Quantitative Trading. Ernest P. Chan
is not to say that you will not find some gems if you are persistent enough, but I have found that many traders' forums or blogs may suggest simpler strategies that are equally profitable. You might be skeptical that people would actually post truly profitable strategies in the public space for all to see. After all, doesn't this disclosure increase the competition and decrease the profitability of the strategy? And you would be right: Most ready-made strategies that you may find in these places actually do not withstand careful backtesting. Just like the academic studies, the strategies from traders' forums may have worked only for a little while, or they work for only a certain class of stocks, or they work only if you don't factor in transaction costs. However, the trick is that you can often modify the basic strategy and make it profitable. (Many of these caveats as well as a few common variations on a basic strategy will be examined in detail in Chapter 3.)
For example, someone once suggested a strategy to me that was described in Wealth-Lab (see Table 2.1), where it was claimed that it had a high Sharpe ratio. When I backtested the strategy, it turned out not to work as well as advertised. I then tried a few simple modifications, such as decreasing the holding period and entering and exiting at different times than suggested, and was able to turn this strategy into one of my main profit centers. If you are diligent and creative enough to try the multiple variations of a basic strategy, chances are you will find one of those variations that is highly profitable.
When I left the institutional money management industry to trade on my own, I worried that I would be cut off from the flow of trading ideas from my colleagues and mentors. But then I found out that one of the best ways to gather and share trading ideas is to start your own trading blog—for every trading “secret” that you divulge to the world, you will be rewarded with multiple ones from your readers. (The person who suggested the Wealth-Lab strategy to me was a reader who works 12 time zones away. If it weren't for my blog, there was little chance that I would have met him and benefited from his suggestion.) In fact, what you thought of as secrets are more often than not well-known ideas to many others! What truly make a strategy proprietary and its secrets worth protecting are the tricks and variations that you have come up with, not the plain-vanilla version.
Furthermore, your bad ideas will quickly get shot down by your online commentators, thus potentially saving you from major losses. After I glowingly described a seasonal stock-trading strategy on my blog that was developed by some finance professors, a reader promptly went ahead and backtested that strategy and reported that it didn't work. (See my blog entry, “Seasonal Trades in Stocks,” at epchan.blogspot.com/2007/11/seasonal-trades-in-stocks.html and the reader's comment therein. This strategy is described in more detail in Example 7.6.) Of course, I would not have traded this strategy without backtesting it on my own anyway, and indeed, my subsequent backtest confirmed his findings. But the fact that my reader found significant flaws with the strategy is important confirmation that my own backtest is not erroneous.
All in all, I have found that it is actually easier to gather and exchange trading ideas as an independent trader than when I was working in the secretive hedge fund world in New York. When I worked at Millennium Partners—a 40-billion-dollar hedge fund on Fifth Avenue—one trader ripped a published paper out of the hands of his programmer, who happened to have picked it up from the trader's desk. He was afraid the programmer might learn his “secrets.” (Lest you think that Millennium Partners is a bad place to work, I should add that its founder, Izzy Englander, personally spoke with my next employer to vouch for me.) That may be because people are less wary of letting you know their secrets when they think you won't be obliterating their profits by allocating $100 million to that strategy.
No, the difficulty is not the lack of ideas. The difficulty is to develop a taste for which strategy is suitable for your personal circumstances and goals, and which ones look viable even before you devote the time to diligently backtest them. This taste for prospective strategies is what I will try to convey in this chapter.
HOW TO IDENTIFY A STRATEGY THAT SUITS YOU
Whether a strategy is viable often does not have anything to do with the strategy itself—it has to do with YOU. Here are some considerations.
Your Working Hours
Do you trade only part time? If so, you would probably want to consider only strategies that hold overnight and not the intraday strategies. Otherwise, you may have to fully automate your strategies (see Chapter 5 on execution) so that they can run on autopilot most of the time and alert you only when problems occur.
When I was working full time for others and trading part time for myself, I traded a simple strategy in my personal account that required entering or adjusting limit orders on a few exchange-traded funds (ETFs) once a day, before the market opened. Then, when I first became independent, my level of automation was still relatively low, so I considered only strategies that require entering orders once before the market opens and once before the close. Later on, I added a program that can automatically scan real-time market data and transmit orders to my brokerage account throughout the trading day when certain conditions are met. So trading can be a “part-time” pursuit for you, even if you derive more income from it than your day job, as long as you trade quantitatively.
Your Programming Skills
Are you good at programming? If you know some programming languages such as Visual Basic or even Java, C#, or C++, you can explore high-frequency strategies, and you can also trade a large number of securities. Otherwise, settle for strategies that trade only once a day, or trade just a few stocks, futures, or currencies. These can often be traded using Excel loaded with your broker's macros. (This constraint may be overcome if you don't mind the expense of hiring a software contractor. Again, see Chapter 5 for more details.)
Your Trading Capital
Do you have a lot of capital for trading as well as expenditure on infrastructure and operation? In general, I would not recommend quantitative trading for an account with less than $50,000 capital. Let's say the dividing line between a high- versus low-capital account is $100,000. Capital availability affects many choices; the first is what financial instruments you should trade and what strategies you should apply to them. The second is whether you should open a retail brokerage account or a proprietary trading account (more on this in Chapter 4 on setting up your business). For now, I will consider instrument and strategy choices with capital constraint in mind.
With a low-capital account, we need to find strategies that can utilize the maximum leverage available. (Of course, getting a higher leverage is beneficial only if you have a consistently profitable strategy.) Trading futures, currencies, and options can offer you higher leverage than stocks; intraday positions allow a Regulation T leverage of 4, while interday (overnight) positions allow only a leverage of 2, requiring double the amount of capital for a portfolio of the same size. Finally, capital (or leverage) availability determines whether you should focus on directional trades (long or short only) or dollar-neutral trades (hedged or pair trades). A dollar-neutral portfolio (meaning the market value of the long positions equals the market value of the short positions) or market-neutral portfolio (meaning the beta of the portfolio with respect to a market index is close to zero, where beta measures the ratio between the expected returns of the portfolio and the expected returns of the market index) require twice the capital or leverage of a long- or short-only portfolio. So even though a hedged position is less risky than an unhedged position, the returns generated are correspondingly smaller and may not meet your personal requirements. For certain brokers (such as Interactive Brokers),