Month: February 2013

Financial Research Summaries

Since I’m cheap, I’ve been looking around for a FREE alternative to Quantpedia, which is a website for summaries of academic research. I found what I was looking for over at Turnkey Analysts’ Academic Alpha Database. So far it has 67 academic papers summarized, but I assume more will continue to come.

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Scaling In (Part Three): IBS & RSI

On my previous two posts regarding pyramiding (first post, second post), I tested three different entry methodologies using a DV2 across multiple securities. To obtain further results of the entry methodology within mean-reversion trading systems, I will test it on a simple IBS system and 2-day RSI system.

IBS

SPY

Default (Buy 100% of equity when IBS < 45, Sell 100% of position when IBS > 50):

  • Exposure: 42.51%
  • CAGR: 10.33%
  • MDD: 25.28%

Purchase at first Dip (Buy 100% of equity the first day the close is less than the close of the day IBS < 45, Sell 100% of position when IBS > 50):

  • Exposure: 16.57%
  • CAGR: 7.38%
  • MDD: 15.63%

Scale In(Buy 50% of equity when IBS < 45, Buy 50% of equity more the first day the close is less than the close of the day IBS < 45, Sell 100% of position when IBS > 50):

  • Exposure: 28.59%
  • CAGR: 8.77%
  • MDD: 19.49%

Nasdaq-100

Default(Buy 6% of equity when IBS < 45, Sell 100% of position when IBS > 50):

  • Exposure: 77.56%
  • CAGR: 24.06%
  • MDD: 41.65%

Purchase at a Dip(Buy 18% of equity the first day the close is less than the close of the day IBS < 45, Sell 100% of position when IBS > 50):

  • Exposure: 68.46%
  • CAGR: 41.04% (Better than DV2)
  • MDD: 32.76%

Scale In(Buy 3% of equity when IBS < 45, Buy 3% of equity more on each subsequent day the close is less than the close of the first day IBS < 45, Sell 100% of position when IBS > 50):

  • Exposure: 71.42%
  • CAGR: 29.46%
  • MDD: 40.33%

Individual Nasdaq-100

Lastly, I tested a system individually on each Nasdaq-100 stock.

Default(Buy 100% of equity when IBS < 45, Sell 100% of position when IBS > 50):

  • Average of Exposure: 44.96%
  • Standard Deviation of Exposure: 2.87%
  • Average of CAGR: 14.58%
  • Standard Deviation of CAGR: 16.04%
  • Average of MDD: 29.14%
  • Standard Deviation of MDD: 16.11%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day IBS < 45, Sell 100% of position when IBS > 50):

  • Average of Exposure: 17.04%
  • Standard Deviation of Exposure: 2.55%
  • Average of CAGR: 3.94%
  • Standard Deviation of CAGR: 9.06%
  • Average of MDD: 21.57%
  • Standard Deviation of MDD: 14.23%

Scale In(Buy 50% of equity when IBS < 45, Buy 50% of equity more the first day the close is less than the close of the first day IBS < 45, Sell 100% when IBS > 50):

  • Average of Exposure: 30.82%
  • Standard Deviation of Exposure: 3.77%
  • Average of CAGR: 9.38%
  • Standard Deviation of CAGR: 11.37%
  • Average of MDD: 23.76%6.96/25.2
  • Standard Deviation of MDD: 14.97%

RSI

SPY

Default(Buy 100% of equity when RSI < 50, Sell 100% of position when RSI > 50):

  • Exposure: 44.40%
  • CAGR: 9.20%
  • MDD: 25.90%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day RSI < 50, Sell 100% of position when RSI > 50):

  • Exposure: 25.27%
  • CAGR: 6.96%
  • MDD: 19.80%

Scale In(Buy 50% of equity when RSI < 50, Buy 50% of equity more the first day the close is less than the close of the day RSI < 50, Sell 100% of position when RSI > 50):

  • Exposure: 34.87%
  • CAGR: 8.19%
  • MDD: 20.34%

Nasdaq-100

Default(Buy 2% of equity when RSI < 50, Sell 100% of position when RSI > 50):

  • Exposure: 68.08%
  • CAGR: 19.74%
  • MDD: 41.65%

Purchase at a Dip(Buy 6% of equity the first day the close is less than the close of the day RSI < 50, Sell 100% of position when RSI > 50):

  • Exposure: 71.59%
  • CAGR: 32.28%
  • MDD: 31.40%

Scale In(Buy 3% of equity when RSI < 50, Buy 3% of equity more on each subsequent day the close is less than the close of the first day RSI < 50, Sell 100% of position when RSI > 50):

  • Exposure: 69.75%
  • CAGR: 29.68%
  • MDD: 34.54%

Individual Nasdaq-100

Default(Buy 100% of equity when RSI < 50, Sell 100% of position when RSI > 50):

  • Average of Exposure: 44.73%
  • Standard Deviation of Exposure: 5.85%
  • Average of CAGR: 9.03%
  • Standard Deviation of CAGR: 11.96%
  • Average of MDD: 60.83%
  • Standard Deviation of MDD: 21.23%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day RSI < 50, Sell 100% of position when RSI > 50):

  • Average of Exposure: 26.98%
  • Standard Deviation of Exposure: 3.39%
  • Average of CAGR: 9.03%
  • Standard Deviation of CAGR: 10.24%
  • Average of MDD: 50.77%
  • Standard Deviation of MDD: 20.91%

Scale In(Buy 45% of equity when RSI < 50, Buy 45% of equity more the first day the close is less than the close of the first day RSI < 50, Sell 100% when RSI > 50):

  • Average of Exposure: 37.99%
  • Standard Deviation of Exposure: 2.19%
  • Average of CAGR: 10.27%
  • Standard Deviation of CAGR: 11.25%
  • Average of MDD: 55.67%
  • Standard Deviation of MDD: 21.57%

Conclusion

At a quick glance, it’s clear that purchasing at the first dip for mean reversion trading systems seems to offer the best risk/reward ratio. At times, the differences are marginal, but after factoring for exposure, purchasing at first dip exceeds scaling in in (5/6) tests and the default trading system in (5/6) tests, on an absolute and risk-adjusted basis.

Scaling In (Part Two)

On Scaling In: Confusion (Part One) regarding pyramiding, I discussed the possibility of the Avg. Profit/Loss% performance metric being a subpar measure of system performance. To get a better understanding of system performance of buying on pullbacks, scaling, and default mean reversion trading systems, I decided to use two other performance metrics (three if you consider exposure a performance metric).

SPY

Default(Buy 100% of equity when DV2 < 50, Sell 100% of position when DV2 > 50):

  • Exposure: 49.61%
  • CAGR: 13.03%
  • MDD: 27.82%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Exposure: 25.52%
  • CAGR: 9.36%
  • MDD: 19.80%

Scale In(Buy 50% of equity when DV2 < 50, Buy 50% of equity more the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Exposure: 37.64%
  • CAGR: 11.50%
  • MDD: 21.94%

Nasdaq-100

Default(Buy 2% of equity when DV2 < 50, Sell 100% of position when DV2 > 50):

  • Exposure: 69.75%
  • CAGR: 33.44%
  • MDD: 27.70%

Purchase at a Dip(Buy 6% of equity the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Exposure: 68.07%
  • CAGR: 37.03%
  • MDD: 29.98%

Scale In(Buy 1% of equity when DV2 < 50, Buy 1% of equity more on each subsequent day the close is less than the close of the first day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Exposure: 68.43%
  • CAGR: 38.03%
  • MDD: 27.22%

Individual Nasdaq-100

Default(Buy 100% of equity when DV2 < 50, Sell 100% of position when DV2 > 50):

  • Average of Exposure: 44.58%
  • Standard Deviation of Exposure: 6.43%
  • Average of CAGR: 15.76%
  • Standard Deviation of CAGR: 10.68%
  • Average of MDD: 54.95%
  • Standard Deviation of MDD: 19.95%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Average of Exposure: 24.22%
  • Standard Deviation of Exposure: 2.69%
  • Average of CAGR: 9.81%
  • Standard Deviation of CAGR: 8.22%
  • Average of MDD: 46.23
  • Standard Deviation of MDD: 18.34

Scale In(Buy 50% of equity when DV2 < 50, Buy 50% of equity more the first day the close is less than the close of the first day DV2 < 50, Sell 100% when DV2 > 50):

  • Average of Exposure: 36.82%
  • Standard Deviation of Exposure: 2.18%
  • Average of CAGR: 14.42%
  • Standard Deviation of CAGR: 9.66%
  • Average of MDD: 49.77%
  • Standard Deviation of MDD: 19.06%

Conclusion

The differences between each method seems negligible. Personally, I plan to use the purchase at first dip method. Even though the scaling in method and the first dip method have similar CAGRs after factoring for exposure (the first dip method has marginally higher CAGRs for 2/3 tests), the scaling in method will have higher commissions and slippage costs. The first dip method also had a lower MDD on 2/3 of the tests, but that has little to do with my decision. In Scaling In (Part Three) I reach similar conclusions, testing these entry methodologies across two other simple mean-reversion trading systems.

Scaling In: Confusion (Part One)

I’ve never quite understood the rational for scaling in for mean-reversion type trading systems. Scaling in for trend-following trades is simple and intuitive. By trading only a portion of your allocated capital at first, you can wait for further confirmation of the trend until you trade the rest of your capital. The trade off is that you will receive a worse entry price. However, for mean-reversion trading strategies you receive a better entry price at the cost of less trading opportunities. This may seem obvious, but my question is why scale in at all? Why not just place 100% of the order on the first or the second scaled-in purchase signal? Intuitively, it seems like either purchasing 100% of the position at the initial buy signal, or purchasing 100% of the position at the first dip after the buy signal, would produce the best results, and scaling in would only produce a return somewhere in between the other two results.  To test this out, I backtested three frictionless versions of a simple long-only DV2 system on SPY from 1/1/2000 – 2/5/2013.

Default(Buy 100% of equity when DV2 < 50, Sell 100% of position when DV2 > 50):

  • Number of trades: 573
  • Avg. Profit/Loss %: 0.30%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Number of trades: 292
  • Avg. Profit/Loss %: 0.43%

Scale In(Buy 50% of equity when DV2 < 50, Buy 50% of equity more the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Number of trades: 575
  • Avg. Profit/Loss%: 0.55%

I tested a similar system on all Nasdaq-100 stocks (that are currently listed as of 2/15/2013. Does contain survivorship bias).

Default(Buy 2% of equity when DV2 < 50, Sell 100% of position when DV2 > 50):

  • Number of trades: 38998
  • Avg. Profit/Loss%: 0.52%

Purchase at a Dip(Buy 6% of equity the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Number of trades: 13056
  • Avg. Profit/Loss%: 0.59%

Scale In(Buy 1% of equity when DV2 < 50, Buy 1% of equity more on each subsequent day the close is less than the close of the first day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Number of trades: 37342
  • Avg. Profit/Loss%: 1.48%

Lastly, I tested a system individually on each Nasdaq-100 stock.

Default(Buy 100% of equity when DV2 < 50, Sell 100% of position when DV2 > 50):

  • Average of Avg. Profit/Loss%: 0.50%
  • Standard Deviation of Avg. Profit/Loss%: 0.22%

Purchase at first Dip(Buy 100% of equity the first day the close is less than the close of the day DV2 < 50, Sell 100% of position when DV2 > 50):

  • Average of Avg. Profit/Loss%: 0.57%
  • Standard Deviation of Avg. Profit/Loss%: 0.34%

Scale In(Buy 50% of equity when DV2 < 50, Buy 50% of equity more the first day the close is less than the close of the first day DV2 < 50, Sell 100% when DV2 > 50):

  • Average of Avg. Profit/Loss%: 1.07%
  • Standard Deviation of Avg. Profit/Loss%: 0.26%

The results produce a unanimous conclusion across all three tests: scaling in produces the best average profit/loss. The only possible explanation I can think of is this: Avg. Profit/Loss % is independent of position sizing (meaning that a 2% gain on 50% of equity is the same as a 2% gain on 100% of equity) so scaling in would produce an outsized Avg. Profit/Loss% because the system contains the trades that never face a loss throughout its life, while being able to average down on trades that do contain a loss. Since these two types of trades will be weighted equally in the calculation of Avg. Profit/Loss% (because of the fact that the metric is independent of position sizing) it substantially boosts Avg. Profit/Loss%. In essence, I picked a subpar performance metric (Scaling In (Part Two) is a posts that run the same tests with a different performance metric). If anyone has any other insights as to why this occurs, please comment below!

Short Selling

My mentor discouraged me from short selling completely until I become a more skilled trader due to its inherent disadvantages. Profitable trading, after all, is the accumulation of small statistical edges that, over time, will produce sustained profits. Here are the disadvantages inherent one faces when short selling:

  1. Asymmetric Returns
    • There is only a possibility of 100% returns, while the downside risk is theoretically unlimited. It is rare, but it is certainty not unheard of for stocks to increase over two-fold.
  2. Negative Edge
    • The markets have historically had an upward bias. This upward bias is not limited to US or European markets only.
  3. Psychology/Career Risk
    • It is easy to make money while others are losing it, but extremely difficult to lose money while everyone else is gaining, especially if you are a professional money manager.
  4. Recall Risk
    • Possibility of the lender requesting the stock back from the borrower before he/she is prepared to close-out. One study suggests that this occurs to roughly 2% of loans.
  5. Rebate Rates
    • These are the rates a borrower is paid for his cash collateral, which are determined by the supply/demand for borrowing a stock. Taken from Fabozzi’s Short Selling: “on less widely held securities or securities with large borrowing demand, rebate rates may be reduced, in which case, the securities are said to be “trading special” or just “special…… In rare cases, when a stock is in high demand, the rebate rate can be significantly negative…. Only well-placed investors (e.g., hedge funds) will be able to borrow specials and receive the reduced rebate. Generally, brokers will not borrow special shares on behalf of small investors..”

For further reading, read Fidelity’s “The hidden risks of short selling