The bulk of today’s research into market action is being employed into attempts to predict the future movement of securities, futures, derivatives, commodities, interest rates, etc. with little success as the markets move in a dynamic fashion. It appears you have spotted trends but they disappear as fast as they appear (usually when you start using them). The other problem is that researchers have a bias toward accepting an unknown as a risk that can be controlled. Even from the beginning, if a system does not sock you in the face the results are probably full of errors that are unknown by simply looking at the summary sheets. These errors often include optimization, lumping of returns, unrealistic drawdowns, small sample, carefully crafted starting and ending dates, corrupt data, and underestimating slippage (esp. systems that trade with the trend).
It has been said that a rising market is a genius. This is realized by buying randomly at any point in a rising market and holding on. In a normal market there are both up and down periods and your entry is not as important as your exit. The entry determines your risk but your exit determines your returns.
Market information is dissipated on a large and fast scale and informed investors such as market makers quickly fill any gaps in info. The question then becomes how can one profit when most market participants have access to the same market information? It may appear that short term and long term moves have a logical reason behind them as can be seen on CNBC or NBR, but these are merely a rational for the journalist presenting a story. The principals to determining any move is the flow of money (no not that technical indicator, you are thinking of), otherwise known as tactical asset allocation. If the money managers are not moving the money then the public or institutions will do it for them. Nothing better reflects this than the price moves of major indexes, interest rates, currencies, derivatives, volatility and to a lesser extent gold (this may be because gold is high risk – something most fund managers would like to avoid as it may cost them what is most precious to them, staying with the pack). The further one goes from the above the further one goes to adding unnecessary risk to their investments.
Today market analyses seem to be able to make use of any tidbit of market data available. It seems that everything is connected in a way only they can figure out. New theories are constantly being tossed about and new technologies being used. Technology is best used if your market theories are valid, however since most things are connected technology will make that connection even if it only exists in your computer. It would seem that the firms making the best use of technology are those using it to assess risk (as seen by the explosive growth of derivatives) rather than some sort of price projection.
It seems one of the most profitable plans of investment is not predicting the movement of your securities but limiting the risk. With off the shelf trading software such as
Tradestation or Metastock we can develop and test trading models. Unfortunately most strategies are used to tout trading systems using limited data and only a summary sheet for listing results. Fortunately such software also has available such tools as percent drawdown on each trade and month to month drawdown. The analysis shows the maximum drawdown on each trade and one quickly notices that a losing trade over a certain percentage (depending on your time frame) stays a losing trades. On the winning side you will most likely have the opposite with a few winners accounting for most of your gains. You must pursue statistically valid strategies.
These results show that losing trades for the most part stay as losing trades. It also highlights the point that exiting trades is far more important than the entry. Just by manipulating this info one could design a winning system.
There seems to be a gambler mentality on the markets that are hot esp. in the options and futures markets. With potential to accumulate great wealth with limited funds it is easy to see the lure. The lure fails to tell the other side of leverage; if it is so easy then why is not every trader successful but only a few percent. The truth is that people playing the hot markets are looking for home runners and they believe this is achievable with limited downside risk.
The question these people should be asking themselves is why is someone willing to risk writing options or futures for only a small gain and assuming an unspecified potential loss. When one looks closely at how many options expire worthless of for much less than they originally were written for you begin to see a clearer picture. Although a writer has unspecified potential loss in reality they have set themselves a threshold of how much total risk they are willing to assume. We can not know the writer’s risk without knowing his entire portfolio.
Risk is the element that the writer attempts to tame where as the buyer attempts to predict price movement within a specified time frame. The buyer most likely believes they have some uncanny ability to predict the markets or that the next move is about to occur because with new indicator is telling him that. Even if the buyer is correct in his assumption that the market is about to move he still has to deal with premium erosion esp. in near term contracts. This erosion is the best ally of the writer. The other factors may be decreased volatility or simply prices moving nowhere or even moving away from his contract.
Since there is a library of information published on option time decay I have attempted to work with the other more important variable, risk. In my attempts to construct profitable tactical asset allocation models I began looking more intensely on losing situations and drawdowns. There appears to be a subtle relation between losing trades and longer-term growth (after each loss you need to gain more to break even). As exits are in our opinion more important than your entry point, any trading methodology must be profitable both on long and short positions. In our work to develop tactical asset allocation strategies we have focused on initiating profitable short positions as markets have steadily increased in the 1990’s and on profitable long positions for the last three years. On review of current commercial trading models you will find over 90% will only show you the long profitable trades. If models can produce profits opposite to the general trend then you begin to see the value of exits.
In summary, there are a lot of asset allocation models that appear to be scientific but are no more than attempts to squeeze information from minimal data or create unreadable statistical models. Focus must be on the downside risk and the correct methods of analysis. After all a 25% loss in one year will require a 50% gain in the next year just to break even – a two year period of no growth and you will find yourself losing most of your clients.
