More on Breadth Models

I’ve experimented with a few breadth models in the past. My hypothesis is that markets have become so efficient and correlated, that all (profitable) strategies break down into long vol or short vol profiles and at the end of the day, your profit will STILL be determined by the movement in the underlying. While utilizing an options structure might benefit or alter the structure of your payout, the extreme inefficiencies that once existed are probably gone and your ultimate profitability over the long run is determined by how well one forecasts’ the underlying.

So momentum jockies know this well and wait only for up-trending markets to trade. If that’s the case, then is momentum trading simply leveraged long in the underlying? Similarly mean-reversion strategies can perform extremely well in ‘stable’ environments and exceptionally well in high to low vol regime shifts but can easily get rocked in low to high vol environments.

Anyway, below is another simple model to forecast equities based on market breadth statistics. I like it cause it’s simple, green = short vol strategies, red = long vol strategies. The model just turned green, hopefully it’s the start of a new bull market! After trading through 08/09 and the recent Euro crisis, I much prefer low vol, uptrending markets. Profit margins may be thinner but far less stress.

2011 YE Review

The Good

- Finally received the risk allocation I was looking for after months of working as a full-time consultant for the firm. Although it was slightly smaller then I had hoped, it’s still enough at this juncture.

- Spending FAR less time reading & researching new trading strategies and focusing on executing my current strategies better. Earlier in the year I would be bogged down looking for more ‘edge’ despite my claims that risk management is far more important then entry systems. It’s hard to stop looking for that ‘holy grail’ of market timing systems and I still spend some occasional weekends testing new ideas but as a whole I’m more concerned with executing properly then a new ‘edge’.

The Bad

- It’s been a tough year return wise, I was caught at maximum exposure during the July/August swoon and spent the rest of the year fighting back. I ended the year down 2%. Being down is a part of the business, what makes the pain acute is that the draw down occured almost immediately after a boost in allocation, so it’s a hit on confidence. EDIT: Down 2% from May till the end of the year. The prior periods returns were much better, i.e. positive, however the structure was different when I received my increased allocation. Part of the reason I even received an increased allocation was due to good performance however it’s not comparing apples to bananas so I look at it as a separate equity curve.

- Without going into too much detail, the firm also renegotiated the payout structure which was one of the most advantageous perks of my current shop. It’s not onerous but not as good as it was previously.

The Ugly

- Our firm let go a few traders this year and it serves as a reminder how fickle and difficult this business is.

Not much to say going into 2012, performance going into November and December was far better and more like normal. I’ve already begun increasing exposure from low levels in August and hoping for no crazy dislocation, correlation spikes, etc. I have no clue what will happen in the market or any predictions. Just trying to spend another day above ground

2011 in review

The WordPress.com stats helper monkeys prepared a 2011 annual report for this blog.

Here’s an excerpt:

The concert hall at the Syndey Opera House holds 2,700 people. This blog was viewed about 15,000 times in 2011. If it were a concert at Sydney Opera House, it would take about 6 sold-out performances for that many people to see it.

Click here to see the complete report.

Follow Up to Op-Ex and Market Timing Model

The Op-Ex indicator started off slow since I posted with 1 break-even trade, 1 stop out, but the last one has been a nice winner:

Keep in mind I haven’t really done much work on optimizing the trailing stop exit, there’s probably opportunity there for improvement.

 

The Market Timing Model also started off slow with some big whipsaws but looks like performance is improving:

 

Ops Ex

Been awhile since I posted anything, I’ve been to busy watching European theater as everyone else has been. But I did find an interesting pattern worth sharing; there has been a strong tendency for the short term trend to reverse after options expiration. I don’t have a very plausible explanation for why but I’m sure one can be rationalized if need be. In any case, I applied a simple stop loss and trailing stop strategy and found over 90% probability of profit for the last 4 years:

Unfortunately prior to 2007, the performance is about the exact opposite of it’s recent performance. Without a reasonable explanation for the mechanism of why this anomaly exists, one is left with the ultimate question, will this strategy continue to work going forward? This is a constant dilemma with any tested strategy. One reasonable approach is to allocate small capital initially and allocate greater amounts as the strategy performs well. Or in other words, trend follow the equity curve. Time will tell.

 

Market Timing Models

The recent sell-off and extremely high correlation in the overall market has given me a renewed interest in market timing models. When correlations are high, stat arb spreads have a tendency to do weird things. Similarly with vol arb strategies. William O’Neill and IBD were my first introduction into market-timing, aka trend-following the index. However IBD’s timing seemed flawed to me and the more I read and researched the less validity I assigned it. It wasn’t until I read Gil Morales/Chris Katcher book that I regained an interest in models to time the SPX. Even then after some research I was skeptical. Mark Minverini is a trader I respect and he has recently begun publishing a market timing model as well.

These models are trend following in nature and hence buying strength and unless I am mistaken ALL utilize market breadth to confirm an uptrend. Some utilize sell signals but most of the gains are from the long side. My first exposure to Market Breadth was in a great book “Winning on Wall Street” by Martin Zweig where he describes a Zweig Upthrust and the corresponding statistics that follow. The book is worth a read but the systems utilized are probably a little outdated.

So utilizing published buy and sell signals from Morales/Katcher, Minervini, etc I set about creating my own market timing model. My goal was just to get close, not straight replication, of their models in order to vary position sizing and exposure of various signals from my other models. If my hypothesis that quantitative systems tend to suffer in extreme volatility, this should act as risk reduction and lower volatility of the overall equity curve. And MAYBE, I could use it directionally as well? Here’s the results from the first pass through:

Looks pretty bad up until 2010 and then it really starts taking off. Good example of recency bias on my part. Nonetheless, it’s not a complete loss.If we look visually at the signals:

 

From the statistics, we have about ~40% percent probability and 1.65 avg win to avg loss. So we’re catching some nice trends with better then 1/3 chance. Not great but given the recent performance and with the notion that this model is intended for risk management and position sizing as opposed to straight alpha generation, it could be a useful tool. I’ll plug at it a little more this weekend and perhaps share signals if there is any interest. Incidentally the model is on a buy since 8/24 and about even on it right now.

Trading idea

It’s been sometime since I posted and markets have changed quite significantly. So called, “easy” trades have not been working and statistical patterns and relationships are breaking down. However, it can’t go on forever (can it?) At some point, ‘normalcy’ will return to the market and those that survive the meltdown should be in a good position to pick up some good money if they have the wherewithal to do so, think going long stocks in 2009.

So here’s a trade to consider in your PA or longer term account, currently the VIX term structure is in massive backwardation. Check it out:

Unfortunately I don’t have 2009 data (100+ VIX) at home but below is March 2010:

Pretty big difference. Keep in mind that the above charts are the CALCULATED VIX levels from SPX options and not necessarily the VIX futures prices. I thought the charts though really exemplify what’s going on in volatility land. The ‘normal’ shape of the term structure is contango, i.e. front month below back months and if you think about it, makes sense. It should be far more difficult to forecast what happens in 1 year then 1 day. But apparently the market is saying the opposite. So take a look at VIX calendar spreads, short front and long back. Unless your a complete cowboy, look in the back months, i.e. Nov/Dec @ 1.50 or Oct/Nov @ 1.40. Normally these should be at negative values. Keep in mind, the closer your calendar is to front month, the more volatile it will be. I also wouldn’t go in there trading these blindly, the term structure can be REALLY volatile so please tread lightly. This is a trade I am strictly looking at but will enter very very cautiously. Like all spreads, there’s no reason it can’t get wider before it reverts.

How we made 18,000% in the Stock Market

Trade Like an O’Neil Disciple: How we made 18,000% in the Stock Market is actually a pretty decent book. I’ve read it and skimmed over various chapter a few times. The most interesting portion of the book was regarding a market-timing tool that, at least according to their accounting, blows away just about anything else and reportedly it has been audited by KPMG.

However I stumbled across this website. Simply titled GilMoralesFundPerfomance, it is written by what is allegedly an investor in Morales’ (one of the co-authors) fund. Check out his performance:

The full monthly performance is on the website. As you can see, -77.33% return, a little off from 18,000%.  Apparently Gil Morales sued this individual and lost; Court documents are also available on the site. He later published a rebuttal on his website here. Basically he states he was able to bounce back from that slump and he has experienced 80% draw downs before.To come back from 80% capital loss seems like a bit of a stretch to me, no? With that much loss of capital one would have to return 400% to get back even.

Granted the market conditions during that time were extremely tough, many of the best funds lost a lot of money during that period. But these individuals are selling a membership/subscription site and it’s important to know how your hard earned money is being spent. In a perfect world, ALL these guru’s would share their monthly or daily returns of their trading accounts. I don’t really know of any subscription site where the owner does this? If you do, please leave a comment as I would be very interested! If you subscribe to one, please ask the proprietor to supply you with one and see what they say, share here as well!

It’s important to realize that no one is infallible in this game and that the bear markets separate the winners from the flash in the pan. 18,000% return was the result of a massive bull market, throw a dart and go long and you would’ve made money in those days. Add a little leverage and you have the title to a very intriguing book! The boring stuff like preserving capital, risk management, etc keep you around till the days of easy money come back. It’s quite easy to get someones attention when everything you touch turns to gold, like in a bull market. And trust me, they will let you know!

Not all these guru’s are bad though and many supply a good learning service or provide a good adjunct to your current work. Just be cognizant that they do not have all the answers, are not gods, and are wrong probably just as often as you are! In my case I know I’m wrong quite a lot! These past few weeks have been quite a difficult market for my strategies. My only saving grace has been my exposure has been greatly reduced so even though I’m not making money, the draw down is easy enough to bounce back from (hopefully!) Capital preservation & risk management!

Subscription Bases Trading Sites

Twitter and social media are obviously changing the way financial markets operate. Information is faster and easier to access then ever before. Unfortunately, trading talent, is still difficult and rare (even in the biz fyi) Stocktwits in particular is a new medium for retail and otherwise unknown talent to showcase their trading ideas to the general public. In an effort to monetize that skill, many have started subscription or premium based services to share trading ideas. I wrote about one such site which has become quite a popular post on this blog. Some random thoughts on this trend and a few humble suggestions for anyone considering paying money for one:

1) First and foremost in my head, if an individual is such a talented trader, why feel the need to sell a subscription service? As I write this, I already have a general idea of the answer; trading ideas is low cost, highly scalable, and it pays. At $50/month, 100 subscribers comes out to $5k month. Not bad residual income. If retail is trading a 500k account and making 50% returns, simple math = $250k/year with an additional $60k in subscription or about 1/4th of the annual take. Now, that annual take is an estimate, as we all know, trading revenue can and is highly volatile so having some steady income is a huge psychological cushion. But back to the original point, I want to know why the guy is selling a subscription and I want to know that he is positive in his account. Even if it’s for the sake of peace of mind, I am highly skeptical at first of anyone selling trading ideas. I don’t even like sell-side ideas

2) It’s unlikely that you take ALL the same trades as your service provider. This is critical! The provider might be highly profitable but if you pick and chose the trades you take, it is highly unlikely that you match his returns. In all likely hood your returns will be worse. Take this situation: you  monitor a new service, see a couple profitable trades in a row, you take the next trade and are stopped out, next trade and your a little gun shy and you miss it, only to take the next one that is stopped out. Something along those lines. When analyzing a systematic trading strategy, we would backtest a strategy both with unlimited capital and one with capital restraints. The capital restrained account obviously could not take ALL trading signals at times because it would run out of money. Otherwise we would also try to randomize signals on any given day in the backtest, all in an effort to see if the GENERAL signal was profitable and it was not based on some type of anomaly. Hopefully this makes sense?  In my opinion the metric YOU should be most interested in is his/her Percent Profitability. So if we take the signals randomly, we should still make money in the long run.

3) Depending on your skill level, one might be interested in trading education versus trading signals. If you are new, you are likely looking to develop a style or strategy that fits you so therefore the above paragraph on hit rate is especially important. Similarly if you have a strategy and are simply looking for someone that trades a similar style for new ideas, then the above may not be as relevant. And in all cases, the provider should place capital preservation and risk management at the top, the last thing you need is some open ended risk that can blow up your account.

4) Be mindful that you’re going to hear/see/read more about winning trades then losing trades on twitter. Everyone does it. I do it and I’m not even selling anything. A winning trade is just more fun to talk about. Just be mindful of the hit rate paragraph when you see someone boasting how many great trades they had in their chat-room, newsletter, etc. I’ll say it again, your probably not going to match that performance.

In conclusion I think a trading subscription CAN be of good service if you know what your looking for and have properly vetted the provider. But keep in mind it is NOT the answer to trading but simply another tool, like tradestation or excel.

Riding the Curve

CBOE website has a nice little tool to generate the VIX term structure at various times and dates. This is the term structure from Monday & today. What a difference a few days makes> Keep in mind the news of the Tsunami hit last Friday.

It is my personal opinion, and somewhat backed up by the statistics, that the optimists always triumph in markets and that this is an excellent fade.  The headlines screaming panic and the constant chatter from various agencies who may or may not know anything will ultimately turn out to be nothing but noise. Timing is always tricky though, I guess nothing in markets is that easy.

Calendar spreads or my recent preferred structure the VXX VXZ pair trade are appropriate however in any spread one needs to consider how to hedge it to avoid catastrophic loss. One can purchase OTM index puts, no sense in buying the straddle or strangle. Or perhaps options on some of the weaker constituents? Or the simpler thing might be to play it small, manage positions, and/or strike when there is confirmation of some resolution.

EDIT 3/20/11

The VIX term structure has come in nicely and it’s likely we won’t hear about Japan or nuclear holocaust ever again. There’s just too many Justin Bieber headlines we’ve been ignoring in the meantime.

Interestingly my idea of VXX/VXZ pair trade has not worked out just yet. I still expect the trade to revert so perhaps there’s still an opportunity here.