What are we to do with Sharpe ratio - forex trading strategies today

What are we to do with Sharpe ratio ~ forex trading strategies today

I wrote several times before how useless Sharpe ratio is for certain types of strategies: see here and here. Not only is a high Sharpe ratio quite useless in telling you what damage extreme events can do to your equity, a low Sharpe ratio is also quite useless in telling you what spectacular gain your strategy might enjoy in the event of a catastrophe. I came across another brilliant example of the latter category in the best-selling book "The Big Short", where the author tells of the story of the fund manager Mike Burry.

Mike Burry started buying credit default swaps in 2005, essentially an insurance policy on mortgage-backed securities, betting that there will be widespread defaults on mortgages. Of course, we now know how this story would turn out: Mike Burry made $750 million in 2007 alone.  But there was nothing but pain for the fund manager and his investors in 2005-2006, since they had to pay an annual premium of 8% of the portfolio.  Investors who measured the performance of this strategy using Sharpe ratio, without knowing the details of the strategy itself, would be quite justified to think that it was an utter disaster prior to 2007. And indeed, many of them lost no time in trying to pull out their investments.

So what are we to do with Sharpe ratio, with its inherent reliance on Gaussian distributions? Clearly, it is useful for measuring high frequency strategies which you can count on to generate consistent returns every day, but which has limited catastrophic risks. But it is less useful for measuring statistical arbitrage strategies that hold positions over multiple days, since there may well be substantial hidden catastrophic risks in these strategies that would not be revealed by their track record and standard deviation of returns alone. As for strategies that are designed to benefit from catastrophes, such as Mike Burrys CDS purchases or Nassim Talebs options purchases, it is completely useless. If I were to allocate my assets over different hedge funds, I would be sure to include some funds in the first category to generate cash flows for my daily needs, as well as funds in the last category to benefit from the infrequent black-swan events. As for the funds in the middle category, I am increasingly losing my enthusiasm.
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Managed Forex What are The Pros and Cons - forex h4 trading system

Managed Forex What are The Pros and Cons ~ forex h4 trading system

The decision to invest in a managed Forex account can be a difficult one. This is a significant decision just like any investment you might make. The big difference in this investment compared to others is the leverage used.

The leverage is actually borrowed money that the broker has given you. Because you are borrowing money you give them the right to close any trade as they need to protect themselves. If you agree to this then sign up and start trading.

If you have made the decision to invest in the Forex market then there are three different accounts you can invest into: standard, mini, and managed. Each option has both pros and cons and it will be up to you to decide which account is best for your needs.

1. Standard. This type of account is the most common. Basically you have access to a major amount of currency. The worth is $100,000. You do not have to put the $100,000 down in order to do trading. Basically, you need $1,000 in the account for t his to work.

Pros Forex brokers will often times give extra benefits and services to this type of account. The potential gain is also the very high as you are investing a serious amount of money into each and every trade.

Cons Capital Requirement - Most brokers would require you to have a starting balance of at least $2,000 and others more than that. Potential to Lose - Just like you could make $1,000 a day, you could also lose that $1,000 in a day.

2. Mini - This account allows money to be moved in blocks or lots. The mini lot is roughly $10,000.

Pros Risk - The risk is much lower because you are using such smaller lot sizes. This is great for who have little to no experience trading the forex market. It also allows for you to test out trading strategies with less risk. Capital required - The amount to start an account can be as little as $250.

Con Low reward - Because you are risking such a small amount of money then of course the potential gains will be much smaller.

3. Managed Account - The managed Forex account is different than the others. You allow your money to be traded by a professional trader in the hopes that he can do a better job than you.

Pro Professional trader - A trader with years of experience will be trading your account giving you more time as you will not have to constantly watch the market.

Cons Fees - You will be required to pay a fee of 20% to 50% of all the gains made on the account each month. Capital - Most managed accounts will have a minimum investment amount of $5,000 to as much as $100,000.

It is always wise to research as much as possible to see which option best fits your needs. Always remember it is your money and you have to be the one watching over it.

By Ryan D. Moxie
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Are Triple Leveraged ETFs suitable for long term holding - forex trading strategies with macd

Are Triple Leveraged ETFs suitable for long term holding ~ forex trading strategies with macd

Triple leveraged ETFs marketed by Direxion have been all the rage lately. The fund management company says that they do not recommend buying and holding these ETFs. But is there any mathematical justification for this caution?

Before I answer this, it is interesting to note that these ETFs (e.g. BGU is 3x Russell 1000, TNA is 3x Russell 2000) are managed as constant rebalanced portfolios, a concept I discussed before. In other words, the fund manager has to sell stocks (or futures) when there is a loss, and buy stocks (or futures) when there is a gain in the market value of the portfolio, in order to maintain a constant leverage ratio of 3. This is also identical to what Kelly formula would prescribe, a methodology discussed extensively in my book, if the optimal leverage f were indeed 3.

However, the optimal f for such market indices are quite a bit lower than 3. Both Russell 1000 and 2000 have f at about 1.8. This means that since the funds are leveraged at 3, there is a real possibility that sustained losses could ruin the funds (i.e. NAV going to zero unless new capital is injected, which, er..., reminds me of a Ponzi scheme). So I would argue that not only should an investor not hold these funds for the long term, the funds themselves should not be leveraged at this level. Otherwise, it is a disaster waiting to happen.
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What are we hedging here - forex trading system australia

What are we hedging here ~ forex trading system australia

I wrote a blog article last year on why hedging isnt always better. The more I try to practice what I preached, the more I am convinced that most of the time, we are hedging the wrong risks.

Hedging should not be about reducing volatility in our portfolio. If reducing overall volatility is our goal, we should simply reduce leverage, as I have argued in my previous article. If volatility in a particular industry group is too much for us, (banks? brokerages? energy stocks?), just reduce the capital allocation in that group.

Sure, if hedging does increase your overall Sharpe ratio, go ahead and hedge to your hearts content. Kellys formula tells us that the higher the Sharpe ratio, the higher the compounded growth rate of your wealth. The problem is, many of us hedge even when doing so do not clearly increase Sharpe ratio. A further problem is that we can achieve this maximum growth rate only if we use the high leverage recommended by Kellys formula, but this leverage often exceeds what our brokerage would allow us. It is not clear that it is beneficial to waste our buying power on the hedge if we can only operate at sub-optimal leverage.

To me, hedging should be about eliminating the risk of ruin (equity reduced to zero) due to unexpected, catastrophic events. (Many sophisticated hedge fund managers cannot even meet this simple survival criterion, giving lie to the whole notion of "hedge" funds.)

For instance, lets assume that the worst one-day drop in the market index can be 20%. Furthermore, lets assume that you are able to endure a 30% reduction in equity during one trading period. Then you should not be afraid to have a net long exposure of 150% of your equity. In other words, not only should you not hedge, but you should go ahead and leverage your long-only portfolio 1.5 times.

I believe this notion of hedging, or buying insurance, extends to all spheres of our lives. We should avoid ruin, not mere losses. Otherwise, you will be paying too much on the insurance policy over the long term. In other words, max out the deductible on your insurance policy!
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Implementing stock strategies using options - forex trading strategies tutorial

Implementing stock strategies using options ~ forex trading strategies tutorial

There are many stock trading strategies that are quite attractive in terms of Sharpe ratios, but not very attractive in terms of returns. (Pairs trading comes to mind. But in general, any market neutral strategy suffers from this problem.)  Certainly, one cannot feed a family with annualized returns in the single or low double digits, unless one already has millions of dollars of capital. One way to solve this dilemma is of course to join a proprietary trading group, where we would have access to perhaps x30 leverage. Another way is to implement a stock trading strategy using options instead, though there are a sizable number of issues to consider. (I recently brushed up on my options know-how by reading the popular "Options as a Strategic Investment".)

1. Using options will allow you to increase your leverage beyond the Reg T x2 leverage (or even the day trading x4 leverage) only if you buy options only, but not selling them. For example, to implement a pairs trading strategy on 2 different stocks, you would have to buy call options on the long side, and buy put options on the short side (but not sell call options). Otherwise the margin requirement for selling calls is as onerous as shorting the underlying stock itself.
2. The effective leverage is computed by multiplying the delta of the option by the underlying stock price divided by the option premium. If you buy an out-of-money (OTM) option, the delta will be small (smaller than 0.5), but the option premium is small also. Vice versa for an in-the-money (ITM) option. So you would have to find the optimal strike price so that the effective leverage is maximized. I personally choose to buy an at-the-money (ATM) call or slightly ITM call without actually computing the optimized strike, but perhaps you have reached a different conclusion?
3. Naturally, the shorter the time-to-expiration, the cheaper the option and higher the effective leverage. Additionally, for ITM options, their deltas increase as we get closer to expiration, which also contributes to higher effective leverage. However, the time-to-expiration must of course be longer than the expected holding period of your position, otherwise you would incur the transaction cost of rolling over to the further-month options.
4. The discussion of finding the right strike price based on its delta is moot if your brokerages API does not provide you with delta for your automated trading system. In theory, Interactive Brokerss API provide deltas for whole options chains, and quant2ibs MATLAB API will pass these on to your MATLAB exeuction program too. However, I have not been successful in retrieving deltas using quant2ibs API. If you have encountered a similar problem, and perhaps have found the reason/cure for this, please let me know. For now, I am reduced to assuming that all my near ATM calls for different stocks have the same delta, and I increase this common value from 0.5 to close to 1 as time passes.
5. Options dont have MOO, LOO, MOC or LOC order types. If one uses market orders to buy at the open or close, one would incur significant transaction costs due to the much wider bid-ask spread compared to stocks. I try to use limit orders on options orders as much as possible.

If you have used options to implement stock trading strategies, and have experiences with these or other issues, please do share them here.

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Reminder: my next pairs trading workshop will take place in New York on October 26-27th.
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Are financial speculations really harmful human activities - forex trading strategy using pivot points

Are financial speculations really harmful human activities ~ forex trading strategy using pivot points

It is worrisome when not one but two eminent economists denounced financial speculation as "harmful human activities" in the short space of 2 weeks. (See Paul Krugmans column here and Robert Franks here.) It is more worrisome when their proposed cure to this evil is to apply a financial transaction tax to all financial transactions.

Granted, you can always find this or that situation when financial speculation did cause harm. Maybe speculation did cause the housing bubble. Maybe speculation did cause an energy price bubble. In the same vein, you can also argue that driving is a harmful human activity because cars did cause a few horrific traffic accidents.

No, we cant focus on a few catastrophes if we were to argue that financial speculation is harmful. We have to focus on whether it is harmful on average. And on this point, I havent seen our eminent economists present any scientific evidence. On the other hand, as an ex-physicist and an Einstein-devotee, I can imagine some  thought experiments (or gedankenexperiment as Einstein would call them), where I can illustrate how the absence of financial speculation can clearly be detrimental to the interests of the much-beloved long-term investors. To make a point, a gedankenexperiment is usually constructed so that the conditions are extreme and unrealistic. So here I will assume that the financial transaction tax is so onerous that no hedge funds and other short-term traders exist anymore.

Gedankenexperiment A: Ms. Smith just received a bonus from her job and would like to buy one of her favorite stocks in her retirement account. Unfortunately, on the day she placed her order, a major mutual fund was rebalancing its portfolio and had also decided to shift assets into that stock. In the absence of hedge funds and other speculators selling or even shorting this stock, the price of that stock went up 40% from the day before. Not knowing that the cause of this spike was a temporary liquidity squeeze, and afraid that she would have to pay even more in the future, Ms. Smith paid the ask price and bought the stock that day. A week later, the stock price fell 45% from the peak after the mutual fund buying subsided. Ms. Smith was mortified.

Gedankenexperiment B: Mr. Smith decided that the stock market is much too volatile (due to the lack of speculators!) and opted to invest his savings into mutual funds instead. He took a look at his favorite mutual funds performance, and unfortunately, its recent performance seemed to be quite a few notches below its historical average. The fund manager explained on her website that since her fund derived its superior performance from rapidly liquidating holdings in companies that announced poor earnings, the absence of liquidity in the stock market often forced her to sell into an abyss. Disgusted, Mr. Smith opted to keep his savings in his savings account.

Of course, our economists will say that the tax is not so onerous that it will deprive the market of all speculators (only the bad ones!?). But has anyone studied if we impose 1 unit of tax, how many units of liquidity in the marketplace will be drained, and in turn, how many additional units of transaction costs (which include implicit costs due to the increased volatility of securities) would be borne by an average investor, who may not have the luxury of submitting a limit order and waiting for the order to be filled?
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Why are quantitative funds losing money these days - best forex trading system free download

Why are quantitative funds losing money these days ~ best forex trading system free download

The New York Times today has an article about several well-known quantitative hedge funds incurring significant losses in recent months. I was quoted in saying that traders running similar quantitative models could contribute to market volatility. This is certainly true if the strategies are trend-following. What puzzles me, however, is that most statistical arbitrage strategies are mean-reverting: they buy during investors panic, and sell during investors euphoria, and should be richly rewarded in this volatile market by providing sorely needed liquidity. And indeed, from my own experience as well as hearing from other traders, mean-reverting strategies are performing very well recently. So where did those losses come from? My guess is that, as I have observed before, many traditional stat arb strategies are getting boring and generating diminishing returns, and therefore many of the quantitative researchers are driven (by their own professional pride or their bosses) to come up with more exotic and higher-return strategies that ultimately may not stand the test of time. For us quants, remembering Occams razor and that our job is to generate returns as opposed to producing brilliant mathematical models is often a hard lesson to learn.
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Are flash orders really so bad - free forex trading strategies videos

Are flash orders really so bad ~ free forex trading strategies videos

I confess I dont know much about flash orders, not being one of the Big Boys on the Street, until I read that the SEC is banning them. (For a clear diagrammatic explanation of flash orders, see here. For a refutation of some of the myths and misunderstanding surrounding flash orders, see here.)

It seems to me that flash orders can be understood as "request for liquidity" issued to various potential market makers/liquidity providers, not unlike the usual "request for quotes" (RFQ) common in other industries. They are issued when there is not enough liquidity on a specific exchange to satisfy an investors need, and they ultimately benefit investors by lowering their transaction costs. The fact that high frequency traders are able to make lots of money by providing this liquidity is besides the point. Liquidity providers are supposed to make money by providing liquidity!

Some people, including Senator Charles Schumer and this New York Times op-ed, believe that flash orders are akin to front-running, a clearly illegal trading activity. But they are wrong. Front-running means that if you know someone is going buy a stock, you step in front of them
and buy it cheaply first, hoping to sell it to this slower buyer at a higher price. In the case of flash orders, the high frequency traders are instead selling this stock to the original investor, often at a lower price than available elsewhere and thus benefiting this investor, hoping that the prices will come down in the future after this liquidity need subsides. This is manifestly not illegal. This is what a market is built for!

Another way to understand that flash orders are not at all front running is that anybody, including you and me, are free to put in limit orders at the same price as those of the high frequency traders, way ahead of time, in a specific exchange, and become liquidity providers ourselves. You dont have to wait for a "request for liquidity" before doing so. And presumably you will reap the same benefits as the high frequency traders. You are not taking any additional risks over the HF traders either, since if no requests for liquidity ultimately arrive, you are not any worse off for wear. You cannot begrudge the profits of the HF traders just because you didnt put the limit orders in place beforehand!

Maybe there are some other angles which I miss which can convince me that flash orders are evil. But until my kind readers convince me otherwise in the comments section, I will regard this piece of legislation as another SEC attempt at demagoguery.
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Are quant strategies in trouble yet again - acb forex trading system

Are quant strategies in trouble yet again ~ acb forex trading system

There were reports that quant strategies have been suffering again in January, given the market turmoil generated partly by the Societe Generale scandal. Mr. Matthew Rothman of Lehman Brothers pinned the blame on momentum strategies (Hat tip: 1440 Wall Street). I partly agree with that assessment, but the full picture is more nuanced.

As I have written in my previous post, December has been a disastrous month for value (or mean-reverting) strategies, based on both public commentaries and personal experience. Yet, as always, mean-reverting strategies bounced back in January and all the pain is gone. In fact, the Societe Generale scandal and the subsequent 1/22 Fed bailout has been a huge bonanza to mean-reversion traders, just like the August disaster had been. (Remember: mean-reversion traders profit from providing liquidity during market panic.) Meanwhile, though December has been a good month for momentum strategies, January has become increasingly inhospitable to them. But one should not be surprised at all. As I have explained before, momentum strategies generally tend to be more unstable and have lower Sharpe ratios than reversal strategies. Any wise quantitative portfolio managers would always allocate a lower proportion of capital to momentum strategies than to reversal strategies. Hence it is no excuse at all to say that a quant portfolio has been hurt by losses in momentum trading -- they are to be expected quite frequently!
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Are high oil prices due to hedge fund speculation - andrew forex trading system

Are high oil prices due to hedge fund speculation ~ andrew forex trading system

The economist Paul Krugman advances an interesting argument today in the New York Times against the idea that high oil prices are due to hedge fund speculation.

He believes that speculative buying can lead to persistent high prices (which has been the case for the last few years) only if there is physical hoarding. Yet oil inventory level has been normal for this period.

Indeed, I have been trying to find a mean-reverting strategy to trade oil and oil-related assets for some time now. So far, none have outperformed (even on a risk-adjusted basis) just buy-and-hold energy stocks for the long term!


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An update on why quantitative funds are losing money recently - best forex trading system ever

An update on why quantitative funds are losing money recently ~ best forex trading system ever

A story just came through Dow Jones newswire ("How Black Boxes Became Pandoras Boxes" by Spencer Jakab) suggesting that recent losses are due to factor models gone bad. Given my expressed distaste for such models, that should have been my first guess instead of blaming the "exotic" models!
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Are flash orders to be blamed for Dows 1 000 points drop - forex trading methods that work

Are flash orders to be blamed for Dows 1 000 points drop ~ forex trading methods that work

Before the smoke is clear, fingers are already pointing at flash orders. See these two NYT pieces here and here. Our reader Madan has convinced me previously that flash orders can indeed be used to  front-run other traders, but until more evidence comes in, I am yet to be convinced that they are the main culprit. Couldnt old-fashioned automated momentum programs accomplished the same thing after an initial erroneous transaction price and/or quote was reported? Perhaps you know of discussions elsewhere on the blogosphere that bring more light to the issue?
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