Trade Universe

Today I want to talk a bit about choosing the markets to trade in. When I first started I admittedly just looked at which structured products are available for which market and then included those markets in my investable universe. That's not a good approach as I quickly realized. When markets plummed in late January, my portfolio went through the bottom. In my quest to diversify, I just forgot about one important aspect: correlation.
So after getting out of many of my positions I took a closer look at my portfolio and decided to reduce the number of markets that I trade. This has the nice side effect that my transaction costs relative to each trade actually decrease but again that's not the main point. My main goal was to decrease the correlation between my markets. I did a very basic calculation of computing the correlation between each market based on daily returns for the past year. Afterwards I started adding markets based on their correlation to the portfolio (I started with mature markets, which admittedly is arbitrary again). As a result I reduced the number of markets that I monitor to 29:

Mature markets: TecDax, FTSE 100, S&P 500, Nikkei 225
Emerging Markets: Nifty 10 (India), MSCI Turkey, MSCI Greece, South Africa, FTSE Vietnam
Metals: Gold, Silver, Platin, Copper, Nickel, Aluminum, Zinc, Lead
Agriculture: Corn, Cotton, Coffee, Cacao, Sugar, Soy Beans
Energy: Natural Gas, Brent Crude Oil
Bonds: Treasury 7-10, Germany10+, Iboxx10+, Euro Corporate

A word about January's performance: BAD... I am confident that the system works, but so far only the MSCI Turkey and sugar future trades are in the money a good bit. Oil has been swinging in between 72 and 80 dollars creating a few wrong signals. Same with the Metals. Let's see if February will be better. My portfolio is definitely set for a bearish month, with short positions in gold, silver, copper, cotton, FTSE 100 and S&P500. There would be a few more shorts but I couldn't find any products that I am allowed to trade for those, which is quite annoying because the soy bean trade my system indicated would have made a nice unlevered profit of about 7.2% minus transaction cost. I will definitely have to look into those restrictions once I have some time after midterms, job applications and my job at the 2010 Winter Olympics...

Risk and Money Management

So, after entering my first trades and realizing my first losses (more on that later) I found a bit of a flaw in my money management system. Strangely all positions were supposed to be the same size, even though they clearly exhibited different amounts of risk. Just to be on the same page, by risk I do not mean the convential notion of risk in terms of standard deviation or Beta but merely the possible loss in the trade. In other words the difference between entering price and exit price marked by the stop loss . After looking at my programming in excel it became clear I should lower the risk each trade represents or otherwise I might be out of money sooner than later... Now the total amount at risk is no more than 10% of total capital. Usually it's less because this number is only achieved when I enter 36 positions (42 possible positions in my investment horizon of which 6 have a negative correlation with the other 36 and hence it is unlikely they will all create a buy signal). Also I included a buffer of 5% added risk to each trade to account for tracking error from slippage cost such as transactions, time delay or tracking error between the underlying and the financial derrvative I'm using. My first trades indicate that the 5% are quite a good proxy but I will make sure to adjust this number once I have more trades in. After applying those money management thoughts on my back test, I actually increased its annual return by almost 1% over the 10 year period I was looking at. In conclusion I now feel more confident I will be saving money to go after the big hit, which should be coming eventually.
That being sad let's look at the (not so amazing) trades since my last post. On the 13th I exited my Nickel Future trade when it hit the trailing stop with a 9% (all gains/losses include transaction cost etc.) loss.

 

Similiarly my trades in corn (-13.7%), lead (-7.5%) and zinc (-9.9%) got stopped in the same way.

Another picture perfect failing signal was demonstrated by my Brent Crude Oil trade (-9.8%). After breaking a high on the 19th, it looked like a nice upward trend was developing with the backing of rising stock markets and continuing positive market sentiment. However, teh oil price was soon to drop, hit the trailing stop and crush my hope for a medium term upward trend. In fact it seems liek markets in general will follow the oil example...

Especially last week hasn't been kind to my positions as markets seem to swing towards the bear side, at least for now. I'm starting to feel how I am still emotionally attached to some positions and how I have been wanting to take my gains on some older positions (been holding the Nifty 10 for quite a while now). This weekend should be my first little challenge as I will most likely have to realize a bunch of losses in most of my positions, even though I would rather "sit-and-hold" with "my dear" financial instruments. Alright, guess I still have some way to go until I reach teh final point of the "game" mindset. Hopefully on the right track though...

Happy New Year 2010 and here we go...

New year, new decade, time for some hands on financial experiment. After reading Micheal Covel's "Trend Following" I decided to try it myself. I mean the results of trend followers seem rather impressive compared to traditional buy-and-hold, everyday mutual funds (obviously Warren Buffet should be regarded as an exception...). Therefore I played around a bit with Excel and some historic data and came up with a rather simple strategy. In a nutshell the goal is to place a number of small bets on different markets that show some technical promise. Naturally there is a clear exit strategy as well, so that (the many) small losses will be cut. The goal is to ride the big waves (dotcom bubble, subprime market bubble, the recent liquidity rally etc.) a good deal of the way and therefore make up  for the small losses incurred from wrong buying signals. Back testing has shown that my strategy indeed does have a positive expactation for each trade. In theory this leaves the trade with a classic call pay-off profile, where losses are known beforehand and restricted to the premium (in my case the stopp-loss for the exit) but gains are unlimited. Another big part of trend following is conservatism (at least in terms of putting money on trades) and therefore money management is important. Without going into any further detail, my particuliar system would have generated a net return of 171% (10.49% p.a.) over the last 10 years (06.11.99-06.11.09), a time where the S&P 500 would have lost 22.5% of its value. It is noteworthy that only long trades were executed, each trade had 1% transaction cost, gains were taxed with 25% (thank you German government for that...) and investments were made in the following markets:

Dax 30, FTSE 100, CAC 40, DJA 30, NASDAQ 100, S&P 500, Nikkei 225

Hang Seng, BOVESPA, Tel Aviv 100, Mexico

Aluminum, Copper, Gold, Palladin, Uranium, Zinc

Corn, Thai Rice, Wheat, Crude Oil, Cotton

US 5 yr treasury, US 30 yr treasury

Unfortunately not all of those markets are accessible to the private investor like me at a decent cost but the investment universe is still huge and this selection still seems like a decent representation to me.

Alright, now it is time for some real life actions. I realize after last year's liquidity rally markets might be saturated and my strategy might leave me with a lot of wrong buying signals, but then again, it did work right after the dotcom bubble. So with the believe that the market is always right and price is the only indicator of its direction, I entered long positions in the following (as of 04.01.10):

Dax 30, FTSE 100, NASDAQ 100, S&P 500, DJA 30, CAC 40, Nikkei 225, DJ Euro Stoxx 50

S&P Nifty (India), MSCI Brazil, MSCI Turkey, MSCI Korea, MSCI Greece, MSCI Malaysia

Zinc, Copper, Lead, Nickel

Corn, Cotton, Sugar

With some of the trades I am rather sceptical but there should not be room for emotions in trading. That is why a technical trading system is so beautiful: Once it is running, you just act according to the rules set before hand...

With that being said, good trades and a succesful new decade to everyone!

Seb