Monday, August 06, 2007

From Traders To Portfolio Managers: Becoming Your Own Hedge Fund

I had the pleasure on Friday of watching a demonstration of the beta version of Trade Ideas' automated trading capability. At present, that functionality is being offered through accounts with OptionsXpress via a pilot program. The way it works is that you determine in advance the universe of stocks you want to track and the specific setups you want to trade during the day. These will be determined by your use of the Trade Ideas Odds Maker, which tests out a variety of user-defined patterns over a three-week lookback period, including stops and profit targets. Once you identify the successful strategies in Odds Maker, you enter them (along with the stocks that you'll be trading) into a "bot" that sits on your desktop. The program will then wait for your entry criteria to be met in each stock, send the orders to buy or sell, and monitor the trades (including P/L for each position and overall) for you. During the day, you can turn strategies on and off based on your read of market conditions.

This frees traders from the task of execution and makes it automatic, reducing the role of emotion in failing to take good trades and chasing bad ones. It enables the trader, instead, to focus on strategy selection and monitoring strategies over time. That is exactly how it works in many institutional settings: the portfolio manager is free to research strategies and manage the portfolio and an execution desk actually handles the details of transactions.

More important, however, is that automated trading enables traders to track and trade multiple strategies across different stock groups--including strategies that are non-correlated. Thus you can trade strategies that are short the market for weak stocks/patterns and strategies that are long the market for strong stocks/patterns. The net effect is to reduce your volatility and the impact of general market swings. This, too, is how the pros do it.

I am not connected financially in any way with OptionsXpress or Trade Ideas. My interest is in helping individual traders find some of the benefits of professional portfolio management. Are there limitations to automated trading for the individual trader/investor? Absolutely. Investment in redundancy is crucial; you don't want to run a book of positions and have orders ready to fire if your computer or online connection fail. (Automation of stops helps this problem somewhat). You also want to make sure that you adequately assess the impact of commissions and slippage on your trading results, particularly with standard retail commission fees and the kinds of slippage possible in volatile market conditions. And, yes, you need an account size large enough to exploit the trading of multiple stocks and strategies.

With ETFs now enabling traders to trade multiple asset classes from a single stock market account and the ability to automate a variety of strategies across different time frames, we're coming ever closer to that point where each trader can manage his or her own hedge fund. Spreading risk across markets and sectors, long and short; trading big idea themes that cut across international markets and asset classes: we're witnessing the continued professionalization of the independent trader.


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Three Myths of Trading Psychology