Archive for August, 2008

Momentum is Instinctual

August 29th, 2008

One of the earliest trading programs I wrote (circa sophomore year of high school), traded on momentum. It acted quiet naively which is a proper reflection of my mind at the time. If the slope of the price for an asset was greater than and less than some prespecified values the asset was bought until it was lower or greater than a terminal slope value; The inverse applied for shorting. My program then searched for the best combinations of entry and exit slopes over a range of different historic windows.

I was quite excited at first when I found some bots that did extremely well. Then I had the insight to try testing the bot on a different time period to confirm they did just as well; They did not. I am actually proud that I recognized the need for out of sample testing. I think at the time the math taught in my connections class (read: dorky kids) was trig/precalculus. I had no knowledge of statistics outside of averages.

The point to take away from this experience was my sixteen year old brain’s expectation of herding behaviour; It is instinctual. Behaviour finance expounds on this concept. At my young age I believed that if a stock was moving up, people would pile on; If a stock was moving down, people would abandon ship. Eventually, the fundamentalists would correct very large errors, but in the short term, I thought the technical traders set movements.

Currently, I believe that momentum is a huge factor for a certain class of trader; This class is not sophisticated. It may be possible to exploit their actions, or their likely actions, but since they probably dominate only over the short term, their is too much noise relative to signal.

Some people (in this case momentum traders) behave in a predictable way. This capacity for prediction does not mean profit. Predicting the movement of one fish in a school does not mean you know the school’s trajectory — although it might give a hint that is occasionally correct.

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My First Investment

August 28th, 2008

I bought ITC this morning at $56.04 per share; The number of shares purchased was embarrassingly low, however, it was in compliance with my no gluttony rule (see: I Am A Gluttonous Trader).

I did not purchase this stock for short-term speculation in price movements; I bought into the company, ITC Holdings, because of my views on the importance of electricity for the future energy needs of the United States. Clearly, I am not the only person who is interested in ITC for this reason as evidenced by ITC’s price-to-earnings ratio being nearly twice as high as the industry average; ITC is a growth stock in the utilities industry.

The ITC Great Plains segment is well positioned to take advantage of the influx of investment in the Kansas wind corridor — thank you T. Boone Pickens (joke). Furthermore, I think the feasibility of alternative liquid fuels is a long way off; Electric cars are going to be a dominant theme for a while.

My fears are vastly diminished income due to reduced projects as the U.S. economy continues its decent. Reduced demand coupled with increased fuel costs and regulatory price caps could cripple utilities and their need for growth — which is their need for ITC. Furthermore, with both political parties asserting their obvious genius (sarcasm — I am of the politicians are leeches school of thought), the number of risks are large and not all obvious.

Summing the possibilities — qualitatively anyway — I believe ITC has more favorable futures than unfavorable ones. I believe there are some parallels with the spectacular rise of commodities and the future rise of utilities. There is likely to be a lull (or crash) in electrical demand as the economy sinks but there is enough foresight to keep transmission investments rolling if possible as electrical demand will continue to rise sharply in the intermediate-term (5-10 years). Construction of new transmission lines cannot happen overnight; If you want it for future demand you need to being new projects soon.

Conservation of energy is rational but the path less traveled; Gluttony is one of the seven deadly sins. I’d rather pump my air conditioning then use the electric ceiling fan. People are not going to inflate their tires.

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I Am a Gluttonous Trader

August 28th, 2008

In addition to being a promiscuous trader, I am a glutton. Not only do I trade too often, but I risk too much of my equity on each individual trade. Perusing my trades from last year, I noticed that eighty-percent of my losses came from about 10% of my trades. It was not that these trades were placed in volatile periods or held for longer than my typical trade but that they represented huge chunks of my equity; Two trades were actually my entire stake!

I believe I do this — stake too much — because I often believe opportunities to be ephemeral; I want to capture profits before my edge disappears. Sometimes, the opportunity may truly be fleeting and should be quickly seized, but the associated mental sloppiness comes at too high a price; It makes me act impulsively.

Furthermore, I sometimes think “well…this could go to point X for Y% return and that would be Z dollars”; This is the antithesis of rationality and discipline. Yes, the asset could move to point X; It could also move to point -X; It could also move to point -2X. I get risk blind when the profit potential is glaring and risk blind people are craps players.

Eventually, I will use more sophisticated methods to quantify risk and lower it appropriately but for now, I am going to intellectually cop out and choose to implement yet another simple rule: Assume each trade is going to result in a 100% loss and limit each trade to 5% of my capital.

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The Every Pattern Ever Engine

August 28th, 2008

Around my sophomore year of college, I wrote an application to analyze technical analysis trading patterns. I read a few books on technical analysis and thought they were horribly unsophisticated. For the most part I found that technical analysis books were basically if match(patternX) then take(positionY).

I had not yet reached any mathematical sophistication, so I did not liken chart pattern trading to tea leaf reading. I did, however, wonder why they relied on this one set of chart patterns if others, especially those not published, might exist.

To satisfy my curiosity, I built an application that constructed every pattern that ever occurred in the listed SP500 stocks since 1980. It was actually fun to write and remarkably fast after all the graph indexes were created. I could choose to set how many days would define a pattern, how close the movements would need to be to considered a match, the importance of relative volumes, and countless other measure that I have long since forgotten.

Returns were based on either holding for a static period length; holding until history suggested deviation from the past pattern and all newly matching patterns suggested movement against my position; and other plays that I can no longer remember. After all matches had been assembled and all returns were generated, I could browse the resulting return distributions for each unique pattern. The result: many appeared to be very profitable but the overall return out of sample was close enough to zero to be discouraging (I am purposely ignoring my current knowledge of statistics for this presentation).

I then went a bit further and looked up trading patterns mentioned in all the fantastic technical analysis books. It was clear that they were no more likely to be included in the strong, in-sample returns set than any random pattern. My intuition was correct; Technical analysis was unsophisticated and, simply, tea leaf reading.

Granted, the experience was incredibly useful and worthwhile. I would not discourage anyone from repeating my experiment; You will learn A LOT. It helps build an intuition for statistical inference prior to studying statistical inference — although studying statistical inference first is not a bad idea.

Many of my subsequent experiments were heavily shaded by this early experiment; Many posts will echo lessons learned.

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Posted in Programming, Trading

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I Am A Promiscuous Trader

August 27th, 2008

I spent the morning looking through my trading history for the past year; It was glaringly obvious that I traded too much. As this is one of the most abused platitudes in trading circles, I will expound upon my particular offense.

Obviously, you cannot say from frequency of trade alone that you are “over-trading”. What is too much for one person or team is not necessarily the same for another. People have different capabilities. However, you can state unequivocally, that if action is taken on nearly every asset reviewed, you are a promiscuous trader. The reptilian part of my brain seems to chase every spark.

The problem with promiscuous trading is not the quantity of trades, but the resulting quality of the aggregate. I noticed that occasionally, I came across trades that seemed too good to be true — but were proved correct. You can argue that I am revising my history, but I should point out that I keep notebooks of all my trades and, looking back at them, the major successes almost always had something along the lines of “VERY GOOD PLAY” scribbled at the conclusion of my analysis. However, these trades make up the minority of my history. The majority of my fills were stocks I looked at, chose a direction, and placed my order. This is promiscuous trading — taking any action because it is available.

At this point in my education, I am not convinced that I have the emotional iron to prevent promiscuity without a set of established rules. Therefore, I am setting the following hard rule: At most I can make one trade every two weeks. Obviously the potential for promiscuous trading still exists (e.g. if I only look at my options once every two weeks) but at least it is somewhat mitigated by my unrelenting interest in the market. I will still take a side on every asset I review, but only send orders on those I feel very strongly about. I will be half paper-trading (for promiscuity’s sake) and half real-trading (for my reptilian brain’s sake).

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I Am Relatively Unintelligent

August 27th, 2008

Compared to the average quantitative analyst, I am unintelligent. To be more accurate, I should say I am less experienced and educated; I believe myself to be of equal innate intelligence and discipline but several years to the left of their capabilities on a time line. The confidence I have in my intellectual faculties might be hubris, but for now I am concluding that it is not unfounded.

Given my current stage in intellectual maturity (intellectual adolescence?), I must admit to myself that, in all likelihood, my efforts at trading will presently be unfruitful (as they have been in the past). I am developing my mathematical skills, but they still lag behind; I read much on history (not only economic), but it is likely to be insufficient at this point. Furthermore, the vast majority of academics — who are also more educated and experienced than I am — assert that trading is a ill-advised adventure; You can not beat the market, you can only take on more risk. Some traders may appear successful, but they are just the lucky ones who happen to land on the far right tail.

So where does this leave me?

I respect (highly) the elegance of modern portfolio theory. A sizable part of my mind has already concluded that it is far more rational to build long term portfolios than to pursue the path of active trading. This is the same part of my mind that gets angry when people buy $29.00 in lottery tickets as I wait to buy my pack of Tear ‘n Share Peanut M&M’s.

On the other hand, I am wary of the conclusions drawn by the academic field concerning the efficient market hypothesis. The majority of studies make heavy use of long term historical price sets; I do not believe that valid inferences can be drawn on these data. Given my own experience, I believe this type of study suffers from, at the same time, too much and too little information.

Furthermore, the reptilian side of me that not only is overconfident but also craves the stimulation that trading provides, still harbors the illusion that I can be a successful trader. I have been interested in investing err, speculation) since I was very young — around five to be precise. There is nothing I enjoy more.

So, probably foreshadowing failure, I choose to stay the course because I believe in my own abilities and am skeptical of the conclusions of the EMH; I am relatively unintelligent but I believe myself to be more capable then those above me.

This does sound like hubris, no?

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Hello World

August 26th, 2008

I earned (in the loosest sense of the word) an B.S. in finance from the University of Maryland’s Robert H. Smith School Of Business in Summer 2007  (3.2 GPA).

I have been developing financial modeling and forecasting systems since 2002. Early efforts were computationally advanced – employing genetic algorithms, pattern matching, and neural networks — but naïve and unscientific. These systems found combinations of conditions that historically resulted in better-than-average returns, which I then tried to rationalize. Essentially, they were great at finding pretty patterns of faux profitability in clouds of randomness.

Later iterations were more intellectually sophisticated. I began to rigorously adhere to the scientific process, instead of groping blindly through data sets. I no longer searched through data; I started to hypothesize and then attempt to confirm or reject my ideas. I came to understand that true alpha is exceptionally rare and, with incredible regularity, misattributed.

While my efforts did not yield any economically significant findings (yet), I consider my expenditure in time to be tuition paid. I developed a strong respect for risk, a deep understanding of markets, and a disciplined skepticism.

This blog represents the next step of my education; I will be trading with transparency.

Hello, World.

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Posted in Introspection