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CHAPTER 2 Fishing for Ideas: Where Can We Find Good Strategies?

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This is the surprise: Finding a trading idea is actually not the hardest part of building a quantitative trading business. There are hundreds, if not thousands, of trading ideas that are in the public sphere at any time, accessible to anyone at little or no cost. Many authors of these trading ideas will tell you their complete methodologies in addition to their backtest results. There are finance and investment books, newspapers and magazines, mainstream media websites, academic papers available online or in the nearest public library, trader forums, blogs, and on and on. Some of the ones I find valuable are listed in Table 2.1, but this is just a small fraction of what is available out there.

In the past, because of my own academic bent, I regularly perused the various preprints published by business school professors or downloaded the latest online finance journal articles to scan for good prospective strategies. In fact, the first strategy I traded when I became independent was based on such academic research. (It was a version of the PEAD strategy referenced in Chapter 7.) Increasingly, however, I have found that many strategies described by academics are either too complicated, out of date (perhaps the once-profitable strategies have already lost their power due to competition), or require expensive data to backtest (such as historical fundamental data). Furthermore, many of these academic strategies work only on small-cap stocks, whose illiquidity may render actual trading profits far less impressive than their backtests would suggest.

TABLE 2.1 Sources of Trading Ideas

Type URL
Academic
Business schools' finance professors' websites www.hbs.edu/research/research.html
Social Science Research Network www.ssrn.com
National Bureau of Economic Research www.nber.org
Business schools' quantitative finance seminars www.ieor.columbia.edu/seminars/financialengineering
Quantpedia (aggregator of all academic papers on quantitative trading strategies!) quantpedia.com
Financial blogs and podcasts
Flirting with Models www.thinknewfound.com
Mutiny Fund mutinyfund.com/podcast/
Chat with Traders chatwithtraders.com
Eran Raviv eranraviv.com
Sibyl/Godot Finance godotfinance.com
Party at the Moontower moontowermeta.com
My own! epchan.blogspot.com
Trader forums
Elite Trader www.Elitetrader.com
Wealth-Lab www.wealth-lab.com
Twitter
Benn Eifert @bennpeifert
Corey Hoffstein @choffstein
Quantocracy (retweet of new articles) @Quantocracy
Mike Harris @mikeharrisNY
Euan Sinclair @sinclaireuan
My own! @chanep
Newspaper and magazines
Stocks, Futures and Options magazine www.sfomag.com

This is not to say that you will not find some gems if you are persistent enough, but I have found that many traders' forums or blogs may suggest simpler strategies that are equally profitable. You might be skeptical that people would actually post truly profitable strategies in the public space for all to see. After all, doesn't this disclosure increase the competition and decrease the profitability of the strategy? And you would be right: Most ready-made strategies that you may find in these places actually do not withstand careful backtesting. Just like the academic studies, the strategies from traders' forums may have worked only for a little while, or they work for only a certain class of stocks, or they work only if you don't factor in transaction costs. However, the trick is that you can often modify the basic strategy and make it profitable. (Many of these caveats as well as a few common variations on a basic strategy will be examined in detail in Chapter 3.)

For example, someone once suggested a strategy to me that was described in Wealth-Lab (see Table 2.1), where it was claimed that it had a high Sharpe ratio. When I backtested the strategy, it turned out not to work as well as advertised. I then tried a few simple modifications, such as decreasing the holding period and entering and exiting at different times than suggested, and was able to turn this strategy into one of my main profit centers. If you are diligent and creative enough to try the multiple variations of a basic strategy, chances are you will find one of those variations that is highly profitable.

When I left the institutional money management industry to trade on my own, I worried that I would be cut off from the flow of trading ideas from my colleagues and mentors. But then I found out that one of the best ways to gather and share trading ideas is to start your own trading blog—for every trading “secret” that you divulge to the world, you will be rewarded with multiple ones from your readers. (The person who suggested the Wealth-Lab strategy to me was a reader who works 12 time zones away. If it weren't for my blog, there was little chance that I would have met him and benefited from his suggestion.) In fact, what you thought of as secrets are more often than not well-known ideas to many others! What truly make a strategy proprietary and its secrets worth protecting are the tricks and variations that you have come up with, not the plain-vanilla version.

Furthermore, your bad ideas will quickly get shot down by your online commentators, thus potentially saving you from major losses. After I glowingly described a seasonal stock-trading strategy on my blog that was developed by some finance professors, a reader promptly went ahead and backtested that strategy and reported that it didn't work. (See my blog entry, “Seasonal Trades in Stocks,” at epchan.blogspot.com/2007/11/seasonal-trades-in-stocks.html and the reader's comment therein. This strategy is described in more detail in Example 7.6.) Of course, I would not have traded this strategy without backtesting it on my own anyway, and indeed, my subsequent backtest confirmed his findings. But the fact that my reader found significant flaws with the strategy is important confirmation that my own backtest is not erroneous.

All in all, I have found that it is actually easier to gather and exchange trading ideas as an independent trader than when I was working in the secretive hedge fund world in New York. When I worked at Millennium Partners—a 40-billion-dollar hedge fund on Fifth Avenue—one trader ripped a published paper out of the hands of his programmer, who happened to have picked it up from the trader's desk. He was afraid the programmer might learn his “secrets.” (Lest you think that Millennium Partners is a bad place to work, I should add that its founder, Izzy Englander, personally spoke with my next employer to vouch for me.) That may be because people are less wary of letting you know their secrets when they think you won't be obliterating their profits by allocating $100 million to that strategy.

No, the difficulty is not the lack of ideas. The difficulty is to develop a taste for which strategy is suitable for your personal circumstances and goals, and which ones look viable even before you devote the time to diligently backtest them. This taste for prospective strategies is what I will try to convey in this chapter.

Quantitative Trading

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