I have spent the better part of my intellectually conscious life trying to algorithmically “beat the market.” (To be precise, I started around age seventeen; I am now twenty-five.) According to some very well-tested academic theories regarding markets, I am pursuing a fool’s-dream. I have continued to labor this long under the assumption that there is a pretty obvious selection problem when it comes to publishing findings that contradict financial orthodoxy: if you were to find a method that earned out-sized returns, I don’t believe academic prestige trumps monetary gains. It is my perception that people who end up as professors of finance are typically people who had the desire to study markets in order to profit from them, but who never found their holy grail. If they had found something spectacular, I don’t think the incentive to publish is very high. (There are exceptions, but nothing ground-breaking.)

After eight years, I have nothing concrete to show for my efforts. As a consequence of shifting needs, I have learned a lot of computer science (e.g. compiler design, algorithms, and some unnecessarily high number of languages). Obviously, this skill set is valuable, but I have no successful projects to use as credentials. Every few months, I find myself excited over the preliminary results of my increasingly sophisticated simulations, only to be disappointed a few short weeks later to find that I was simply wrong. This has happened so many times that I no longer grow excited when I see positive results — I’ve grown into a hardened, semi-depersonalized skeptic.

My latest iteration of development appears exceptionally promising, but I expect it to bear no fruits. I learn each time, and my understanding of markets (and complex systems in general) is approaching some level of refinement, but I have no way of estimating when I might cross the line into profitability; worse I may be approaching this level asymptotically, with my limitations acting as a ceiling just below my goal. I feel like a modern day Tantalus.

I recognize that “beating the market” algorithmically may be either impossible or simply out of my reach, but I soldier on because I still find it fascinating. I believe that, had I switched course years ago, writing off the project as foolish, I would have probably, or at least possibly, been wealthy by other means by now. (Every time I started pursuing a product development project, I found myself shifting back towards market soon after the initial new project euphoria had faded.) If I could offer advise to my younger self, prior to perusing this path, I’d probably say don’t make the attempt. I have neither ethical nor moral objections to profiting by speculation. I merely believe I could have acquired the satisfaction that comes from achievement a long time ago, instead of bearing the frustration that accompanies not achieving something in spite of my best efforts. Nonetheless, I will not stop trying. I’m not blind to the possibility that I am a smart fool, but I want this more than anything else. I’m not sure where I would draw the line, where I would finally say giving up is the proper thing to do. I hope I never have to make that decision. I hope success finally obliterates the need for that decision.

I’m not sure why I wrote this. To some degree, it might be a warning notice to those who are considering following this path. As I said, I find markets fascinating, but most people (my earlier self included) enter the fray believing it to be a sure and short path to riches; it’s not. There are far less risky paths to wealth, especially for entrepreneurial programmers.

Nancy Pelosi is now an vocal exponent of H.R. 4191, the “Let Wall Street Pay for the Restoration of Main Street Act of 2009.” (This makes me pine for Orwellian naming templates. If they titled this bill, “The Freedom and Security for the American Financial System Act,” at least I could delude myself into thinking that its true purpose was obfuscated to the average nightly news watcher, rather than being an unmistakable deference to mob opinion.)

The following is a reasonably accurate summary of the bill:

The U.S. Government’s fiscal situation is FUBAR. For foreseeable and unforeseeable reasons, the deficit is now a leviathan. For the sake of expediency, it is best to go with the tried-and-true Democratic narrative that places all of the blame squarely on the shoulders of the evil Wall Street fat cats. (This narrative is mostly a pastiche of Scrooge McDuck. The government has an odd tendency to use cartoon ducks to sway popular opinion.) Since Main Street’s unemployment has persisted while Wall Street’s profits have returned, the best course of action is to use fervid populist opinion, to take money from the ostensibly stable and wealthy Wall Street firms and redistribute it to the unstable industries that would obviously be irreparably damaged if not for the infusion of money.

Since the political actors are perennial fans of war analogies, I’ll make one of my own: H.R. 4191 is similar to a situation in which there are 5 wounded soldiers and one unharmed soldier left on a battlefield. Upon reviewing the situation, the feckless medic who has just entered the fray realizes that these soldiers will need blood transfusions. The medic proceeds to shoot the unharmed shoulder in the thigh, allowing the blood to messily drain into a pan to be given to his comrades. This is hyperbole; it is also not far from the truth.

Irrespective of the fact that the Wall Street firms are far from healthy — they may be making large profits but they are still exposed to some terrific risks — a cursory glance at the numbers using basic arithmetic, would suggest that Wall Street is not likely to be the one bearing the costs of such a tax raise. (Basic arithmetic is probably above the botox battered brain of Nancy Pelosi.) I am not talking about the pedestrian argument that suggests the tax would be passed on to consumers. I am referring to a more damning flaw: no market maker could pay this tax.

Take, for example, the 25 basis point tax on plain old stock transactions. Looking at Yahoo Finance right now, I see the bid-ask on SPY is 111.20/111.21. Market makers looking to make a few pennies on every transaction might have difficulty staying in the black with a 25 basis point tax per transaction. (I was unable to ascertain whether the tax is levied once per side or once per round-trip; For a conservative estimate, I’ll assume it is only levied once per round-trip). This would mean the market maker could only profit on swings of at least 28 cents if he was hoping to avoid bankruptcy.

(Ironically, some of the proponents of this bill were touting it as a structural method of reducing volatility! They argue that with a tax, there are incentives to hold positions longer. That may be true for marginal day traders. However, market makers would have to significantly widen spreads in order to survive. Wide spreads translate into higher volatility.)

Since market makers are integral elements of markets, it seems likely that they would be exempt from this tax. While the tea-party crowd loves to shout that the “Progressives” are socialist wolves in sheep’s garb who are looking for any and every way to demolish capitalism, I’m not so conspiracy-minded. Progressive Congressmen and Congresswomen would be forced to exempt market makers in order to maintain market integrity. At which point the absurdity of the bill comes into sharp focus: the bill that would force Wall Street to “contribute” to the economic recovery would…EXEMPT WALL STREET?!

P.S. I appologize for the discordant feel to this post. I am a bit peeved by this bill and could not proceed stoically. I have spent the past 9 years of my life learning about markets so that I could be a competitive trader. This bill would render 9 years of sacrifice (lower grades in college; no traditional forms of employment to build my credentials; less time with friends and family) wasted for arbitrary reasons. I suppose this is true for most congressional edicts.

By perfect trade I mean executed well and taken for the valid reasons. In yesterdays post, Liquidity Black Holes, I stated that I bought NOV SPY 83 Puts for $2.20. I sold them at the end of the today for $6.46. This was a lot of fun.

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.

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.