Sunday, August 28, 2016

Hammers, Nails, and Improving Your Trading Toolkit

A reader recently asked the question of whether market movements are random.  At an informal level, I am struck by the number of skilled traders at each firm where I've worked who have accumulated multi-year track records of success, making money with a high Sharpe ratio trading actively in markets.  To be sure, these are not the majority of traders, but they are a distinguished minority.  As a trading coach working with them, I'm able to appreciate their talent first hand and recognize that their success represents far more than luck.   

Of course, on a more formal level, there is an entire research literature in mathematical finance detailing the non-randomness of financial returns.  These excess returns can be categorized by factors, such as value (the purchase of undervalued assets and sale of overpriced ones), momentum (the tendency of strength or weakness to persist), and carry (the returns that come from owning an asset, as in the case of dividends or interest rate differentials).  A strength of asset management comes from harvesting expected returns from portfolios that cut across these factors.  Balancing and rebalancing factor-based portfolios produces a level of diversification that smooths return streams and allows investors to count on returns superior, on average, to simply buying and holding a given asset or throwing darts at boards.

Factor portfolios have no opinions about markets; they do not trade expectations regarding the Fed, the election, data releases, or world events.  When individual traders ground their decisions on their opinions, they often are not factor neutral.  They implicitly take a position in a particular strategy, such as momentum or volatility.  Many naive traders, for example, trade from technical patterns that have them buying weak readings and selling strong ones (value) or buying/selling upside/downside breakouts (momentum).  Their weakness is that they apply the same strategies across markets and market conditions.  They are not diversified.  They are like Maslow's holder of the hammer, treating everything as nails.

So how can active individual traders achieve diversification and yet stay true to their trading strengths?  This is a challenge generally ignored in trading psychology.  Too many trading coaches assume that you'll make money if you just stay in the right emotional state.  If you trade a flawed strategy while keeping yourself in a calm, positive state, you'll most likely lose money with minimal emotional disturbance.

Participation in financial markets can be categorized broadly as trading versus investment.  Holding period is part of that difference, but only part.  Trading is predicated on microanalysis, the real-time construction of patterns by moving markets.  The trader thrives on rapid pattern recognition: the recognition of what markets are doing as they are doing it.  This requires fast, broad thinking and quick response times.  The investor thrives on the macroanalysis of broad conditions that impact markets and an understanding of their unfolding implications for future market movement.  To a large degree, trading/pattern recognition is about intuition and a feel for markets; investment is about formal reasoning and the understanding of patterns.

Traders achieve diversification when they trade multiple, independent "setups".  For example, they may trade momentum patterns in which price movement is accompanied by volatility breakout as well as reversal patterns in which price movement becomes exhausted, with a loss of volume and volatility.  Because they trade many setups during the day, they achieve diversification--even though they may be trading a single instrument.

The investor achieves diversification by participating in multiple, independent hypotheses about the world.  For instance, an investor might buy crude oil based upon geopolitical conflict and seasonal factors and might sell U.S. assets in favor of emerging market ones based upon differential monetary policies.  The investor places fewer trades across multiple markets for multiple reasons.  The trader places many trades in a limited number of markets with a defined set of independent setups.

Either way, whether you are an investor or trader, the smartest thing you can do to produce greater returns is to diversify.  One trick ponies run out of tricks when market conditions don't favor their particular factors.  A great strategy for your trading development is to identify the kinds of markets where you typically don't make money, figure out which factors are working during those occasions, and produce a strategy to allow you to participate in returns from that factor.  There will always be a high level of randomness/noise in financial returns.  We are most likely to find success if we can exploit multiple sources of signal amidst the noise.

Further Reading: A Systematic Approach to Discretionary Trading