April 22, 2011

After adding some modifications to the Gyro script used in the two previous tests, it was time to reevaluate if the improvements to the holding functions would show higher returns.

The task of improving performance is most often daunting; you think that by improving on, such or such, parameter that the output will show improved overall portfolio performance.

But like most, you soon realize that the improvements you bring to your script are not across the board, across time or across stock selections.

When you make improvements to your script; it is usually done on a single stock. Then to know if the improvements have real value, you have your script go through your watch list. The improvements often tend to be some form of curve fitting or optimized settings on your test stock. Usually, the improvements break down; not every stock it the list benefit from the modifications. As a consequence, it's back to the drawing board to start the whole process again until you find worthwhile trading procedures. The more improvements you bring, the more the performance of your watchlist improves as should be expected. It's like finding that 37.56432 is the perfect moving average period to obtain the maximum portfolio performance on your watch list. This makes your trading strategy very fragile: its good on past data on your test portfolio, but you certainly don't know how your script will behave in the future on an entirely different stock selection.

I used the same list of stocks as the last one (Second Gyro Test) on an improved script where I wanted to increase across board the number of trades in the right direction, meaning more profitable trades with a higher win ratio and higher profits. The following table resulted:

Gyro Test 22Plus

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It is relatively easy to compare with the previous test.

The number of trades increased by 981 while the number of losing trades increased only by 67; an impressive upward push. Alpha points are very hard to come by at this level. Buffett has achieved an outstanding 22% over his career (which translates to about 12 alpha points) and he did predict recently that he will not be able to sustain this level in coming years. Yet, in this improved script, we are looking at some 40 alpha points generated solely by improved trading procedures.

The improvements to the script added more than 5 alpha points to an already high compounded return while the Buy & Hold managed to add 0.10 points during the same test period.

The across board performance improvement (read at the portfolio level) is that more remarkable that up to 3 out of 4 trades were triggered by a random function. The average loss per trade remained about the same while the average profit per trade decreased a little but on a higher number of trades. The added trading procedures produced more than 12.3 million in additional profits while increasing losses by some 14 000 dollars (13 774 to be exact). There were sufficient profits to consider the losses as trivial, and the added commissions amounted to less than 2 000 dollars; again a trivial number compared to the added profits.

My first question was: why the improvement? NO, not really, I knew before the test why everything would improve. I opted to accumulate shares at a slightly higher rate which would increase the number of trades which would increase the potential for higher profits. I technically increased my holding function.

It is all within the mathematical framework presented in my Alpha Power paper trading methodology. The Jensen Modified Sharpe paper says the same thing but with a higher level of mathematical equations. The underlying philosophy is that we can not change the price except maybe the very second we make a trade; the price is the same for all: past, present or future. As for future price, well I have no control over that. But the equations in the papers state that by managing the inventory with an accumulative stance you can improve performance: you can gain alpha points. You try to increase and hold your positions longer for higher profits and you do this gradually in time. It is a reasonably simple concept.

The above-mentioned table shows that by increasing your holding function you can achieve higher returns and not necessarily with that much-added risk. And this can be done across the board on your stock selection. In this case, the stock selection might have been unorthodox or on the lazy side (pick what others are looking at). Nevertheless, all the stocks in the list saw improved performance metrics by adding more trades even if some were triggered by a random function.

The equations of page 33 of the Jensen Modified Sharpe paper are sufficient to plot the course of action of the would-be generated profits. A sample quadratic profit equation is presented. It is one solution among many. One could design on his own terms on what grounds a trade should be taken. When looking for improvements - return wise - to the trading methodology, I most often refer to these equations as they can answer the questions: a) How much profit should I expect adopting the set of trading procedures, b) How many shares should be acquired in the process, c) How much capital will be required to accomplish the trading strategy from a to z.

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 Created on ... April 22, 2011,   © Guy R. Fleury. All rights reserved.