Quote from WRey:
Hi Tom,
I've been following your threads for a long time. Your project really looks interesting. I like seeing all the progress you've made.
The implementation of the random walk was really impressive.
I noticed in some of your results a relatively large amount of the PnL is determined by a single instrument.
I was wondering if this is avoidable, resulting in a better hedging game?
I'm also interested in your current opinion of the T game (after the simulations). Do you think it is necessary to be able to protect against extreme market movements?
Hi WRey,
thanks a lot for the comments.
This project is based essentially on the assumption that either the market is completely unpredictable or, in any case, we disregard any possibility to predict price direction. This perspective has led us to an approach which could be defined "mechanical". But what is the "mechanism" ?
Following J P Morgan, who when asked his opinion of the direction of the stock mkt, responded that <i>"It will fluctuate"</i>, we start with a countertrending game that is ideal to capture all these fluctuations.
The problem clearly arises when the price takes a direction unfavorable to current position. And this is <b>the problem of all strategies and traders in the world</b>.
In other words, while nobody seems to have much problem grabbing profits when he sees them, the main problem are the actions to carry out when start losing. Now assume, for instance, we have a long position on a futures contract and the price begins to fall. Let's examine some of the "systematic" actions we have at our disposal:
1. We readily close the losing position when Loss > Threshold.
I have examined this action for long time in innumerable simulations. It seems that with this approach it's impossible to have a systematically profitable strategy. Results, in the very best case, tend to be fluctuating around a zero profit and eventually one may lose all or stay negative on a sufficiently long series of stop.
2. We essentially continue buying either with entries equispaced or gradually increasing the distance of the buys. (This is what we called CT LS). If we were a bank or so we could continue this process for a much longer time many other investors can. So <b>we would see in the way down</b> innumerable <b>stops</b> to be hit and many poor souls to be <b>liquidated</b>. However, we have no problem with the large fluctuation and when it reaches the "bottom", or even at some intermediate point (a <b>local minimum</b>), we have accumulated so many positions that a <b>relatively (with respect to the global price move) small retracement</b> will make us return profitable. We have seen in most of all test as this worked fine most of the times, but if one is not a bank it's more or less like sitting on a bomb, which might or might not blow sometime in the future. Especially in case multiple correlated instruments begin a deep runaway.
3. We overlay on top of the previous CT game, a directional trending game (T). In fact, while we accumulate positions, this could be also interpreted as an indication of a <b>directional move</b>. So while we might still believe that the price will reverse sometime in the future, on the other hand we want to take advantage of the <b>directional move</b> (we called this CT T LS). We might therefore start selling. This could have an hedging effect respect to the current loss. On the other hand it would reduce the gain in case price reverses, and in case we don't stop the short trending position when price reverses we are actually <b>adding a loss to the previous loss</b>. The "hedgers" would also help breaking correlations.
Now the game 3 is complex to tune effectively because we need to <b>balance in the most effective way 2 opposite needs</b>: 1: profiting from reversal, 2: make some directional profits or to hedge. That's why we have developed the random walkers (GBM) to have some idea how to balance those 2 opposite needs, while avoiding (as much as possible) curve fitting. Clearly, the T component cannot be too tight because it would "kill" the countertrending component and engage in several so called "false" trend start (if we believe in "trend"), on the other hand it cannot be too late because it would be stopped early most of time and catch too little or none of the directional movement.
In any case what is expected is that game 3 (CT T LS) should be a much <b>slower</b> gainer, but hopefully a "safer" approach, or in any case an approach that most of traders will accept more easily. From a conceptual point of view, the drawdown can grow large in any case. In fact, even when we do inversions our drawdowns could grow unlimited if, at each position inversion, also the market coincidentally inverts direction. Clearly, most traders reject the idea that it's much likely that at each position inversion also the market will punish us with a direction inversion, because the market it's there for all and (hopefully!) does not trade specifically against us ;-)) On the other end, the traders and investors have been <b>conveniently scared to death</b> and so gently persuaded to use <b>stops</b> with occasional <b>flash crash</b> and marked <b>correlations</b>.
This way the big players can continue their game collecting all the stops and liquidation of the poor souls with relatively smaller capital.
While this "hedged" game may be much slower, conceptually might be more "acceptable" by most traders. It's pretty difficult to balance though. The features that should make it more acceptable is the idea that a big crash cannot hurt unrecoverably, and also instrument correlation is more effectively contrasted. What will bother are, usually, longer period of drawdown, although it's expected to see in general a growth of the <b>realized component</b> (while CT LS can have <b>much longer "stagnation"</b>), even when being drawn down. A bank or very large investor would probably not care: just play the CT LS unleashed and make money all the way up and down, ignoring drawdowns, stagnations, and laughing at traders' little stops.
Let me know what are your thoughts ...
Tom
