Kaufman, A Guide to Creating a Successful Algorithmic Trading Strategy

Perry J. Kaufman, the author of twelve trading books, encapsulates some of his best ideas in A Guide to Creating a Successful Algorithmic Trading Strategy (Wiley, 2016). The book is short (under 200 pages and a small page size) because, as Kaufman explains, “it just deals with the most important issues of developing a successful trading system and because you’re more likely to read it all.” (p. 2)

Kaufman differentiates between long-term and short-term trading strategies. In the long term, most markets exhibit trends, although some trend more efficiently than others. For instance, the equity markets of mature economies are, or at least were, noisier than those of emerging economies. Short term, markets are noisy and tend to mean revert.

In practical terms, this means that profit taking doesn’t work for trend following “because you cut your profits short and give up the fat tail, the extremely big profits.” (p. 51) If you’re a short-term trader, however, and “if you get a larger-than-average move in your direction, then you should take at least part of your gains off the table because you expect prices to reverse.” (p. 54)

As for stops, they are “short sighted for a trend strategy.” Using stops “looks to reduce a short-term loss by giving up a long-term profit, and it can significantly lower the percentage of good trades, which are already low for moving averages.” (p. 46) Stops are not the most efficacious way to control risk for most short-term systems either. “If you have a mean-reversion or arbitrage strategy, its profile will be a lot of small profits and a few large losses. When you add a stop-loss, you reduce the high percentage of small profitable trades and upset the balance. You can turn a profitable system into a losing one.” (p. 56)

How should you manage risk in a trend following portfolio? Kaufman recommends, among other things, that you start every trade with the same risk, and he suggests that system diversification is better than market diversification.

I’ve extracted just a couple of illustrative points from Kaufman’s book. The trader who is looking for a detailed guide on how to create and backtest trading strategies will be disappointed with this book. But anyone who is trying to develop a conceptual framework for systematic trading, which he can then implement with the appropriate algorithms, will find a lot of useful information here.

Helfand, A Survival Guide to the Misinformation Age

David J. Helfand, a bearded, bespectacled, Santa Claus-like astronomer, taught at Columbia for 38 years and recently served as president of the experimental Quest University Canada. He is on an impassioned mission: “to provide a set of tools to be used in promoting a rational and attainable future for humankind.” He is doing battle with “blind faith—in God during the Middle Ages, in creativity during the Renaissance, in reason during the Enlightenment, and in technology today,” which he describes as “a shibboleth, … a fantasy ungrounded from a rational assessment, in quantitative terms, of what is possible and what is not.” (p. ix)

In A Survival Guide to the Misinformation Age: Scientific Habits of Mind (Columbia University Press, 2016) Helfand argues that the defining characteristics of science “stem from a mindset built upon a specific set of habits that are employed when interacting with the world. … Cultivating these habits is the most efficacious approach to surviving the Misinformation Age—and for helping one’s fellow citizens to survive it as well.” (p. 28)

What kinds of habits distinguish a scientific mind? Skepticism heads the list, with an emphasis on falsifiability. Scientists also insist on the temporary nature of models. They have “the ability—and willingness—to make rough estimates of unknown (and often unknowable) quantities.” (p. 56) Fermi problems, such as “How many piano tuners are there in New York?,” are good examples of these back-of-the-envelope calculations.

The proper use of probability and statistics is also critical to scientific thinking. “[P]robability now shapes our understanding of the physical world, and statistics stands as the arbiter between our theories and the observations we use to test them. They are core habits of a scientific mind and provide a bulwark against skullduggery and exploitation.” (pp. 132-33)

Helfand applies the scientific habits he describes in his book (far more than I’ve mentioned here) to the problem of climate change. His goal, he claims, is not to draw a conclusion but rather to provide the tools for coming to “informed and independent judgments.” (p. 239)

He does, however, share the list of things most people “are conditioned by the media” to worry about and the list of things he himself worries about. The former list includes stronger and more frequent hurricanes, rising sea levels, hotter summers and more deaths from heat stroke, and the demise of polar bears.

Helfand argues that the hurricane scare is fictional, sees no secular trend in heat-related deaths, and more or less debunks the near-term concern over, and the purported causes of, rising sea levels. The seas are rising at a little over three millimeters per year, not enough to “transform the world economy or shake up the geopolitical order in the next few years.” And the reason for rising sea levels is not melting Arctic sea ice because floating ice does not increase the volume of water when it melts. Melting glaciers do add water to the oceans, but this is a minor cause of rising sea levels. “In fact, the real explanation for most of the sea-level rise is that the oceans are expanding as the temperature rises. … Today, roughly two-thirds of the rise we observe is likely a consequence of [thermal expansion]; over the next century, with a four-degree Celsius increase in global temperature, the total effect could be measured in meters, not millimeters.” (p. 238)

Helfand’s own list of near-term worries includes “the spread of tropical disease vectors and emerging zoonotic diseases, the collapse of biodiversity, CO2 from boreal bogs, and freshwater exhaustion.” (p. 241)

Unfortunately, most of the people who read this “survival guide” will undoubtedly be sufficiently scientifically inclined that they will not need to be persuaded that Senator James Inhofe of Oklahoma is—well, let’s say kindly—off base when he states: “The Genesis 8:22 that I use says that ‘as long as the earth remains there will be seed time and harvest, cold and heat, winter and summer, day and night.’ My point is, God’s still up there. The arrogance of people to think that we, human beings, would be able to change what He is doing in the climate is to me outrageous.” (pp. 205-06)

But even though Helfand’s readership will be self-selecting, even this readership often gets things wrong when it comes to science. This book will help to redirect them.

Jubak, Juggling with Knives

Jim Jubak’s Juggling with Knives (I couldn’t resist the alliteration): Smart Investing in the Coming Age of Volatility (PublicAffairs, 2016) is a thoroughly enjoyable if somewhat unnerving book. It takes us on a roller coaster ride of volatility in the markets as well as in everyday life. And it offers some investing recommendations, which Jubak optimistically prefers to call solutions.

Volatility runs in cycles. After a period of very low volatility (from roughly 1981 to 1997) and a transitional phase (1998-2007), we are now in a period of very high volatility, a period that started in 2008. This new era, he contends, is “something more, something different from these historical cycles.” The new spike in volatility isn’t confined to financial markets. Real-world trends such as aging populations and environmental costs are combining with the flood of cheap money from the world’s central banks to produce real-life volatility.

Jubak does a masterful job of describing global volatility trends, their causes and dangers, paying special attention to China. But he also brings volatility home, dealing with real estate prices, educational costs, and the job market.

Although most of this book is about long-term volatility trends, Jubak notes that they “are accompanied by big surges in instances of short-term volatility. Because long-term volatility produces change that operates in fits and starts as it moves toward a new equilibrium, accelerated long-term volatility results in an increased frequency of bouts of short-term volatility.” (p. 296) Investors and traders should use asset classes that “match the duration of the volatility trends that [they’re] trying to profit from or hedge against”: stocks and bonds for long-term volatility trends, options for short-term volatility events.

What are some long-term volatility strategies? For the most part Jubak suggests dividend-paying stocks over bonds, although he points the reader toward some short-term bond plays. He identifies stocks that have strong long-term trends at their backs. These, he says, are the stocks you want to buy low and sell high, over and over again. “Volatility here is your friend—or at least that’s the goal.” (p. 287) He also describes an investing strategy using a basket of emerging market stocks.

If you understand the sources of volatility, Jubak concludes, you might “feel less out of control and less a victim of cosmic forces beyond your ken and more like a captain who, because of an ability to read the waves, knows how to steer a ship safely through dangerous storms.” (p. 314) Perhaps yes, perhaps no, but Jubak’s book is a worthwhile read in either case.

Reamer and Downing, Investment: A History

Investment by Norton Reamer and Jesse Downing (Columbia Business School Publishing, 2016) is a sweeping history, organized both chronologically and thematically. Just to give an idea of the book’s reach, its nine chapters are titled: “A Privilege of the Power Elite,” “The Democratization of Investment,” “Retirement and Its Funding,” “New Clients and New Investments,” “Fraud, Market Manipulation, and Insider Trading,” “Progress in Managing Cyclical Crises,” “The Emergence of Investment Theory,” “More New Investment Forms,” and “Innovation Creates a New Elite.”

The early chapters span centuries and cross continents. We read, among many topics, about Greek real estate loans, usury in Islamic and Asian societies, Italian city-states and their merchant banks, trade in India, and pensions in Rome. As the authors turn to the seventeenth to nineteenth centuries, we learn about the creation of joint-stock companies, the Industrial Revolution, and the advent of public markets.

Despite its broad scope, the book does not move at a dizzying pace. Nor is it objectionably superficial. The product of a seasoned asset manager and a young investment analyst, along with a team of research associates, mostly Harvard economics majors, the book is a well-crafted history designed to highlight a few themes, such as the increasing democratization of investment opportunity and shifting elites.

A few words on this last point. In ancient economies, where agriculture was usually associated with nobility and commerce or trade with low status, land ownership was the preferred way to store and accumulate wealth. It was the privilege of those in high economic, social, and political positions. But these landowners frequently “lacked the knowledge to manage their assets and had to draw upon the talent of others to do so. Therefore, elite landowners often hired lower-status people, including slaves, to manage their estates.” (p. 15)

Fast forward to the late twentieth century when investment management started to become the business of the elite and clients (such as insurance companies and pension plans) often represented a broad swath of the population. That is, lower-status people, through their agents, hired the elite to manage their assets. In 2014, according to Forbes, American billionaires in finance and investment made up 25 percent of all billionaires in the United States. “This is, of course, in an industry that employs far less than 1 percent of the country’s workers.” (p. 303)

This book does not tell the reader how to invest, though it does tout four basic investment principles: real ownership, fundamental value, financial leverage, and resource allocation. Its own value lies in providing a historical context for today’s investment landscape. And it does that in a remarkably interesting way.

Cunningham et al., Quality Investing

Quality Investing: Owning the Best Companies for the Long Term (Harriman House, 2016) by Lawrence A. Cunningham, Torkell T. Eide, and Patrick Hargreaves brings the principles that have made the London-based AKO Capital a successful equity fund to the investing world at large.

Three characteristics indicate quality: “strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.” The investor’s challenge is to assess “the characteristics that combine to enable and sustain these appealing financial outputs.”

Through the use of extensive case studies of mostly European companies, the authors illustrate how to unearth patterns of quality. For example, good managers are essential. But “shareholders should be wary of any company whose chief executive is portrayed in the media as a business celebrity.” A study by two economists found that “award-winning CEOs subsequently under-perform both relative to their prior performance and relative to a sample of non-winning CEOs.”

The authors also point out the pitfalls of investing mechanically in companies that achieve solid cash generation, high returns on capital, and growth. Companies that seem attractive at first blush may simply be buoyed by “cyclical growth, the temporary tailwinds of fickle consumer trends, or technological leadership vulnerable to disruption.”

Quality investing cannot be reduced to numeric measures. This is one of its greatest challenges. As the authors write, “It is easier to explain that a stock is cheap than that a company is great.”

Quality investing is not a quest for the undiscovered. “In fact, many of the best companies are simple businesses that have done what they do consistently for decades. Worse, their quality is often, to some extent, already appreciated.” Successful investing “means accepting the relative dullness of analyzing what is often in plain view.”

Investors with a long-term perspective can profit in two ways from reading this book. First, they will enjoy the process since the book is clearly and engagingly written. Second, they will learn what has driven the success of some of the world’s top investors—and that they have the power to emulate this success. It’s not a simple formula and it involves work, but it is doable.

Piper, The Way to Trade Better

John Piper, the author of The Way to Trade, has written a sequel: The Way to Trade Better: Transform Your Trading into a Successful Business (Harriman House, 2016). The book is most useful for the beginning trader, but there are some ideas that even a more advanced trader could experiment with.

The five pillars of success, according to Piper, are focus, right style, right trading, right size, and making these winning habits. He discusses trading systems (two that he uses are explained in appendices), money management, psychology, and good and bad habits. Incorporating the pillars of success, he offers a guide to trading professionally within a year.

The most interesting chapter, at least to me, was the one on money management. Piper details a method based on his ZeitGap trading system, which has a high percentage of small winners and a low percentage of large losers, using a 52 point stop. He asks how much you should risk on the next trade if your previous trade was a winner. His suggestion is that you increase your trade size in such a way that, if you get stopped out, you never lose more than half of the prior profit in addition to the normal loss. So, you divide the amount of money made in the previous trade by 50 (simpler than dividing by 52), and then halve that result so you’re risking only half of that previous profit. Let’s say that you had a profit of $150 betting $5 a point. Dividing the profit by 50 and then halving that gives 1.5. The next time you should bet $6.50 a point.

To add a little extra juice to your trade, you could divide the amount of money at risk into two equal parts. The first part is calculated as above. For the second part you could use a tighter stop than the standard 52 points. The example he uses is placing the second stop five points beyond the high or low of the first five-minute bar. In his example, this would be a risk of 17 points.

How far should you push your luck with this method? Piper writes: “[T]he odds mean that every successive profit is less likely as the string gets longer and longer, but each independent result has the same probability as usual. Nevertheless you may feel it worthwhile to be more cautious after the third/fourth/fifth trade and become less aggressive.”

Oh, and what if your previous trade was a loser? It’s probably time to push the reset button and start back at the beginning.

Speziale, Market Masters

Canadians complain, and rightly so, that Americans pay them no mind. For instance, we can name scores of famous U.S. investors, but we’ve never heard of the leading Canadian investors. Robin R. Speziale helps fill this void with his 600-page Market Masters: Proven Investing Strategies You Can Apply: Interviews with Canada’s Top Investors (ECW Press, 2016). The only non-Canadian investor included is Bill Ackman, deemed to be “almost an honorary Canadian, since he’s been heavily involved in the Canadian market through three large and notable plays: Wendy’s/Tim Hortons, Canadian Pacific Railway, and Valeant.” (p. 451) Of course, in the case of his Valeant investment, Ackman’s “Canadian love affair” has been anything but happy.

In six parts—value (and sometimes contrarian), growth, fundamental (a mix of value and growth), macro (top-down), systematic (or technical), and other styles—Speziale shares 26 conversations. He then summarizes what he calls “master keys,” the most important things he learned from the market masters.

These interviews often repeat the old saws of investing, but here and there the reader catches a glimpse into the sweat equity that goes into running a fund, especially in trying times. Ryaz Shariff is a case in point. He is a commodity investor who has had to expand beyond his core area of expertise (the junior and mid-size mining market) to survive the prolonged commodities bear market. His interview is full of insights into the necessity of a hands-on approach in under-followed areas of the commodities market as well as into the nature of commodity cycles.

Throughout the book, the reader is privy to the range of biographical arcs that resulted in these men and women adopting their particular styles of investing and the skills critical to a becoming top investor.

Baranowski, Outsmarting the Crowd

Retail investors have been fleeing U.S. stocks, in part I suspect because they don’t understand that over time, despite all its gyrations, the stock market has been the best place to “grow money.” And that with no work on their part, just buying an index fund and pretty much ignoring it.

Bogumil K. Baranowski (Tocqueville Asset Management) wants to convince people to do just a little bit of work and thereby make more money. In Outsmarting the Crowd: A Value Investor’s Guide to Starting, Building, and Keeping a Family Fortune he defines the three pillars of investing and explains how they should be understood—philosophy (think differently, be patient, embrace failure), path (learn, simplify and focus, earn, save, invest) and principles (stocks are business, moody Mr. Market, and margin of safety).

This book is written for people who are in the early stages of their investing career, people who are comfortable with index investing yet are willing to expand their horizons by buying individual stocks. Although it doesn’t break new ground, it offers a clear, easy to follow account of the merits of investing in general and the principles of value investing.

Along the way it echoes the kind of lifestyle advice we have heard from the likes of Warren Buffett and Charlie Munger. For instance, read. According to the Pew Research Center, 23% of Americans didn’t read a book in 2014, a figure that was only 8% in 1978. Now that’s a depressing trend. “If,” Baranowski advises, “you want to succeed as an investor, you need to stay curious and continue to learn.” (p. 82)

Lien, Day Trading and Swing Trading the Currency Market, 3d ed.

Kathy Lien’s Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves has become something of a classic. In this third edition (Wiley, 2016) “all of the content has been updated with new chapters and strategies.” Although I haven’t compared it point by point with the second edition, there are some obvious differences (beyond replacing the longer chapters with bite-size pieces and updating many of the charts). For instance, the chapter on seasonality has been dropped in the new edition. Unfortunately, as is usually the case with a new edition, some old material remains, which can be jarring. Do we really care, for example, how FX dealers changed their ranking of the importance of economic data between 1992 and 1997?

Nitpicking aside, Lien’s book offers both an excellent overview of the FX market and a set of time-tested trading strategies. One such strategy involves the use of double Bollinger bands. Since currencies trend, the standard Bollinger bands (the 20-period moving average with two standard deviation bands above and below the moving average) don’t work as overbought and oversold levels. Lien adds a second set of bands, at one standard deviation from the moving average. Using the bands to pick tops and bottoms, for a long trade she has six rules, beginning with three entry rules: “Look for the currency pair to be trading between the lower first and second standard deviation Bollinger Bands. Look for a close above the first standard deviation Bollinger Band. If so, BUY at close of candle or 4 pm NY time.” (p. 103)

Another suggestion is to use one- and three-month option volatilities of currency pairs to time foreign exchange spot movement. “As a guideline, there are two simple rules to follow. The first one is that if short-term option volatilities are significantly lower than long-term volatilities, one should expect a breakout, though the direction of the breakout will not be defined by this rule. Lastly, if short-term option volatilities are significantly higher than long-term volatilities, one should expect a reversion to range trading.” (p. 192)

Anyone who’s brave enough to venture into the FX market needs guidance. Lien’s book may not turn a rank novice into a profitable currency trader, but it’s a good place to start. It also provides clearly written, valuable information for traders in markets that intersect with the currency market—and that’s just about every market. Bonds and commodities are obviously linked to currencies, but equity markets are also dependent on currency moves, as CEOs always remind their investors when reporting earnings that were negatively affected by currency headwinds. So it behooves traders and investors alike to learn something about how the currency market works.