Sunday, November 19, 2006

Broadening Your Trading Horizons

One of the questions I most frequently hear is a version of, "I'm doing well with trading. How can I grow my size?"

To me, that's like saying, "I'm doing well with two dozen eggs in my basket; how can I load it with three?"

Yes, it can make sense to take full advantage of an edge by trading at the largest size that allows you to survive any possible risk of ruin created when markets change and you get an inevitable series of losing trades.

But it can also make sense to smooth out your equity curve by using your trading prowess to diversify into other trading vehicles. The key is to find instruments to trade that are not correlated with your original market.

Fortunately, the world of ETFs offers a number of trading instruments with modest correlations to the major stock indices. The recent book Exchange Traded Funds for Dummies is, as its name suggests, a primer on the topic, but it is quite thorough and informative, pointing out ETF options I didn't know existed. The author understands the need for non-correlated instruments and also the need to focus on ETFs with low expense fees. All that is laid out in the text.

So let's take an example. The Deutsche Bank Commodity Index Tracking Fund (DBC) came out in February, 2006 and tracks six groups of commodities: crude oil, home heating oil, aluminum, corn, wheat, and gold. The day-to-day correlation in price movement between DBC and the S&P 500 Index since inception (N = 191 trading days) has been .086--essentially zero. When you trade DBC, you are trading something relatively independent of stocks.

How can we use this to broaden our trading horizons? Trading instruments such as DBC have their historical market patterns, just like the stock indices. SPY, for example, displays mean reversion tendencies following five-day moves: returns are subnormal following five-day rises and superior after five-day declines.

In DBC, the reverse seems to be the case. When DBC is up over a five-day period (N = 102), the next five days in DBC average a gain of .38% (53 up, 49 down). That is stronger than the average five-day change of .24% (102 up, 89 down). Conversely, when DBC is down over a five-day period (N = 89), the next five days average a subnormal gain of .07% (49 up, 40 down). My research further suggests that volume and money flow, when added to the analysis, improves the batting average of this pattern.

Imagine a basket of ETFs, each traded by a tested pattern and each producing returns independent of the others. When one pattern/instrument shifts and goes into slump, others are performing normally. The result is that you can avoid high leverage, produce consistent returns, and minimize drawdowns.

For the stock trader, ETFs have opened the world to currencies, commodities, fixed income, and international equities. This is surely one of the great trading opportunities out there.

2 comments:

John Wheatcroft said...

Thanks for the tip - I like the "for dummies" books. They inform even know it alls such as myself.

Brett Steenbarger, Ph.D. said...

I agree, John. I've found many of the Dummies books to be good basic resources.

And, yes, they keep me humble...

Brett