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How Tradeable Is a Market?

November 15, 2010

Everyone seems to have a favorite market, sector, or stock. The justification for this preference is often arbitrary– being a function of time zone, past trading successes, or a preference for market behavior. One question many traders fail to ask is: How tradeable is a market? The truth is that not all markets offer good opportunities to make money. A poor market will have: 1) low and sporadic liquidity 2) a high but unpredictable degree of noise 3) few if any discernible patters or anomalies. Measuring how good a market is cannot be biased by trading style, it should consider the overall profitability of different types of trading methods. The only way to do that is to create a diverse set of quantitative strategies and test the average  and maximum profitability that could be achieved by different styles. This diverse set should be spread across varying parameters to be useful for generalization.  At this point, we can calculate one key component in determining how tradeable a market is by looking at the PQ or Profitability Quotient:

PQ= (average or maximum annual points won across strategies or within the best strategy category)/total possible annual points available

where the annual points available is the sum of the absolute value of the daily changes in closing prices over 252 days

The PQ can be used to compare markets, where the higher the PQ the more tradeable a market is likely to be assuming liquidity is sufficient. A high PQ suggests that the market offers either abundant alpha across many different strategies, or contains one strategy category that is highly lucrative.

 

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7 Comments leave one →
  1. Aristotle permalink
    November 15, 2010 9:30 am

    An interesting comparison would be a strategy that captures a high portion (say 75%) of a market with not so many absolute points with a strategy that captures 45% of a high number of absolute points. It seems it might still come back to risk adjusted CAGR.

    • david varadi permalink*
      November 16, 2010 3:04 am

      hi aristotle, good comment–truthfully when looking at a strategy within markets the risk-adjustment does not need to be made since the standard deviation is very similar for all strategies. when comparing across markets this is more important due to differences in vol. BUT, because we are comparing points vs total possible, this is essentially vol-adjusted. it is not possible to capture a large portion of points without having high risk-adjusted returns since you need to have high predictability to do so.

      best
      dv

  2. Carl permalink
    November 15, 2010 10:20 am

    One should have a training period for the PQ measure as I think you will find things move in and out of favor….

    • david varadi permalink*
      November 16, 2010 3:06 am

      hi carl, on that point we completely agree (good comment), and I often stress the time-variance in edges. that said this is meant to be shorter term– ie 5 years to 10 years at the most with weighting the the recent period. still, having an equity curve moving average or trendline filter is key towards drawing conclusions.
      best
      david

  3. November 15, 2010 11:53 am

    David,
    Always look forward to your work. But, on this measure I am a bit dubious because it carries an implicit assumption of universal order to all markets. It also implies that there are universal metrics.

    Think about the simplest case, a day trader, he will want the market with the largest intraday range whereas a trend follower will desire a market with low volatility. I like the idea but not sure that a single measure will be very informative.

    If you could come up with a bankruptcy probability measure for stocks below $5 then that could be something that would interest me.

    • david varadi permalink*
      November 16, 2010 3:08 am

      Hi Curtis, good point, although I believe we are on the same page more than you think because we are looking at a spectrum of strategies (which could include intraday). We are taking the average absolute value or maximum absolute value for a category spanning multiple strategies. Also, you may wish to look into Altman’s z-score and piotroski’s f-score for that last thing.
      best
      david

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