Am I on the right track?

[NoDoji]

LD, your 1., 2. post above reminded me that I'm supposed to test a theory of mine and today I got my sim trading account set up, so tomorrow I'll do it with RIMM because it's a nice high volume stock with decent moves.

The theory is that you could take any stock that's not too thinly traded, enter trades without looking at a chart at all, place 2:1 profit:loss bracketed orders, repeating this process as soon as the trade closes out at stop or target, and end up net profitable.

My first test will be intraday, with the first trade taking place as soon as the market opens.

 

[illiquid]

Quote from lost dilettante:

Some further thoughts. I like to make models of systems to gain an understanding. Doing this it is possible make two simple models of the market.

1. A random-only model market. Imagine that the closing prices for every security is set by elves rolling dice. In this market the closing prices would be completely random and hence unpredictable (assuming the dice are unbiased). It would not be possible to gain an edge through any sort of fundamental analysis, but it would be possible to intraday trade against other traders. As long as you were able to outplay the other traders then you could make a profit. This is really a "poker" model where the fundamentals are random (ie like the order of the cards) and everyone is playing against each other. If the market is like this then most traders are really just playing a version of poker and I guess it is not surprising that so many successful traders like card games.

In this model issues like understanding the psychology of the market and "gut feel" become important. Success in this market is all about outplaying the other market participants. Thinking too much would be a major disadvantage because what is needed to succeed is to get inside the mind of the other traders. This is very hard to do if you don't think like the other players in the market - if the majority of players are average thinkers, then being a high level thinker will be a real handicap. The best players in this model would think just like the other players, but be slight faster or brighter. If this model accurately reflect the real market then it is not surprising that smart people come unstuck so often.

2. The predetermined market model. Imagine that the closing price is set by the number of degrees above or below the daily average the actual temperature was in Bismark, ND 3 days ago. In this market the closing price is totally predictable if you happen to know the average and actual temperatures in Bismark and you would have a perfect money machine. The problem faced here is not that the market is not 100% predictable, but in finding the cause. You could go data mining through all the past market data, find 100 or 1000 of rules that model the closing prices, yet when you go to use them they will all be wrong. If we assume this market is a zero sum game then most traders will fail, some will break even, and some will succeed fantastically, all of this by chance alone. The successful traders will fool themselves into think they have found an edge, when all they have done is be lucky. The key to success in this market is finding the cause, but when you are faced with the fact that data mining will find hundreds of false causes that pass back testing.

The actual market is obviously not an extreme like either of these models, but has some aspects of both. Over the long term prices are driven by fundamentals like earnings, but in the short term prices are driven by the "poker" traders. Given this is should be possible to play the market in one of two ways. 1) With a short term "poker" strategy focused on the other traders in the market, or 2) With a longer term strategy focused on identify the fundamental causes of price movement. The first strategy is better suited to an average player, while the second is better suited to a higher level thinking player.

It's obvious which model attracts you more.

Yet the premise/conclusion you draw from your first "random only" model is completely off the mark. There is a missing dimension of the market that this thread totally ignores.

A clue: your higher thinkers aka nobel prize winners seem to blow out every few years or so playing "poker" with the market . . .

 

[lost dilettante]

Quote from illiquid:

It's obvious which model attracts you more.

Yet the premise/conclusion you draw from your first "random only" model is completely off the mark. There is a missing dimension of the market that this thread totally ignores.

A clue: your higher thinkers aka nobel prize winners seem to blow out every few years or so playing "poker" with the market . . .

I think it is more a case of horses for courses.

The market may displays no features of model 2 at all. If this is true then smart people should stay out of the market. They don't think like the other players so can't understand what is going on. Just as it is nearly impossible for average people to understand what smart people are thinking, it is just as hard for smart people to understand what average person thinks. Smart people are really prone to assuming that average person is not thinking at all, when the real answer is they don't understand what is driving the average person. This would certainly explain why the nobel prize winners in the market mange to blow themselves up so regularly when "poker" trading

 

[ivanbaj]

There are very smart poker players out there with tons of cash. It is scary.

 

[lost dilettante]

Quote from ivanbaj:

There are very smart poker players out there with tons of cash. It is scary.

Yes, but there are even more high level thinkers that are really poor poker players.

Actually poker is not a very good model for the market because of the problem of segregation. Poker players don't all play at the same table at the same time, but in little groups. If you consider a large tournament, the players progress through multiple tables and the best end up playing each other for the final prize. If the market was like this then the nobel prize winners would only be playing each. In this case it would be a significant disadvantage to be an average player.

 

[lost dilettante]

More musing from my reading. In my first post I made an assumption that all edges that can be constructed from publicly available data are being fully exploited and that gaining an edge would require access to unique data.

This seemed quite reasonable at the time given my ignorance and the level of competition in the market. An edge that is easily exploitable from public data is like the joke about economists finding a $100 bill in the road and saying that it can't be there because it would have been arbed away . I was surprised to find that there is actual a very large literature on this topic (ignorance know no bounds) and there are many simple strategies that can be constructed from public data which offer good returns. Given these are basically money machines it seems strange that they would persist in the market, but maybe the underlying cause(s) are so strong that they can't all be arbed away. One way this could come about is if the strategy is only accessible to small players because of a lack of liquidity, but there just aren't enough (or any) small players exploiting the edge. All very interesting and it has made me think a lot more

One thing I did notice from going through all the published strategies is the alpha is inversely proportional to the easy of collecting the data (ie. the harder it is to gather the data the better the returns). This observation does suggest that my original hypothesis might still contain a grain of truth and that unique data may offer returns far above what can be generated using publicly available data. This makes sense since even if a strategy that can be constructed from public data is not being fully exploited, the returns offered are likely to be lower since their will be some people out there making use of it.