s a bit more complex in reality.

* TRAINING THE BRAIN – For a while now I’ve enjoyed the Sharp Brains blog, which focuses on the science and practice of brain fitness. Their book The Sharp Brains Guide to Brain Fitness: 18 Interviews with Scientists, Practical Advice, and Product Reviews, to Keep Your Brain Sharp (Amazon link) consists of 18 interviews with practitioners and researchers in the field. It debunks a number of myths about optimizing brain function, with practical chapters on nutrition, stress management, exercise, and mental exercise/stimulation. My own chapter focuses on “Achieving Peak Performance in High-Pressure Professions”; other interesting topics include training the brain for attention span and lifelong learning.

* FINDING AN EDGE – High Probability ETF Trading: 7 Professional Strategies To Improve Your ETF Trading (Amazon link) by Larry Connors and Cesar Alvarez is a nice follow up to the earlier volume How Markets Really Work. Subtitled “7 Professional Strategies to Improve Your ETF Trading,” this manual covers a number of tested historical patterns and trading rules. A worthy feature is that a range of ETFs are covered in the tests, including SPY, QQQQ, IWM, GLD, FXI, EEM, and quite a few sector ETFs. Many of the patterns involve buying weakness in a rising market and selling strength in a falling market. I suspect that at least some of the patterns might make useful starting points for the development of trading systems. A nice feature is that the strategies can be automated via TradeStation.

* MAKING FRIENDS OF TRENDS – Michael Covel’s Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets takes an updated look at trend following strategies and the firms that trade them. It includes a chapter on market crashes and quite a bit of performance data relevant to trend following strategies. A new chapter on trend following in the stock market is also a worthwhile addition. It’s interesting to see Covel’s book juxtaposed with Connors’ strategies (above); the takeaway surely has to be that there are many ways of making money in markets. The key is to find what best fits your own views and style.
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