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The Future of Tactical Trading

January 3, 2010

Related Reading: Brett Steenbarger of Traderfeed discusses our primitive reactions via the availability bias: http://traderfeed.blogspot.com/2010/01/turning-availability-bias-into-trading.html

One has to question the future of quantitative analysis in the age of computers and the internet and how it will shape the future of tactical trading. There was a time when data was expensive and largely unavailable to all but the largest institutions. There was a time when computers were so large that they filled an entire room. Few people even had the skills or knowledge to properly execute sound quantitative studies. In this brave new era, it seems as if all the PhD talent in the world is lining up to offer their services to banks or large hedge funds. Computing power has advanced so much that quantitative testing is now available to the common man. Today, I can download free data from Yahoo Finance and start backtesting in Starbucks and my laptop will generate results almost immediately. The barriers to entry for simple testing at least are very low needless to say. To think that identifying simple quantitative “effects” will guarantee you success in the market these days is more than a little naiive. This begs the obvious question: what kind of strategies will work in the future? Perhaps John Maynard Keynes had a time machine and was able to see the future of tactical trading when he wrote this related piece a very long time ago:

“Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgement, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.”

What does this all mean? And how will this affect the future? Trading based on simple observation of quantitative effects is like picking the prettiest faces from the group without considering what everyone else is thinking. What Keynes is saying is identical to what happens in competitive poker–they are indistinguishable in concept and theory. Drawing from my vast No-Limit Texas Holdem poker experience, I can fairly easily create analogies to speculate on the natural progression of trading.  You see in poker, at the low and middle levels of play, the winning strategy is to play high “edge” hands in high edge situations against amateurs that are willing to gamble against you (they choose knowingly or unknowingly to play lower edge hands/situations and thus end up losing money to you). At the higher levels of poker, where there are a lot of experts and experienced players, few of them will make obvious mistakes and rarely will they choose to willingly gamble against you in low edge situations.  To win at these levels, you must have a strong understanding of the game theory and psychological elements of the game. At the higher levels of play, winning comes from understanding your opponent and predicting what his actions are likely to be.  The sad irony is that many “newbie mathematical” players that are very smart and disciplined show up at these limits and learn a very hard lesson.  They lose inexplicably to their often more unsophisticated counterparts due to their inability to recognize that knowledge of the odds and their edges is less important in this higher level dimension of competition. They are trying to win by holding strong hands and try to get paid for them while their opponents are all too aware of their intentions. They get bluffed relentlessly when the situation warrants, and their opponents only confront them much stronger hands.  

The next level of tactical trading will be to keep an eye on incorporating some of these concepts. Many of you who keep an eye on the fundamentals were in shock and disbelief at what has happened over the course of 2008-2009. Historic levels of government intervention made discretionary trading in 2008 a terrible minefield to those uninitiated in the tactics of deception and game theory.The mismatch between market performance and fundamentals wreaked havoc on the many intelligent and  knowledgeable market players. Many quantitative strategies that performed well in previous years (estimate revisions, dividend yields, valuations, earnings acceleration, balance sheet ratios) went out the window in this environment as well. What one has to understand is that when the stakes are high—such as the threat of the dissolution of the entire financial system—one is no longer operating at the poker table with the mere amateurs or even unsophisticated institutions. The last 2 years have been a high stakes game with the most sophisticated and powerful opponents of all–the big banks and the federal reserve. Make no mistake, these players know what you will think, and take great pains to influence you into making the choices they want you to make. In 2010, keep this in mind as the great “bull market” as we know it may turn out to be one of the biggest bluffs of all time, put on by the pros. The creeping treasury yields are a faint sign that not all is well in wonderland. They want you to believe the worst is over, and that the future is bright. Understanding this motivation, you can more easily understand their future actions.

Regardless of what time frame you operate in, or what instruments you choose, you should start asking yourself every day: a) who are my opponents, and how will I extract my edge? b) if my opponents are sophisticated, what do they want me to think in order to turn things to their advantage? Is this intraday breakout real, or just a trap designed to take my money? The implication for tactical trading is twofold: 1) If you want to play against sophisticated opponents, mere knowledge of obvious strategies is not enough–you must think at the second and third levels. 2) If you want to play against unsophisticated opponents, you must have a quantifiable edge. One of the easiest ways to adjust your trading is to stick to areas that are likely to contain comparatively unsophisticated opponents such as the smaller capitalization stocks. Another is to operate in the liquid markets where your sophisticated opponents cannot easily manipulate things against you and may even tip their hands–this occurs in the longer time frames in the form of  long-term trends and relative momentum (relative strength). Lastly, if you do plan on confronting the big boys, try to do the opposite of what they want you to do–this means buying weakness and selling strength–and this is why mean-reversion strategies and the DV2/RSI2 have been so successful in an increasingly sophisticated market, especially when trading them according to the longer-term trend.

10 Comments leave one →
  1. January 4, 2010 10:42 am

    David,
    I was preparing to write my own cautious lament for traders in the new year focusing on market manipulation forces, hype creep and the rise of gaming. You’ve done it for me . . and with your usual excellence and thoroughness. This is core intel that needs to be said . . and, more importanlty, listened to if you intend to adapt and survive in today’s trading environment. Darwin was right. Adapt or move on.
    Thanks also for sharing your poker perspective . . most prop shops now provide extensive training in game theory to complement trader education . . it’s an aspect often overlooked by the average retail trader who’s just trying to keep his head above water.

    • david varadi permalink*
      January 4, 2010 11:55 am

      hi bzb, thanks a lot for your compliments. i suppose i was discussing these things from a theoretical point of view rather than from experience as I do not trade intraday. but, im glad that I am not out in left field on this!!! nonetheless it certainly makes the market constantly challenging—and that is what makes it fun to figure out.

      dv

  2. Alex permalink
    January 4, 2010 2:19 pm

    Great post! The bad guys just re-raised today! b4stards. they better not like oreo cookies cause i’m watching them

    • david varadi permalink*
      January 4, 2010 2:25 pm

      lol, thanks alex, and a nice rounders reference🙂 certainly will be interesting to see how far this charade can go!

      dv

  3. John French permalink
    January 4, 2010 9:34 pm

    David, couldn’t agree more about your observations re Texas Hold’em.

    • david varadi permalink*
      January 5, 2010 2:04 am

      thanks john…..does that mean you agree with my observations on how that relates to the market :o) ?
      cheers
      dv

  4. quantivity permalink
    January 5, 2010 1:39 am

    Interesting post, David. If we believe the premises of this post, I posit the conclusion is actually severely more dire than you suggest for three reasons.

    First, the result of commodity compute (as played out across many industries) has been hard-core quantitative analysis becoming an “entry bar” for playing. If we believe this applies to investing, than there is no reason to believe the same outcome will not result: the “efficiency penalty” for not doing hard-core quant will only grow exponentially over time.

    Second, your analogy with poker actually understates the problem (while being accurate in spirit), as it conflates psychology from sociology: poker is about individual or small group psychology, which can be observed by an individual; large-scale market forces are inherently sociological, particularly when due to explicit manipulation (see 1920s). Why this matters: individuals have no *potential* for observing such, and moreover only a single institution has the means and resources to conduct econometric study of the relevant systematic sociological factors (and indeed does so every year). As you imply, that institution is indeed only the govt.

    Third, game theory assumes rationality (in the economic utility sense). Thus, the investment problem is compounded further as game theoretic solutions are easily defeated by non-rational actors–which both individual investors and sovereigns are well-known to be (hence fun of the fx market). Given we lack a theory of non-rational game theory (meaning non-existent or unknown utility functions), we cannot even appeal to mathematics for insight.

    • david varadi permalink*
      January 5, 2010 2:02 am

      hi quantivity….welcome back my friend!

      i agree with all three points–my post was merely a simplification to illustrate the folly of drawing conclusions that it is easy to make money based on crude/simplistic analysis with little or no adaptation. It also illustrates the importance of understanding how sophisticated your opponents are in different time frames and/or situations. The penalty to poor quantitative analysis will be severe and exponentially so indeed—although I must point out to be fair that the improper application of “rigorous” and highly sophisticated techniques can also be dangerous if not applied properly–just ask Ernie Chan about that. Its a fine line between degrees of freedom and rigor–not that I purport to be an expert in that area!

      I also agree that poker is less about group psychology/sociology than the markets where the sum of the behavior of participants can produce different properties. This group/crowd behavior is responsible for many of the longer term effects that have persisted throughout time such as trends and momentum. However on the third point, I think I should have avoided using game theory as a description in a technical sense, for what is actually just an intelligent adaptive response to the predicted actions of your opponent even if they are irrational. This is what allows expert poker players to more efficiently fleece weak opponents than the best computers.
      I guess its a modified version of game theory.

      best
      dv

  5. dha3936420 permalink
    January 5, 2010 9:09 am

    What I find interesting is the final para, in which we keep coming back to two “durable concepts” : relative strength in intermediate time-frame, mean reversion in short time frame. I’m working on a model portfolio that is half mean reversion (DVO and its derivatives) and relative strength ETF rotation in the other half. Adding equity curve triggers will be the final step. 🙂 Dave

  6. February 7, 2010 4:16 pm

    Hi Quantivity, your note on ‘hard-core quantitative analysis becoming an “entry bar” for playing’ is spot-on! I’ve now spent a couple of month developing a trading system, but still not ready to put my hard earned money on it.
    On the other hand, computer power has been available for institutional investors for some time now, I guess that the raw power is not a bottleneck any more, but the intelligence of your strategy is.
    Recent years have given us a great dataset for backtesting: if you manage to think up a strategy that performs equally well from 2001 to 2010, it will most probably keep working in the future.

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