July 26, 2011

I have been in the implementation phase for over 6 months now. A lot of backtesting has been done, always improving on the trading model and pushing performance higher and higher. From the first implementation, where the compounded annual growth rate (CAGR) was around 50%, to the latest iterations, where the CAGR exceeds 100%, it has been a long journey.

All backtests were done for the sole purpose of proving that the concepts presented in my papers had a real foundation in reality. And the simulation results on real market data demonstrate that the underlying trading methodology is not only valid but also gives credence to the whole mathematical framework presented in my papers.

Originally, all my testing was done on randomly generated price series, which I tried to design to mimic the market as closely as possible, fat tails included. My price series, however, were designed, on purpose, to exhibit less volatility than in the real world. All I  wanted was to have random price series that I could not predict. The magnitude of the moves was secondary.

In all the tests using random price series, there was no way to predict price movement on any individual stock over any time interval. And since all generated series would have singular price signatures for each test, there was no way of predicting which stocks would outperform. It is on this basis that my papers evolved.

As mentioned in my first paper, Alpha Power, in 2007, my portfolio management theory had the seeds to shake some basic notions of Modern Portfolio Theory by advancing the concept of an exponential Sharpe ratio resulting from a modified Jensen alpha equation. The second paper, The Jensen Modified Sharpe Ratio, gave a more elaborate view using stochastic differential equations. But the message was the same: one could design trading strategies that would result in having an exponential Sharpe.

This exponential Sharpe implied that one could generate alpha points and even gain the ability to control the amount to some extent. It was a major departure from acceptable Modern Portfolio Theory, which has advocated for the past half-century that the most expected outcome of any portfolio management was to tend to achieve average long-term performance. And this implied, over the long term, that alpha, if there was any, tended to zero.

By simply modifying the holding function (the stock inventory levels), and the perception on how to react to market prices, one can gain alpha points that can push performance results way beyond the Buy & Hold investment strategy.

All my recent tests show that someone could trade stocks, really outperform, and generate alpha points simply by mathematically prearranging his/her participation in the market instead of trying to predict where the market will go.

It is as if you designed to play your game within the game. You determined in advance what you intended to do following price swings. Basically, my trading methods have long-term objectives and therefore have for underlying strategy a Buy & Hold attitude.

I am still in the implementation phase, running different strategies with different trend definitions that I adapt to better suit my purpose. The objective is to find which one I like best; since the future occurs only once.  At the same time, I’m also exploring and trying to find the limits, boundaries, and brick walls in my trading methods. How far can this thing go? For sure, I want to know; and I will continue to chronicle my journey in finding better trading methods.

My methods of play advocate very simple ideas:

1. Start with the Buy & Hold strategy and adopt Mr. Buffett’s long-term view; prepare, select, and be ready to hold forever 
2. Take small bets over an over-diversified portfolio 
3. Accept short-term profits to return cash to the account 
4. Use the paper profits to accumulate more shares, again for the long term 
5. Accept stop losses and return what is left to the trading account 
6. Use the profits and excess equity to accumulate more shares 
7. Try to increase the inventory on hand as you go (exponentially)

I like to think of this trading methodology as a mini-Buffett style of investing as it does mostly what he does on a smaller scale but at a much higher rate.

The Buy & Hold strategy is not dead, it only needed a boost. See my other articles: “My Trading Methods“ or  “How It Works“ for a more detailed view.

Created on ... July 26, 2011,     © Guy R. Fleury. All rights reserved.