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What is the future of Algorithmic Trading?

What is the future of Algorithmic Trading? by Laurent Bernut

Answer by Laurent Bernut:

If investment is a process, then automation is the natural conclusion. “He, who controls the past controls the future”, George Orwell. Before attempting to guess and inevitably fail what the future holds in store for us, let’s take a step back and understand why they are not so prevalent today

Complexity is a form of laziness and the gaze heuristic

Investors inherently distrust “black boxes”. We can accept someone giving us bad directions. We hate when Google maps sends us off course. This has implications on AUM.

Computing power is not the answer, it is merely one solution. AI is an attempt at solving complexity with complexity. Complex problems can be solved with simple solutions. Example: a fast moving projectile bouncing around is rocket science, literally. Now, when was the last time Serena Williams solved stochastic equations? Gaze heuristic. The point is that behind every algo there is a person formalising her current perception, fears, beliefs of the markets.

The hard part is articulating complexity in simple heuristics and only then apply sophisticated solutions. Algorithms that survive have to be robust. Complexity is fragile. For that reason only, i do not share the current enthusiasm on AI. We live in a technological world, governed by sophisticated algorithms (train schedules, traffic lights, chromatography etc). Yet, we have failed to apply our genius to the markets. AI is just the latest attempt.

Instead of thinking about the model logically, we try to discover it through tuning, optimisation, Monte Carlo, neural networks, AI, whatever. It is exactly like tuning an engine until You realise You need to build something called a carburetor.

Asset Allocation algorithms

To me, the immediate future of algorithms starts with asset allocation. There is a growing consensus that asset allocation is the primary driver of performance. Robo-advisors are still in their infancy, but this is where the industry is heading.

Unfortunately, they rely on Markowitz CAPM. It was invented in the year that the US Army drafted Elvis. Since then, doctors have stopped prescribing cigarettes to pregnant women, people have walked on the moon and non-alcoholic beer was invented

Here are a few things that Markowitz did not think of:

  1. Bear markets: this has been a 30 year mega bull markets for bonds. We are officially in the longest equity bull run in history. What happens when trends revert? Correlation will go to 1. Short selling is the asset class that remains terra incognita for the overwhelming majority of investors
  2. Time (synchronicity) is a form of asset allocation: mean reversion is a time frame issue. Any security trends on longer and/or shorter time frames. When trading the same strategy on the same security across multiple time frames, synchronicity smoothes the equity curve
  3. Volatility is NOT a measure of quality: Markowitz defaults to volatility as proxy for quality. CDOs, lending club and sovereign bonds are quality until… Integral of drawdowns is a robust measure of quality
  4. Position sizing is a form of asset allocation: this is where algorithms will find their first low hanging fruit. Risk parity has correlation issues

Time is the wrong container: 1st derivative of time, price and volume is speed

HFT is here to stay. Whether they should be legislated and taxed away is a different debate. For now, most algos fail because they are conceived on wall clock time. Algos will gravitate toward HFT when they are conceived with speed as opposed to wall clock time in mind.

Flash crashes happen in thin markets: mid-afternoon, middle of the night. This is because they are designed to react to wall clock time. We have been conditioned to see time as linear, wall clock time. Volume is not distributed uniformly through time.

Picture a bottling line. Bottles move only when they are filled. Now, imagine two shifts, day shift with everyone along the line, the other with two people and bottles moving every 5 seconds regardless. When everyone is here, they would overflow. When no-one is there, they would move half empty. It does not make sense, does it ?Time is the wrong container: 1,000 or 20 ticks per second are different markets.

The first derivative of time, volume and price is speed. HFT algos do not need to be so quick to react in slow moving markets. Conversely, conventional algos will gravitate toward higher frequency when they are set on speed (i-e constant volume) as opposed to time. Time is the wrong container.

Short selling algorithms

Contrary to popular belief, short selling is the province of algorithms. Firstly, successful shorts shrink, successful longs balloon. So, there is a need for more ideas, more often just to hedge exposures. The way to accomplish this is to systematise the process, hence algos

Secondly, on the short side, the market does not cooperate. Write and test algos for the short side. If they survive the short side, they will thrive on the long side.

Thirdly, the secret to raising AUM is to master the short side. Ask John Paulson about this. Next bear market, when everything drops 50%, all this AI, factor optimisation covariance matrices mumbo jumbo is highly unlikely to garner any sympathy from disgruntled investors. You may not like it, but if You intend to survive, do You have a choice?

Conclusion

The privilege of simplicity is that it imposes itself, even to those who do not understand its sophistication.

My own journey into the algorithmic world has been an unquenchable thirst for simplicity. When faced with a complex problem, I work until a simple solution emerges (the answer is rarely better signal processing by the way). This is like peeling an onion: solving one problem leads to the next one. In the end, algos are like iOS, next update is coming soon

What is the future of Algorithmic Trading?

#Quora: How do normal day traders manage to profit 200-300% annually and hedge funds are able to return only 20-40%?

How do normal day traders manage to profit 200-300% annually and hedge funds are able to return o… by Laurent Bernut

Answer by Laurent Bernut:

Day traders have one person to answer to: themselves, HF dudes don’t. Sticky Vs Fast money. It is not that they can generate good returns, it is that their clients will not allow them enough wiggle room. So, they are stuck in the month to month tyranny of positive returns. Size-Matters

HF is a fixed cost business

Keeping the lights on at any HF will cost You between half to one million USD per year. There are cheaper arrangements, but those funds are not institutional grade: pension guys will not even look at them. That is all before the principals can extract a dime out of it.

Now, contrary to popular beliefs, HF is a fixed cost business. You have bills to pay and for that You need to attract investors and raise your AUM. Performance does not pay the bills. Performance attract investors who pay the bills. Guys who waltz in with 10M thinking their performance will take care of the costs, stay at 10 forever

HFs are expensive underachievers.

In the mind of an investor, why would You invest with a HF when You can get cheaper better elsewhere? Yeah, yeah, yeah, the low correlation to the markets, downside protection, asset class diversification, i hear You, but who cares: 8 years of bull markets tend to dull people’s perception of risk and frankly. Every time the market had a hiccup, those wise dudes tumbled hard anyways. That is a fact, but that also has to do with the nature of the people they cater to.

Sticky Vs Fast money

HFs are stuck in a rut where they struggle to attract sticky, pension type money. Calpers pulled out of the HF game and many other endowments, pensions follow suite.

It takes roughly half to one million USD to keep the lights on. So, they market to fast money schmocks who put pressure on them. If You don’t perform 2–3 months in a row, or if You lose me 5%, i will cut You off. HF wise dudes don’t like those nervous investors, but they have no choice. Those Shylocks are the guys they have to perform cosmetic surgery with, as in lock their mouths to those guys’ money-makers, in order to one day reach institutional size.

What happens when You are not allowed to lose money? You don’t take risk. When you are up on the month, You take money off the table. When You are down, You cut risk. You never allow positions to fully develop.

At the heart of it are three things:

  1. Mismatch between assets and liabilities: HFs fund their LT strategies with short term funding. This cannot work. This is really the heart of the problem, from which everything flows
  2. Poor portfolio management skills: I started my career building portfolio management systems. Think of this as flying on instruments.If You don’t have good instruments to land at night on foggy days, game over. When i take a look at my HF buddies portfolio management systems, of course they struggle. I have seen only 2 which were investment grade in 15 years. Bottom line, these guys fly blind, no wonder they crash
  3. Short selling incompetence: selling futures as a hedge is for tourists. Most guys who come from the Long institutions think they are good at short selling. 2 years in, they give up on short selling. You don’t learn MMA by signing up for the UFC octagon, You train at the gym first

Institutional HFs

SAC/Point 72, Millennium, Balyasny are successful have a different philosophy. Investments are leveraged and managers have a tight stop loss. As a result, they generate 15–18% p.a. for their clients. Now as a manager, at -5% your AUM is cut in half. At -7%, stop loss. There is a direct disincentive for managers to take extra risk. Very few managers have the patience and discipline to clock in boring returns month in month out.

Do individual investors roll up into HF managers

Some do in the CTA world. This is how Paul Tudor Jones started. The game has changed though. It used to be easy. Ken Griffith started trading bonds in his dorm. Now, according to him, he would never be able to pull this off.

My thoughts on this. I used to want to start up a HF. We were quite advanced and then the cost of the whole thing hit me. I would be bankrupt before we would have enough assets under management (AUM) to be deemed investment grade. So, i rewired my thinking. I promised myself i would do whatever it takes never to need investors. Welcome to MT4 Forex Autotrade: trading 24/5 leveraged 100:1. It has been a long arduous road, but now we do not need investors. Autotrading puts wine (my kind of food) on the table

How do normal day traders manage to profit 200-300% annually and hedge funds are able to return only 20-40%?

#Quora: How should I manage a client’s portfolio if he wants a 8-10% return and no negative years worse than -5%, and has a starting amount of $2…

How should I manage a client’s portfolio if he wants a 8-10% return and no negative years worse t… by Laurent Bernut

Answer by Laurent Bernut:

Experience has taught me that people like this are a plague. They are not risk adverse. They are conservative to the point of being risk seeking: by refusing to accept moderate waves of volatility, they invite left tails tsunami. If You cannot afford to turn his money away however, here are the formulas

A. Psychology of conservative people

If You can’t stand losing, then You shouldn’t play. When they say they are willing to accept modest returns as long as You don’t lose much, what they mean is they do not want to lose at all.

Conservative is not synonymous with risk adverse. They are opposite in fact. Risk adverse means You have articulated and pieter_bruegel_the_elder_-_the_parable_of_the_blind_leading_the_blind_detail_-_wga3512quantified your risk appetite. Conservative means You are afraid of taking any risk. You are ready to discount your ambitions to the point they will be met with certainty. Kodak, Nokia were risk adverse…

It also means they are afraid and think everything is risky. It is your responsibility to educate them on risk. Do not step into dissertation mode about China, the Fed, Venusians landing in Central Park and Yoyogi park in Tokyo (i will sacrifice myself and volunteer if those sexy Venusians want to perform tests on my body). Risk is not a story, risk is a number.

Secondly, if You deliver, they are likely to demand more over time: 8–10% turns to 10–12% etc. Two reasons for this: you will be put in competition with other managers who promise they can deliver better with the same risk. Since your returns are underwhelming, You will be in constant competition. Secondly, and this is more insidious, they become overconfident. Since they believed everything was risky but now are making money, and they still don’t understand risk, they turn euphoric, literally drunk on testosterone and dopamine. They are laughing their way to the bank until the day you start losing again.

B. Market’s money

The strategy is to start small with minimum risk and increase gradually as you generate performance. Then, before year end, you reduce risk so as to start the new year afresh.

Many people do the gradual increase well, but forget about the decrease. Investors think in calendar years.

Example: first quarter, you generated 2%. You can now increase risk by x% of your gains (10–33%). So instead of risking 0.10% per trade, you would risk, 0.12% and so on and so forth.

Comes November, You are currently risking 0.20% per trade. Now, it is time to de-risk down gradually down to 0.10% so as to start January with a low risk, low concentration portfolio, ready for the new year. Remember: in the investors mind, January is the beginning of a new year, not the continuation of last year’s market.

C. Risk:“how much is enough?”, Steven Seagal, obese mythomaniac

You will often read that you should not risk more than 1–2% of your capital per trade. This does not mean position size, but equity at equity at risk. In your case, if you apply that rule over 5 stocks, one bad month and game over for good. So, get a better bad idea …

What is the maximum risk You can afford on each trade? This is one of the thorniest questions in financeI have pondered that question for years, until one day i came up with a simple elegant solution. Input variables

  1. Drawdown tolerance: If Your investor redeems, game over. he said he would tolerate -5% max drawdown. So, in order to be safe, you should probably calibrate your risk to a fraction of this. If You calibrate at 100%, he will redeem and this is one time where being right is bad, very bad. Besides, you need to rebound from drawdown, so let’s say somewhere between 50%-66.67%, say 2/3
  2. Avg number of positions: over 1 turnover cycle, what is your average number of positions? let’s say: 50
  3. Loss rate: over 1 turnover cycle, what is your average loss rate. In case You don’t know use 60% as loss rate (Yes, it means you lose more often than win, and it is called prudence)

Equipped with this:

Max risk per trade = Drawdown tolerance / (Loss rate * Avg #positions)

= 5% * 2/3 / [50* 60%]

Max risk per trade = 0.11%

Now, that was the max risk per trade. Let’s move to the min risk per trade. This is a fraction of that: usually 40%. So, your min risk per trade would be around 0.05%

Add trading has a cost: 0.036% blended avg, between DMA and high touch at Credit Suisse for example (as a good friend complained again this morning while we were naked in the gym shower !?!).

Now, You probably start to understand why i mean that those customers are toxic. When You go through a drawdown and you will have rough periods, You will simply not be able to dig yourself out.

Conclusion

Once in early 2013, i was cruising at a hedge fund party nursing some nasty Chardonnay and some dude who just launched was explaining his strategy:

-“fundamentals pairs trading”, he proudly said

-“So, You must be Long Toyota and Short Mazda, right? Mazda has gone up 400% and Toyota 30%. That must be a painful trade? ”, i asked

-”Nah, positions are small anyways, so no it does not hurt”, he confidently replied

-”Well, if they are too small to hurt, do You think they are big enough to contribute?”, i candidly asked

And he did the unthinkable rudest thing someone can do in Japan. He gave me back my business card and walked away

How should I manage a client’s portfolio if he wants a 8-10% return and no negative years worse than -5%, and has a starting amount of $2…