Statistics shows that the larger the sample size as a percentage of the population, the more confident you can be in whatever conclusion you draw. However, the more specific the information the more useful the information.
Seasonal data follows the laws of statistics in that it requires a large number of samples to allow you to draw a conclusion, but how actionable is that conclusion? For example, if seasonal data of an individual stock says 9 out of 15 times (60%) a particular stock outperformed the S&P during the month of October, perhaps you can only be 52% confident that this particular stock will outperform and that the result weren't just due to randomness. Yes you more likely have an edge than not, but not one with substantial confidence. Considering that if you don't have an edge any bet is too large, and if you only have a slight one, only a very small bet is permitted and the fees and commission will reduce that edge even more.
On the other hand, consider sector data that goes back for hundreds of years that contain an AVERAGE of every stock in the sector. If thousands of stocks over 50 years had on averaged outperformed, this is extremely significant and a very large sample size. So if it tells you that there is an edge, with thousands of "trials" you can be much more confident that going forward tech stocks will outperform in October.
The problem being it won't tell you whether or not a specific company like GOOGLE is likely to outperform. However, you can deduce that a stock, selected at random in the tech sector should produce an average tech performance, and give you outperformance over time. Now if you can look at the same seasonal data and also determine that google has a 54% chance of outperforming the average tech stock, then even if you are wrong and it's average, you still outperform the S&P.
Take a scenario where 75% of the time tech outperforms, Even if you select the bottom 50% of tech, you still have 25% of those bottom 50% that outperform the market, and only the other 25% doesn't. So overall you can increase your odds slightly AFTER determining a sector by choosing an individual stock's seasonal data, but you won't have much of an edge just looking at that data. As such, the seasonal data can be almost irrelevant or extremely relevant depending on how you use it. The same is true with most data.
Ultimately you want a large number of samples in similar situations to deliver a combination of both a large sample size as well as a very similar and high quality size.
I love candlestick patterns because of the ability to test millions of them and get a very large sample size, and I feel they are more objective than price patterns. I still like price patterns though. Ultimately, statistically speaking SECTOR seasonality as a guiding principal to focus more on and allocate more towards the sectors with strong seasonal data will provide you with a statistical edge. Then selecting entry criteria in that particular sector measured by candlestick data will add an additional edge, and throw in support/resistance if you'd like and F.A.S.T. Graphs (intrinsic value fundamentals) or other data which perhaps has been statistically tested, and that is where you have an edge on top of an edge on top of an edge. The probability of all of those edges failing and stock under-performing is slim, and that is how you can use statistics to your advantage.
Thursday, September 26, 2013
Thursday, September 19, 2013
Stock Trading Philosophy vs Strategy
A trading/investing philosophy is a set of conceptual guiding principals. It is in theory what your strategy may aim to accomplish, without any specifics. A philosophy contains an example of what you might do in your strategy to illustrate how it will work.
A strategy is a more specific set of ideas as to how exactly you will carry that philosophy out. It should contain a checklist as well as a set of strict rules to follow. The checklist is something you should make ahabit of reading before every purchase.
Right now I have done a lot of work on philosophy and have begun only some work on the strategy.
The philosophy's example of what you may accomplish in the strategy is illustrated below as an example.
I have discussed how you might protect your capital and various concepts you may implement, but keep in mind this is only a philosophy, not a strategy.
So how does one make the transition from philosophy to strategy? You could just set up some sort of set of rules you are comfortable with, but to me, I want to be precise as possible, and that makes it a long and laborious process of market study and more importantly, self study.
That means finding out exactly what information you need to make as precise of a decision as you can with regards with "what to buy", "when to buy it" "at what price" and "what conditions must be met to sell" and perhaps more importantly "with how much capital" and "how to divide up your capital", and "how flexible is your strategy... what are the specific rules that may allow you to differ from it and by how much". In reality the strategy defines your parameters, including when to change those parameters and by how much, but it makes more sense to people if you look at an exact strategy that is static and then provide rules for "exceptions". Really though, your portfolio's philosophy should be fluid enough to shift as in the example above, and the strategy should provide specifics.
This isn't the only philosophy either. Your strategy might simply seek to determine a particular win rate that you have, and find a strategy, such that if you were 100% long, your risk would still become acceptable. This means much more index hedging and finding a particular ratio. For example, every 3 trades you might buy 2 times the normal trade size in some long dated puts. (or perhaps 3 puts to every 5 calls) This way if you are 100% long you are 66% long calls and 33% long puts and that would be maximally aggressive in your strategy, but still only 33% levered long (66%-33%). Or maybe you stick 20% in cash and income related non leveraged investments and you really set it up so that the maximum aggression you can get is 52.8% calls and 26.4% puts (26.4% levered long). Getting that aggressive, you better be right about the market moving. At least the long term puts will help you mitigate some of the time decay if market trends sideways and shorter term option calls expire worthless as market perhaps moves sideways, but will still potentially cause you to lose a bit MORE than the premium. Worst case scenario every option expires at the strike price and market trades up, but with the extra time on it you can close out your puts without too much damage, and/or roll some/all of them to longer term options and enter the next batch of trades.
If you want 20% leveraged long as maximally aggressive, you can work backwards and find that you need 40% of your capital to be occupied by cash related investments. Or if you prefer a larger amount than that, maybe 50-65% allocated towards stock, income, and investments with some larger degree of "risk". Even though in terms of calls minus puts you may be only something like 15% leveraged long, when you consider you also own maybe 20% stock investments and 20% low beta income investments the risk may be close enough to the volatility as if you were 20% leveraged long.
Either way, you need to set rules, and it needs to make sense with what you have defined that you want to accomplish. You might calculate on average over the long term how much you expect to gain on trades and how much you expect to lose on hedges, and make sure that whatever the ratio that the longs provide a positive gain. Then you also want to make sure that the calls don't reach any particular extreme. That is how you might construct an exact strategy and also it will help you determine the parameters of the trade. But when calculating the trade, you want to figure out gains plus average losses, or losses plus average losses from hedging into the equation.
For example, IF your calls gain 200%, what do your hedges do over that period. Gains minus losses = your actual gain. Say it's 50%. So 200% on a position size of $3000 to a 50% loss on a position size of $2000 is $3000*3=$9000 - $1000=$9000 ($4000 net) on total cost (including hedge) of $5000 is $4000/$5000=.8=80% Return on capital. Then you break down what happens if your calls gain 100%? If they do nothing? and if they lose 50% or 100%? If you can map out the trade with a hedge, you should have less extreme declines, and that will allow you to take on a larger risk if you were to do one particular trade.
You of course need some kind of position sizing algorithm such as a kelly criterion or monte carlo simulation to determine your expectations. Either way, even if you aren't putting it all into one particular trade, it's probably better to divide that trade up into many trades for the sake of reducing risk further (provided the fees and opportunity costs of putting everything into your best trade don't outweigh the upside from diversifying.). The information you determine from the position sizing algorithm will be very relevant and significant to strategy
A strategy is a more specific set of ideas as to how exactly you will carry that philosophy out. It should contain a checklist as well as a set of strict rules to follow. The checklist is something you should make ahabit of reading before every purchase.
Right now I have done a lot of work on philosophy and have begun only some work on the strategy.
The philosophy's example of what you may accomplish in the strategy is illustrated below as an example.
So how does one make the transition from philosophy to strategy? You could just set up some sort of set of rules you are comfortable with, but to me, I want to be precise as possible, and that makes it a long and laborious process of market study and more importantly, self study.
That means finding out exactly what information you need to make as precise of a decision as you can with regards with "what to buy", "when to buy it" "at what price" and "what conditions must be met to sell" and perhaps more importantly "with how much capital" and "how to divide up your capital", and "how flexible is your strategy... what are the specific rules that may allow you to differ from it and by how much". In reality the strategy defines your parameters, including when to change those parameters and by how much, but it makes more sense to people if you look at an exact strategy that is static and then provide rules for "exceptions". Really though, your portfolio's philosophy should be fluid enough to shift as in the example above, and the strategy should provide specifics.
This isn't the only philosophy either. Your strategy might simply seek to determine a particular win rate that you have, and find a strategy, such that if you were 100% long, your risk would still become acceptable. This means much more index hedging and finding a particular ratio. For example, every 3 trades you might buy 2 times the normal trade size in some long dated puts. (or perhaps 3 puts to every 5 calls) This way if you are 100% long you are 66% long calls and 33% long puts and that would be maximally aggressive in your strategy, but still only 33% levered long (66%-33%). Or maybe you stick 20% in cash and income related non leveraged investments and you really set it up so that the maximum aggression you can get is 52.8% calls and 26.4% puts (26.4% levered long). Getting that aggressive, you better be right about the market moving. At least the long term puts will help you mitigate some of the time decay if market trends sideways and shorter term option calls expire worthless as market perhaps moves sideways, but will still potentially cause you to lose a bit MORE than the premium. Worst case scenario every option expires at the strike price and market trades up, but with the extra time on it you can close out your puts without too much damage, and/or roll some/all of them to longer term options and enter the next batch of trades.
If you want 20% leveraged long as maximally aggressive, you can work backwards and find that you need 40% of your capital to be occupied by cash related investments. Or if you prefer a larger amount than that, maybe 50-65% allocated towards stock, income, and investments with some larger degree of "risk". Even though in terms of calls minus puts you may be only something like 15% leveraged long, when you consider you also own maybe 20% stock investments and 20% low beta income investments the risk may be close enough to the volatility as if you were 20% leveraged long.
Either way, you need to set rules, and it needs to make sense with what you have defined that you want to accomplish. You might calculate on average over the long term how much you expect to gain on trades and how much you expect to lose on hedges, and make sure that whatever the ratio that the longs provide a positive gain. Then you also want to make sure that the calls don't reach any particular extreme. That is how you might construct an exact strategy and also it will help you determine the parameters of the trade. But when calculating the trade, you want to figure out gains plus average losses, or losses plus average losses from hedging into the equation.
For example, IF your calls gain 200%, what do your hedges do over that period. Gains minus losses = your actual gain. Say it's 50%. So 200% on a position size of $3000 to a 50% loss on a position size of $2000 is $3000*3=$9000 - $1000=$9000 ($4000 net) on total cost (including hedge) of $5000 is $4000/$5000=.8=80% Return on capital. Then you break down what happens if your calls gain 100%? If they do nothing? and if they lose 50% or 100%? If you can map out the trade with a hedge, you should have less extreme declines, and that will allow you to take on a larger risk if you were to do one particular trade.
You of course need some kind of position sizing algorithm such as a kelly criterion or monte carlo simulation to determine your expectations. Either way, even if you aren't putting it all into one particular trade, it's probably better to divide that trade up into many trades for the sake of reducing risk further (provided the fees and opportunity costs of putting everything into your best trade don't outweigh the upside from diversifying.). The information you determine from the position sizing algorithm will be very relevant and significant to strategy
Thursday, September 12, 2013
Contrarianism vs Trend Followers
The following illustrates the difference between contrarians and trend followers
There is a tremendous amount of overlap for Trend Followers and Contrarians. Contrarians should be long early about half the time and late about half the time. They might grab the bottom early 12.5% of a total cycle, and 12.5% of the time they are late, which translates to being early half the time and late half the time. The trend follower will always seek to be late on grabbing the bottom and early on the top. The trend follower wants to grab the middle 50-75% of the move, which means the 12.5-25% of the top and bottom will be missed.
Thus, they both will be exiting around the same timeframe. The difference is if the contrarian and trend follower both seek to be short, the trend follower will just sell and go to cash, and wait for the middle move downward to start considering a short, and the contrarian will seek to sell and then start going short in that same range.
Then at the bottom the contrarian and trend follower will both begin to cover, except that the contrarian will also start buying in the same range that the trend follower is merely covering and going to cash. The Contrarian will already be long and have it's entire position while the trend follower is merely positioning to grab the middle chunk of a move.
I think the Contrarian should be early with half of his buys (before the exact bottom) and late with the other half. No one can get the exact bottom every single time. Same thing with the sells. But of course that means they are mostly with the trend except for the bottom 10-20% and top 10-20%. On average though they get pretty close and can check themselves with their early+late percentage.
If you aren't occasionally early, you are waiting too long. If you aren't occasionally LATE, you probably aren't waiting long enough.
It's like the old poker adage "If you aren't getting caught bluffing, you aren't bluffing enough".
To modify the quote for contrarians, "If you aren't occasionally getting caught waiting too long to buy the bottom and sell the top, you aren't being patient enough and aggressive enough" Or conversely, "If you aren't occasionally getting caught LONG before the bottom, or in cash or short too early before the top... you aren't going to be able to hit the exact bottom enough and will also miss too many opportunities."
Exactly HOW CLOSE you get to the exact bottom or top is a matter of skill and liquidity.
However, I suspect it's slightly better to be early more often than late when it comes to selling high... and better late (or not at all), than early when it comes to buying (or covering shorts) low. Maybe 60% late on bottoms and 60% early on tops.
Parallel to this, a notable contrarian once said "The most successful contrarians are with the trend 80% of the time". That would mean they are grabbing the bottom 20% (half of it moving against them to the downside, and the other half to the upside again), and selling the top 20% (half of it moving against them to the upside and the other half to the downside again. That leaves them with the trend 80% of the time and against it 20% with the breakdown as follows:
10% of the time when it is going down, they are long.
10% of the time when it is going up, they are short or in cash.
80% of the time they are either long when the market is trending up or short/in cash when the market is trending down.
Thus, they both will be exiting around the same timeframe. The difference is if the contrarian and trend follower both seek to be short, the trend follower will just sell and go to cash, and wait for the middle move downward to start considering a short, and the contrarian will seek to sell and then start going short in that same range.
Then at the bottom the contrarian and trend follower will both begin to cover, except that the contrarian will also start buying in the same range that the trend follower is merely covering and going to cash. The Contrarian will already be long and have it's entire position while the trend follower is merely positioning to grab the middle chunk of a move.
I think the Contrarian should be early with half of his buys (before the exact bottom) and late with the other half. No one can get the exact bottom every single time. Same thing with the sells. But of course that means they are mostly with the trend except for the bottom 10-20% and top 10-20%. On average though they get pretty close and can check themselves with their early+late percentage.
If you aren't occasionally early, you are waiting too long. If you aren't occasionally LATE, you probably aren't waiting long enough.
It's like the old poker adage "If you aren't getting caught bluffing, you aren't bluffing enough".
To modify the quote for contrarians, "If you aren't occasionally getting caught waiting too long to buy the bottom and sell the top, you aren't being patient enough and aggressive enough" Or conversely, "If you aren't occasionally getting caught LONG before the bottom, or in cash or short too early before the top... you aren't going to be able to hit the exact bottom enough and will also miss too many opportunities."
Exactly HOW CLOSE you get to the exact bottom or top is a matter of skill and liquidity.
However, I suspect it's slightly better to be early more often than late when it comes to selling high... and better late (or not at all), than early when it comes to buying (or covering shorts) low. Maybe 60% late on bottoms and 60% early on tops.
Parallel to this, a notable contrarian once said "The most successful contrarians are with the trend 80% of the time". That would mean they are grabbing the bottom 20% (half of it moving against them to the downside, and the other half to the upside again), and selling the top 20% (half of it moving against them to the upside and the other half to the downside again. That leaves them with the trend 80% of the time and against it 20% with the breakdown as follows:
10% of the time when it is going down, they are long.
10% of the time when it is going up, they are short or in cash.
80% of the time they are either long when the market is trending up or short/in cash when the market is trending down.
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