TradingSystems

The third- and our flagship - is now at around 16% real money return over three months. We tried some stunts - leveraging it, adding/deleting capital etc. - just to see how it performs. But now we're back with a non leveraged system - and 16% is the auditable profit.

Interesting some other systems come into play once in a while - not every day, or every week - but just once in a while. Kinda like Kaushik's Gold/Nifty pair trade (29% in three weeks there).

One such thing I'm thinking of is a Nifty option straddle or strangle. The Nifty was at 4300 on June expiry, and at about the same level in the July expiry. In August it closed at 4210.

This is a fairly tight range, and I looked back a little bit to see how such a scenario has panned out. Nifty has had futures only since 2000, but real trading probably started in 2002. SO let's check a 1 month (expiry to expiry) move and a 2 month move since 2002:

• Every time both one month and two month moves have been less than 4%, there has been a 10% move (expiry to expiry) in the subsequent two months (either one month or two month).
• Except once, in Sep/Oct 2002 where such a situation lasted two months (i.e. one and two month moves were less than 4%) and the third month there was a 10% move. Even then I'm not sure I should bother because the nifty future turnover on expiry day was 100 cr. We do that
• There may be large fluctuations within the month but I'm not counting those.
• Our current one and two month moves - as of end August - are 2% each.

I can't really back test - because I have only a few data points and options only got really liquid only after 2005 or so. But it seems like there is a profitable opportunity if one were to buy a straddle for around 5% when such situations occurred.

Current straddle rates are around 8% (300 points on a Nifty of 4200). Not entirely profitable, to be honest - but if the Nifty stays in this range till mid-month, things might be better. Need to do a comprehensive back test, but it's fodder to start.

Now other situations exist. There could be the situation that an intermediate move will take you into a profit zone. Also need to test strangles. Finally of course, implied volatility plays a part - so perhaps the idea is to buy low IV strangles, as compared to the rest of the option chain.

This is more of a low frequency, high probability (LFHP) trade. It won't set up every day or every month, but when it does set up it has a high chance of success. Now if we were to get 50 such LFHPs, maybe we can get a more stable return. (Of course, with Murphy's law, all will set up at the same time, and you will not be able to allocate capital). Still, if the returns are reasonable on a per-setup basis, this might be a way to get alpha in the longer term.

Disclosure: Long a Nifty strangle [Couldn't resist]

Most people quote that they have seen a thousand of them earlier and they didn't work. While I understand systems tend to fail (especially after they are public for a while), I am willing to bet that most systems "appear" to fail because of the lack of discipline. Most people fear for their life after a few bad trades and have no real way to prove that a system has indeed stopped working; so they throw out the system.

If there's a series of losses the position sizing techniques (always only risk a percentage of equity, post losses) should keep the position down - but a discretionary impact may be to stop real money and paper trade the next few trades, until there is confirmation that the system has gone bust. Or, to put lesser money in. The concept of throwing out a system on a few trades is probably the most attractive to a human mind, yet, the logical thing is to await some quantitative proof that the system no longer works.

The other problem people have is they are incredulous. How can a system that is computerised and requires no human intervention, perform at any consistent rate? But that's precisely why it does, because it has no human emotion to contend with. The more humans get involved in trades, the more likely it is for mistakes to happen. Now there are many traders who are excellent at intuition, and the vast majority of trades happen on "gut feel" - so there is always the feeling of a loss of control when you let it all happen in an automated way. But you can't back-test "gut feel" and you can't establish how something might have worked in the past when it's based on intuition.

This goes for a lot of fundamental stuff too. People say that's better because it's a more logical way to invest. I doubt it. Fundamentals are scary in these times when companies will lie through their teeth to prevent their stock from falling, or scream buyback, or ask for SEBI to investigate - anything to protect their stock price. You can't trust anything anyone says - at least one thing you can trust is the stock price! And the concept of buy and hold will soon be apparently flawed, as people who bought RNRL at 212 and DLF at 1200 realise how interesting life becomes when you buy and hold for a long time.

Still, value works - and can be backtested - if there is a measure for value. You can check things like how far below we are from a long term moving average, how much cash a stock has in comparison to price, how much of past earnings growth over say 5 years is reflected in the P/E. These concepts can be back tested, and even automatically traded (imagine, automated fundamental trading!) The concept there may yield far too few trades - maybe a few a year - but may be far more attractive in the long term (10+ years)

Lastly people are cynical about such systems. They think it's a fad, it will go away. Yes, sorta like fundamental investing "went away". Or stock markets "go away". There are examples of HUGE profits from such systems - look at DE Shaw, Jim Simons of Rennaissance Technologies, Ken Griffin of Citadel or Man Investments. These guys manage billions and billions of dollars, through automated systems, and make a ton of money - some put their annual income (performance fees + management fees) as upwards of $1.5 billion. That's enough to silence most critics - because you only need one such case to DISPROVE the argument that systems don't work.

I'm not saying other forms of investing don't work. Warren Buffett's has, obviously, and so have those of Peter Lynch or Rakesh Jhunjhunwala. Or even the discretionary trading of John Arnold or Steve Cohen. But that doesn't mean pure automated systems don't work - they do, as the performance of the big hedge funds mentioned above are well known.

My aim, and Kaushik's, is to become that kind of automated trading firm for the Indian markets. Obviously we lack the money (otherwise life would be different) to invest in the technology and the connectivity/membership required to make this happen. Also the track record necessary to attract the right kind of money. Keeps us excited!

Okay, so why are we still so badly mauled? This is a time to be careful and please, respect those stop losses. I'm expecting another bounce soon, we're back to oversold territory.

Unfortunately this volatility ripped apart our systems. The two intraday systems made money on all the last three days - Tuesday going down 4%, Wednesday up 5% and Thu down 4%. On one system we are up nearly 10% in July (3 trading days) and the other, we're up 15%. Pretty good.

Our longer term systems got hosed pretty badly (in our view). One system is up only 1.5% in the last three days, and the other is down nearly 9% (which is lousy even if the system isn't designed to take this kind of volatility). Net of all four systems, we are at +0.33% for the month (each system has a different amount of money on it). With the index falling about 3% in the same time, we have done better, but this is not satisfactory - we should have gotten better results.

(Note: I'm not comparing earlier times. FTR, June has been kind to us: 9.9% returns versus a Nifty drop of -17%, and half of May - our first system went online on May 15 - was at 1.46% versus Nifty drop of -2.81%)

Am I going to reveal what's in the system? No. We need to run our money on it and this is our sole source of income - there is no way I will jeopardize that right now. And, we will eventually move into a money management role and then OTHER people's wealth will run on these (or variations of these) - and I don't want to let that opportunity go either.

But one thing is for sure: This is a SIMPLE system which takes only ONE factor into consideration: Stock Price. We trade only liquid stocks, and the systems look ONLY at price. If anything else is used it is volume (in determining which stock to trade). Sometimes the simpler the system, the better.

I will see if I can post a small graph of our systems (since we had real money behind it) versus the Nifty. I know this is just me showing off, but what the heck, I feel proud of it.

I think this field will soon need smart programmers. If you're interested in this field and have some ideas, touch base with me (deepakshenoy at gmail). What will be needed is people with a mind to automate, and the ability to code - not the trader who wants to put discretion into every trade. Meaning: if you think you have to be there to know the current news, the data, what people are saying etc. before buying or selling, we aren't going to gel. Eventually we want to create a hedge fund where all trading is done by computers and only a few people will exist - and make a lot of money.

The project gives you an idea about how trading systems can be created and what is important. While this uses U.S. data it can be applied to Indian data as well.