In this month’s Traders Talk, we’re chatting with Jeff Augen, well-known author of a number of highlyregarded books on option trading and the markets. Jeff has actively traded and analyzed the markets since the late 80s. That work, combined with his background in molecular biology, computer algorithms and dealing with venture capitalist and private equity investors, led to the development of his proprietary Augen Phase Indicators and the creation of the Swing the Ax program in partnership with Preston and Karson. In this first of a two-part interview, Jeff shares some about his background, critical changes he’s witnessed in the market, the Phase Indicator and his unique insight.
TEI: Much of the work you do now is centered on the program trading and algorithms utilized by institutional trading groups and investors. What in your background led you to this area of expertise and influenced your work today?
JA: I started as a research scientist at IBM. I went to graduate school in molecular biology. I wrote computer programs and algorithms used for automated pattern search and recognition of protein structures. That work is the basis of this work now. The whole approach of pattern discovery and automated pattern search is underneath all of this work.
TEI: How did you end up working with venture capital groups, given you were a molecular biologist?
JA: I was at IBM in the Life Sciences Computing Group, which was a good fit for me given my molecular biology background. One of the most important goals of the group was to invest in venture capital funds. We had $400 million to invest in venture capital funds. The idea was to identify small emerging companies with exotic new technologies that we could use as headlights into new and future technologies. We weren’t trying to make money from the venture investments, although the portfolio did make money. In 2001 and 2002, we were investing in companies that had very advanced biomedical and computing technologies. The idea was to focus on the computer side of the businesses—especially the algorithms and programs.
TEI: What was the biggest lesson to come out of that experience?
JA: I spent a lot of time with venture capitalist evaluating investments. What I came to realize is that people in general make reckless investments. Venture capitalists and private equity investors pore through every fine detail of a company and they only invest after getting to know everything about them. Yet if you asked an individual investor who purchased 1,000 shares of AAPL just a handful of simple question about the company, they couldn’t answer you. Karson and I are always critical of long-term stock investing because we don’t really know anything about these companies. I tend to know more than others, given my background, but I don’t feel that I know enough to have any business investing in them. That perspective came to me by working with the venture capitalists and it forever changed my perspective on investing.
TEI: How would you characterize your early approach to trading?
JA: I was an option trader dating back to the late 1980s. I wrote a number of books on option trading, so my focus all along was options. As the markets became more efficient and more difficult to invest in, I started to focus on finding subtle distortions in the market and trading those distortions and trading the statistics and trying to make money in a way that didn’t have a bias… I’m not long, I’m not short, and I’m not picking the direction or picking a stock.
TEI: You mention changing your approach to trading options as the markets became more efficient. Please explain what you mean?
JA: There are two types of option traders. First is the type who trade the mathematical and statisticalparameters around options—the pricing models and distortions—pure option traders. Then there are those that use options to trade stocks. They structure option positions because you can hedge with them, cap potential losses or gains, magnify the gains, trade more or less bullish, etc. Basically there’s a litany of opportunities for option traders to trade stocks they have an opinion on. I used to be that kind of investor. I would have an opinion that a stock would go up, but instead of buying the stock, I would structure an option trade as a more sophisticated way to bet on stocks.
After spending a lot of time in the private equity world and with venture capitalists and looking at how they did their due diligence, I came to realize that I was really just getting lucky investing during the boom time when the market, especially the NASDAQ, was rising sharply. I was taking advantage of a boom period in the market. Granted I was making more sophisticated trades than most investors, but I was doing it during a boom time when the direction was pretty predictable.
Then after the NASDAQ crash, I realized that you could make much more money being short in a crashing market—markets crash down and not up. Sophisticated investors can make much more in a crash than in a rally. The second thing I realized was that picking the direction of anything was really very foolish. At that point I focused my full attention on trading the underlying mathematics of option pricing. So I switched from being an options trader using options to trade stocks as a proxy for stock investments to an options trader who trades the underlying mathematical properties of the options. That was a big turning point for me…probably about 12 years ago.
TEI: Why have programmed trading and high frequency trading proliferated in recent years?
JA: I say this all the time—the market has changed quite a bit in the past six months, but if you go back a year or more the change is really dramatic. Highperformance super computers have taken over the market. The reason this has occurred is that the cost of super-computing has plummeted. Even going back two to three years, if you wanted to build a very high performance super computing infrastructure you really needed to spend hundreds of millions of dollars. Now for $10,000 you can have a desk-side super computer that has the power of a super computer from a couple years ago. This has created a proliferation of extremely high performance machines connected to the stock exchanges.
TEI: How does this impact the individual trader?
JA: The fact is that at any given time at least 80 percent of the action you see is not individual traders buying and selling, but computers doing the trading. Because of this, all the work that people have done on trading and analysis and charting over the last 50 years is all completely out of date. What you see now that appears to be long-term trends is really nothing more than the accumulated results of all these algorithmic trades
going on all the time. Opportunities that might exist are now very quickly and efficiently extinguished, so it’s very tough to trade such opportunities versus in the past. The notion that you can make an investment and hold it because of some insight you might have is now completely wrong because the markets change from hour to hour in today’s environment. People don’t want to believe that, but it’s the reality of the situation now.
TEI: So you’ve created a proprietary indicator to track and take advantage of the algorithmic trading programs that are controlling the markets, correct?
JA: Yes, the main indicator that we use in the Swing the Ax service is called the Phase Indicator. To understand how it works, you have to first understand what constitutes a trend in the markets. Say you have an underlying set of circumstances or confluences of events that cause a computer algorithm somewhere to start to buy something, such as the S&P 500. That buying in itself triggers moves in the market that other algorithms start to sense. There are always groups of algorithms seeking opportunities to go long and others to go short. Because of this, you get the beginning of a rally, but there are moments of drawdowns because there are opportunities to short the rally, causing dips. So different programs are coming in at different times executing longs and shorts. Over time that createsvarious phases in the rally. You may see a sustained strong rally followed by a minor correction. Then another rally, but not as strong, with fewer programs going long and more taking profits and some looking to go short. Then another phase begins that is not as strong or fast and corrections are larger. You get different phases in the overall rally. That continues till eventually you reach a point where the programs looking for long positions start to time out and stop and close trades. Finally the buying and selling pressure start to equalize and the rally ends or reverses and does what it will, but the real activity underlying the rally is finished.
TEI: In simple terms, what does the Phase Indicator do?
JA: What the Phase Indicator does is to deconstruct the market into those individual phases and studies them to determine which ones are more powerful. If you have a steep but short rally versus a less steep but longer rally, there’s no simple way to compare the two, but the phase indicator does have an underlying mathematical capability of doing so. It can sense accurately when the rally is beginning to end. Same is true if the market is falling. The indicators are following the behavior of trading programs. They take rallies that are triggered by groups of trading programs behaving in different ways and they deconstruct them into different individual phases. Each phase is marked at the end with a subtle reversal. Some reversals matter and some don’t and picking the right phases is not that simple. The indicator does it. It appears on our screen as a peak followed by a smaller peak and yet another. We can actually draw a trend line through those peaks, signaling the end of the rally. We call it right almost every single time. To give you an idea of the strength of our indicators, we have an automated trading program (very crude at this point) that works off the indicators. We’re actually going to replace it in the near future. It runs full time on the site trading AAPL. That program is making an unprecedented return and we joke about the fact that while it makes good entries, it makes terrible exits and is always giving up big pieces of profits. Regardless, despite the fact it’s a crude automated system, it makes more money than the best investors at the best funds in the world.
TEI: Do you use any other indicators within the Swing the Ax service?
JA: We’ve actually applied the indicator across all the individual stocks in the S&P 100 simultaneously. We’ve taken that output and summed it and tracked it. We are now using that as our composite leading indicator, which is an enhancement to the Swing the Ax program. To give you an idea as to the indicator’s capability, an early version of that indicator went completely off scale a couple hours before the flash crash of a year ago.
TEI: As far as Swing the Ax, please explain how a subscriber is able to use the service?
JA: Subscribers have been logging in to view the indicators streamed over our site, but now the indicators will be available for people to access directly on their own machines and choose anything that they would like to trade. Each month when people renew their subscription they will get a new package of updated indictors. They will always have the latest version this way. The Swing the Ax site will be a backup for subscribers. The users will be able to trade anything they want, be it Gold, oil, futures, currencies or anything else.
TEI: What’s your comment to those that might be skeptical?
JA: We do something that nobody else does that I’m aware of—anywhere. We go live every Thursday morning in a webinar in front of hundreds of people. We put up the indicators and we trade real-time with real money, no matter the conditions. And we make money. We tell you to buy the ES now and we let you know that we’ll tell you when to sell it. Then five minutes later we tell you we’re approaching the top and the trend is over and time to exit. We get a flood of emails from subscribers each week telling us howsuccessful they’ve been using the indicators—literally thousands of dollars weekly. Frankly, you won’t find others willing to do that, but we do so every Thursday.
TEI: What about people using traditional indicators to try to look for institutional footprints?
JA: I have a negative view of using more traditional indicators in today’s market. They are all based into so many programs on millions of screens around the world now. Trade Station has something like 140 indictors or more on it. So anything that you see in any combination of those indicators will be extinguished in an instant. So they really have very limited value. That wasn’t true before everyone had a computer, but now so many millions of people have access to indicators. The proliferation of indicators being used and the explosion in program trading have negated much of the utility provided by traditional indicators.
TEI: Best advice for traders, both new and experienced?
JA: To begin with, I would tell people that anything that is long-term is dangerous. Aside from that, the biggest mistake people make is to follow the investment advice that they get on financial news networks. Never take investment advice from anchors. It’s a waste of time to do anything that they say. The things they highlight are already ancient history and the market has already reacted. Another mistake is paying attention to the big names and what they are doing. Like Warren Buffet is buying this railroad. People have to realize they are not Warren Buffet. When he buys he’s not buying 100 or 1,000 shares, he’s buying the whole company. His risk tolerance is much different than you have and he trades in a much different manner than you do. Trading on the advice of someone with 100,000 or 1 million times more money than you do doesn’t make any sense. So, don’t take investment advice from billionaires. It’s a different game and you’ll lose. Another is the concept of having a portfolio and being in the portfolio all the time. Diversifying is a mistake for most. That simply means spreading your money into a lot of different places with the hope you don’t lose too much money in any one place. It’s much better to become an expert at a single financial instrument or on one particular thing. Trade a very limited set of financial instruments and become an expert at that, be it option trades, stocks, etc. We trade a limited number of very specific things we focus our attention on and we become experts on them.
Jeff Augen, currently a private investor and writer, has spent over a decade building a unique intellectual property portfolio of databases, algorithms, and associated software for technical analysis of derivatives prices. This work forms the basis of a subscription service that he recently launched with Trader’s Edge Network. It has also been the subject of six books from Pearson Education/Wharton School of Finance (Financial Times Press): The Volatility Edge in Options Trading, The Option Trader’s Workbook; Trading Options at Expiration, Day Trading Options, Trading Realities, and Microsoft Excel for Stock and Option Traders.
Augen has a 25 year history in information technology. As founding executive of IBM’s Life Sciences Computing business, he defined a growth strategy that resulted in $1.2 billion of new revenue while managing a $400 million portfolio of venture capital investments. From 2002 to 2005, Augen was President and CEO of TurboWorx Inc., a technical computing software company launched at Yale University. During the past several years he has been an invited guest speaker at more than 50 industry events, an author of more than 150 articles, book chapters, and editorials, a member of 3 editorial boards, a weekly columnist for Stocks, Futures, and Options magazine, and the author of a graduate-level textbook, Bioinformatics in the Post-Genomic Era (Addison- Wesley 2005).
Augen has undergraduate and graduate degrees in biochemistry from Rice University and the University of Texas.