Transcription
To help me, uh, build out a framework for someone watching, specifically who's learned, uh, things online. They've learned strategies online but they are not finding success, but they find it in back testing, but in live markets, they don't. It can only be a psychological gap. How can they go about fixing it now and say, "This is how I find a more congruent strategy to my temperament."
So the first question you have to ask yourself is, are your back tests valid? Um, because frequently, your back test is not valid, even if it shows a very large rate of return. So I'll give you the classic example of this, which many people still do, which is surprising. So people will say, "I want to trade a moving average crossover strategy," and then they'll find, you know, some asset that they want to trade, and then they'll find that exact combination of two moving averages that produce the highest back test, and then they'll say, "Well, I need to trade this." The chances that that's going to work in the future are very low. Why? Because you've almost certainly hit upon some peak in the back test, and that just happened to be at random at that specific spot, and the future returns are going to be substantially lower, if not negative.
What you really need to do if you're going to do that is you want to find a stable set of parameters. You're not looking for the highest rate of return. You're looking for the most stable rate of return. Did you find a plateau? Can you vary your parameters and still get basically the same rate of return? And as I told you last time, can you add noise to your to the prices that you're using? And by adding noise, your return slowly degrades. Is it doing that? That's that's a good sign, too, that you've found a good back test. So that's the first thing you got to do. You got to get a good back test, >> right? >> How do you do it? >> A good back test. >> Yeah, cuz I mean myself and most, we we go on TradingView and we rewind and we play price action and we see what we would do. So manually, >> you have to first Good, it's a good question. You have to first ask yourself, you don't have supercomputers. You don't have 100 PhDs working for you. So, you can't play the Renaissance game of, "Let's find every pattern and trade them all." So, you have to do the opposite. You have to really drill down. You have to ask yourself, "What is my thesis? What am I saying? What is it that I know or understand that is allowing me to make this excess money in the market?" Once you can define that and you can actually state it precisely and clearly, "I think my thesis is the following," then you can put together a back test that's of some use.
So I'll give you an example. Um, uh, recently I I started back testing a couple of things, just basically for fun, although I haven't started using them yet. Um, one thing that I read, uh, from a bunch of commentators is that we, the US, has lots of debt, and its debt keeps going up, and so therefore the dollar is going to collapse, and if the dollar collapses, that's going to be terrible for the market. So I said, "Okay, that seems reasonable to me. I don't know if it's true or it's false. Why don't I look at DXY and ask myself, do extreme moves in the DXY, which is the dollar index, in the past, have they ever told me anything useful about the market?" The answer is no. So maybe the dollar will collapse, maybe it'll be bad for the market, but is there any evidence for this assertion? None that I can find. So can you trade that? I wouldn't.
On the other hand, um, you can look at, for example, the high yield option adjusted spread, right? Uh, for high yield bonds, there is some evidence to suggest that when there's stress in the high yield bond market, that the stock market is about to have significant risk. Correlation or causation? >> Good question. But it is fairly consistent, which suggests that it's causation, or at least an early warning canary, if you want to call it that. So, in other words, there is stress in the system. The stock market hasn't seen it yet because it hasn't quite affected stocks. And so, uh, you could treat the high yield option adjusted spread, um, however you want to do it, as a leading indicator of something, and then you have to think about it. But so that's the dichotomy. So you're always trying to find a reason, a good, sensible reason for why this might be true. You know, the old joke is that, you know, butter production in, uh, in Bangladesh is, uh, heavily correlated to stocks that begin with A, or something like that. I forget, I forget the exact thing, but something like that. >> Okay. >> I mean, I'm giving you a ridiculous example because it is ridiculous. >> But you have to be very careful with what it is that you're actually back testing, because there's no other way of finding a signal.
This begs the question, two questions. Number one, most people watching, especially new traders, uh, the arena when we see how can we estimate price, it's fundamentals, it's sentiment, it's, uh, trying to understand people's behavior, psychological, and then there's also technicals. Price. Most people end up at price because it's easy to open up a chart and and draw lines. Uh, what would you argue in the case of, can technicals alone be a way to model and trade price? If you use technicals because you're trying to control your risk, there's a decent chance it will work. If you're using technicals with some exceptions, we can get into that, to try to pick assets or, um, stocks or whatever it is that are going to go up, say, there's a decent chance, with some exceptions, that that's wrong. That's the best thing that I can I can tell you, be because it's a question of base rates. I mean, you know, you you know medicine as well as I do. The base rates are in your favor if you're talking about risk. The base rates are against you if you're talking about return, with one exception. Okay.
The reason I was asking about technicals is because the the premise has to be, to them, believe it or not, is, can past price predict future price? Yes, to some extent. But the question is, can does it predict it enough that you can make money? Is there a variance on time horizons? Shorter versus longer time. >> Yes, there is. So if you are a small investor and you decide that you want to day trade, you actually have a chance of making some money with small positions, and I can even explain how. Um, if you are a larger than small investor, then it's quite, excuse me, difficult to deploy enough capital on a very short-term time horizon as an individual investor. You don't have the nanosecond execution. Um, the the exception that I was mentioning is that, um, the one thing that seems to work in almost every market and almost not quite every time frame is momentum. So you can certainly trade, for example, breakout systems if you're willing to live with the risk. So essentially, you know, you have a channel, draw it however you want, doesn't matter. Bollinger bands, lines, it makes no difference, and when the market breaks above, you trade one way, market breaks below, another way. You you have to have strict risk control. You have to worry about, um, stop losses. You have to worry about all kinds of things, but actually you have a chance of trying to make some money. There's a limited amount of capital you can deploy, but you can do it. So momentum is the one exception to that statement. I I I assume the reason you say limited capital can be put through that needle of alpha, yes, is because, uh, the market >> uh, was >> no, you'll move the market because you've only got so much liquidity at that point, and you need to enter at that point because if you don't enter at that point, it's no longer profitable. >> Mhm. >> I I remember last time you told me that there's a lot of liquidity in the market, but at at an instant, it's it's very, uh, finite or limited. >> Yes. >> Uh, even in something like the S&P, which I found pretty cool. >> Exactly.
Um, okay, so let's say my my goal is now to find, uh, something like this, a technical pattern like a breakout, and I'm I'm trading momentum, and then there is a certain limit that I could, uh, put into it before I've moved the market and I've missed the opportunity. Is that something a retail trader should be concerned about, or is it very big limits, relatively speaking? >> It's pretty big limits for a retail trader. You don't have to worry about it too much. And then again, for a retail trader, there are some other very clever things that you can do. Um, one of them is, uh, there are three kinds of momentum. And so as a retail trader, you should look at all three kinds of momentum and see if any of them are to your liking, fit your personality, and you want to trade them. Um, and those three kinds of momentum are, uh, time series momentum. So that is to say, the momentum of the thing itself, right? So like if you decide to trade, let's say you take a moving average and you buy it when it's above and sell it when it's below, that's time series momentum. You >> Time series momentum is is effectively how much it moved in a set amount of time. Um, well, the reason it's called time series momentum is that it's just calculated from the time series of the thing that you're trading. Okay. >> So you just a moving average is the last N days averaged together. Right? That's why it's called time series momentum. Got it? >> So that's one kind of momentum. The second kind of momentum is called cross-sectional momentum. So in cross-sectional momentum, you do you don't look at how the asset did by itself. You put the asset in a basket of relatively similar assets. Let's say all stocks or something or the other. And then you say, "Okay, I'm going to buy the top X% of the performers in this basket." That's that's cross-sectional momentum. The reason it's cross-sectional is that you have more than one asset in that basket. And peculiarly, you can even take unrelated assets and throw them in there and do the same thing, and it'll work. Don't ask me why, but it does work. >> Okay. >> Um, so that's two kinds of momentum. But there's a third kind of momentum, which is, uh, a way of taking advantage of the stupidity of academic finance. Okay. So you remember I was telling you earlier that alpha may not be defined. It might be, it might not be. I just wish people would realize that it's not as clear-cut as people claim it is. So because of because it's unstable, there's something clever that you can do. You can take any given stock or even portfolio like an ETF or whatever, and you can quote decompose it into factors. So you can ask, how much of its return comes from, uh, size, and how much comes from value, and how much comes from growth, and how much, that's called, those are factors. Now, the fact is, my pun, that factors are themselves unstable. So this entire statement that you can decompose a set of returns of a portfolio into factors is, to put it politely, the technical term is crap, but never mind. Um, that gives you something that you can use, and the something that you can use is use factor momentum. So let's say that you've got a, um, you're looking at, um, oh, I don't know, some collection of stocks that you decide to break out in a certain way. You can ask, which factors are working now, and then you can invest in the factors that are working now, >> and because they are unstable for a short period of time, at least, that factor is likely to outperform the other factors. So you can make a bit of extra return from being in those factors and not in the other factors. Now, you have to keep watching this, and so when that changes, you have to change to the other factors, and you just keep hopping from factor to factor to factor to factor. This works because of the instability. Would all three of these, uh, types of momentum, especially the factors one, could be condensed down into just reading price? It would reflect on a chart. No, because two of them are relative. So you would actually have to put a few hundred stocks on the same chart, say, and then try to figure out, you know, which are the strongest and which are the weakest. So then you're better off not doing it.