The Tao of Trading - introduction - Ariel Faigon (2008)
Intro Case Pivot Position Simulation
Contents:
Introduction: Why Trade? The self evident case for trading
The Optimal Trading Problem
1) The optimal pivot sub-problem
2) The optimal position-size sub-problem
Some simulations of the ideas
Introduction: Why Trade?
For years many of us have been 'trained' to be passive in the markets.The "buy and hold broad passive indexes" mantra is alive and doing great. I'd go further and say that the "indexing" philosophy makes perfect sense for most investors. Pioneered be Vanguard's John Bogle, this indexing philosophy boils down to two sound ideas:
I actually believe that if your goal as an investor, is to put minimum effort into investing, then "Buy and Hold"ing the broadest asset class (or even better: a diverse mix of broad assets) is a near optimal strategy.
- Stay diversified and don't try to beat "the market"
- Minimize activity which leads to higher costs (commissions, price spreads, and taxes)
But this section is titled "Why Trade?" what gives?
I've been a passive investor for years, but the more I looked at the data and analyzed it, the more I became convinced that I can do better by being active. Much better, actually. Moreover, the more active I actually got, after careful analysis of the data and testing of the models, the better my results compared to the market (with the S&P500 as my benchmark) have gotten as well.
I started collecting financial data about 2.5 years ago, in Feb/March 2006. It took me some time to have enough data to make sense, build models, back-test assumptions and strategies, see what works more often than not, and what works better under different conditions (which I call "current market preferences"). These years have been a long learning journey for me. I've made numerous mistakes and wrong calls, and learned from them. I also had some significant good calls which led to out-performance. Overall, in these 2.5 years I've done significantly better than any of the broad US indexes (S&P500, Midcap, SmallCap) while assuming significantly less risk. See [trading record on marketocracy.com] for a reference. I know I can still do better.
To be completely honest, I also applied some shortcuts by learning from other people's experiences, as long as they seemed honest, convincing, and above all, had a real documented record. Each of these Guru-site discoveries has helped me make crucial improvements to my own methods. Among these I especially value: Henry To of MarketThoughts.com, Steve LeCompte of CXOadvisory.com, Walter and Hickey of bespokeinvest.typepad.com, and William Dirlam of decisionmoose.com. I've also learned a lot from watching a few of the top performers on marketocracy.com.
After going through this learning process, and thought transformation, I now believe that given three conditions, one can do much better by being actively trading, than by being passive.
The three conditions are:
- Being totally logical/rational. Rely on the data and not on hunches. Build predictive models, and thoroughly subject them to independent data testing. Build convictions that your models are valid, and act based on the models.
Not every investor can act rationally. In fact, it is a widely known empirical fact, that most active investors -- and most professionals for that matter -- fail to outperform the broad indexes on both absolute returns and risk adjusted returns over the long term. One of the main reasons is that human beings are emotional, and emotions are what cause us to chase assets that go up (buy high) and sell in panic when what we bought is going down (sell low). Based on many experiments I can categorically state that chasing short term momentum is always a risky approach, and almost always a losing strategy.
- Willingness to spend a lot of time/effort. Out-performance, unfortunately, doesn't come free. There's a price you need to pay for being active. It is not that spending this effort is hard, it is just essential in order to establish a conviction. Without a conviction, you simply can't act.
If you don't like this kind of activity -- both the analysis and validation steps needed to come-up with a model and trading plan, and the actual trading activity which comes afterwards -- then obviously, being an active investor isn't for you.
- Being small: managing billions of dollars is hard. Being able to move all your portfolio with barely affecting the price of the underlying asset, is a huge advantage of the small investor over the big institutional money. I believe this last condition is not absolutely necessary if you're extremely good (like James Simons can prove). But it is definitely a critical advantage to have when you make your first steps into becoming more active.
The good news is that if you do meet these three pre-conditions, you can cross the chasm. You can become active, and profit from the activity, while enjoying it at the same time.
The following are my thoughts trying to frame the problem of "Optimal Trading", and to take some steps towards its solution.
My solutions are not optimal in the sense that I don't have a formal mathematical proof of them being optimal. Finance is an inexact science and the data is dominated lot of random noise. What I do have, is a lot of evidence that categorically shows their superiority over buy and hold, both in total returns, and in risk adjusted returns.
If you're ready for the journey, read on.
The rest of this article, is divided into 3 parts:
- The self evident case for trading
- Lays out the initial case for being active vs. the alternative of Buy and Hold.
- The optimal pivot sub-problem
- Attempts to optimally solve the question of when to buy or sell.
- The optimal position-size sub-problem
- Attempts to optimally solve the problem of how much to buy or sell at each decision point given by the Pivot solution.
- Validation of the thesis
- Some simulation examples showing that the method and approach has some validity.
Disclaimer: there's much more to the method than presented here. These simulations are of a very early version, employing gross simplifications of what I'm actually using. Since writing this, me and my friend Adi, have made many improvements and changes designed to reduce both risk, and number of trades. As presented, the method is not really viable or practical. It is far from optimal when market conditions change to a bull market. Trying to follow this simple method at home may result in great risk exposure, too much activity, and sub-optimal results. A fair warning.
Intro Case Pivot Position Simulation
Disclaimer: this should not be considered as investment advice. It is merely describing my own thoughts and actions.
Feedback is welcome.
-- ariel