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Comments on: Q&A on trading http://hornes.org/2007/09/qa-on-trading/ Tue, 22 Jul 2014 20:14:12 +0000 hourly 1 https://wordpress.org/?v=4.9.1 By: Steve http://hornes.org/2007/09/qa-on-trading/#comment-1450 Tue, 09 Oct 2007 16:27:50 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1450 Sorry for the excessive posts, but my daily read of the New York Times picked this up, which is relevant to the issue of erroneous collective perceptions:


By: Steve http://hornes.org/2007/09/qa-on-trading/#comment-1449 Tue, 09 Oct 2007 15:59:16 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1449 A second consideration is the statistical properties of your trade return distribution. If your testing shows tons of small negative returns and a few super huge returns that generate all of your profit, that is a big concern, because who knows if those few big hits are likely to happen in the future? On the other hand, if your testing shows that you make positive returns (some small, some large) most of the time, with only relatively few (and small) negative trades, then it is more reasonable to expect that your system will continue to be effective in the future.

This would be one of my concerns with some of the trend following systems, like the turtle system. From my understanding, they tend to have too great a reliance on rare positive events to generate their returns.

As Jay mentioned, taking care to avoid over-fitting is really important as well. Jay, how many variables are we talking about in your system? And how far back do you usually backtest?

By: Steve http://hornes.org/2007/09/qa-on-trading/#comment-1448 Tue, 09 Oct 2007 15:02:50 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1448 I highly recommend the Way of the Turtle book for its discussions of building systems, benefits and perils of backtesting, etc. With respect to building robust systems, here are a couple of important guidelines.

First, you need to have tested your system against a wide variety of market conditions. These include high and low volatility markets, and trending (up or down) and flat. It is also beneficial if you’ve tested against catastophe scenarios (perhaps not as bad as 1987, but bad). If your system does well in all of these situations, then you’ve covered a pretty broad part of what the future might be like.

By: Steve http://hornes.org/2007/09/qa-on-trading/#comment-1447 Tue, 09 Oct 2007 14:54:52 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1447 Rusty, you make some great points. To your first, I would agree that the presence of irrational people is not inherently opposed to the idea of efficient markets, but I think a little more nuance is helpful. Take an example: IBM is currently trading somewhere around $117, and let’s assume that this is the efficient, rational price. I buy a large amount of IBM stock, and send out email spam with fake rumors about how IBM’s profits are going to skyrocket. Lots of people believe my fiction, and the price goes to $120. A few more people notice that the price is going up, think that there must be some information in the market that they are unaware of, and also buy IBM. End of the day, IBM is up to $125. Is this also an efficient/rational price? In some tautological sense you can say it is, because it is the sum total of everyone’s beliefs and knowledge in the market (but, again, I think this is more tautological than anything). The next day, I’m exposed as a fraud, and the price is back to $120. Back to efficiency/rationality?

So I think there are two important considerations with respect to efficiency/rationality. First is time scale. I believe that prices have both rational and irrational components, and that the rational component generally operates on a longer time scale than the irrational component. This implies that a buy-and-hold investor is not negatively affected by “noise traders” or speculators, even if their behavior is irrational (not that I think it always is). In the long run, the noise/irrationality tends to cancel itself out.

The second factor is whether the actions of irrational actors in the market tend to cancel each other out. If they do, then perhaps then net effect really is zero, on all time scales. With respect to this, I would say that human psychology is much more prone to exhibit behavior patterns that reinforce, rather than cancel out. People look at what the people around them are doing, and they do the same thing; it feels safer. Monkey see, monkey do, right? So I think that we really do see short time scale irrationality because of collective perceptions that are not accurate, or collective behaviors that tend to propogate.

By: Jay http://hornes.org/2007/09/qa-on-trading/#comment-1446 Tue, 09 Oct 2007 04:25:04 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1446 Rusty, you’ve posed some good questions… I’d even go so far as to say the right questions. I’ll give a short answer to a few of them, though they deserve more careful treatment, and I’ll try to address some of the details in future posts.

In my opinion, backtesting is where it’s at. You have to really get to know your system, and yet you also have to remain a bit distant. My approach to trading has been to try to become excellent at backtesting, balancing that “getting to know” and “remaining distant” paradox.

You have to keep some distance to minimize (I don’t think it is possible to entirely avoid) backfitting the data. My actual system, which, oddly enough, I call System, went through a pruning process the past few months. I started with some good ideas but not enough detail. By April of this year I came out of that beta phase with a solid system, well articulated, that traded reasonably well. But I knew I had far too many variables with far too much risk of backfitting. So version 2 of System finally came out around August and had about 70% fewer variables but with similar performance characteristics. It’s like you have to unfocus your eyes and see the trees not the individual leaves.

But you have to have an intimate knowledge of what to expect from your system and what you are going to do in response to the unexpected.

Regarding luck versus a real (e.g. profitable) system, generally the number of trials is considered crucial to ascertaining the validity of a sample (as well as the distribution of the results within the sample). That’s the huge advantage of trading quickly. For all of 2007, I’ve held 10 to 15 positions each day and am entirely in cash at night. You get a lot of samples quickly, and then it’s more a matter of waiting around for new market conditions and gathering yet more samples.

So if you had a method to tilt the odds of rolling a 6 on a die up to about 20%, and you had 10,000 samples to prove it, you’d start to feel confident, until you changed the surface on which the die was rolling, and then you’d have to collect more samples and see where you stood.

But, once again, I have found the most important aspect of all of this is being very good at backtesting. And, to be perfectly honest, it took me probably 3 years and change to get where I had any demonstrable skill at doing useful backtesting.

By: Rusty Burlingame http://hornes.org/2007/09/qa-on-trading/#comment-1445 Tue, 09 Oct 2007 02:01:01 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1445 Wow. A 40-page schedule D. You’re really doing this, aren’t you? Absolutely amazing.
With the point of view I have had for years about the financial markets, prior to your posts I would have viewed such claims as I would claims of cold fusion or a perpetual motion machine. The fact that you’re honest, not trying to sell me something, and are actually still doing this with success for this long completely blows my mind. I am really going to have to think about this some more.
I’m trying to find my copy of Random Walk, which is either not yet unpacked or was sold at Half Price long ago.
A few posts in the comments that I would take issue with. One seems to be saying (as I read it) that the existence of irrational people means markets can’t be efficient. Far from it – who do you think is losing all that money to Jay? :) Efficient markets just mean that the irrational and clueless will take a beating in the market, or (alternately) that those with knowledge of the market can make money exploiting their knowledge.
Re: Navellier, Frank. I don’t know these gentlemen and will have to do some investigating.
Buffet invests in companies where he thinks he can add value, and then actively gets involved in the management of those companies. That’s investing and managing, not trading. I’m not sure how that would disprove efficient markets.
Taking nothing from Peter Lynch, who I only know by name, if the efficient market/random walk theories are true, some fund managers will indeed beat the markets. Some will do it for several years. There are thousands of funds, so this isn’t hard to believe. Out of thousands of competent fund managers all rolling the dice bunches of times, somebody will roll 7 many times in a row every once in a while. This person typically becomes famous for their management style. :)
Harbor Capital Appreciation (HACAX) is one the 401(k) investment options at Southwest. For years after I started, the fund selection committee pointed out how HACAX had beaten the S&P 500 for something like 7 years running. Then it turned in a real stinker of a year a few years ago – so bad it almost wiped out all of years it was ahead. Same fund manager, I believe.
Hopefully this isn’t too long. I find this terribly fascinating. A few questions for thought.
If you were trading a system, how would you convince yourself you’re not trying to find patterns in random data?
There are at least tens of thousands of active traders, I’ll guess. How would you convince yourself you’re not just lucky like the dice roller mentioned above?
If something changed in the market and your system stopped working, how would you know?
Suppose I came up with a system, Jane, uncorrelated to Tarzan, but with the same returns when run over the last 79 months. How would I choose one to use for trading in the future? What basis would I have for expecting one to do better than the other in the future?

By: Jay http://hornes.org/2007/09/qa-on-trading/#comment-1444 Sat, 06 Oct 2007 03:39:21 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1444 Absolutely. I couldn’t do it without Tradekeeper.

It spits out a flawless schedule D that can be imported into your tax software such as Turbo Tax or TaxCut. Last year, my schedule D printed out at about 40 pages and took about 20 minutes to prepare. One of those amazing bang for the buck applications.

By: John http://hornes.org/2007/09/qa-on-trading/#comment-1443 Sat, 06 Oct 2007 03:08:18 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1443 The efficient market concept has been disproven by many including Louis Navellier (dissertation on alpha), Al Frank (Prudent Speculator newsletter), Peter Lynch (Fidelity Magellan), and Warren Buffet (Berkshire) who have all consistently beaten the market for periods over 20 years. These folks have invested large sums of money with their strategies and investments published.

I prefer the long term investing strategy of Buffet taking advantage of the market psychology that causes some stocks to be priced well beneath their true value. However, this does take considerable time to implement so now I’m finding myself attracted to the leveraged index funds such as QLD and SSO.

Jay, is there some tool you use to ease the tax preparation burden of technical trading?

By: Steve http://hornes.org/2007/09/qa-on-trading/#comment-1442 Wed, 03 Oct 2007 14:55:32 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1442 It is indisputable that “beating the market” is not easy (what is it, something like 70% of mutual funds underperform their targets?). So for almost everyone, I would say the lowest cost index fund is the way to go (some people would advocate international diversification, but I don’t have an opinion on that at the moment).

As an engineer/computer scientist with an interest in finance, using my technical skills to try and develop strategies that outperform the market is as much of a hobby or a game than anything else. With a great way of keeping score…

By: Jay http://hornes.org/2007/09/qa-on-trading/#comment-1441 Wed, 03 Oct 2007 14:11:41 +0000 http://www.hornes.org/2007/09/qa-on-trading/#comment-1441 Chris, I have to admit, I love working on my trading. I didn’t discover this until my early 30’s, but it is a real passion for me. However, I can completely understand not wanting to put time into something that is drudgery for unspecified, and potentially non-existent, gain.

However, I get the feeling that you and a couple others have in mind a specific notion of what “beat the market” means. And I’m guessing that correlates with what you feel is a worthwhile investment of time.