The Case of the Mysterious 7th Derivative
quote of the day: “Buying stocks used to be about long-term value, doing your research and finding the company that you thought had good prospects. Maybe it had a product that you liked the look of, or perhaps a solid management team. Increasingly such real value is becoming irrelevant. The contest is now between the machines — and they’re playing games with real businesses and real people”— Paul Wilmott
Speaking of playing games, experimenting with new concepts late night can be lots of fun–it tends to be more unstructured than the serious research that gets done earlier in the day. As a result, sometimes you end up testing things that are just plain wacky, and recently one of these midnight forays brought forth a new treasure.
I call it the “case of the mysterious 7th derivative” because it is actually the 7th 5-day moving average of the 5-day rate of change. The rate of change is today’s close minus the close five days ago. Essentially you take 7 sequential 5-day moving averages of the 5-day rate of change. Surprisingly, if you BUY after the 7th derivative is greater than zero (and SHORT below zero), performance is strong across a wide variety of stocks, indices, bonds, commodities and even currencies. In fact i was so shocked that i tested our 7th derivative against various benchmarks like 1) the 200-day moving average 2) the 50-day moving average 3) the 50 vs 250 day crossover 4) and the increasing 200-day moving average. The result: it generally beat all of them–with the odd exception here and there. Robustness like the 7th derivative is pretty hard to find, it is actually more robust than the above mentioned moving average rules.
The problem is, i just don’t understand it. I mean, what is the 7th derivative of the 5-day rate of change? And so it shall remain a mystery to why it works so well. I could provide a mathematical explanation, but as a general rule, if i can’t explain a quantitative strategy to my mother, then i refuse to use it in real life (a funny, but highly useful rule that the banks should learn about). So if any of you out there have any good explanations–i’m all ears! In the meanwhile, if you choose to invest in such a trading strategy, and others join the bandwagon, millions of capital will flow in and out of stocks, moving their stock prices and affecting their capital raising efforts. All of this because you had faith in the 7th derivative! You would be the scorn of the old guard, and Mr. Wilmott (see above quote) would not be impressed.
FYI: the DVI part 2: the DVS should be published on Monday.