Sunday, 31 October 2010

Update on Trading

Back in the summer, I had thought that I had a pretty good outline of what it was that the trading would consist of. But what has surprised me is that we have been able to develop entire research programmes out of the basic model, and some of these are now ready to roll out into our trading. Dozens of these research programmes are currently in the works

A book I have been glancing at recently is a biography of Casanova. For traders, he is famous for his use of so-called "Martingale" betting systems - the familiar "double your bet if you lose, till next you win" strategy for 50/50 gambles. These fail as they require huge capital resources to make the next bet whenever there is a long losing sequence. And Casanova lost the fortune of the nun he was hoping to break out of the convent using just these methods. Such is life - haven't we all been in this situation. You seduce a nun, gamble away her fortune in an attempt to raise the money to buy her out of her convent, move on . . . .

I rather enjoyed the recent Heath Ledger movie

But one idea that does fall out from this is the idea of increasing a position if you have more reason to suppose that a favourable event can come out (something the original Martingale doesn't do). For instance, a counter-trend trader might open a position using a particular system and then, if the trade's open losses reach a particular level, a new position is opened, adding to the initial. This is not just doubling up a losing bet. It is more like a planned staggered entry into a trade, where the loss on the first trade is itself supposed to indicate that the probability of success with the second is now greater.

One area in which this sort of thing can become apparent is when you try to assess stop levels. Often it turns out that a trading system has no effective stops. For every stop that effectively avoids a large loss, there are trades that are losing at some point, but then rebound into profit and which are caught by the stop. Counter-trend systems are particularly prone to this sort of trade pattern - initial loss followed by rebound (while trend following often produces initial profit followed by give back). Indeed some potential stop points actually do worse than not doing anything, and these are the elusive new trade points.

We have been studying this issue in detail and are now splitting our trades into several pieces with the aim of adding the additional trades after the first has made losses. In honour of Casanova, we are calling these trades "Martingales", but actually they aren't really - there are just a form of progressive trade entry

Another new type of trade are our so-called "Taleb trades" (named in honour of Nassim Taleb, whose books I have been re-reading). We have decided that a very small part of what we do will be trades anticipating possible "Black Swan" events - huge moves well beyond our view of what is likely. So we have been buying massively out of the money crude oil calls and DAX puts. These have been set to cost us 2-3 pts a day. But if Israel bombs Iran and the Arab nations decide to withhold oil from the West, then the DAX could drop 20% and oil could rise $40. In this scenario, we would make around 200% in a day!

And well worth it at 2-3 pts a day when our daily gains continue to average around 40 pts a day.

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