Part 1 (1/2)

Alpha trading : profitable strategies that remove directional risk.

Perry Kaufman.

Preface.

I wanted to write this book after the collapse of the tech bubble in 2000, but it wasn't until the subprime disaster of 2008 that I decided to do it. Investors should not be subject to the tremendous losses that the market serves up. And traders do not need to make a commitment to a long or short position all the time. There are other choices, and those choices do not necessitate compromising returns. They do require somewhat more complicated positions, but the reward is that, if the S&P collapses because of a terrorist attack, or program trading by one of the big investments houses runs amok and causes a 10 percent drop in the S&P, you are safe.

We've learned greater respect for risk in the past few years. It's a lesson that we all should have learned much sooner, but any time is a good time to improve your skills. Part of that advancement is to be aware of unconscious risks. When we trade more than one stock, each trade should have equal risk. That gives each trade an equal opportunity to contribute to the final results. If you don't do that, you are consciously or unconsciously saying that you think the trade with the largest risk is most likely to give you the best return. If that's the case, you should only make one trade in the best item and forget about diversification.

This book is as much about the process as it is about the results. Its target audience is active traders but not necessarily intraday traders. The intended reader is someone who spends time deciding which stocks or futures markets to buy or sell and doesn't hold a trade indefinitely when it goes the wrong way. Each step is explained, and there are examples of how the numbers should look. There is also a website that has the basic spreadsheets needed to do all the calculations.

The strategies in this book are well known to be profitable. They are called statistical arbitrage, or stat-arb, and they can be traded by holding positions for a few days, as suggested here, or for milliseconds, as implemented by the big investment houses. To trade, all you need is a spreadsheet to do a few calculations; then enter prices at the end of the day or anytime during the day when you think there is an opportunity. Trades have a high probability of success.

You cannot just believe that something works; you need to prove it to yourself. The black box approach is unacceptable and has proved a disaster to many investors. It's your money, and you owe it to yourself to understand and verify everything-even what is shown in this book.

It is one thing to be given a strategy and another to use it successfully. Once you have verified and paper-traded the strategies, you have a better chance of being successful because you have become part of the development process.

The development process is an exciting exploration. It begins with a sound premise and moves down various paths that may or may not turn out to be useful. But at the same time, it teaches valuable lessons. You understand why one idea works and another doesn't. You understand the robust and the fragile parts of the strategies. At some time in the future, you may be called upon to change the strategy because the market has changed-volatility has dropped to a level that limits opportunity or risen to a point of unacceptable risk. Markets that used to move together no longer do so, or as in the fourth quarter of 2008, markets moved together for no apparent reason.

Without having gone through the process, you do not have the knowledge to make these changes or the confidence that they will work. This book will present important strategies that should be part of any trader's portfolio. It will develop and explain the features that are incorporated, as well as choices that were not taken. But it is the sound premise of these ideas that is the underlying reason for its success. At the end, I hope you have learned a lot and that you trade successfully.

Perry Kaufman.

January 2011.

Chapter 1.

Uncertainty.

The investment world had a rude reminder in August and September of 2008 that forecasts and risk have more uncertainty than it would like to believe. From August 28 to the following March 9, the Standard & Poor's (S&P) 500 dropped 47%. Even more remarkable was that every investment was dragged down with it-hedge funds that were expected to offer diversification, commodity funds where you have the security of so-called hard currency, real estate, art, and of course, every possible stock in nearly every country.

Oddly, the U.S. dollar strengthened against the euro by about 15% during that time. It was odd because it was the United States that originated what we now call the subprime disaster. Yet in a crisis, investors still move money to the United States for safety.

What did we learn from this? Mainly, we learned that there is more uncertainty than we thought in the world of investments. Maybe that's not entirely correct. We just tend to ignore the risks when everything goes well for a long time. During the late 1990s, a similar move occurred in the tech stocks, with NASDAQ dropping from 5000 to below 1200. For those a bit older, or students of history, there was the crash of 1987 resulting in a drop of 39.8% in the S&P from October 6 to October 22. But the stock market had recovered by the end of the year, so investors who didn't react to the drop never suffered a sustained loss. By contrast, the recent drop in the S&P lasted from August 11, 2008, to March 3, 2009, far longer than 1987 but not comparable to the Black Monday of 1929.

At the time of this writing, the stock market is down only 15% from its highs. Again, investors who had closed their eyes are still suffering a loss in their pensions, but nothing devastating. Those who liquidated their portfolios and moved them to money market funds locked in their losses. The right decision is only known afterward.

IMPACT ON TRADING.

But this book is about trading, not investing, and 2008 was a banner year for futures traders at the same time the equity markets were collapsing. The same could have been true for someone trading exchange-traded funds (ETFs) or any investment in which going short is a natural part of trading. The main beneficiaries were trend followers, who were able to get short (equity index markets), or long (interest rates), and stay with the trend for months, capturing what is known as the fat tail.

We can then say that many traders lost money and some profited, but the most important lesson is that the risk was enormous. Volatility rose from under 20% to 80%, a previously unthinkable level (see Figure 1.1). If you can't manage risk, then your interim losses may be too big to ever see the profits.

FIGURE 1.1 The volatility index (VIX) for S&P 500 from August 2008 through mid-May 2010. Yahoo!

Money Moves the Markets.

Normally, risk is reduced through diversification, but that wasn't true during this last crisis because the movement of money reversed the direction of all markets at the same time. In a crisis, most investors simply want to get their money out. If they are long equities, then equities fall; if they are long the Goldman Sachs Commodity Index (GSCI), then that falls; and if they are short the j.a.panese yen in the carry trade, the yen rises. Cash, or guaranteed government debt, is the only safe place, provided it's not Greece, Italy, Spain, Portugal, or a variety of emerging markets that may have even greater risk.

THE INEVITABLE PRICE SHOCKS.

We all know that price shocks are extreme price moves that cannot be predicted. We also understand that they are worse when the investing public is holding the wrong position, that is, when we expect the Fed to lower interest rates to stimulate the economy, but instead they raise rates to prevent inflation. Of course, that's not supposed to happen in our new era of transparency. But what about a military coup in an oil-rich country that cuts off the needed flow of supply to the West? Or an a.s.sa.s.sination? Or a surprise election result? All of these have happened.

We might think of all price movement as a series of price shocks of different sizes---all reactions to today's news. Most often, these shocks are very small, but some are bigger, and occasionally one is gigantic. Do you ever wonder how these price shocks net against your market positions? Is it different if you are a long-term rather than a short-term trader? Is there something you can do to take advantage of a price shock, or at least not be hurt by it?

Biased against You.

First of all, understand that you can't change the odds to have better than a 50% chance that you will profit from a price shock. Realistically, you would be lucky to have 50% of the price shocks in your favor. However, it does seem clear that when more people hold the same positions, any surprise that is contrary to that direction will have a greater impact while surprising news in a favorable direction will have little effect. But that information is not enough to make money because we still don't know when the next price shock will come.

Very few traders, professional or amateur, recognize the importance of price shocks and the effect that they have on profits. Given how ill-prepared and undercapitalized many traders are, one large price shock is all they need to be forced out permanently.

Price Shocks and Your Position.

Do price shocks hurt the short-term or the long-term trader more? To find out, we ran a moving average test of a few different markets and totaled the value of the price shocks that caused profits or losses. Specifically, The moving average calculation periods ranged from 10 days to 200 days, in steps of 10 days.

A price shock was defined as any day in which the ratio of today's price change to the standard deviation of the previous 10 day price changes was greater than 2.5. That means, if the standard deviation of the S&P daily price changes was 6 big points, then a gain or loss of 15 points would trigger a price shock. Specifically, if the threshold for a price shock t = 2.5 and n = 10, then if we can say that day t is a price shock.

By using the standard deviation of the daily changes, we can test using either the cash index or back-adjusted futures. Back-adjusting does not change the price differences or the standard deviation, although it will change any percentage calculation because the divisor is scaled to an artificial price. When working with futures, it's best to use price differences, and with stocks or stock indices, we should use returns.

S&P Price Shocks.

The impact of price shocks on the S&P is unique. We believe that there is an upward bias in the index markets, caused by favorable tax treatment of capital gains as well as legal restrictions in some pension plans, which results in investors holding long positions. Short sales are limited to a far smaller group of professional traders, perhaps a few more now that inverse ETFs and bear funds (inverse mutual funds, such as ProFunds) allow easy access. Investors also seem to gravitate toward a clear bull market in any investment, whether the stock market or gold or oil. It should not be a surprise that downside shocks would hurt most investors. Our moving average system, however, is unbiased because it goes long or short according to the direction of the trend and not because of tax consequences.

Figure 1.2 shows the daily price changes of the S&P futures as a ratio of the standard deviation of the previous 10 days, as given in the previous formula. The data cover 13 years, ending in May 2010. Even though prices were well off the lows of the subprime crisis by February 2009, it is easy to see that there is still a bias toward downward price shocks. By looking at the 4 lines on the left axis, we see that only seven events came close to that level, and not many moved above the 2 level, while there were many more both crossing 2 and penetrating 4. We might have expected that more computerized trading, and perhaps more investment sophistication, would cause shocks to be more symmetrical in recent years, but that doesn't seem to be the case.

FIGURE 1.2 S&P 1-day volatility as a ratio to the standard deviation of the previous 10 days.