mindmoneymarkets

Trend following & when the market won't pull back.

[I wrote a draft of this piece the other night and with well timed irony, the S&P 500 has finally pulled back]

One thing that's puzzled me is what to do with trend following markets. There has been a lot of research on what to do with a mean reverting market using short term indicators such as the DVB or RSI (2) (2 period RSI) - I.e. buy over sold and sell over bought readings etc. 

But what about markets which are not as prone to mean reversion? Should you just reverse the rules and buy on strong readings etc? Another options its to employ a relative strength rotation model which holds the best trending markets as with the Livermore Active Issues. 

Many people have also be commenting on the recent rally on the S&P 500 and other markets. I can't remember the exact stats, but Bespoke pointed out that it had been some time since there was a 1% correction. 

Anyone trading the basic short term mean reversion rules for indicators such as the RS2 or DVB will have had their patience tested in recent weeks as the market continued to push higher. The screen grab below shows the S&P 500 with the DVB indicator below it. The basic trade idea is to buy when the DVB drops below 50 and sell when it moves above 50. As you can see, the DVB has been above 50 for some time. 

I wondered what would happen if you used the average of the DVB as a trading input, specifically to adapt any methods to situations like this. 

I tested the 20 period average of the DVB on the S&P 500. 

Interestingly, your average return per trade is increased by trading in line with the 20 period average of the DVB. For example, if the DVB is below 0.5 and the average DVB is above 0.5, no trade. 

It's not a spectacular addition, but maybe worth some further investigation. Looking into the standard deviation of the DVB or RS2 also seems to be useful from my quick study. Essentially the returns from trading a short mean reversion strategy are lower when the standard deviation of the short term indicator is below average. This kinda makes sense as if you look at the chart above, you can see the DVB barely moving for weeks, which is what you get during a steady uptrend (bad for mean reversion). 

Trend following markets

This got me thinking about trend following markets and the best approach to take. If a market is more prone to trend following then trading short term mean reversion will be ineffective and trading the opposite rules may actually work out better. 

Foreign exchange (Forex) is certainly more prone to trend following and in my experience short term indicators such as RS2 don't work when applied in the usual way. They actually make a small profit when traded with the opposite rules (Buy on high readings etc). 

I wondered what would happen if you applied the 20 period average of the DVB to EUR/ USD (Euro to US dollar spot rate). The red line is the 20 period moving average of the DVB. 

 
The rules were as follow: 

Buy the EUR/ USD when the 20 period average of the DVB is above 0.5
Sell(short) the EUR/ USD when the 20 period average of the DVB is below 0.5. 

No commission spread etc. EUR/ USD spot since 1998. 

The average margin per trade is small, with the average trade making 0.03% profit with a 51% strike rate. Too small in its own right to be a devastating strategy. However, it does lay out a good platform on what is usually a very tricky market to trade and I've found a few interesting angles already by delving deeper. I'll have to keep those under my hat for the moment though. 

Some thoughts: 

• There is a massive difference in the reaction of the euro ETF (FXE) and the EURUSD spot rate in how they respond to mean reversion strategies despite being highly correlated, they appear to be two different beasts and this difference mainly came about in the last 12 months. 
• I have only quickly tested the RSI2 average and it appeared to make similar ish results, though not as good. 
• Standard deviation of the DVB/ RSI2 etc could be fruitful area to look at. 
• Correlation between the EUR/ USD and the SPX has also yielded some interesting results for the average DVB idea. As the SPX has responded well DVB type strategies in the last few years (though as MarketSci point out, simple buy on down day type stuff has gone off the boil), this will also impact on currencies when they are correlated highly with stocks. 
• The dollar index actually performed the best in my testing compared to the eur/ usd, indicating that it is the dollar itself on a trade weighted average which is the core trend following element of the eurusd (though the euro contributes a big slug of this trade weight). 

Appreciate any thoughts...

[Post Script] David Varadi's De trended indicator concept looks to be an elegant way to deal with trending markets. I just haven't had chance to analyse it yet. 

Anomaly/ Regime momentum

After my recent post on indicator rotation, I noticed the excellent CXO advisory put something up on anomaly rotation.

Their general finding is that investment anomaly's do persist and basing your trading/ investment strategies on the hottest anomalies can produce outstanding returns.

What is an anomaly?

Well according to efficient market hypothesis, there should be no profitable angles that maintain over time. Something simple like trading around the January effect (stocks out perform in January) shouldn't work in the long run because in theory, the moment something starts to work, the market starts to discount it, thus neutralizing its effect.

Except, it seems that the effect does persist for longer than it should according to the Efficient Market Hypothesis. Hence the term anomaly. Perhaps for a while the effect persists because enough investors buy into it, thus making it a self fulfilling prophecy. Perhaps there are underlying reasons for the anomaly that persist for logical despite their existence becoming widely known.

'Trading regime' could be another way to describe this phenomenon. Mean Reversion is perhaps a good example of a trading regime. As you can see with this post from Market Sci, Mean Reversion is currently a dominant regime/ anomaly but that's only been the case since 1997 until then, the market experienced more follow through momentum. 

The are perhaps logical reasons for mean reversion. The average period of stock ownership is now measured in days not years so perhaps traders are more prone to take profits quickly after an up day and vice versa. Who knows, perhaps its best not to over analyse these things. About the only thing we can say with reasonable certainty is that mean reversion is an anomaly that has persisted.

It won't do so forever.

Short term indicator rotation

So in effect the last post about indicator rotation is looking at persistence of various sub themes of an anomaly (mean reversion). It seems that these sub themes (RSI2, Dv2 etc) may have their own momentum, just as regimes themselves have momentum. 

By implication, you could potentially build an adaptive system that A) trades the anomalies with the best momentum B) trades the best sub themes of those anomalies. 

This is starting to sound like Star Trek.

CXO have whole series of posts on this which I'm working my way through including:

• Success of switching across 'style' ETFs based on 6 month momentum.
• Beat the market with hot anomaly switching.
• Diversifying across anomalies

Animated bank reforms

The FT have put up an excellent presentation on the reforms proposed by President Obama

Clicky

As the conclude at the end, it will be interesting to see what kind of watered down reform gets through congress.

Very interesting interview with Volcker here

Leverage & prop trading

It's interesting to read the various reactions to the Volcker plan. Some are calling Obama a communist while others are backing it.

Unfortunately there seems to be little by the way of solid detail on the plans, but I agree in principle that something major had to be done. Separating retail and more speculative banking was one way of doing hits. The devil is of course in the detail. One of the best posts I've read on it is here from someone who used to be in the thick of prop trading activity.

Interesting thought:

"Never mind the issue of if my friend trading merger arb with my deposits is any more or less risky than his bank instead taking the money and lending it out to small businesses and homebuyers (cause that's what they do!) - I think the past few years have cemented the fact that mortgage lending is not necessarily less risky, but it certainly looks better on paper, in terms of subjective categories like benefit to society."

This leads nicely to an interview with Richard Thaler, one of the leading lights in behavioural economics.

Again, another choice quote:

"What was the ultimate cause of the financial crisis? Poor regulation? Greed? Bad market signals? Human frailty?

Leverage caused the crisis—and I would say that is a pretty uncontroversial statement. Human frailty comes into play at two levels. One, the people who were taking out the subprime mortgage loans—many of them didn’t understand what they were doing. Two, the C.E.O.s clearly didn’t understand what their traders were doing. I call that the “dumb principal” problem. Go down the list—A.I.G., Citigroup, Bear Stearns, Lehman Brothers. These companies were destroyed or devastated by a small part of the firm that was hurtling forward and was risking the entire firm. The people in charge were either greedy or stupid, or possibly both"

Going back to Kid Dynamite:

"In addition to trying to separate commercial banking and prop trading, wouldn't a good first step to be to actually separate the commercial banks from the non commercial banks?   People aren't mad because GS is making money trading - they're mad because GS is making money trading with what they (the people) think is taxpayer money or taxpayer backstops.

The decision to allow non-banks access to  (near zero cost) Fed funds resulted in these non-banks making extreme amounts of money which angered the populace.

As I said, I fully understand the desire to implement a situation where commercial banks do not engage in proprietary trading.  However, the real problem isn't proprietary trading - it's leverage - it's actual risk.  Even if/after we successfully separate proprietary trading from commercial banking, what are we doing to prevent the next  Long Term Capital Management blowup?"

Putting these two together, I personally gain a sense of clarity on the crux of the problem. I hope it helps you.

As the quotes above have inferred, it's not prop trading, it's not bad loans, its any risk that is over leveraged. If Northern Wreck wasn't so dependent (leveraged) on short term funding it may not have have starred in act 1 of the crisis. 

Aleph blog has further thoughts on the role of leverage in the crisis

PS an update to my little conspiracy theory. Goldmans could (surprise surprise) be the bank with the most to lose with a ban on prop trading. By extension, you could argue they are one of the biggest market makers out there. By further conspiratorial extension, you could argue that as Goldman's are one of the most active program traders on the NYSE, they have the ability to nudge the market a little here and there.

New Quant wizards?

Well there was no bounce on Friday, but a few things seemed a little odd to me. Not that the markets 'should' have bounced, indeed the trendline break and the potentially game changing news announcement were a red warning lights in retrospect.(S&P futs up 0.5% Monday as I write this though)

However, there's something else that doesn't smell right to me. Firstly, as you can see on the chart below, in recent times, the Aussie and New Zealand dollar have been a good proxy for risk taking. These two currencies have the highest interest rates in the Western world and are the weapon of choice for carry traders.

 

Correlations/ relationships like this wax and wane but I did find it odd that the risk proxy currencies finished the day unchanged with a muted reaction across other currencies as well. 10 year notes also showed a muted reaction relative to that of the Dow & S&P 500. It could imply that the move on Friday was not a general flight from risk that the VIX jump implied (imperfect as this is), but a concentrated slump in equities and in the financial sector in particular.

It's a small sample set (A slump in oil prices argues against this for example) so these are just musings, which lead me to one conspiratorial thought. In Barry Rithholz book on credit crisis he writes about the mythical plunge protection team which some have speculated may have links with Goldman Sachs. To take this on the fly conspiracy theory to its extreme, could certain players have thrown the metaphorical rattle out of the pram on Friday in order to influence the final outcome of the still to be solidified Volcker plans?

Speaking of the unquantifiable, Friday's plunge did make me think about pure quant trading vs adding discretionary layers. Had I been actively trading on that day, I would have been wary of buying the dip on Friday because of the trendline break and unknown impact of the Obama/ Volcker plan. This is of course in retrospect as I was entirely out of the market so unencumbered by thoughts of a position or potential position, but it does raise some interesting thoughts.

In the original Market Wizards book by Jack Schwager, few of the traders interviewed were pure quants. This may be due to the lack of readily available computing power back then, but it made me think. Does the human brain's ability to adapt and sense what it cannot articulate mean that discretionary trading or adding some discretionary layer to quant trades will always have an edge over pure quant? Or does quant trading allow us to override our worst instincts and buy into dips like Friday? The human input is therefore the discretion in knowing when to drop a quant strategy and the research and hunches that go into its creation.

There does seem to be an emerging new wave of quants, at least in the blogosphere. Is it time for a 'Quant wizards'?

By Quant here I'm not referring to dark pool HFT type stuff. 

Project goals

Project goals:

Financial milestones (In ascending order)

1.       Not to lose money over 12 months.

2.       Beat returns from guaranteed index linked bonds. Compound return at 7%

3.       Beat average total stock market returns at 12%

4.       Beat total stock market returns from time of investment.

5.       50% return on my investment net of costs.

6.       100% return on my investment net of costs.

7.       Original investment place in Guaranteed Index linked bond.

Behavioural goals

1.       Research thoroughly and blog on my findings. Estimated time 1-2 months, but continuous process.  Document progress positive and negative, every step of the way.

2.       Forward test a strategy 1-9 months

3.       Confidently commit funds. Timescale unknown.

4.       When working do something towards goal every day even if small.

5.       Create in depth monthly reviews and check/ tweak annual goal against reviews. 

6.       Create weekly goals and check against monthly milestone every day.

7.       Create daily goals and check progress every day.

8.       Be brave and put trades on even when the fear factor kicks in.

The strategy I want

1.       Time to trade, no more than 1-2 hours each day.

2.       Further research/ tweaks etc may take longer, but this can be done in my own time.

3.       A Portfolio of strategies. Some aggressive, some conservative.

4.       Plans for what to do with my trading profits. For example if I make 100%, should I re-invest it every time or put it in something more conservative?

5.       Have ‘control’ of financial affairs including movement of funds from short term speculation to longer term conservative growth.

Change we can believe in?

Change we can believe in?

There was a heck of a lot of talk in the intimidate aftermath of the credit crunch regarding regulatory changes that would be made, but what if anything has actually been done?

Sure there are some capital ratios that have been tweaked, but what about wider, more pervasive changes?

My argument is that the credit crunch happened due to flaws in human psychology - well duh! you might say.

But if this is such an obvious explanation, why are all the proposed changes still ignoring well known and well researched biases from the world of behavioral economics?

In the years leading up to the bust, banks were run with a testosterone fueled target driven culture. Want your bonus? hit your targets! This comes from the top down. Your boss is screaming at you to make the numbers because his bonus depends on it, you in turn scream at your underlings and so on.

Somewhere in this process corners are cut. Risk factors were ignored.

Picture the broker in this situation. He knows he has to turnover X amount to make his bonus.

He could play it safe or deal with the new fangled CDOs. He might question,

"Is this CDO really worth £X million, should it really be AAA rated?"

He gets that feeling of doubt in his stomach. It doesn't feel 100%, but he knows he's got to make his numbers. Anyway everyone else is dealing in them and if they go kablooey in 2 years, he'll still get his bonus.

Maybe it's not his own greed that's driving this. Maybe its the desire to not let the team down, keep his boss happy. Maybe it's not the money per say but his station amongst his peers. Come bonus time, they'll be buying another flat in Chelsea, how will he feel if he can't even take his wife on that holiday?

Now, I'm not for a minute saying all bankers were or are bending the rules like this. I have some good friends working in the banking industry who are fine upstanding fellows. What I'm trying to demonstrate is how easy it is for someone to start cutting corners and trading in assets they wouldn't otherwise touch with a barge pole.

There are two behavioral traits at work here.

1. As explained here, if your peers are bending the rules you are more likely to as well. 
2. No-one starts out believing or thinking they will bend or break their own moral boundaries, but breaking/ bending the rules one bit at a time can lead to a point that you would have thought unthinkable at the outset. When they interviewed the people involved in the Watergate scandal, they asked certain people how they let themselves get to that point. The answer was simple, they did it one small rule break at a time.

Where does that leave us now?

There's nothing wrong with an aggressive bonus/ target driven culture per se. Many business use this model. It works fine most of the time. However, all too often, aggressive targets can encourage some bending of the rules. This might be selling something to someone you know isn't appropriate for them. Most of the time, this will result in a loss of business. If you sell faulty goods, it usually won't take much time for the client to realise they've been duped and complain, then look for someone else to provide the service.

But what if the payback period is over years not months. What if you could sell something to someone that might have hidden risks, but those risks won't become apparent until next year, or maybe 2 years down the line. What if the risks aren't clear? The seller might be able to justify to themselves that they have no way of knowing how the future will work out and the buyer should be sophisticated enough to know this anyway. You might then be temped to sell something you wouldn't want to put your own money in.

You can see that the financial markets could be highly prone to mis-selling in these circumstances. 

The last few major financial bubbles demonstrate this well.

We've had a junk bond frenzy, tech stock bubble, Asian stock bubble and of course mortgage bond mania. 

We can't say we weren't warned, plenty of well placed people have shared their experiences of working inside an investment bank or written about the reasons for past explosions.

Richard Thomson's Apocalypse Roulette from 1999, and Phillip Augar's Merchants of Greed  (2006) provided some clear examples of the culture running within investment banks and how they gave rise to the current crisis.

What's next?

Because unless there are real changes, there will be a next time. China? Oil?

So what is the answer?

Gordon Brown's call for a tax on banking won't work, or at least as well as he hopes. You're dealing with 'the smartest guys in the room' who will no doubt find a way to minimize the impact by driving revenue offshore or using over the counter products. No doubt it will be the retail investors who end up bearing the cost without the added protection it is supposed to be bringing.

Brown is right on one level though, any changes need to be applied across the globe.

Ideally, bonuses from the very top down would be tied to long term results. For example, 10 year stock options with tiered payouts that rover the years reward long term performance. This is in an ideal world though and may be hard to implement.

Perhaps the best option as proposed by the likes of Talleb, and ex Fed chairman Volcker etc is to make banks smaller and to split investment banks from retail banks. The speculative operators can therefore gamble away and fail without bringing down the whole system. The trouble with this argument is that the financial system is now so tightly interlinked that a supposedly small independent operator could cause a ripple effect.

There's probably no single solution and mandatory training on previous collapses and insights into human psychology for new employees would probably help too.

Banks do provide training on the dangers of insider trading and brokers have achieve various qualifications before being let loose with client funds. Adding a compulsory module on behavioral economics and lessons from the past sure won't hurt.

Thin Slicing Blink

I'm a few chapters into reading Malcolm Gladwell's Blink. An entertaining read and Gladwell certainly knows how to spin a good yarn.

But in keeping with the advice I've read so far in Blink, I thought I'd share some potential criticism based on my initial reaction

The central tenet of the book is that we should not ignore our gut feelings – Although we can't articulate why we know something, sometimes we just get a feeling and often this can turn out to be right.

He's provided some very good examples so far of how powerful our subconscious mind can be. Another good book on this sort of thing is consciousness by Rita Carter. Essentially consciousness is what we experience milliseconds after something is happened. The conscious brain is the output of a giant filter and the bits of life we are aware of. The unconscious brain receives a heck of a lot more information and it is impossible for all of this to make it to the surface. However some of it can reach our autonomic nervous system and cause a reaction like sweaty palms. Phobias are a good example of this.

Gladwell also has some good examples of the tennis coach being able to know when a player will double fault. He can't say how he knows, he just knows. The pre-conscious brain is picking up things that the conscious brain can't articulate. Is this a bad thing? Gladwell is right, we probably do place too much emphasis on conscious decision making.

On this I agree.

However, so far, all of Gladwell's examples have involved people using their instincts to make better decision – with the benefit of years of experience. The guy who can predict the outcome of a marriage has been studying it for decades. Guidance counsellors etc performed only slightly better than chance in being able to predict the outcome of a marriage, but how often do guidance counsellors get to see the eventual outcome of a marriage?

Although our preconscious mind is very powerful, it can also be very stupid. In their book 'mistakes were made' Aronson and Tarvis provide some graphic examples of when our gut feel gets it completely wrong. A Police training strategy in the US that showed officers how to look for hidden clues that demonstrated guilt in a suspect. It turns out this training was downright dangerous and responsible for many wrongful convictions. In this case, their training taught them to listen to their gut feel.

There is also mountains of literature on the stupid mistakes we make when it comes to money, especially when we let our natural reactions take over.

Experience + gut will generally (but not always) be more powerful force than someone just acting on intuition.

The firefighter who knew how to get out of the building was using experience + intuition. The people able to judge character traits from viewing someone's room are doing so from a position of experience. We've been around people all our lives so we have all built up experience in this area. That's the difference.

So it is interesting and yes we should listen to our intuition more, but I hope he stresses the opposite side of the coin more. When to listen to your intuition and when not to. Something tells me he won't do enough of this, it might ruin the story. I'll update the review when I've finished the book.

Just a gut feel!