It's Easier to Hit Singles Than Home Runs
Our professors and partners have come from as far away as Australia to contribute their wisdom and guidance. Throughout the next two days we will be highlighting some of their ideas on managing risk and staying in the game as catalysts for discussion.
-I'm using a risk-adjusted strategy to trade the U.S. / European equity and fixed income futures markets (U.S. equity indices are the primary focus). The approach seeks to combine discretionary trade decisions with historical analogs and allocate risk based upon the probability of the trade's success.
-It's important to distinguish between probability and predictability. We cannot predict with certainty the direction of equity markets. The statistical margin of error alone creates an unacceptable level of inherent risk. However, I believe that patterns generally recur and that some level of probability can therefore be assigned. To calculate this, I use historical analogs that are based upon short-term patterns in the markets. I am interested in the consistency of the open, high, low as well as the close. The patterns are often referenced against exterior events such as: economic releases, earnings dates, seasonal tendencies, other markets, and actual date / times of the month.
-As you would expect, the timeframe for these trades is very short-term (1-5 days). Reducing the timeframe allows us to remove the fundamental influences on the market and focus instead on the impact of emotion and psychology. Naturally, no method is perfect and there are some drawbacks to this approach: (1) the strategy is very location sensitive; (2) the method will tend to under-perform in trending markets; and (3) patterns may repeat generally but rarely are they identical. The advantage is a well-executed policy of risk management.
-Consistency: At the risk of sounding cliché, it is easier to hit singles than home runs.
-Probability: The impact of emotion on markets is a recurrence of similar patterns. The outcomes become even more probable when the study surrounds exterior events.
-Systems: The increase in trade systems is one of a number of reasons that volatility continues to contract. Generally speaking, markets have become even more mean reverting. But this creates significant risk to the exception trade. Let's use the current year as an example. Despite little movement in the broader indices, we've seen a substantial number of record streaks (of higher or lower closes) in widely held individual names and sectors. This is a direct result of trend following systems and highlights the enormous risk to the "outlier" trade.
Outlook for the financial markets:
-Markets: Small-cap stocks will under-perform large-caps over the next several years. The annual return for the Russell 2000 exceeded the S&P 500 for each of the past five years. And historically, a flattening yield curve has had a more negative impact on the smaller cap stocks.
-Investments: CTA (Commodity Trading Advisor) funds will become the next bubble in alternative investments. Although CTA assets under management have increased to more than 125 billion, only 23 managers control 95% of those assets. And more than 25% of the total is controlled by just 3 managers. I expect more investors will seek return via CTA funds and the number of managers to increase accordingly.
Thoughts on controlling risk and staying in the game:
-You don't have to trade. I'd rather miss a trade than press one with fewer odds of success. It's simply a function of risk
-Analyze your risk / reward per unit of trade.
-You don't have to be right; you just have to make money.
-There are essentially two types of days. Roughly 1 in 8 days are trend days and the rest are range trades. Learn to recognize and anticipate them.
-"One stock does not make a market"
-"Triple bottom in pattern identifies 2004 low"
If I could give one piece of advice to attendees:
Trading is unlike any other profession. You may be wrong as often as you are right (imagine lasting more than a week in any other career). The key to long-term success lies in your ability to accept this fact and adapt to changing markets.
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