The Engineer or the Chef?
There are two broad styles to trading the financial markets.
- The Engineers – The specialists whose approach to trading is through the use of expert knowledge applied to a few select investments – eg. the Fundamental guys (global macro), the Value Investors (aka the Buffet’s or the micro guys), the Quants and technical analysts (aka the pattern recognition or market behaviour specialists); or
- The Chefs – The generalists whose approach to trading the financial markets is through the systematic application of general principles such as markets are adaptive and non-stationery moving feasts. These systematic rules are based on a general market principle as opposed to any specialist knowledge of the underlying asset and hence the same underlying logic is applied to any liquid instrument. – eg. the systematic trend/momentum followers.
Each have their pluses and minuses but they require different philosophies, skill sets, and risk tolerances. As a result, you need to take a stance in determining from which camp you reside.
Approach 1 is for the engineers who apply the principles of ’cause and effect’ to market action. These guys hate uncertainty and like precision. They want a rational reason for why things move and tend to view the markets as wrong, when things don’t work out the way it is planned.
They favour accuracy and preciseness and tend to view the trade entry as one of the most important aspects of trading. This is understandable as their philosophy is couched in terms of ‘predictability’ such as assets are ‘overvalued or under-valued in relation to the notion of fair value (or intrinsic value) or prices are over-extended and will revert to a predicted estimate of value, or a given configuration of data leads to a predicted outcome of apparent certainty.
Each trade strategy is expertly crafted to achieve a specific outcome and the number of variants of strategy applied in this approach are virtually unlimited. However given the specifics involved in each applied strategy, these guys are rarely diversified unless they have large research houses to support their philosophies.
Approach 1 takes an intense market research point of view where the aim is to gather market/investment information that is not readily available to or missed by the general participant and requires specific expertise and knowledge. In a nutshell these guys are seeking to exploit information that is not available to the general participant to gain an arbitrage opportunity.
They typically are expert analysts or professional traders who have a thorough understanding of the investments and the markets they trade and can determine with a high degree of precision the current and future intrinsic value of an instrument.
They can assess whether:
- current price is above/below the intrinsic value and take a position to capitalize on the future propensity of price to converge towards that intrinsic value or historic mean (a convergent approach to trading); or
- adopt a convergent risk approach to their trading trading where risk is defined in terms of a degree of certainty….in other words….my hypothesis about the future is right but the timing might be wrong.
The skill sets required to be good in this game are time intensive and very demanding. Given the extent of analysis that needs to be undertaken, these guys simply do not have the resources to invest their efforts towards a wide universe of investments and hence they are very selective in the instruments they trade and are intensely discretionary in nature.
They have a far greater risk tolerance than my appetite, as they have high conviction in their analysis and are willing to bear intolerable drawdowns in their assumption that they are right. As a result, the volatility of returns associated with Approach 1 is a continual conundrum. While you may be right in your assessment of future direction, it is the timing that can kill you…..hence the drawdowns while waiting for your analysis to be confirmed. Frequently these guys therefore add Technical Analysis to apply to their entry and exit decisions.
It is the timing issue that causes Approach 1 to significantly vary in performance metrics. You can be wildly successful or you can end up in tears (eg. Valeant Pharmaceuticals).
If you plot CAGR against drawdown of some of these style of funds like global macro and deep value investors, the scatter plot is all over the place. This is because in this field you can either be wildly successful or horribly unsuccessful dependent on the validity of the info you have obtained. To have consistent sustainable investment earnings from this approach is an exception as opposed to a rule.
Approach 2 is for those who view markets as complex moving feasts…..the chef’s so to speak who construct their diverse menus to capture a general market principle, or in more familiar terms, the diversified systematic fund managers.
Advocates in this camp use long term backtests to address market uncertainty and view the trade exit, rather than the entry, as a critically important element of the trade.
The primary focus for these guys is on risk management and the process, as apart from the outcome. A good trade is one in which you have faithfully applied your system, whether or not the trade outcome was successful or not. They look at the next 1000 trades as a sign of success and always view the markets as right.
They tend to be humble folk that avoid any form of predictive stance about what will happen in the future and hence simply follow price with the recognition that the market is always right….and hence typically apply tight stop conditions to avoid any form of ‘large loss’. They accept they are wrong and that the markets are always right hence never hold on to large losses and mercilessly apply the principle of cutting losses short every time.
They therefore have a low win rate and are victims of the frequent whipsaw….but the general principle of their philosophy (aka that anomalous moves are more frequent than normal distributions imply) and the unbounded profit ended nature of their system design gives rise to the non-predictive occasional huge win that ‘pays for em all’.
There are only a handful of broad principles such as trend following and momentum which capture the attention of this camp and as a result, the trade strategies deployed tend to be very simple but extensively diversified.
Approach 2 takes a more generalist statistical point of view to capturing alpha. The assumption is that each return stream in their diverse portfolio on their own may offer small degrees of alpha applying a simple yet robust approach of a general market principle such as the prevalence of price overextending beyond what a normal distribution would imply (eg. momentum, fat tailed distributions and levy drift), and thus it is necessary to spread the approach as wide as possible to increase trade frequency and capture a large number of return distributions to compensate for their individual low contribution to overall equity.
Because you are applying a simple principle across a broad range of instruments again and again……a scatter plot of CAGR versus drawdown for methods in this approach tend to cluster better. There is less style drift in this approach simply due to the persistent application of the same trading rules. Skill is not as essential in this class of approach…but what is essential is systematic application. If you are not systematized in this game of diversification you are severely handicapped. The skill in the chefs game comes from portfolio construction as opposed to system specialty.
You have often heard that algorithms (expert advisers or EA’s) simply don’t work in all market conditions…..Well that of course is right and the trend followers and momentum chasers are restricted to a few classes of market condition…..but….. what many traders however fail to recognise is that in the systematic space of this approach you may be trading 100’s of different instruments and timeframes and an array of divergent but simple strategies that seek to capture a general market principle such as momentum is a persistent feature of the overall market for any liquid instrument. You simply cannot do this as a discretionary trader…no matter how good you think you are.
So which type of trader are you? Unfortunately you can’t be both as each philosophy effectively undermines each other as they hail from opposite ends of the trading spectrum. Do you like pork crackling or a spanner?
If you are like me, then it is time to put your chef’s white’s on and adopt the following mantra’s.
- Trade as many different return distributions as possible to capture small amounts of available alpha but consolidate uncorrelated return streams with a small edge into powerful portfolios using the ‘free lunch’ that is available through diversification. A return distribution is generated from every instrument, timeframe and system deployed.
- Catch as much available edge as possible which includes reducing the costs of trading by reducing the tendency to over-trade, shop around for the best brokers and available interest on your surplus cash, reinvest your profits back into your trading strategies etc, etc etc. All these small edges add up and while they may appear small….guess what….available alpha is also small……but with the Pareto principle, this creates a bias in your favour in the long term where non-linear power laws start to kick in.
- Trade the longer term timeframes and avoid market noise. As you step out towards longer timeframes the impact of interference reduces the market noise and amplifies the signal to noise ratio.
- Having multiple return distributions allows you to significantly benefit from improved risk-weighted returns (through diversification)
- Apply a very small trade risk % to every trade of <=0.50%. Never look at or worry about a single trade….Only worry about the next 500 to 1000 trades. The name of the game for me is survival over a large sample size.
- Never trade for a living unless you are well capitalised. Treat trading as a wealth creation exercise that can supplement your primary income. You can never predict with confidence any sense of a cashflow. You must have significant capital backing to play this game full-time if you are that way inclined.
- Most of the trades will be losers so apply stringent risk management techniques that ensure that any loss is minuscule in terms of equity deterioration. Some of the trades, simply due to the Law of Large numbers, will be significant winners. You can never analyse in advance which trade will be successful so don’t even bother. Simply apply a rinse and repeat procedure on every trade and ‘follow price’. Simple as that….no prediction. Avoid any form of ‘predictive selection’.
- Focus on risk management at all times and do not worry about profits. They will simply arise through the Law of Large numbers;
- Don’t listen to the news – Your backtesting includes the major news events so be confident and simply ignore news events and trade through them. With a small trade risk applied to every trade, even fat tailed events such as the Swissy de-peg or Brexit turmoil can be ridden through without enduring ulcers…..Better still….if you happen to be trading on the right side of these black swan events….then that beautiful black swan turns into your white swan pay day. Fortunately if you trade the longer timeframes an individual news event tends to be insignificant in the scheme of things. In predating on momentum you are actually looking for the serial repetitive release of news events and good ol ‘fear and greed’ market behaviour that occurs during more exotic market conditions that drives momentum in the same direction.