Friday, October 10, 2008

Strategy tweaking


Regardless of all the hype of discipline, having a solid trading strategy (or business model) remains the critical key to trading profitably. The next logical step then lies in continuous improvements, where vulnerabilities, unexpected risks are not only addressed by also resolved.

The confirmation fallacy

Mentioned in “The Black Swan” by Taleb (great book by the way), historical “confirmations” of where the strategy had succeeded means nothing. A large string of winning trades as result of a particular strategy suggests little if backed by purely quantitative means alone; likewise, just because you have survived another day does not suggest you are an ageless immortal.

Remedying weaknesses

You should instead search for incidences in the past where the interested strategy has failed (spectacularly), however improbable they may seem for the future. Once analyzed, you must create ways to adapt to these implausible but unavoidable events so that when they occur the next time, the strategy would result in break even or a net profit anyway. Like all business models, creativity is crucial.

Examples:

Someone who believes in long-term investment in the stock market might find the improbable yet inevitable fundamental risk of bankruptcies highly damaging. The investor then decides to only invest in index futures and ETFs. As a result, he experiences no more devastating portfolio losses from single company failures.

A typical trend following strategy carries very low winning rate as it depends on low-probability fat-tails off return distributions. As a solution, the trader could keep track of historical and implied volatilities, and exploit it to improve winning rate significantly. See here for more details concerning Trend Following improvements.

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